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More Disclosure Coming Soon for Hedge Funds

Date: Tuesday, April 24, 2007
Author: Jeff Neal, Optionetics.com

Given all the attention that hedge funds have received lately it should be no surprise that some action is about to be taken. A report crafted recently by central bankers and finance ministers from seven leading industrial nations are demanding that hedge funds disclose more detailed data in respect to the specific risks involved and strategies used.

The new report contends that for market discipline to function effectively, both investors and counterparties need accurate and relevant information. For this to be realized it is essential that hedge fund managers provide information with enough detail and frequency to inform investors and lenders of strategies, as well as the amount of risk being assumed. Keep in mind, hedge funds are mostly private, unregulated pools of capital where managers can buy or sell any assets, participating quite significantly in the profits.

In respect to the United States’ position, Federal Reserve Chairman Ben Benanke says he would support a lighter regulatory environment than the one advocated because hedge funds have enhanced the liquidity in financial markets, generated innovation and reduced risks. The chairman went on to say that hedge fund investors are sophisticated and the banks that lend to them have an interest in ensuring that excessive risks are not taken.

Of course, if there are many more Amaranth hedge fund stories out there, look for the U.S. position to change. Hedge funds typically carry a big price tag. Some charge management and performance fees, which, combined, can easily exceed 20 percent. In addition, large institutions simply will not keep paying hefty fees for mediocre performance. Given this scenario, too much money chasing too few opportunities often leads to frustrated investors. The current fear is that hedge fund managers around the world are making riskier bets to overcompensate for poor performance.

As a group, individuals have been quicker to invest in hedge funds than all other types of investments. Requirements ensure that most individual investors in hedge funds are wealthy with a high annual income. Hedge funds may impose other restrictions. Because of limits in the number of investors, hedge fund managers often refuse small investments, thus simplifying compliance and reporting.

Corporations have made significant investment in hedge funds. The investments are small, relative to the capital structure of most corporations, but remain one of the largest sources of hedge fund capital. Corporations may invest in hedge funds for a variety of reasons.

One company may seek to reinvest capital until it is needed for the plant or equipment. Another may simply use hedge funds as a fairly low-risk way of increasing the returns. Others may want to put additional assets on the books to cushion other risks the corporations face. Relative to the powerful factors that can influence corporate earnings, hedge fund returns are fairly predictable class of assets.

Despite the popularity of hedge funds, along with its diverse client base, look for major changes in terms of disclosure to be coming shortly. Both the strategies employed along with possible risk will most certainly have to be detailed going forward.

Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent