PDF Ebook The Law and Economics of Hedge Funds: Financial Innovation and Investor Protection
A persistent theme underlying contemporary debates about financial regulation is how to protect investors from the growing complexity of financial markets, new risks, and other changes brought about by financial innovation. Increasingly relevant to this debate are the leading innovators of complex investment strategies known as hedge funds. A hedge fund is a private investment pool not subject to the full range of restrictions on investment activities and disclosure obligations imposed by the federal securities laws, that compensates management in part with an annual performance fee, and typically engages in the active trading of financial instruments.
Hedge funds engage in financial innovation by pursuing novel investment strategies that lower market risk (beta) and may increase returns attributable to manager skill (alpha). Despite the funds’ unique costs and risk properties, the historical performance of hedge funds suggests that the ultimate result of hedge fund innovation is to help investors reduce economic losses during market downturns. Most recently, during approximately the first year of the subprime mortgage-initiated credit crisis (from June 1, 2007 through May 30, 2008), the U.S. stock market lost 8.27 percent of its value whereas, by a conservative estimate, hedge funds produced gains averaging 1.83 percent. By increasing investors’ ability to maximize risk-adjusted returns, hedge funds advance the same goal that federal investor protection regulation seeks to advance.
This Article shows that the economic outcomes attained by hedge funds are in part attributable to the legal regime under which they operate. The hedge fund legal regime includes not only federal securities law but also the entity and contract law provisions governing the fund, its manager, and investors. Federal law applicable to hedge funds enables the funds to pursue innovative investment strategies employing the trifecta of leverage, short sales, and derivatives. The entity and contract law governance of hedge funds provides high-powered incentives for fund managers to engage in and capture the gains from financial innovation.
A general lesson from the law and economics of hedge funds is that when a legal regime permits financial intermediaries to be flexible in their investment strategies and aligns the incentives of investors and innovators through performance fees and co-investment by managers, financial innovation is likely to complement investor protection.
CONTENTS
INTRODUCTION
I. The Hedge Fund Legal Regime
- A. Uncorporate Governance
B. Hedge Fund Operating Agreement
- 1. Hedge Fund Manager Compensation
2. Restrictions on Share Liquidity
C. Investment Company and Investment Adviser Law
- 1. Investment Company Law
2. Investment Adviser Law
D. Securities Regulation
- 1. Raising Investment Capital
2. Trading Registered Securities
II. FINANCIAL INNOVATION, MARKET RISK, AND HEDGE FUND GOVERNANCE
- A. Financial Innovation
B. How Hedge Funds Innovate
- 1. Investing and Diversification
2. Transaction Costs and Idiosyncratic Risk
3. Hedge Fund Investment Strategies and Market Risk
4. Unique Costs and Risks of Hedge Fund Innovation
C. Why Hedge Funds Must Innovate
D. Hedge Fund Governance and Innovation
- 1. Hedge Funds Versus Corporate Governance
2. Hedge Fund Manager Incentives
3. Illiquidity Transaction Costs
III. HEDGE FUNDS AND INVESTOR PROTECTION
A. Diversification and Investor Protection
B. Hedge Fund Disclosures
C. Hedge Funds and Loss Protection
- 1. Performance in the Modern Hedge Fund Industry
2. Hedge Funds During the Credit Crisis
IV. CONCLUSION
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PDF Ebook The Law and Economics of Hedge Funds: Financial Innovation and Investor Protection
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