Hedge Funds: Overview of Regulatory Oversight, Counterparty Risks, and Investment Challenges
Published: 2009-05-07T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In 2008, GAO issued two reports on hedge funds--pooled investment vehicles that are privately managed and often engage in active trading of various types of securities and commodity futures and options contracts--highlighting the need for continued regulatory attention and for guidance to better inform pension plans on the risks and challenges of hedge fund investments. Hedge funds generally qualified for exemption from certain securities laws and regulations, including the requirement to register as an investment company. Hedge funds have been deeply affected by the recent financial turmoil. But an industry survey of institutional investors suggests that these investors are still committed to investing in hedge funds in the long term. For the first time hedge funds are allowed to borrow from the Federal Reserve under the Term-Asset Backed Loan Facility. As such, the regulatory oversight issues and investment challenges raised by the 2008 reports still remain relevant. This testimony discusses: (1) federal regulators' oversight of hedge fund-related activities; (2) potential benefits, risks, and challenges pension plans face in investing in hedge funds; (3) the measures investors, creditors, and counterparties have taken to impose market discipline on hedge funds; and (4) the potential for systemic risk from hedge fund-related activities. To do this work we relied upon our issued reports and updated data where possible
section_title: What GAO Found
paragraphs: Under the existing regulatory structure, the Securities and Exchange Commission and Commodity Futures Trading Commission can provide direct oversight of registered hedge fund advisers, and along with federal bank regulators, they monitor hedge fund-related activities conducted at their regulated entities. Although some examinations found that banks generally have strengthened practices for managing risk exposures to hedge funds, regulators recommended that they enhance firmwide risk management systems and practices, including expanded stress testing. The federal government does not specifically limit or monitor private sector plan investment in hedge funds. Under federal law, fiduciaries must comply with a standard of prudence, but no explicit restrictions on hedge funds exist. Pension plans invest in hedge funds to obtain a number of potential benefits, such as returns greater than the stock market and stable returns on investment. However, hedge funds also pose challenges and risks beyond those posed by traditional investments. For example, some investors may have little information on funds' underlying assets and their values, which limits the opportunity for oversight. Plan representatives said they take steps to mitigate these and other challenges, but doing so requires resources beyond the means of some plans. According to market participants, hedge fund advisers have improved disclosures and transparency about their operations as a result of industry guidance issued and pressure from investors and creditors and counterparties. Regulators and market participants said that creditors and counterparties have generally conducted more due diligence and tightened their credit standards for hedge funds. However, several factors may limit the effectiveness of market discipline or illustrate failures to properly exercise it. Further, if the risk controls of creditors and counterparties are inadequate, their actions may not prevent hedge funds from taking excessive risk and can contribute to conditions that create systemic risk if breakdowns in market discipline and risk controls are sufficiently severe that losses by hedge funds in turn cause significant losses at key intermediaries or in financial markets. Financial regulators and industry observers remain concerned about the adequacy of counterparty credit risk management at major financial institutions because it is a key factor in controlling the potential for hedge funds to become a source of systemic risk. Although hedge funds generally add liquidity to many markets, including distressed asset markets, in some circumstances hedge funds' activities can strain liquidity and contribute to financial distress. In response to their concerns regarding the adequacy of counterparty credit risk, a group of regulators had collaborated to examine particular hedge fund-related activities across entities they regulate, and the President's Working Group on Financial Markets (PWG). The PWG also established two private sector committees that recently released guidelines to address systemic risk and investor protection.

section_title: Letter
paragraphs: I am pleased to be here to participate in today’s hearing on hedge funds. A  hedge fund is a pooled investment vehicle that is privately managed and  often engages in active trading of various types of securities and  commodity futures and options. In general, hedge funds qualify for  exemption from certain securities laws and regulations, including the  requirement to register as an investment company. When we conducted  the two studies on hedge funds in 2007, the hedge fund sector was growing  in importance and continuing to evolve within the financial system. Hedge  funds, largely driven by investments from institutional investors, such as  endowments, foundations, insurance companies, and pension plans,  seeking to diversify their risks and increase returns, have grown  dramatically over the last decade. From 1998 to early 2007, the estimated  number of funds grew from more than 3,000 to more than 9,000 and assets  under management from $200 billion to more than $2 trillion globally. An  estimated $1.5 trillion of these assets is managed by U.S. hedge fund  advisers. Hedge funds have significant business relationships with the  largest regulated banking organizations. Hedge funds act as trading  counterparties for a wide range of over-the-counter derivatives and other  financing transactions. They also act as clients through their purchase of  clearing and other services and as borrowers through their use of margin  loans from prime brokers.
Much has happened in the financial markets since we issued our reports.  Hedge funds have been deeply affected in the financial turmoil. According  to an industry survey, most hedge fund strategies produced double-digit  losses in 2008 and hedge funds saw approximately $70 billion in  redemptions between June and November 2008. Some observers blamed  hedge funds for dramatic volatility in the stock and commodity markets  last year and some funds of hedge funds were heavily invested in the  alleged Madoff fraud. Nevertheless, an industry survey of institutional  investors suggests that these investors are still committed to investing in  hedge funds in the long term. Financial regulators’ views on hedge funds  appear to be shifting as well, perhaps signaling recognition that hedge  funds have become an integral part of the financial markets. For example,  hedge funds are allowed to borrow from the Federal Reserve for the first  time under the Term Asset-Backed Securities Loan Facility (TALF)  intended to support consumer credit. While the Federal Reserve Chairman  and Treasury Secretary have supported the position of enhanced market  discipline over stricter regulation of hedge funds in 2007, Treasury has  recently called for greater regulatory oversight of hedge funds. Despite  changes surrounding the hedge fund sector, the issues and concerns  related to regulatory oversight of hedge funds and challenges posed by  hedge fund investing that were raised in our 2008 reports remain relevant  today.
This statement is based on our January 24, 2008 and August 14, 2008  reports. Specifically, I will discuss: (1) the oversight of hedge fund-related  activities provided by federal financial regulators under their existing  authorities; (2) the potential benefits, risks, and challenges pension plans  face in investing in hedge funds; (3) the measures investors, creditors, and  counterparties have taken to impose market discipline on hedge funds;  and (4) the potential for systemic risk from hedge fund-related activities  and actions regulators have taken to address this risk.
To do this work, we reviewed and analyzed relevant regulatory  examination documentation and enforcement cases from federal financial  regulators. We also analyzed relevant laws and regulations, survey data,  speeches, testimonies, studies, and industry protocols and guidelines  about private pools of capital. In addition, we interviewed officials  representing various U.S. regulators, as well as representatives from  market participants such as commercial and investment banks, large  hedge funds, pension industry participants, credit rating agencies, a risk  management firm, trade groups representing hedge funds and institutional  investors, and academics. We conducted these performance audits from  September 2006 to August 2008 in accordance with generally accepted  government auditing standards. Those standards require that we plan and  perform the audit to obtain sufficient, appropriate evidence to provide a  reasonable basis for our findings and conclusions based on our audit  objectives. We believe that the evidence obtained provides a reasonable  basis for our findings and conclusions based on our audit objectives.
subsections: section_title: Hedge Funds Generally Are Subject to Limited Direct Oversight and the Federal Government Does Not Specifically Limit or Monitor Private Sector Plans’ Investments in Hedge Funds
paragraphs: SEC’s ability to directly oversee hedge fund advisers is limited to those  that are required to register or voluntarily register with SEC as investment  advisers. Registered hedge fund advisers are subject to the same  disclosure requirements as all other registered investment advisers. These  advisers must provide current information to both SEC and investors  about their business practices and disciplinary history. Advisers also must  maintain required books and records, and are subject to periodic  examinations by SEC staff. Meanwhile, hedge funds, like other investors in  publicly traded securities, are subject to various regulatory reporting  requirements. For example, upon acquiring a 5 percent beneficial  ownership position of a particular publicly traded security, a hedge fund  may be required to file a report disclosing its holdings with SEC.
In December 2004, SEC adopted an amendment to Rule 203(b)(3)-1, which  had the effect of requiring certain hedge fund advisers that previously  enjoyed the private adviser exemption from registration to register with  SEC as investment advisers. In June 2006, a federal court vacated the 2004  amendment to Rule 203(b)(3)-1. According to SEC, when the rule was in  effect (from February 1, 2006, through August 21, 2006), SEC was better  able to identify hedge fund advisers. In August 2006, SEC estimated that  2,534 advisers that sponsored at least one hedge fund were registered with  the agency. Since August 2006, SEC’s ability to identify an adviser that  manages a hedge fund has been further limited due to changes in filing  requirements and to advisers that chose to retain registered status. As of  April 2007, 488, or about 19 percent of the 2,534 advisers, had withdrawn  their registrations. At the same time, 76 new registrants were added and  some others changed their filing status, leaving an estimated 1,991 hedge  fund advisers registered. While the list of registered hedge fund advisers is  not all-inclusive, many of the largest hedge fund advisers—including 49 of  the largest 78 U.S. hedge fund advisers—are registered. These 49 hedge  fund advisers account for approximately $492 billion of assets under  management, or about 33 percent of the estimated $1.5 trillion in hedge  fund assets under management in the United States. In an April 2009  speech, Chairman Schapiro stated that there are approximately150 active  hedge fund investigations at SEC, some of which include possible Ponzi  schemes, misappropriations, and performance smoothing. In a separate  speech in April, Chairman Schapiro renewed SEC’s call for greater  oversight of hedge funds, including the registration of hedge fund advisers  and potentially the hedge funds themselves.
SEC uses a risk-based examination approach to select investment advisers  for inspections. Under this approach, higher-risk investment advisers are  examined every 3 years. One of the variables in determining risk level is  the amount of assets under management. SEC officials told us that most  hedge funds, even the larger ones, do not meet the dollar threshold to be  automatically considered higher-risk. In fiscal year 2006, SEC examined  321 hedge fund advisers and identified issues (such as information  disclosure, reporting and filing, personal trading, and asset valuation) that  are not exclusive to hedge funds. Also, from 2004 to 2008, SEC oversaw  the large internationally active securities firms on a consolidated basis.  These securities firms have significant interaction with hedge funds  through affiliates previously not overseen by SEC. One aspect of this  program was to examine how the securities firms manage various risk  exposures, including those from hedge fund-related activities such as  providing prime brokerage services and acting as creditors and  counterparties. SEC found areas where capital computation methodology  and risk management practices can be improved.
Similarly, CFTC regulates those hedge fund advisers registered as CPOs or  CTAs. CFTC has authorized the National Futures Association (NFA), a  self-regulatory organization for the U.S. futures industry, to conduct day- to-day monitoring of registered CPOs and CTAs. In fiscal year 2006, NFA  examinations of CPOs included six of the largest U.S. hedge fund advisers.  In addition, SEC, CFTC, and bank regulators can use their existing  authorities—to establish capital standards and reporting requirements,  conduct risk-based examinations, and take enforcement actions—to  oversee activities, including those involving hedge funds, of broker- dealers, of futures commission merchants, and of banks, respectively.
While none of the regulators we interviewed specifically monitored hedge  fund activities on an ongoing basis, generally regulators had increased  reviews—by such means as targeted examinations—of systems and  policies to mitigate counterparty credit risk at the large regulated entities.  For instance, from 2004 to 2007, the Federal Reserve Bank of New York  (FRBNY) had conducted various reviews—including horizontal reviews— of credit risk management practices that involved hedge fund-related  activities at several large banks. On the basis of the results, FRBNY noted  that the banks generally had strengthened practices for managing risk  exposures to hedge funds, but the banks could further enhance firmwide  risk management systems and practices, including expanded stress testing.
The federal government does not specifically limit or monitor private  sector pension investment in hedge funds and, while some states do so for  public plans, their approaches vary. Although the Employee Retirement  and Income Security Act (ERISA) governs the investment practices of  private sector pension plans, neither federal law nor regulation specifically  limit pension investment in hedge funds or private equity. Instead, ERISA  requires that plan fiduciaries apply a “prudent man” standard, including  diversifying assets and minimizing the risk of large losses. The prudent  man standard does not explicitly prohibit investment in any specific  category of investment. The standard focuses on the process for making  investment decisions, requiring documentation of the investment  decisions, due diligence, and ongoing monitoring of any managers hired to  invest plan assets. Plan fiduciaries are expected to meet general standards  of prudent investing and no specific restrictions on investments in hedge  funds or private equity have been established. The Department of Labor is  tasked with helping to ensure plan sponsors meet their fiduciary duties;  however, it does not currently provide any guidance specific to pension  plan investments in hedge funds or private equity.
Conversely, some states specifically regulate and monitor public sector  pension investment in hedge funds, but these approaches vary from state  to state. While states generally have adopted a “prudent man” standard  similar to that in ERISA, some states also explicitly restrict or prohibit  pension plan investment in hedge funds or private equity. For instance, in  Massachusetts, the agency overseeing public plans will not permit plans  with less than $250 million in total assets to invest directly in hedge funds.  Some states have detailed lists of authorized investments that exclude  hedge funds and/or private equity. Other states may limit investment in  certain investment vehicles or trading strategies employed by hedge fund  or private equity fund managers. While some guidance exists for hedge  fund investors, specific guidance aimed at pension plans could serve as an  additional tool for plan fiduciaries when assessing whether and to what  degree hedge funds would be a prudent investment.
section_title: Pension Plans Seek Various Investment Objectives through Hedge Funds, and Such Investments Pose Challenges That Require Considerable Effort and Expertise to Address
paragraphs: According to several 2006 and 2007 surveys of private and public sector  plans, investments in hedge funds are typically a small portion of total plan  assets—about 4 to 5 percent on average—but a considerable and growing  number of plans invest in them. Updates to the surveys indicated that  institutional investors plan to continue to invest in hedge funds. One 2008  survey reported that nearly half of over 200 plans surveyed had hedge  funds and hedge-fund-type strategies. This was a large increase when  compared to the previous survey when 80 percent of the funds had no  hedge fund exposure. Pension plans’ investments in hedge funds n part  were a response to stock market declines and disenchantment with  traditional investment management in recent years. Officials with most of  the plans we contacted indicated that they invested in hedge funds, at least  in part, to reduce the volatility of returns. Several pension plan officials  told us that they sought to obtain returns greater than the returns of the  overall stock market through at least some of their hedge fund  investments. Officials of pension plans that we contacted also stated that  hedge funds are used to help diversify their overall portfolio and provide a  vehicle that will, to some degree, be uncorrelated with the other  investments in their portfolio. This reduced correlation was viewed as  having a number of benefits, including reduction in overall portfolio  volatility and risk.
While any plan investment may fail to deliver expected returns over time,  hedge fund investments pose investment challenges beyond those posed  by traditional investments in stocks and bonds. These include the reliance  on the skill of hedge fund managers, who often have broad latitude to  engage in complex investment techniques that can involve various  financial instruments in various financial markets; use of leverage, which  amplifies both potential gains and losses; and higher fees, which require a  plan to earn a higher gross return to achieve a higher net return. In  addition to investment challenges, hedge funds pose additional challenges,  including: (1) limited information on a hedge fund’s underlying assets and  valuation (limited transparency); (2) contract provisions which limit an  investor’s ability to redeem an investment in a hedge fund for a defined  period of time (limited liquidity); and (3) the possibility that a hedge fund’s  active or risky trading activity will result in losses due to operational  failure such as trading errors or outright fraud (operational risk).
Pension plans that invest in hedge funds take various steps to mitigate the  risks and challenges posed by hedge fund investing, including developing a  specific investment purpose and strategy, negotiating important  investment terms, conducting due diligence, and investing through funds  of funds. Such steps require greater effort, expertise and expense than  required for more traditional investments. As a result, according to plan  officials, state and federal regulators, and others, some pension plans,  especially smaller plans, may not be equipped to address the various  demands of hedge fund investing.
section_title: Investors, Creditors, and Counterparties Have Increased Efforts to Impose Discipline on Hedge Fund Advisers, but Some Limitations Remain
paragraphs: Investors, creditors, and counterparties have the power to impose market  discipline—rewarding well-managed hedge funds and reducing their  exposure to risky, poorly managed hedge funds—during due diligence  exercises and through ongoing monitoring. Creditors and counterparties  also can impose market discipline through ongoing management of credit  terms (such as collateral requirements). According to market participants  doing business with larger hedge funds, hedge fund advisers have  improved disclosure and become more transparent about their operations,  including risk management practices, partly as a result of recent increases  in investments by institutional investors with fiduciary responsibilities,  such as pension plans, and guidance provided by regulators and industry  groups.
Despite the requirement that fund investors be sophisticated, some market  participants suggested that not all prospective investors have the capacity  or retain the expertise to analyze the information they receive from hedge  funds, and some may choose to invest in a hedge fund largely as a result of  its prior returns and may fail to fully evaluate its risks. Since the near  collapse of LTCM in 1998, investors, creditors, and counterparties have  increased their efforts to impose market discipline on hedge funds.  Regulators and market participants also said creditors and counterparties  have been conducting more extensive due diligence and monitoring risk  exposures to their hedge fund clients since LTCM. The creditors and  counterparties we interviewed said that they have exercised market  discipline by tightening their credit standards for hedge funds and  demanding greater disclosure.
However, regulators and market participants also identified issues that  limit the effectiveness of market discipline or illustrate failures to properly  exercise it. For example, most large hedge funds use multiple prime  brokers as service providers. Thus, no one broker may have all the data  necessary to assess the total leverage used by a hedge fund client. In  addition, the actions of creditors and counterparties may not fully prevent  hedge funds from taking excessive risk if these creditors’ and  counterparties’ risk controls are inadequate. For example, the risk  controls may not keep pace with the increasing complexity of financial  instruments and investment strategies that hedge funds employ. Similarly,  regulators have been concerned that in competing for hedge fund clients,  creditors sometimes relaxed credit standards. These factors can  contribute to conditions that create the potential for systemic risk if  breakdowns in market discipline and the risk controls of creditors and  counterparties are sufficiently severe that losses by hedge funds in turn  cause significant losses at key intermediaries or instability in financial  markets.
section_title: Regulators View Hedge Fund Activities as Potential Sources of Systemic Risk and Are Taking Measures to Enhance Market Discipline and Prepare for Financial Disruptions
paragraphs: Although financial regulators and market participants recognize that the  enhanced efforts by investors, creditors, and counterparties since LTCM  impose greater market discipline on hedge funds, some remain concerned  that hedge funds’ activities are a potential source of systemic risk.  Counterparty credit risk arises when hedge funds enter into transactions,  including derivatives contracts, with regulated financial institutions.  Some regulators regard counterparty credit risk as the primary channel for  potentially creating systemic risk. At the time of our work in 2007,  financial regulators said that the market discipline imposed by investors,  creditors, and counterparties is the most effective mechanism for limiting  the systemic risk from the activities of hedge funds (and other private  pools of capital). The most important providers of market discipline are  the large, global commercial and investment banks that are hedge funds’  principal creditors and counterparties. As part of the credit extension  process, creditors and counterparties typically require hedge funds to post  collateral that can be sold in the event of default. OCC officials told us that  losses at their supervised banks due to the extension of credit to hedge  funds were rare. Similarly, several prime brokers told us that losses from  hedge fund clients were extremely rare due to the asset-based lending they  provided such funds. While regulators and others recognize that  counterparty credit risk management has improved since LTCM, the ability  of financial institutions to maintain the adequacy of these management  processes in light of the dramatic growth in hedge fund activities remained  a particular focus of concern.
In addition to counterparty credit risk, other factors such as trading  behavior can create conditions that contribute to systemic risk. Given  certain market conditions, the simultaneous liquidation of similar  positions by hedge funds that hold large positions on the same side of a  trade could lead to losses or a liquidity crisis that might aggravate financial  distress. Recognizing that market discipline cannot eliminate the potential  systemic risk posed by hedge funds and others, regulators have been  taking steps to better understand the potential for systemic risk and  respond more effectively to financial disruptions that can spread across  markets. For instance, they have examined particular hedge fund activities  across regulated entities, mainly through international multilateral efforts.  The PWG has issued guidelines that provide a framework for addressing  risks associated with hedge funds and implemented protocols to respond  to market turmoil. Finally, in September 2007, the PWG formed two  private sector committees comprising hedge fund advisers and investors  to address investor protection and systemic risk concerns, including  counterparty credit risk management issues. On January 15, 2009, these  two committees, the Asset Managers’ Committee and the Investors’  Committee, released their final best practices reports to hedge fund  managers and investors. The final best practices for the asset managers  establishes a framework on five aspects of the hedge fund business— disclosure, valuation of assets, risk management, business operations,  compliance and conflicts of interest—to help hedge fund managers take a  comprehensive approach to adopting best practices and serve as the  foundation upon which those best practices are established. The final best  practices for investors include a Fiduciary’s Guide, which provides  recommendations to individuals charged with evaluating the  appropriateness of hedge funds as a component of an investment  portfolio, and an Investor’s Guide, which provides recommendations to  those charged with executing and administering a hedge fund program if  one is added to the investment portfolio.
In closing, I would like to include a final thought. It is likely that hedge  funds will continue to be a source of capital and liquidity in financial  markets, by providing financing to new companies, industries and  markets, as well as a source of investments for institutional investors.  Given our recent experience with the financial crisis, it is important that  regulators have the information to monitor the activities of market  participants that play a prominent role in the financial system, such as  hedge funds, to protect investors and manage systemic risk.
Mr. Chairman, this completes my prepared statement. I would be happy to  respond to any questions you or other Members of the Subcommittee may  have at this time.
section_title: GAO Contact
paragraphs: For further information on this testimony, please contact Orice M.  Williams on (202) 512-8678 or at williamso@gao.gov.Contact points for our  Office of Congressional Relations and Public Affairs may be found on the  last page of this statement.
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