17 April 2003
Jonathan G. Katz
Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: File No. 4-476-Hedge Funds
Dear Mr. Katz:
The Association for Investment Management and Research ("AIMR®") is pleased to present its views on hedge funds to the Securities and Exchange Commission (the "SEC" or the "Commission").
The Association for Investment Management and Research is a global, non-profit organization of over 62,000 investment professionals of which 55,800 are holders of the Chartered Financial Analyst® (CFA®) designation in 115 countries. The organization includes 125 Member Societies and Chapters in 44 countries. AIMR provides global leadership in investment education, professional standards, and advocacy programs, and is renowned for the CFA Examination program. This year, 102,300 candidates worldwide have registered for the June 2003 CFA Examinations.
Through its advocacy committees, AIMR regularly reviews and responds to major new regulatory, legislative, and other developments that may affect investors, the investment profession, and the efficiency and integrity of global financial markets.
General Comments
AIMR believes that the Commission's proposal to assess "the regulatory framework applicable to hedge funds and their investment advisers" is both timely and in the best interests of investors and the financial markets generally. We also concur in the proposed discussion topics:
(1) the structure, operation and compliance activities of hedge funds;
(2) marketing issues;
(3) investor protection issues;
(4) the current regulatory scheme; and
(5) whether additional regulation is warranted.
AIMR's 40-year commitment to ethics and high-quality standards of professional conduct is predicated on the principle that the best interests of clients and other investors should come first. That is, investors' interests should supercede all other considerations. This principle is the bedrock of participants' trust and confidence in the financial markets.
In recent years, the sudden collapse of a number of the largest hedge funds, some managed by the most experienced hedge fund professionals, have raised a number of questions regarding the funds' strategies and operations, disclosure, performance measures, and potential effects on market systemic risk. These concerns, coupled with occasional allegations of fraudulent practices in some funds, have done little to enhance investors' trust and confidence in these funds and the adequacy of the current regulatory oversight framework. Consequently, we believe that a broad review of the current regulatory structure is warranted.
These concerns aside, we believe that hedge funds can and do serve an important market function by providing certain market participants with a vehicle for acting on a "view" of future market movements and trends. For example, long-short funds can efficiently and effectively take positions depending upon their evaluations of whether a particular security is under- or over-valued. Such activity can enhance the efficiency of markets by allowing market prices to more fully and quickly reflect the consensus of investors' expectations.
However, the returns-magnifying leverage routinely employed in a number of the strategies used by hedge funds can produce sharp reverses, quickly eroding both positive returns and invested capital. Indeed, the failure rate for such funds remains alarmingly high.
Investors with sufficient knowledge, experience, access to required information, and resources to accept the risks inherent in leveraged hedge fund strategies should be permitted to pursue all legal and ethical investment opportunities. Current regulation permits the marketing of hedge fund securities to such investors as non-public offerings. However, it is less clear whether hedge funds in their current or altered forms are appropriate for less-sophisticated investors, given the current regulatory and disclosure environment for such funds. It is a question that is relevant for all types of investments and strategies. Even traditional buy-and-hold equity or long-term fixed-income strategies are not always appropriate for every type of investor.
Traditionally, regulators have made distinctions about the appropriateness of certain classes of investments based on the relative sophistication of the individual investors involved. In general, investors have been categorized as either sophisticated or unsophisticated. Sophisticated investors typically include large and small investment institutions, as well as high-net-worth individuals, who have sufficient financial resources to acquire the necessary expert knowledge of advisers and to absorb potential losses. Regulators have generally defined unsophisticated investors as individuals or even institutions that lack the financial resources, experience or understanding to engage in certain high-risk types of investing activities.
However, we are concerned that the rapid growth in affluence in the U.S., particularly in the decade of the 1990s, may have rendered obsolete the static regulatory yardsticks for determining investor sophistication. The criteria for designating "accredited investors" include: $200,000 in annual income, or $300,000 combined income with spouse, or a minimum of $1,000,000 in net assets. Indeed, many potential investors today could meet these criteria who have never invested in any securities, including traditional mutual funds, and who have no relevant knowledge in the investments area.
Consequently, we believe that these criteria should be reconsidered with a view to sharply raising the hurdle so as to re-establish meaningful thresholds consistent with the original intent of the provisions. In addition, we believe that advisors and fund managers should be required to take into account qualitative factors including the investor's knowledge and experience in determining the suitability of hedge fund investments for their portfolios.
AIMR members are guided by the organization's Standards of Professional Conduct (the "Standards") in determining whether an investment is appropriate for a given client. Specifically, under Standard IV, Section B.2, of the Standards, members are required to:
(a) Make a reasonable inquiry into a client's financial situation, investment experience, and investment objectives prior to making any investment recommendations and shall update this information as necessary, but no less frequently than annually, to allow the members to adjust their investment recommendations to reflect changed circumstances.
(b) Consider the appropriateness and suitability of investment recommendations or actions for each portfolio or client. In determining appropriateness and suitability, members shall consider applicable relevant factors, including the needs and circumstances involved, and the basic characteristics of the total portfolio. Members shall not make a recommendation unless they reasonably determine that the recommendation is suitable to the client's financial situation, investment experience and investment objectives.
(c) Distinguish between facts and opinions in the presentation of investment recommendations.
(d) Disclose to clients and prospects the basic format and general principles of the investment processes by which securities are selected and portfolios are constructed and shall promptly disclose to clients and prospects any changes that might significantly affect those processes. [A copy of the AIMR Standards of Professional Conduct is attached.]
Beyond these Standards, AIMR's advocacy committees also must follow seven core principles mandated by the AIMR Board of Governors. These principles serve not only to guide the committees when debating new proposals and formulating new positions on issues, but also to focus committee thinking on the importance of maintaining market transparency, credibility, openness, and investor confidence. Those principles are:
(1) That there should be reasonable disclosure of information to the capital markets to permit well-informed decision-making is a paramount objective; but the benefits of this disclosure must be weighed against the cost of gathering and reporting the information and the cost of competitive disadvantage unless the result is inadequate information for decision-making.
(2) All markets should be transparent and regulation should operate to this end.
(3) Regulation should be designed and enforced to maintain and enhance market credibility, openness, and investor confidence, thereby helping to lower the cost of capital.
(4) There should not be a two-tiered disclosure system. The same information should be available to all market participants at the same time.
(5) Investors should have a voice in corporate governance.
(6) All markets and market participants should be ethical. They should strive to abide by the principles set forth in the AIMR Code of Ethics (the "Code") and the Standards (collectively referred to as "the Code and Standards"); but, at a minimum, they must abide by the International Code of Ethics and International Standards of Professional Conduct issued by the International Council of Investment Professionals (ICIA).
(7) AIMR members should foster self-regulation of the market in lieu of government-imposed regulation.
Hedge Fund Risk Exposures
Many hedge fund strategies involve the assumption of high levels of
risk, in addition to the traditional risks such as price risk and
interest rate risk, in the search for superior returns. These risks may
include:
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Leverage-Achieved primarily through the use of
derivatives, short selling, and borrowing, which are restricted or even
barred for more-traditional investment vehicles. The use of these
instruments and strategies can raise the volatility of returns of an
investment portfolio by increasing the magnitude of both gains and
losses.
-
Limited Transparency and Disclosure-Hedge funds typically
do not disclose information about their strategies and holdings. This
allows managers the flexibility to act quickly on their beliefs about
the most appropriate strategies. In addition, those actions are not
transparent to the rest of the market.
Such flexibility also means that a fund's strategy can change quickly without prior notice. For example, a fund can quietly change from a relatively conservative market-neutral strategy to a highly-leveraged, high-risk strategy within a short period of time based on the manager's outlook.
-
Lack of Standards for Performance Measurement and
Disclosure-The hedge fund industry does not yet subscribe to a
uniform standard for the measurement and reporting of performance for
transactions involving leverage and derivatives. Recently, however,
AIMR issued for public comment proposed amendments to the Global
Investment Performance Standards (GIPS®) to address the calculation
and presentation of investment returns affected by the use of leverage
and derivatives. (See Proposals for Required Minimum Disclosure and
Regulatory Oversight below.) The lack of industry-wide performance
standards is particularly problematic for hedge funds given the high
level of risks assumed and volatility of returns associated with many
of the strategies.
-
Counterparty Risk-Many funds use over-the-counter
derivatives, instruments that rely heavily on other entities or
financial institutions-referred to as counterparties-for their
performance characteristics. If the counterparties fail to perform,
then the funds' returns will suffer and investors may face
losses.
-
Sector Risk Concentration-Some fund managers seek
superior returns by taking advantage of their specialized knowledge of
specific industry sectors, and by focusing their investment activities
in those sectors. In this case, investors are vulnerable to adverse
moves in the sector, even if they do not relate directly to the
individual positions owned by the funds.
-
Focused Security Risk Concentration-In a strategy similar
to sector risk concentration, other funds concentrate their positions
in relatively few securities (or instruments), attempting to take
advantage of significant moves in those securities. However, such a
strategy may make it difficult for a fund to unwind its positions
should economic or operational events turn against them. In such
situations, fund investors could face sharp losses as the process of
unwinding those large positions causes prices to move against the
fund.
-
Lack of Regulatory Oversight-The current hedge fund
industry has minimal to no regulatory or audit oversight of its
activities. Evidence suggests that some managers may have overstepped
legal boundaries, resorting to fraudulent activities, in their pursuit
of superior returns. Such activity creates another potential risk to
investors.
Non-Public Hedge Fund Investments by Sophisticated
Investors
In general, AIMR has regarded hedge fund investments as
appropriate and acceptable for highly sophisticated investors, subject to
our concerns about the criteria for designating investors as
"accredited investors". The current regulatory framework requires
that such securities be offered as non-public investments and marketed
only to sophisticated investors. We believe these investors possess, or
have the means to acquire, the (1) experience, (2) knowledge, and (3)
access to the information needed to manage properly the risks inherent in
these types of investment vehicles. These qualities are important because
hedge fund managers have sometimes achieved significant returns through a
combination of superior knowledge and strategy, and significant risk
derived from the use of varying combinations of leverage, industry focus,
stealth, and flexibility.
Sophisticated investors can manage the risks inherent in the investments through a combination of knowledge and financial resources. Because of their experience and expertise-or the experience and expertise of a hired investment adviser-such investors are able to understand and gauge the risks associated with various hedge fund options. Thus, they are able to assess and make investment decisions that best meet their investment objectives, including tolerances to risk. Moreover, their resources allow them to not only absorb possible losses, but also to avoid losses by performing background checks on managers' past performance and employment records as a measure of the managers' competence.
Sophisticated investors are also able to overcome the lack of transparency and disclosure because of the important roles they play for hedge-fund managers. Besides serving as a significant source of investment funds and as partners in these funds, many of these investors also serve as advisers to the managers themselves. With this kind of access, such investors can demand the type of information they want or need to assess the strategies employed by the fund.
However, we are concerned that the regulatory criteria for determining whether investors can be assumed by hedge fund managers and those marketing the funds to be "accredited investors", or sufficiently sophisticated, are out of date as a result of the high growth of affluence, especially in recent years. Now many potential investors would meet the thresholds who possess neither the investment knowledge nor the experience to be able to properly evaluate the strategies used by the funds and their inherent risks. Consequently, we believe that the criteria should be reconsidered with a view to raising them to meaningful levels. In addition, we believe strongly that qualitative criteria, including knowledge of the strategies employed and their attendant risks, experience in high-risk investments in general, and the suitability of the investments for the particular investor's portfolio, should be taken into account in evaluating the advisability of the investments.
Marketing of Hedge Funds to Less-Sophisticated
Investors
Ultimately, the primary issue is whether hedge funds, as
currently structured, are appropriate for marketing as suitable
investments to less- or unsophisticated investors.
Some have argued that:
- Risk is an inherent and unavoidable aspect of any investment strategy whether it includes hedge funds or more traditional investments, such as stocks and bonds. Indeed, investors who purchased bonds or equities of many dotcom or telecom companies in the 1990's may well have experienced losses equal to most, if not all, of their original investments.
- All investors should have access to the potentially high returns offered by some hedge funds. That is, investors should not be barred from participating in investment opportunities based solely on wealth.
- Certain hedge fund strategies are not only acceptable as retail products, but could provide investors with a lower-risk option than traditional mutual funds, if done well and correctly. For example, they argue that diversification through a "fund of funds" is a way to potentially limit the risks retail investors would have to accept. Likewise, a straight-forward long/short hedge fund strategy with a higher threshold for short selling than more traditional mutual fund strategies might actually achieve lower risk and higher returns for retail investors.
However, it is critical to observe that many of the advantages available to sophisticated investors-(1) sufficient financial resources, (2) expertise, and (3) access to information-advantages that may make these investments suitable for such investors, are not available to retail investors. As a result, these deficiencies often raise the risk levels for less-sophisticated investors to unacceptable levels.
Among the difficulties faced by less-sophisticated investors:
-
Lack of Information-It is unlikely that the size of their
investments would afford them the same level of access to management
strategies and information enjoyed by more affluent investors.
In traditional investment funds, less-sophisticated investors are able to overcome such hurdles as a result of the existence and enforcement of regulations and oversight that require frequent, timely, and substantial financial reporting and disclosures. To the extent that some hedge funds may operate in jurisdictions beyond the regulatory reach of even the SEC, it is unlikely that less-sophisticated investors will receive the kind of information they need to make well-informed investment decisions.
-
Lack of Necessary Expertise-Because most
less-sophisticated investors would not possess the same level of
expertise as sophisticated investors about a specific strategy, sector,
or investment vehicle, it is also unlikely that they would be able to
adequately evaluate the relative risks and returns of the hedge
strategies.
As described above, hedge funds routinely employ investment strategies and vehicles that are complex and sophisticated, and often are not permitted for use by traditional retail investment funds. As a result, most less-sophisticated investors will not have the necessary experience or knowledge to understand fully such strategies and instruments and, in turn, cannot gauge the degree of risk such activities pose to their investments.
Compounding this lack of understanding is that hedge funds benefit from their ability to move swiftly among different positions, different investment vehicles and different strategies, all without disclosing these moves to investors. Investors expecting lower-risk strategies may find that the fund is in a higher-risk category than is comfortable or appropriate for them.
-
Lack of Financial Resources-Retail investors, as a
general rule, do not have the financial means needed to absorb losses
created by higher-risk investment vehicles or strategies. Nor do they
typically possess the means to hire someone who has the requisite
expertise to understand the investment strategies of hedge funds. In
such cases, AIMR members would have to consider suitability of such
investments for their clients as set out in the Standards.
As a result of these limitations, AIMR members would have difficulty advising less-sophisticated clients to invest in hedge funds as they are currently marketed. These instruments fail to meet the appropriateness requirements of AIMR's Standards of Professional Conduct-specifically Standard IV, sub-section d of Section B.2-because of their lack of disclosure, lack of access and the limited ability of regulators to control their activities. Moreover, because of the lack of transparency of such investment vehicles, together with the potential for unequal disclosure and corporate governance principles, they also fail to meet the principles of AIMR's advocacy program.
Proposals for Required Minimum Disclosure and Regulatory Oversight
General Requirements
Consistent with the transparency and disclosure requirements of
AIMR's Standards and advocacy principles, we propose that the following
minimum disclosures and regulatory oversight requirements should be
mandated for offerings of hedge fund securities to less-sophisticated, or
retail, investors. Obviously, sophisticated investors would benefit
directly as well from the provision of higher quality disclosure,
including standardized performance presentation data. Such minimum
disclosures and requirements might include:
- Full and transparent descriptions and explanations regarding strategies employed;
- Requirements that the funds adhere strictly to the disclosed strategies or provide participants with sufficient advance notice of changes in strategy and adequate opportunity to dispose of the investments;
- Complete and understandable discussions of the risks inherent in the strategies employed, both at the time of offering and on an on-going basis;
-
Disclosures of fund performance, both on an absolute basis and against
an appropriate benchmark;
AIMR recently has issued for public comment proposed amendments to the Global Investment Performance Standards (GIPS). The proposed provisions were developed by the Leverage and Derivatives Subcommittee of the AIMR Investment Performance Council, comprising industry representatives with global representation, who provided practical experience and global perspective to the process. The comment period will end on 30 April 2003. A copy of the proposed amendments is attached.
- Full, fair, and accurate discussions at the time of offering about the performance and history of the fund managers by type of strategy employed;
- Require such funds to separate the compliance function from that of the manager;
- Require funds to undergo regular audits to prevent managers from engaging in self-beneficial activities at the expense of the funds' investors; and
- Provide a listing of securities owned on regular intervals and a description of the methods used to value those positions and disclosure of the assumptions used in those valuations.
We believe that enforcement of such disclosures and requirements would be essential in order for these proposals to provide the appropriate safeguards.
Funds of Funds
Some (proposed) regulations in some jurisdictions (would) permit
institutions to market hedge fund products to unsophisticated investors
through the use of vehicles known as "funds of hedge funds" or
funds of funds. These proposals are based largely on the belief that
through the purchase of interests in multiple hedge funds, such funds of
funds have the potential to reduce overall risk through diversification.
Indeed, modern portfolio theory has proven that overall risk in a portfolio with less than perfectly correlated returns declines below that of the riskiest holdings, even if the holdings have equal risk measures. Nonetheless, diversification into securities whose returns are correlated may not achieve the kind of risk reduction that unsophisticated investors may expect from diversification. For example, if a fund of funds takes positions in one particular industry sector, it is unlikely the fund will achieve significant risk reduction.
Consequently, for such funds to be suitable for investors who may not understand the risks associated with correlated-returns funds, the regulator would need to consider rules that prevent funds of funds from concentrating investments in correlated sectors, strategies, or holdings. Similarly, it would need to ensure that the funds' strategies are stable as a means of preventing movement from a conservative, risk-reduction strategy into a leveraged, high-risk one. Finally, such funds of funds would need to adhere to the same kinds of disclosures-performance, holdings, risk, and managers' history-as would be required of traditional investment funds.
Closing Remarks
AIMR believes hedge funds can and do provide value and service to certain classes of investors who are sophisticated enough to understand the complex and risky strategies, and who possess sufficient resources to absorb the losses that such investments might entail. However, for AIMR members, who subscribe to AIMR Standards, to accept such investments as appropriate and acceptable vehicles for less-sophisticated investors, the regulator would have to raise the level of disclosures, raise the accreditation criteria for investors, impose tighter restrictions on the activities of funds, and ensure enforceability of these requirements.
AIMR appreciates the opportunity to comment to the Commission about the regulation of hedge funds. If you or your staff have questions or seek amplification of our views, please feel free to contact Rebecca Todd McEnally, CFA, by phone at +1.434.951.5319 or by e-mail at rebecca.mcenally@cfainstitute.org.
Sincerely,
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Rebecca Todd McEnally, CFA Vice President, Advocacy AIMR |
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