August 7, 2008

Fending for Themselves: Creating a U.S. Hedge Fund Market for Retail Investors

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This article published in the New York University Journal of Legislation and Public Policy, Vol. 11, No. 2, Winter 2008, shows that financially sophisticated retail investors in the United States likely suffer from undue economic losses because they are not permitted to invest in hedge funds. A hedge fund is a type of private investment pool that compensates managers in part with an annual performance fee, is not subject to the full range of restrictions on investment activities and disclosure obligations imposed by the federal securities laws, and typically engages in the active trading of financial instruments. Modern portfolio economics teaches that diversification helps to prevent investment losses, and the absolute return strategies employed by hedge funds can help to diversify an investment portfolio already composed of traditional investments such as stocks and bonds.

However, U.S. federal securities law requires individual investors to be wealthy to qualify to invest in hedge funds. Although intended to protect investors, wealth-based qualifications prohibit sophisticated retail investors from benefiting from hedge funds and do not prevent unsophisticated investors from bearing hedge fund-like risks. The Securities and Exchange Commission has expressed some desire to increase access to hedge funds while maintaining investor protection, and the reforms proposed in this Article explain how to accomplish that goal. The proposed reforms seek to create a retail fund of hedge funds that privately raises capital through an underwriter who in turns lists the securities of the fund on an electronic trading platform accessible only by sophisticated investors.