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 information Lack 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

Example of Fraud February Manhattan Investment Fund found guilty of fraud. Lost $400 million on bad bets on internet stocks Issued false financial reports Allowed them to pay old investors with new investors money Bear 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 That is up from a minimum of $30 million in 2001 and 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