Hedge Funds and Investor Protection Regulation

Franklin R. Edwards
Economic Review, Vol. 91, No. 4, 2006

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A recent Securities and Exchange Commission (SEC) ruling requiring hedge fund advisers to register with the SEC aims to foster conduct and compliance to better protect hedge fund investors. This article focuses on investor protection regulation, considering its goals and likely costs and benefits. After reviewing some alternative regulatory approaches, the author examines the current U.S. regulatory structure for hedge funds, which has, perhaps unwittingly, separated hedge fund investors into two distinct classes—retail and wholesale—defined by wealth levels.

The SEC's recent ruling reflects its concern about the growing "retailization" of hedge funds—the increasing ability of less qualified (retail) investors to access hedge fund investments—as general wealth levels rise and as more affordable investments, such as funds of hedge funds (FoFs), proliferate. In addition, institutional investors have increased their investments in hedge funds, exposing even more individual investors, at least indirectly, to a type of risk they may be unfamiliar with.

The author believes that the costs of increased regulatory protection for hedge fund investors will ultimately prove to outweigh the benefits, and he argues that hedge fund investment strategies be made more, not less, accessible to a broader array of retail investors. In particular, he recommends that the SEC consider authorizing FoFs under a regulatory structure that better enables hedge funds to pursue absolute-return strategies so that retail investors can benefit from them.

December 2006