Hedge Fund Regulation

John Lydon

April 24, 2007

What is a hedge fund?

Large managed pool of money invested in many assets Securities, Stocks and Bonds, Real Estate,

Commodities, Currency, and Derivatives Selling Short

To borrow and sell shares one hopes to buy later at a lower price

Each fund’s pool of investors is typically comprised of a few (very wealthy) individuals Wealth is no guarantee of sophisticated investing

As an Industry

Estimated $1 trillion dollar industry growing 20% per year.

Approximately 9,000 current hedge funds Not forced to register with SEC To invest in hedge fund

$1,000,000+ investment in fund At least $5,000,000 invested in other markets

(National Securities Markets Improvement Act of 1996)

Benefits of Hedge Funds

Ability to gain positive returns regardless of rise or fall of bond and equity markets

Some managers are especially skilled and successful investors Better at managing your money than you would be?

They may reduce overall risk (diversification in portfolio)

Free-flowing, less restricted environment Independent from reporting requirements

Drawbacks of Hedge Funds

Investors inability to access informationLack of transparency

No forced financial reporting Investors lack ability to gain info on

managers Inability to check hedge fund manager’s

portfolio valuation techniques Inability to detect unlawful behavior and

fraud at an early stage

Investors’ Concerns

Managerial Compensation Managers typically take 2% off the top and at least

20% of profits. James Simons (Renaissance Technologies

Corporation) $1.7 billion in 2006 Kenneth Griffin (Citadel Investment Group) $1.4

billion in 2006

Fraud SEC cited 51 cases of fraud from 2000-2004

Example of Fraud

February 2007 -- Manhattan Investment Fund found guilty of fraud.

Lost $400 million on bad bets on internet stocks

Issued false financial reportsAllowed them to pay old investors with new

investors moneyBear Stearns (prime broker) ordered to

pay $160 million in restitution

In the News

New York Times – April 24, 2007 – Jenny Anderson and Julie Creswell Institutional Investor’s Alpha magazine ranks top 25

hedge fund earners Rich are getting MUCH richer To make Alpha’s list, “a manager needed to earn at

least $240 million last year, nearly double the amount in 2005. That is up from a minimum of $30 million in 2001 and 2002. Combined, the top 25 hedge fund managers last year earned $14 billion – enough to pay New York City’s 80,000 public school teachers for nearly three years.”

In the News continued…

Gains like this have not been seen since the Internet boom Internet boom defined by youth, hedge fund growth showing “experience

indeed pays” Average age of Alpha’s top 25 is 51

Managers exact huge incomes even with low returns because of enormity of assets.

However, “With a greater proportion of the assets in the hedge fund industry controlled

by fewer managers, some investors worry that managers are at a turning point. The same young and brash managers who achieved huge successes are now controlling vast sums of assets, and the incentive may be to protect their wealth rather than take risks to increase it.” – Anderson and Creswell

Mark W. Yusko, Morgan Creek Capital Management president, “I think one of the significant issues of this business that we are all struggling with is that there is an inverse correlation between compensation and drive. In many cases the incredible wealth that is created by this incentive compensation structure has a propensity to dull the senses and dull the drive.”

Conclusion

SEC lacks capacity to regulate effectively without accurate, contemporary information

They may be private pools of money, but they are so large, they need to be more heavily regulated to protect the interests of all investors, private and public

More regulation is necessary An enormous industry with volatility

Successful investing Major gains Few bad bets Immediate demise

Must be more transparent Regardless of manager’s skill, investors must be able to see where their money lies If you were investing millions of dollars, would you want to know what the manager is

doing with it? Fraud is typically discovered only after major financial losses

Periodic reports to investors Disclose investment strategies Fund valuation

Maintain independent setting Forced financial reports will preserve this freedom It is a step in the right direction to guard against unlawful behavior and fraud.

Hedge Fund Regulation

John Lydon

April 24, 2007