The evolution and regulation of hedge funds

Hedge funds have attracted increased attention in recent years. In part, this is because investment in hedge funds is becoming “mainstream”. A wider range of investors has sought exposure to these investment vehicles, and this has been associated with rapid growth in both the number of funds and the volume of assets under management. In part, too, greater attention has been the result of worries that hedge funds could in some circumstances exert a destabilizing infl uence. With the growth in the market share of hedge funds, and their greater “visibility” in the market place, concerns have been expressed about the consequences of limited transparency and lack of regulation of the industry. Despite the recent focus on hedge funds, their origins can be traced back more than fifty years. The first such fund is generally considered to have been established in the United States in 1949 by Alfred Winslow Jones. The term “hedge fund”, which was coined only later, was applied because the investment style of the original funds was designed to be neutral to general market movements, by combining short and long positions. In this way, funds could pursue absolute returns, in varying market conditions. More recently, however, the term “hedge fund” has been applied to any privately offered, collective investment vehicle for “sophisticated” investors that is lightly regulated and employs leverage. Since the 1950’s, the number of hedge funds has grown steadily, as has the volume of assets under management. Precise statistics are not available, given the lack of reporting requirements, and difficulty in defining the population of institutions that should be covered. The most rapid growth, however, seems to have occurred in the period since about 1990, with an interruption in 1998-99 following the much-publicised near-failure of Long Term Capital Management (LTCM) (Chart 1). Regulatory attention can be dated back some ten years, to the LTCM episode, and the Asian financial crisis that occurred at roughly the same time. The problems encountered by LTCM demonstrated both the size of some hedge funds, and their capacity, through their leveraged position-holding across a number of counterparties, to generate system-wide repercussions. The Asian crisis was thought by some to show that the market power of hedge funds could in some circumstances undermine offi cial policies. Following these episodes, there was a spate of offi cial reports on hedge fund activities and the issues involved in deciding whether and how to regulate them. In this paper, I will begin by analyzing the characteristics that distinguish hedge fund from other investment vehicles. I will go on to consider recent trends in the industry and potential future developments. Then I will assess some of the regulatory concerns that have been expressed and conclude with some remarks on alternative regulatory approaches.