As the movement for stronger regulation of hedge funds gathers pace, Roberto Pitaguari Germanos of Machado, Meyer, Sendacz e Opice Advogados looks into their future.
At its last meeting, the G20 group of the world's leading economic powers gave its support to stiffer regulation for the hedge fund industry. What was not clearly explained, probably due to the impossibility of doing so, was how these countries will impose more aggressive regulation of these funds.
The first obstacle to an internationally coordinated regulation pledge is the fact that none of the G20 countries has legally defined what hedge funds are. So first of all, any regulatory action will require some legal indication of what constitutes one of these funds.
In some countries, the task may be simpler than in others. In Italy, for instance, there is a vehicle that accounts for the most common characteristics of a hedge fund: the so called fondi speculativi.
In other countries, such as the United States, hedge funds do not have uniform frames, being constituted through different and sometimes complex contractual or corporate arrangements (such as trusts, LLCs, LPs and their combinations), which makes it difficult to define them by legal structure alone.
Brazil’s securities regulator the CVM has a definition for “multimarket investment funds”, which seems to fit most hedge funds, but it is also used by traditional investment funds (such as mutual funds), which the market does not recognise as hedge funds
The question remains: what is a hedge fund? Or at least how can one recognise it, if it has no legal definition. There is no definitive answer to this problem, at least in transnational terms. But, since the inception of the first hedge funds, in the second half of the last century, up to their booming, in the beginning of the 21st century, the market has recognised a few common features that enables one to distinguish a hedge fund from other investment schemes.
One way is to define them by their function. A hedge fund can be recognised as an investment scheme that has a considerable freedom to operate, or in other words, a hedge fund’s managers have the power to use virtually any licit investment tactic in order to meet its goals. These managers can then choose from a myriad of financial instruments, at any concentration or speed: leveraging, short selling or the use of the seemingly limitless possibilities of derivatives.
The managers must, of course, stick to the mandate as agreed with a fund’s investors. But in some hedge funds, these contracts give only the fund’s final objective, giving the manager discretion to use any financial instrument or technique in order to reach it, even if such actions result in negative returns or even actual losses to the investors.
Another misconception about hedge funds stems from its name: not all hedge funds seek to hedge their portfolio risks. This was indeed the objective of the first hedge funds, notably those managed by A. W. Jones & Co, the management company founded in 1949 that invented this kind of investment strategy. Jones’ funds had an absolute return strategy. That is, his hedge fund used financial instruments such as derivatives, short selling, or leverage in order to hedge its long positions against index-related downshifts.
Nowadays, although many hedge funds do seek absolute returns above normal market growth, this is not a golden rule. There are some investment vehicles recognised as hedge funds that simply do not use financial instruments in order to hedge their positions at all.
While most hedge funds do focus on absolute return, others may, in extremis, have no underlying assets whatsoever, but only naked short selling agreements. The fact remains that it is an industry which allows its managers to adopt virtually any investment strategy, and therefore defies their being catalogued.
But there are some other common features usually found in hedge funds: manager compensation through fixed management fees and aggressive performance fees (even if the latter are now being reviewed by angry investors); managers that investing their own money alongside that its investors (theoretically addressing moral hazard); and restricted access to qualified investors, who are supposed to be capable of measuring risks before investing in purportedly risky schemes.
Still, none of these individual characteristics indicates certainty of existence of a hedge fund. While is very likely that a hedge fund has some of these characteristics, most will not have all at the same time.
One possible objective of the G20, in recommending the stricter regulation of hedge funds was to address the likelihood of systemic risks. But in the recent crisis the mean average of the hedge funds registered milder losses than those suffered by traditional index-based funds. This is probably thanks to the fee-reign given to hedge fund managers, which allowed many of these highly skilled professionals to quickly respond to the crisis with an array of tactics, to protect their client’s (and their own) assets. A few hedge funds even registered good profits.
Further, the very few academic studies that have tried to relate hedge funds with systemic risks so far, have not proved that there is a clear relation between hedge funds and systemic risk, in spite of what supporters of greater regulation would like to believe.
Moreover, the systemic effects of the hedge fund industry are relatively small, when compared with those cause by investment banks that collapsed during the crisis. Those banks had far greater debt exposure than the hedge funds. Additionally, the roughly 10,000 or so hedge fund managers constitute a real competitive alternative for investors as opposed to the very few concentrated decision makers in the investment banks. Therefore, before any aggressive, populist attempt to impose stringent regulations to the hedge fund industry, one must first understand and define what is to be regulated, and what are the efficient steps and methods to do so.
Otherwise we may end up a set of reflex mechanisms, that at the end of the day will compromise the liquidity of the financial market, as well as economic freedom, both of which are essential to national and international economic recovery.
(Latin Lawyer 14.07.2009)
(Notícia na Íntegra)