After attracting a massive influx of capital and talent, hedge funds now face the challenge of stepped-up regulatory scrutiny.

The public profile of the hedge fund industry is increasing dramatically–which is only fitting for an investment opportunity that is growing worldwide. And with that increased visibility comes differing views on the effect of this burgeoning industry.

Federal Reserve Chairman Alan Greenspan thinks that hedge funds create “a very significant amount of liquidity in our system,” helping to stabilize the financial markets–and do not need the kind of regulation that would come from registration with the Securities and Exchange Commission.

SEC Chairman William Donaldson, on the other hand, would like to see mandatory registration for hedge funds, which would permit the agency to gather information about fund management and operations. A proposal that would require registration was approved by the SEC and released for public comment in July, and the SEC has budgeted for increased staffing for next year to accomplish these goals.

To Warren Buffett, hedge funds are still “a fad” that is more about Wall Street marketing than sound investing. He told the annual meeting of Berkshire Hathaway stockholders that he believes hedge fund fees are “unfair.”

Meanwhile, the California Public Employees’ Retirement System, Sacramento, the nation’s largest public pension plan, has shown its continued faith in the industry by stating its intention to raise its hedge fund allocation to as much as US$5.2 billion of its US$105 billion in global equity investments, making CalPERS the industry’s largest known investor. Harvard University, Cambridge, Mass., with about US$2.5 billion in these funds, is second largest.

An Industry on the Rise

U.S. investors searching for new investment opportunities poured almost US$75 billion into these private investment pools in 2003–more than they invested in the previous four years combined. Total hedge fund assets are now close to US$1 trillion and are divided among more than 6,000 U.S. and offshore hedge funds. Over the next five years, assets are expected to reach US$2 trillion as an additional 7,000 new funds are formed. Indeed, hedge funds have become a standard allocation class for many corporations, including General Motors, which pioneered their use in pension funds; educational institutions such as Yale and Duke universities; and state and local pension funds.

In Europe and Asia, too, the industry is booming, both as management centers and investments, and has widened its appeal in some cases. Germany has made hedge funds available to investors with no minimum investment requirement (although they must be purchased through private placements), rather than only to the high-net-worth individuals and institutions for which they were originally intended.

A Matter of Performance

What accounts for the explosive growth of hedge fund assets over the last few years? Wall Street insiders say the reason for their [hedge funds] success in the marketplace is simply that their performance has outdone other investments, in good times and bad. For the past five years (first quarter 1998 through third quarter 2003), the average hedge fund has outperformed the average mutual fund, with the top 10% of hedge funds earning five-year compound annual returns of 30.3%, compared with 14.8% for the top 10% of mutual funds.

Comparison of Best- and Worst-Performing U.S. Hedge and Mutual Funds

Five-Year Net Compound Annual Returns, 1Q98 to 3Q03

Hedge Funds Mutual Funds
Top 10% 30.3% 14.8%
Top 25% 23.5% 10.7%
Bottom 25% 0.6% -1.4%
Bottom 10% -4.9% -4.2%

Source: Van Hedge Fund Advisors International

Moreover, the superior returns provided by hedge funds in most multi-year periods also have been realized at lower statistical volatility than the Standard & Poor’s 500 stock index or mutual funds (see below). As a result, risk-adjusted returns, as measured by the Sharpe ratio, show hedge funds handily beating mutual funds.

U.S. and Offshore Hedge Fund Net Returns

1/1/88-9/30/03

Net Compound Annual Return Standard Deviation Sharpe Ratio
Van US Hedge Fund Index 17.0% 8.9% 1.7
Van Offshore H.F. Index 14.3% 9.0% 1.4
Van Global H.F. Index 15.8% 8.7% 1.6
MSCI World Equity 5.4% 16.3% 0.3
S&P 500 11.9% 15.5% 0.7
Morningstar Avg. Equity Fund 9.2% 16.0% 0.5

Source: Van Hedge Fund Advisors International

Hedge funds have demonstrated a particular ability to protect investments during market downturns. From January 1988 through September 2003, the S&P 500 experienced 16 negative quarters, dropping 69.4%, while the average hedge fund lost only 10.7% in those 16 quarters. In the U.S. market recovery of 2003, in contrast, hedge funds posted average gains of only 19%, compared with 32.7% for the average equity mutual fund, 28.7% for the S&P 500 and 50.8% for the Nasdaq.

What is indisputable is that hedge funds have enormous performance potential. This largely is driven by their ability to attract the most talented individuals and the wide range of strategies those managers are able to employ, including short selling, swaps, merger arbitrage and derivatives. Hedge fund managers can invest in almost any opportunity in any market where they foresee impressive gains without increasing risk, based on their style and dedication to that strategy as outlined in the funds’ offering documents.

Issues Facing Hedge Funds

Not surprisingly, hedge funds have been dealing with the same issues that other areas of the financial services industry have been struggling with in the wake of corporate scandals, including, most recently, improprieties in the mutual fund sector. The primary issues facing hedge funds center on governance, transparency and reporting, and regulation.

Governance

Governance, which has become such an intense issue for most types of investments– including mutual funds– in the wake of recent corporate scandals, also has captured the attention of hedge funds. However, this increased interest in governance is more likely to be evolutionary than revolutionary. It was only a matter of time before governance concerns would reach the hedge fund sector, but so far, at least, governance is not the great battle cry it has become in other industries or for investors. At the moment, the governance debate relating to hedge funds mainly is focused on the responsibilities of the boards of offshore funds, which have been somewhat formalized. Domestic U.S. hedge funds are not yet required to have boards, although this is seen as an eventuality.

Transparency and Reporting

Transparency and reporting provide additional credibility and investor confidence. As demand for greater transparency increases, hedge funds must walk a fine line between providing valuable information to investors and not providing details that could give a competitor the keys to understanding their unique trading strategies.

Since most hedge funds are not regulated entities, there is no requirement to provide certain information. As a result, industry practices vary greatly in terms of what information, if any, is provided to clients. However, the trend is toward providing more information to hedge fund investors. Investors increasingly are asking for more information regarding the hedge fund’s positions, risk levels and pricing methodologies. The SEC has published a report citing transparency as one of its major concerns and is contemplating regulating hedge funds to help create a uniform approach to what is reported to investors.

For the IRS, this trend is geared toward partnership reporting in general; for hedge fund partnerships, this means providing more details on a greater variety of transactions. This might mean disclosing transactions, analyzing the difference between financial statement income and taxable income or providing more information about transactions reported on a tax return. Some emerging issues in this area definitely are worth watching. Recent legislative proposals have included:

Reportable transaction rules. Hedge funds make thousands of complex, sophisticated transactions every month. Legislative proposals contemplate imposing penalties for failure to disclose “reportable transactions,” which would place increased pressure on hedge funds and their service providers to accurately track and determine which items need to be reported. At this time, however, further clarification from the IRS is needed to provide greater certainty about which transactions are included.

Similarly, the Treasury Department has proposed new rules for hedge funds that would require them to provide specific details on certain types of transactions. The department’s goal is to provide information to the IRS so that it can determine whether those transactions have tax shelter potential, even if they were not designed to achieve that purpose.

Matching hedge fund and investor tax returns. The IRS continues to focus on improving its ability to match items from a partner’s Schedule K-1 with items reported on the individual’s tax return. To facilitate matching and increase compliance, it is considering a revision of the Schedule K-1 for 2004, which hedge funds use to report many different categories of income and other information to their individual partners.

Regulation

Regulation is one of the hedge fund industry’s big stories. While the Commodities Futures Trading Commission is leaning toward less regulation of hedge funds, since last fall the SEC has been considering stepping up the level of regulation.

The SEC proposal approved by a 3-2 vote in July would require most hedge funds to register with the SEC. About a third of funds already are registered on a voluntary basis. If approved, the proposal also would require fund advisers to adopt compliance procedures and to appoint a compliance officer.

How would a registration requirement affect the industry? On the one hand, there seems to be general agreement in the industry that registration and increased regulation are not a terrible idea. It may even be a good one. Increased registration and regulation will allow the industry to gain greater legitimacy, creating a better environment for the sophisticated and institutional investor and possibly helping the industry to achieve even faster growth. Regulation also might change the industry for the better, as the adoption of best practices is accelerated by the SEC’s ongoing scrutiny.

On the other hand, it’s difficult to determine just how much regulation is appropriate. A significant characteristic of the hedge fund business is that its investment operations are unregulated. Arguably, this decision-making freedom is the foundation on which the industry’s broad and diverse investment strategies are based, and the source of its competitive advantages as an asset class. Striking the right regulatory balance will be essential. Too much regulation–a real danger in today’s environment–could destroy the investment model. Making hedge funds more like mutual funds, or something very close to that, would strip them of their distinctive characteristics as an asset class.

The industry acknowledges that its greatest problem is the possibility that more fraud and the reaction to it might bring overregulation. How much regulation is acceptable to forestall the possibility of fraud is unclear. Like all legislation, what looks appropriate now could have adverse effects down the road–but we won’t know until it’s too late.

Preventing Fraud

Regulation means different things to different people, but the primary regulatory objective of the SEC appears to be the prevention of fraudulent activity through deliberate mispricing of investments. In a report issued last fall, the SEC staff rated portfolio mispricing as the agency’s “most serious concern” about the hedge fund industry. The fair market value of securities held by a fund is the basis for calculating its performance; if the numbers are suspect, so is the performance. A Capco Consulting study found that operational risk is the largest single cause of hedge fund failure and that misrepresentation of the value of portfolio holdings has contributed to these failures.

The SEC’s proposed rules will require funds to disclose their pricing policies, though not necessarily forestalling mispricing. The matter of valuations of hard-to-value securities is difficult to resolve, as seen even in the retail fund world, because hedge fund managers can override valuations obtained from brokers.

The Biggest Challenge: Growing Pains

Hedge funds are entrepreneurial operations that, in some ways, have more in common with small businesses than with their more institutionalized mutual fund brethren in financial services. Being in a dynamic, high-growth industry that is moving at such a rapid pace presents some real challenges for hedge funds.

First, there’s the basic nature of the beast: They are not mutual funds and cannot absorb assets as quickly, since nearly every hedge fund manager is hampered by capacity constraints brought on by the scalability of his or her unique investment strategies. This means that the industry grows by adding new funds based on new strategies. This growth model puts a significant strain on the talent pool–particularly these days, when mutual funds are making a vigorous effort to hold on to their people.

Not everyone has the skills needed to run a hedge fund, which requires an ability to adjust quickly to changing market conditions while adhering to a well-defined investment strategy. Hedge fund managers live every detail of their work every minute of the day, making split-second trading decisions as market conditions dictate. They are able to maintain performance in a competitive environment because they stick to a specific strategy that’s all their own. Even managers who follow generally similar strategies don’t do it in exactly the same way. Each has its own way of making profits and minimizing losses.

The Talent Gap

Will there be more money chasing hedge funds than the top talent can absorb? The lack of talent to deal with the amount of money coming into hedge funds may be the biggest problem facing hedge funds over the next few years. But while this talent shortage–and what to do about it–might be new to the hedge fund industry, it’s not unusual in the world of entrepreneurs. Until the right talent falls into place, hedge fund managers can deal with the growth challenge by wearing as many hats as feasible, using as much outside assistance as possible for non-core services.

In the end, it is the hedge fund industry’s unique performance profile, as well as its unique talent pool, that is creating such a tremendous influx of capital into the industry. Whatever lies ahead, this industry is sure to remain a powerhouse.

Howard Leventhal, Joel Press and Art Tully are partners in Ernst & Young’s Global Hedge Fund Practice and are based in the firm’s New York financial services office.

Contact Robert F. Keane with questions or comments at: bkeane@investmentadvisor.com.