The Impact of Hedge Fund Regulation

From the CIR archives, Winter 2008.

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pylonsHedge funds have collectively accumulated over two trillion dollars in assets as of 2007. Hedge funds typically promise investors alphas of 5% or more, which (implausibly) implies there will be over $100 billion in excess returns for hedge funds. Further, the increasing pool of hedge fund capital under management and activist investment strategies has the potential to move other markets and impact financial stability. These developments have attracted increased regulatory scrutiny to the hedge fund industry in many countries around the world.

The purpose of this study is to facilitate an understanding of the impact of hedge fund regulation on fund governance and performance. In theory, there is an ambiguous relation between hedge fund regulation and hedge fund structure and performance. On one hand, a lack of regulatory oversight may give rise to fund managers that disguise investment schemes and merely capture the fees. Hedge fund registration and oversight would curb this type of behaviour and thereby improve hedge fund structure and average performance. On the other hand, regulatory oversight may hamper fund performance where hedge fund managers and their investors lose freedom to contract and organize their resources in the way that they deem to be most efficient, and thereby exacerbate agency problems.

The international data examined in this paper indicate regulatory requirements in the form of restrictions on the location of key service providers as marketing channels that permit wrappers tend to be associated with worse performance and a reduction in risk. But the reduction in risk is not sufficient to compensate for the lowering in performance. Read the full paper here.

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