The Billion Dollar Grin

Hedge funds are not new to the investment world. But, the sheer volume of assets under management for the industry as a whole -- $1.225t at the end of 2006-- indicate that hedge funds aren't going anywhere fast. Perhaps even more astonishing than the explosive growth of AUM are the paydays of those hedge fund managers whose performance hasn't lagged with the size of their funds. Most notable are perhaps Eddie Lampert at ESL Invesments, the first to manager to earn over $1b in a single year and James Simons, who commanded a whopping $1.5b in 2005. Couple these salaries with the nearly $6.5 billion that Connecticut based hedge fund Amaranth Advisors LLC lost on a single bet on natural gas futures and you've got yourself quite a story.

Such news is bound to draw more attention to the industry, so it is no wonder some eyebrows have raised over at the SEC. In his quest to protect unsophisticated investors, SEC commissioner Roel Campos has proposed a new rule that would dramatically change who would be able to invest in hedge funds. When the law on accredited investors was adopted back in1982 an investor was 'accredited' if he/she had $1m of net worth or $200K of disposable income in two of the last 3 years. In 1982 that excluded all but 2% of US households. Today, due to inflation and other factors almost 9% of US households qualify. Clearly the SEC thinks that a change is needed, but is it really? Consider this from Richard Rahn, a director and board member of several economic policy organizations:

"Financial regulation is most often justified by arguing it is needed to protect all participants from those who would engage in fraud or theft, and to protect unsophisticated investors from losing money in investments they do not understand. The U.S. Securities and Exchange Commission (SEC) has just proposed that the amount of liquid net worth an individual must have before investing in hedge funds and other so-called risky investments be raised to as much as $2.5 million. People meeting a net liquid worth requirement are considered "accredited investors."

The new SEC proposal and other proposals for increased regulation raise a number of important questions, such as: Are hedge funds riskier than stocks and bonds that everyone is allowed to invest in? Is a liquid net worth requirement an appropriate measure of one's ability to evaluate an investment opportunity? Is it fair to the nonwealthy to only allow people who already have a large amount of money to invest in certain things that may provide higher rates of return? Why is liquid net wealth as opposed to total wealth an appropriate measure, particularly now that almost all real estate, and many other non-liquid assets, can easily be securitized?"

None of these questions have easy answers. The SEC's mission statement is "to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation." While it is surely important to protect investors from fraud, it seems equally important to recognize the freedom of investors to choose their own investments. In my view increasing the universe of investment choices is a good thing. It should be left up to investors to analyze the risks.