A major US academic study of the hedge fund industry wonders whether attempts to make the sector totally transparent can succeed without killing it.

The following article is from Chris Hamblin, editor of Offshore Red and Compliance Matters, which are sister publications to this one.

When a sophisticated investor is persuaded to invest in a hedge fund, they should realise that there is no realistic prospect of that investment vehicle being regulated effectively for the risk that it poses to the financial system, according to research from Michigan State University.

Although one hedge fund on its own may present little or no threat to the global economy, hedge funds in general actively manage and invest vast sums. They are far more able than other investment vehicles to use debt and their investment strategies are flexible. Because of this, and the interconnected nature of the world's markets, the ripple-effects of their trading manoeuvres are very powerful. BarclayHedge reports that in the second quarter of 2013 the world's hedge funds were managing $1.9 trillion. (That figure since has risen, some estimates say, to $2.3 trillion.)

A lengthy new report from Michigan State University has concluded, after four years of US attempts at hedge fund regulation, that it is “largely impossible” for regulators to rein in the risks that hedge funds pose to the financial system at large. Because hedge funds do not necessarily take into account the trading activities of other investment-based institutions, it argues, the consequences of any “bad bet” may be passed to entities that act as counterparts to hedge fund trades (which may or may not be major participants in the same markets). The report says: “It is precisely this complex and interdependent nature of the risk that makes it impossible to regulate the hedge fund industry from the top down.”

Before the financial meltdown of 2008, hedge funds were largely unregulated and generally left to their own devices. After the financial crisis, financial regulators across the globe decided that the hedge fund industry had to be regulated more tightly. The US Congress, as readers may know, included the Private Fund Investment Advisers Registration Act 2010 or PFIARA in section 4 Wall Street Reform and Consumer Protection Act, otherwise known as the Dodd-Frank Act, while the European Union issued the Alternative Investment Fund Managers Directive or AIFMD.

Over-regulation to no good effect?

The report goes on to say that the flexibility of hedge funds is only possible because they are very lightly regulated, a fact that contributes to their financial prowess. They can move in and out of markets quickly and efficiently, without fear of investors withdrawing at any moment. They use debt and can diversify their portfolios quite freely. The report defines regulation as negative prohibitions and positive obligations such as capital requirements, debt limits and pay structures, and says that it is having unforeseen consequences. It goes on: “The AIFMD's rigid approach...is really an attempt to dismantle the hedge fund industry, not an effort to regulate what currently exists, and may actually result in increased creation of systemic risk.”

The report does, however, have kind things to say about regulators who attempt to remove the shroud of opacity that cloaks so many hedge fund activities. It likes the Securities and Exchange Commission's “filing requirements” because they “provide benefits to all investors through increased information gathering and disclosure”. These requirements, it thinks, will allow the SEC to “de-fragment the various trading markets and to see the effect [that] third party actions may have on overall market liquidity,” which presumably has some systemic virtue.

The report says the SEC’s disclosure policy, although very costly to firms, will give it a good overview of systemic risk throughout all markets. This is to damn the regulator with faint praise, however, as the report goes on to imply that government agencies do not truly understand how hedge funds create systemic risk and that the SEC’s disclosure requirements will give it a picture of market-wide risk levels for the first time.

The European Union's efforts, indeed, come in for much more criticism than America's. Under a banner saying “the AIFMD Is Counterproductive in its Efforts to Combat Systemic Risk,” the report intimates that the directive's depositary requirements, independent asset valuation rules and restrictions on delegation seem ambiguous for investor protection purposes at best. The requirements are certainly going to hobble hedge fund performance because they conflict directly with the limited partnership organisational structure of many hedge funds and with “funds employing prime broking strategies”. The “objective justification” requirement for a certain delegation structure, meanwhile, interferes with another great virtue of hedge funds – the freedom they have in determining their organisational structures.

It also seems doubtful to the authors (although this has not been tested in the courts) that a prime broker, who is not also part of a credit institution subject to laws that have the same effect as EU law, may continue to function as a depositary – another blow to the smooth running of many hedge funds.

All for nothing, or all for not very much benefit?

A $5 billion hedge fund firm can expect to spend more than $500,000 on technology, consultants and staffing in order to comply with the new Form PF requirements, according to Bank of America’s hedge fund consulting unit, which surveyed 14 fund operators in 2012 about their experiences collating huge amounts of data in preparation for the filing.

Form PF – the information-gathering document that the Dodd-Frank Act obliged the SEC and Commodities and Futures Trading Commission to compose for their firms to fill in – requires hedge fund managers to collect and process some 2,000 data points, much of it from trading partners and other external sources. The BoA report states that this form draws an unprecedented amount of detail about hedge fund investments, debt and “investor composition” from managers’ internal systems, fund administrators, prime brokers and counterparties. This particular avenue of disclosure is confidential because it requires hedge fund advisors to disclose proprietary trading information.

The Michigan report concludes: “Short of eliminating the hedge fund industry as we understand it today, there is no way to regulate the hedge fund industry for systemic risk, at least not in the way the AIFMD attempts to.” It is kinder to the American regime, which threatens not to crush hedge funds but merely to stifle them under a mountain of costs, and for no particularly good reason. It ends with a warning about what is likely to happen once the disclosures are flowing as planned: “The difficulty in achieving this utopian vision of SEC monitoring is the technological backwardness of the SEC. Depending on the type of analysis necessary to piece all this information together, the SEC may not be up to the task.” Perhaps in twenty years' time, asset managers will be asking each other the question: “Do you remember hedge funds?”