December 2, 2008

An Artifact of Law: U.S. Prohibition of Retail Hedge Funds

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This article published in the Journal of Financial Transformation, Cass-Capco Institute Paper Series on Risk, Vol. 24 is available here.

The U.S. hedge fund market is one of the largest and most sophisticated hedge fund markets in the world, yet due to U.S. securities regulation it is also one of the least accessible. In the U.S., federal securities law requires individuals to be wealthy to qualify to invest in hedge funds. Nonwealthy individuals, or retail investors, are effectively prohibited from purchasing hedge fund securities. Wealth-based qualifications are meant to ensure that those investing in hedge funds possess enough financial sophistication to make informed investment decisions. However, the application of wealth-based qualifications to hedge fund investors is more an artifact of the specific regulatory framework under which the funds operate than a reflection of any fundamentally unique economic characteristics of the funds.

Hedge funds possess risk and disclosure characteristics comparable to a wide range of investment opportunities that U.S. retail investors are currently permitted to invest in and also typically make disclosures sufficient for retail investors to make informed investment decisions. Limiting hedge funds only to the wealthy prevents financially sophisticated yet nonwealthy investors from using the funds to minimize losses and maximize the risk-adjusted returns of their investment portfolios. To more fully advance the regulatory goals of investor protection and capital formation, U.S. financial regulators should therefore enact reforms to permit retail investors to invest in hedge funds directly or permit registered investment companies to more easily pursue hedge fund-like investment strategies.