SEC, if people want to risk money in hedge funds, let 'em

Date: Friday, February 2, 2007
Author: Harry Koza, Globe and Mail

Central banks have been leery of hedge funds ever since Long Term Capital Management went kablooie back in '98, spawning the classic trader's riddle: How many Nobel prize-winning economists does it take to unwind a losing derivatives trade? (None, of course, the Fed will bail you out.)

LTCM lost $4.6-billion (U.S.) in four months, which is less than Amaranth Advisors vaporized when it Chernobyled recently. But LTCM leveraged $4.72-billion in equity into $129-billion worth of assets, and also had off-balance-sheet derivative positions totalling $1.25-trillion. Yowzah!

That sucker was geared higher than a Lamborghini. I don't want to replay the whole sordid affair, but it is worth pointing out that it was one of those danged exogenous events that started LTCM's meltdown: when Russia defaulted on its government bonds. (Like that had never happened before. I wonder how many of the investment whizzes that got hung with bonds in the Russian default already had old defaulted Tsarist Russian bonds framed and hanging on their office walls.)

Today, of course, things are different. For one thing, outfits like LTCM are a dime a dozen, squatting on the market landscape like big-box retailers at an outlet mall. There's something like, what, 80,000 hedge funds out there? There certainly seems to be a lot of them.

The world's central bankers, including the Federal Reserve, of course, which should know better than anyone, seem unperturbed by the profusion of hedge funds. Maybe it's just central banker sang-froid, maybe they're following the tenets of the Led Zeppelin school of investing -- "If there's a bustle in your hedge funds, don't be alarmed now, it's just a downtick in the market."

Anyway, while aside from the occasional laconic Fed Head comment, and the usual editorial hand-wringing in the financial press (okay, mea culpa), it's still gold rush days in the hedge fund business. Not that long ago, any trader who suddenly found himself, er, pursuing other interests, would decide to launch a new Internet company, the proverbial stupididea.com. Nowadays, if you get canned, or even if your year-end bonus was so big that your head swells and you become convinced that you can do better trading your own book (here's a hint, fellas: The best way to make a small fortune by trading derivatives is to start with a large one), you start your own hedge fund.

Better look out, though, because Daddy's gonna take the T-Bird away. I was reading in U.S. author and investment adviser John Mauldin's newsletter this week that the U.S. Securities and Exchange Commission is proposing a new rule to redefine "accredited" investor.

In the United States, an accredited investor needs a minimum of $1-million in net worth (including his house) to invest in hedge funds.

In Canada, an accredited investor is someone who, with his/her spouse, has a million dollars or more in financial assets, or has pretax income of more than $200,000 (Canadian) in each of the past two years, or who, with his/her spouse has a combined income of $300,000 or more in the past two years.

In Britain, by the way, there are no minimum requirements, other than your investment geezer's judgment that you are sophisticated enough that hedge funds are "suitable" for you. Fair enough. The sporty end of the investment spectrum is not something you should play with the mortgage money, anyway, which is why most people stick to lottery tickets.

The SEC, though -- and bear in mind that what the SEC does, the rest of the world's market regulators will follow faster than you can say Sarbanes-Oxley -- plans to raise the hurdle to $2.5-million (U.S.) in liquid assets, not including your house. That will eliminate about 88 per cent of the individual investors currently eligible to invest in hedge funds, reducing their number to about 1.29 per cent of U.S. households. The SEC is soliciting comments on whether the minimum amounts proposed are too low, too high, or just right. They're looking for the Goldilocks amount, the one that will protect investors from themselves and also take some of the exuberance out of the hedge fund phenomenon.

I dunno, though. The thing about Goldilocks that always gets me is: What the heck was the silly girl doing breaking into the bears' house in the first place? Similarly, what business is it of the securities regulators if I want to put some of my money into hedge funds anyway?

Why should there not be some vehicle for retail investors to invest in hedge funds? I don't mean all those principal-protected notes, either, though since Portus imploded they've become the poster child for increased regulation.

Nonetheless, hedge funds have their purpose. Because they are, theoretically at least, highly uncorrelated with stock and bond markets, their use can reduce the risk of your investment portfolio and lower the volatility of your returns. That's why institutional investors and rich people use them.

The rich already have a huge advantage in building assets for retirement -- they have more assets in the first place. Rather than making hedge funds vehicles only for the very rich rather than for the merely rich, John Mauldin says that maybe securities commissions should be looking for a regulatory structure that makes alternative investments available to everybody.

Philosophically, I have to agree. Caveat emptor, or like Harry's First Law of Capital Markets: Make the stupid pay.

Harry Koza is senior Canadian markets analyst at Thomson Financial and a columnist for GlobeinvestorGOLD.com.