Hedge Funds, ‘unsophisticated’ investors, Brexit and the AIFMD

This article is based on some research done by the author whilst working at Her Majesty’s Treasury but which has since been modified and articulated for public consumption.

Although Brexit is not without its significant risks, it does also carry significant opportunity for positive regulatory and legislative reform. Rodrigo Zepeda (2014) published the article “To EU, or not to EU: that is the AIFMD question” in the Journal of International Banking Law and Regulation and reading this recently particularly opened my eyes to the regulatory landscape faced by the Hedge Fund industry due to the European Union through (partly) the Alternative Investment Fund Managers’ Directive (AIFMD) which impacts Hedge Funds disproportionately. Although the author works to evaluate the benefits and costs and concludes that, in the medium-term, it will not be harmful to the Hedge Fund industry and that it will undoubtedly provided a harmonised regulatory and supervisory framework across the EU, there are far more problems highlighted within the paper such as disclosure requirements, liquidity- and risk-management requirements and so on that, to my mind, can help foster serious systemic risks (financial, economic, (human) security, etc.) in light of my previous contention that money, goods and services are instruments of expectations-management.

The author also extensively cites Shadab’s (2009) paper, “The Law and Economics of Hedge Funds: Financial Innovation and Investor Protection”, at the Berkeley Business Law Journal in support of unregulated or relatively less-regulated Hedge Funds. On balance, although Zepeda (2014) believes that the AIFMD is not as harmful as it could be, the wider principle of restricting risk-management (and, therefore, expectations-management) techniques to a particular types of investors will inevitably lead to systemic imbalances and exacerbate the detrimental impact of financial crashes. Indeed, we have often observed that, during crashes, though everyone suffers, the poorest suffer the most whilst, although the rich do often lose a lot of wealth, since they often have a greater range of options through which to manage risk and expectations more broadly, they do not suffer as badly.

Policy suggestion: To allow Hedge Funds to access a greater range of retail investors directly and, therefore, to allow all retail investors to invest in Hedge Funds directly rather than being forced to only have indirect access through their investments in other institutional investors (such as pension funds). This would naturally mean that such investors would have the option of choosing to exempt themselves from government-mandated investor protections if they feel that that would serve their preferences better.

Rationale

  • So that Alternative Investment Funds (which includes Hedge Funds, Private Equity Funds and Real Estate Funds) to have access to a greater range of investors and the fact they would have access to a deeper portion of households in the UK than they do anywhere else would make it more attractive to remain (invested) in the UK despite Brexit-associated risks.
  • Usually only institutional investors or the very wealthy can invest in Hedge Funds because it is suggested that they are too ‘complex’ and ‘risky’ for ‘unsophisticated’ investors – however, Hedge Funds have, generally, a record of weathering downturns very well. However, the contention that many retail investors are not ‘sophisticated’ enough to take risks with their money by investing in Hedge Funds directly, for example, stems from the assumption and belief that people on lower incomes or who do not conform to a particular standard of financial education need to be protected from malpractice. On the one hand, this is a fair and just presumption but, on the other hand, protection through restriction of choice is merely tyranny masquerading as protection. As such, the full range of investors should be allowed to educate themselves accordingly and have the opportunity to manage risk accordingly.
  • Since many Hedge Funds tend to perform relatively well during downturns, this would also mean that more retail investors would have the ability to manage their risk and weather the risks of a potential Brexit-associated slump more effectively by having a wider range of options available to them.
  • Whereas those retail investors were previously indirectly exposed to Hedge Funds through the institutional investors they are allowed to invest in, their having direct access to Hedge Funds would also mean that there would be a greater consumer surplus (since, currently, the institutional investors will pay management and performance fees to Hedge Funds that they invest in on behalf of ‘unsophisticated’ retail investors and then they charge their own fees on top of it for that investor whose money is pooled).
  • The worry that Hedge Funds take massive risks with investors’ money may even be offset if they are allowed to access a greater range of retail investors and, if certain Hedge Funds do choose to offer their services to a wider range of customers rather than an exclusive clientele, fund managers may have even more natural incentive to manage risk appropriately since the people whose money they may lose will suffer relatively more from those losses than their currently ‘exclusive’ clientele. As such, this could actually work to reduce the systemic risk of the Hedge Fund industry rather than simply making a greater ranger of retail investors more directly exposed to it.

Concluding Remarks

Finally, although the analysis here uses Hedge Funds as a case study because of some rudimentary research into a particular set of EU regulations, I do think that this has wider applicability when we consider even more specific applications of the theory of money as an instrument of expectations-management in addition to Free Banking (which would be amongst the most desirable scenarios in terms of a genuine choice of multiple monies through which agents can manage expectations and risk optimally and be largely free of prevailing, enforced and imposed price controls). Indeed, there is much more to be said in terms of providing more choice to agents through which they can manage their expectations optimally (especially if we are expecting a financial crash so that we can dampen the potential fallout).