Hedge Funds: Background and Policy Issues

Hedge Funds: Background and Policy Issues

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October 17, 2023
Hedge Funds: Background and Policy Issues
Hedge funds are asset management vehicles that generally
Investment Styles
pool accredited investors’ money together and invest it on
Common hedge fund investment styles include the
their behalf for a fee. Hedge funds are often identified by
following: Macro funds base investment decisions on
their use of complex investment strategies relative to other
macroeconomic conditions, such as changes in interest
conventional funds. They originally deployed hedging
rates, security and commodity prices, and exchange rates.
strategies to offset the risks of their investment losses by
Short sales funds focus on short selling. Long-only funds
taking opposite positions in related assets, thus receiving
have long positions, meaning direct ownership of the
their name. Given the industry’s size and complexity, it has
securities (instead of shorts). Market-neutral funds aim to
been an area of ongoing congressional attention. This In
reduce market risk by taking offsetting long and short
Focus discusses hedge fund operations, regulations, risks,
positions, which is the style closest to the traditional hedge
and policy issues.
fund investing. Relative value funds profit from perceived
mispricing between related financial instruments. Event-
What Is a Hedge Fund?
driven funds take actions during special situations or
The first well-publicized hedge fund was created in 1949 by
distressed scenarios (e.g., bankruptcy, change of
Alfred Winslow Jones, a sociologist who researched market
management control, and mergers and acquisitions).
behavior. Hedge funds typically rely on leverage (i.e.,
Sectoral funds focus on a particular industry (e.g., IT,
borrowed money) to multiply returns and losses. Some also
health care, or financial services). Fund of funds are hedge
use short selling (i.e., borrowing a security to sell and
funds that invest in other funds.
buying it back at a later time) to profit from a security’s
price drop within a given period of time. These and other
Regulatory Frameworks
hedge fund strategies are less common for conventional
SEC hedge fund regulation includes investor restrictions,
public funds—such as mutual funds and exchange-traded
reporting requirements, and other operational compliance.
funds (ETFs). Thus, hedge funds are often characterized as
“alternative investments” given their different investment
Investor Restrictions
styles, and they are also subject to a different regulatory
Hedge funds are private funds, meaning they face investor
framework. Investment styles and the regulatory framework
restrictions and are available only to accredited investors.
are discussed in more detail below. Hedge funds are private
An individual can qualify as an accredited investor if (1) he
funds, meaning their investor pool is limited to certain
or she earned more than $200,000 (or $300,000 together
institutional and individual investors who are perceived to
with a spouse) in annual gross income during each of the
have more sophistication to understand and sustain
prior two years and can reasonably be expected to earn a
financial risks (i.e., accredited investors).
gross income above that threshold in the current year; or (2)
he or she has a net worth of more than $1 million (either
Market Size
alone or together with a spouse), excluding the value of the
Per Securities and Exchange Commission (SEC) filings, the
primary residence. Effective December 8, 2020, the SEC
hedge fund industry consists of close to 10,000 funds with
expanded the definition of accredited investor to include
nearly $10 trillion in gross assets under management as of
some natural persons with financial expertise, such as (1)
the fourth quarter of 2022 (Figure 1).
individuals with certain financial credentials (e.g., Series 7,
Series 65, or Series 82 licenses); (2) “knowledgeable
Figure 1. Hedge Fund Number and Size
employees” as defined in Rule 3c-5(a)(4) of the Investment
Company Act of 1940 (P.L. 76-768), which includes the
funds’ directors and certain employees involved in
investments; and (3) “family clients” of a family office as
defined in SEC Rule 202(a)(11)(G). Family offices are
entities established by wealthy families to manage their
assets and provide other financial services to family
members.
An institution can qualify as an accredited investor if it
owns more than $5 million in investments. Corporations,
partnerships, trusts, nonprofits, employee benefit plans, and
family offices holding more than $5 million in assets could
also qualify. Moreover, a number of entities—such as

banks, insurance companies, SEC-registered broker-dealers,
Source: CRS using data from SEC Form PF reporting.
SEC-registered investment companies, and business
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Hedge Funds: Background and Policy Issues
development companies—automatically qualify as
$1 trillion worth of exposure for other institutions. The
accredited investors.
event prompted the Federal Reserve Bank of New York to
organize a consortium of large banks to invest $3.6 billion
Operational and Reporting Compliance
to acquire 90% of LTCM’s ownership. Lessons learned
Hedge funds are generally exempt from the Investment
from the LTCM failure include the risks of excessive
Company Act of 1940 (P.L. 76-768) but are subject to
leverage and the need for enhanced disclosure.
Investment Advisers Act of 1940 (IAA; P.L. 76-768)
requirements. Prior to the 2010 Dodd-Frank Wall Street
In 2023, the build-up in the hedge fund basis trade between
Reform and Consumer Protection Act (Dodd-Frank; P.L.
Treasury futures and cash Treasury securities led to a new
111-203), hedge funds had limited oversight, and regulators
round of financial stability discussions. Multiple financial
were largely unaware of the market’s size, investment
authorities, including the Federal Reserve and the Bank for
strategies, and number of players. Title IV of the Dodd-
International Settlement, have voiced concerns about hedge
Frank mandated registration, reporting, and recordkeeping
funds’ potential effects on financial stability.
requirements for hedge funds through amendments to IAA.
Market Event: The Flash Crash and a $1 Trillion
The SEC finalized major private fund adviser and private
Stock Valuation “Near Miss”
fund reporting reforms in 2023. The reforms include new
On May 6, 2010, U.S. capital markets experienced an
timely reporting requirements for large hedge fund advisers
abnormal decline and subsequent recovery of significant
(with more than $1.5 billion under management). These
scale. Many stocks and ETFs saw price declines and
advisers would have to file with the SEC, in addition to the
reversals of 15% or even 60% within one day. This event
quarterly and annual reports, certain current reports within
was later referred to as a “flash crash.”
72 hours from the occurrence of trigger events (such as
extraordinary investment losses, and selected operations
Some attribute the crash to hedge fund trading programs
and redemption events). Other key regulatory requirements
that use automated orders. Because certain algorithms were
include quarterly statements to investors detailing
programmed to execute trades without regard to price or
performance, fees, and expenses; annual audits; and
time, they may have contributed to trading pauses and
valuation opinions in connection with certain secondary
heightened market volatility during the crash. One of the
transactions. The fund advisers also face prohibitions from
biggest lessons learned was that it took regulators many
some activities that may harm investors and the public
months (with lingering debates) to clarify what happened.
interest.
Although the market quickly recovered from a temporary
$1 trillion valuation loss, this “near miss” led to policy
Policy Discussions
debates about regulators’ lack of understanding of modern
Hedge funds have been associated with some disruptive
financial markets and their participants.
market events that harmed financial stability. They have
also drawn policy concerns because of their opacity and
Policy Concerns
high fees.
Hedge funds play an important role in asset allocation and
market participation, but they also raise policy concerns.
Market Event: The Basis Trade and the Collapse of
Long-Term Capital Management (LTCM)
Risks coupled with opacity. The hedge fund industry is
both large and complex. The funds have proven to
The basis trade was first made famous by LTCM, a large
significantly influence financial markets and the economy.
hedge fund run by Nobel laureates that collapsed in 1998,
Some observers worry that policymakers and market
prompting the Federal Reserve to organize a rescue. Basis
participants may need more data and disclosure regarding
trading normally refers to a trading strategy that seeks to
hedge fund activities for risk diagnosis and systemic risk
exploit the difference in prices between a derivative and its
monitoring.
underlying instrument. For example, a basis trade in
Treasury securities could involve shorting Treasury futures
Effects on financial stability. As demonstrated by LTCM,
while buying the underlying Treasury securities using
hedge funds have the potential to pose financial stability
borrowed money (often via the repurchase agreement
concerns, particularly through the use of leverage and their
market). Such an arbitrage technique, in theory, is low risk
interconnectedness with other financial markets. Hedge
if an asset’s different prices in different markets eventually
funds’ concentrated trades and rapid exits during market
converge. Specifically, an arbitrager could start by selling
distress could spread shock waves and amplify stress.
the higher-priced asset in one market and buying the same
(lower-priced) asset in a different market. When the prices
High fees. Hedge fund fee structures often include an
converge, it could capture a profit by selling the formerly
annual asset management fee of 1% to 2% of assets under
lower-priced asset and buying back the formerly higher-
management and an additional 20% performance fee on any
priced asset. Because the price differentials are typically
profits. This fee structure could motivate a hedge fund
very small, a hedge fund must build a large position
manager to take greater risks in the hope of generating a
through borrowed money to make a meaningful profit.
larger performance fee, yet only the investors—not the
hedge fund—bears the downside risk.
Unfortunately, in the case of LTCM, unexpected events,
Eva Su, Specialist in Financial Economics
such as the market distress caused by Russia’s default in
1998, dislocated the expected price convergence. When
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LTCM collapsed in September 1998, it created more than
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Hedge Funds: Background and Policy Issues

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