October 24, 2006
Regulatory McCarthyism—A Commentary by Jonathan Macey '82
The following op-ed originally appeared in the October 24, 2006 edition of The Wall Street Journal.
By Jonathan Macey
Virtually every month sees some newly warmed-over argument to regulate the $1.2 trillion hedge fund industry. Having failed to stir up sufficient fear that hedge funds are ripping off their investors or are somehow harming the companies in which they invest, the latest complaint is that hedge funds pose a "systemic risk" to the financial markets.
Systemic risk is policy-speak for the danger that some event (such as the collapse of a large number of hedge funds) could spark a financial system breakdown that would include waves of bank failures, the collapse of the stock market, and general panic and chaos. The threat that some economic activity or other poses systemic risk is a favorite of regulators because a putative meltdown is not only a very scary prospect but difficult to disprove. So frightening is this vague notion that regulators are safe in suggesting that even the slightest threat should justify massive regulatory intervention. And better to regulate now, before it is too late, since we cannot know for sure whether a particular activity poses a systemic risk until the event occurs.
In the case of hedge funds, however, the very structure of the industry proves that they do not pose any systemic risk to the economy. Unlike the accounting and investment banking industries, the hedge fund industry is disaggregated and highly diverse. There are more than 10,000 hedge funds -- no two identical. Many, but not all, specialize in equity investments, others in debt and some in foreign exchange trading. Some hedge funds are entirely independent, while others are linked with various financial institutions, including investment banks and mutual funds. Some hedge funds are highly leveraged. Many invest in companies whose stock is heavily traded. Some specialize in owning stocks, others bet on financial downturns by selling short. Moreover, hedge funds, unlike private equity funds and commercial banks, tend to prefer investments with short-term time horizons, so that they have ready access to liquidity.
Precisely because of this enormous diversity, the investment strategies of hedge funds cannot pose systemic risk. From a societal perspective, the economy has a fully diversified portfolio of hedge funds. When some do well, others are bound to do poorly because their investments strategies are in no way correlated.
Cries about the threat of systemic risk from hedge funds first emerged in 1998. A large hedge fund, Long-Term Capital Management, suffered massive losses when the value of Russian debt took a nose dive. The latest uproar came just last month, when it was reported that Amaranth Advisors had lost almost $5 billion on risky investments in natural gas. In both cases, the financial markets continued to operate seamlessly, without a hint that any sort of systemic risk would actually manifest itself.
In addition to their diversity, the secrecy in which hedge funds are able to operate further ensures that such funds will not present systemic risk. Unlike investments by corporate insiders or mutual funds, because hedge funds are unregulated they need not disclose their investment choices to other investors. Some decry this lack of "transparency." However, the ability to operate without disclosure prevents copy-cat investments and other forms of "herding" behavior that might actually generate systemic risk.
The current light regulation, which includes the usual strict prohibition on insider trading, protects the valuable intellectual property interests that hedge funds have in the research that guides their portfolio selections. Thus, from an economic perspective, the absence of hedge-fund regulation both increases wealth by protecting property rights in information, and eliminates systemic risk by preventing other investors from rushing like lemmings to copy the investment strategies developed by hedge fund managers.
Further, unlike mutual funds and corporate insiders, hedge funds, because they are unregulated, can sell stock short, thereby profiting not only when they predict increases in share prices, but also when they are able to predict that shares will drop in value. This, in turn, reduces risk by contributing to the efficiency of the capital markets: The more efficient the markets, the more information we have about which firms are doing well and which are imploding.
Another major distinction between hedge funds and other institutional investors is that some hedge funds take active roles in corporate governance. Hedge funds agitate to remove underperforming CEOs of companies in which they invest. They lobby directors and management to streamline businesses and to return cash to shareholders. This leads me to believe that the big push to regulate hedge funds is done not only in ignorance, but also by vested interest groups who dislike the hedge fund managers' capacity to pressure management to perform. Ultimately, these accusations about systemic risk come from people have their own reasons for pushing for regulation. Bureaucrats seek to expand their own turf; corporate executives want to remain free of the oversight posed by hedge funds. Still, the irresponsible accusation that hedge funds pose a threat of systemic risk is a form of regulatory McCarthyism.
Hedge funds are already thoroughly regulated by market forces. Those that perform well for their investors will flourish. Those that perform poorly will whither. This is the best and only form of regulation that hedge funds require.
Mr. Macey is a professor at Yale Law School.