Hedge Fund Regulations

Although the SEC is currently examining how it can address the Goldstein decision, commentators have stated that the SEC currently has neither the staff nor expertise to comprehensively monitor the estimated 8,000 U.S. and international hedge funds. One of the commissioners of the SEC has stated they are forming internal teams that will identify and evaluate irregular trading patterns or other phenomena that may threaten individual investors, the stability of the industry, or the financial world.

In February 2007, the President Bush's advisory group on Financial Markets rejected further regulation of hedge funds and said that the industry should instead follow voluntary guidelines.

How do Hedge Funds Work

Since they are unregulated, they can make investments without scrutiny by the SEC. Unlike mutual funds, they don’t have to report quarterly on their holdings. This means no one really knows what they are invested in. Their use of derivatives (complicated financial instruments, like options and futures contracts, that derive their value by reference to an underlying asset or index) means that, with little actual money invested, they have the capability to create large swings in the market. For example, many experts have said that the run-up in oil prices in July of 2006 was caused, in part, by hedge funds.

Hedge Fund History

Hedge funds were created by Alfred Winslow Jones in 1949. Jones brought together two economic concepts to create what he considered a conservative investment scheme. He used leverage to buy more shares, and used short selling to avoid market risk. This approach has become a hallmark strategy of many hedge funds known today. He bought as many stocks as he sold, so regardless of whether the market was up or down, Alfred tried to maneuver himself into a good position. To Alfred this meant the crucial question, then, would not be the direction of the market but whether the manager had picked the right stocks to buy and sell. The fund avoided requirements of the Investment Company Act of 1940 by limiting itself to 99 investors in a limited partnership.
Alfred took a very proactive approach to this hedge fund. He chose to take 20 percent of profits as compensation and he charged no fee unless he made a profit. In summary, these three elements: a partnership structure where a percentage of profits is paid as compensation to the general partner/fund manager, a small number of limited partners as investors, and a variety of long and short positions, have now become the core elements of hedge funds today.