Last time, I wrote about the reasons why there is currently an increased demand for compliance in general. Today, I will analyze specific compliance in the respect to hedge funds. Leaders at a recent G20 meeting agreed on stronger regulations for the financial industry. In addition, Treasury Secretary Timothy Geithner laid out a plan to more tightly oversee hedge funds. While certain groups are clamouring for more regulation, others are pressuring to keep the status quo of little oversight.
Fundamentally, hedge funds invest in a diverse set of financial instruments using a variety of investment techniques. Historically, hedge funds have focused in such a way as to be “hedged”, in large measure, from material changes in stock and bond markets.
Have you seen the excellent film Lost in Translation 2003, starring Scarlett Johansson? Hedge funds often involve complex, illiquid or opaque investments and these instruments often lack the transparency associated with more conventional investments, making them more difficult to understand.
Over the years, the number of hedge funds has increased dramatically. This creates competition, which puts pressure on managers to take bigger risks or skate toward the edge of malfeasance. Hedge funds generally are led by traders, who may not be accustomed to functioning in an environment where there are rigid internal controls and procedures. That’s part of the reason why there is a growing concern about portfolio managers’ risk and compliance officers’ understanding of their risk exposures.
People investing in hedge funds are mostly high net worth individuals and institutions, and have a greater understanding of the investment structure, the risks and the management strategy than would be typical for traditional investment vehicles. Funds have also recently drawn money from the less wealthy, increasingly via pension funds, therefore exposing a wider sphere of investors. Because hedge funds’ complex structures are not fully understood, they have discovered that purchasers are more attracted to firms that have the infrastructure and procedures to demonstrate internal controls. It is highly important for a hedge fund purchaser prior to investing in order to assess whether a specific hedge fund is an appropriate choice for the portfolio. Thus, hedge funds themselves have recently taken steps towards regulation.
It is important that compliance should not be overwhelming because it is easy to get lost in too much regulation. Also, it is key that hedge funds not become less competitive because of increased supervision and that returns are not harmed by increased operational and compliance costs.
There has been much disagreement and resistance to regulation from the hedge fund industry and stakeholders in the financial markets. The self-regulatory setup may not be optimally efficient and may not respond as quickly as it could. The US government is now willing to bring hedge funds under federal supervision. It is for world leaders to pursue comprehensive regulatory reform and coordinate globally in order to re-instate and inspire confidence for the financial system.