Hedge Funds Need Not Be Gated Communities

Broader clientele can benefit from financial expertise
July 26, 2019 Updated: July 26, 2019

Some of the most lucrative parts of capitalist markets are off-limits to most Americans, not because of the money, but because of regulations. Investing in private equity, which includes high-performing vehicles such as hedge funds, is only allowed for the wealthiest among us: those who earn more than $200,000 annually or have a net worth of at least $1 million.

Regular Americans have been unable to invest in some of the world’s most successful tech companies before they went public. Until recently, Uber, Lyft, WeWork, and other startups were the domain of so-called accredited investors, who make up little more than 8 percent of U.S. households. This select demographic owns 70 percent of private wealth in the country—$45.5 trillion.

Being part of this exclusive club grants access to lucrative opportunities in private placements, venture-capital funds, venture-debt funds, and more. Granted, these investments can be riskier than public equity, which are required to extensively disclose internal information and are listed on regulated stock exchanges.

The Securities and Exchange Commission (SEC) claims that its accredited investor regulation limits the exposure of the general unsophisticated investor to private equity for his own good. Startups fail all the time, wiping out the billions in seed and growth capital. The argument goes that the wealthy can afford those losses, while mom-and-pop investors could lose their life savings.

However, Trump’s appointee to chair the SEC, Jay Clayton, believes the time is due for a revision of private-equity rules. “Our retail investors… aren’t having access to those investment opportunities, and over some periods of time those investment opportunities perform better,” he said in an April 9 Bloomberg TV interview. “We want to make sure retail isn’t left behind.”

In June, the SEC issued a 211-page document asking for comments on how to increase access of retail investors—and firms that manage retail money such as mutual funds—to private equity.

Benefits of Private Investment Funds

Even millionaires do not usually buy equity straight from a startup or private firm. They entrust their money to specialized managers in private-equity funds or hedge funds who apply all sorts of investment strategies to maximize returns and minimize risk.

These institutions pool billions from many wealthy individuals and institutional investors and then look for private equity to buy, although they also trade listed stocks, bonds, real estate, commodities, foreign currencies, and financial instruments such as options and derivatives.

Hedge funds stand out from the rest of private funds because they are the Wild West of financial markets. Exempt from many disclosure obligations and limitations that the SEC imposes on other vehicles, they pursue more speculative and daring strategies, investing in virtually anything for a gain. Unlike other funds, they resort to leverage—borrowed money—and short-selling—trading securities they do not own—magnifying the potential for profits or losses.

As with all promises of large returns, hedge funds are not cheap. Management fees are from 1 to 3 percent, and principals take a sizeable portion of annual profits, usually 20 percent after meeting an agreed threshold. Investors must also lock up their money for a year or more.

Hedge funds seek to turn a profit regardless of the overall market’s ups and downs. That is why they are regarded as a good portfolio diversification strategy. In 2018, hedge funds even outperformed the public stock market. They tend to attract some of the highest-paid analysts and traders, who devise innovative investment strategies.

The Need for Greater Access

Some instruments have appeared that speak to the greater demand for hedge-fund prowess. Anyone can buy exchange-traded funds (ETFs), which are either owned by major hedge funds or mimick their investing strategies. Liquid alternative investments or alternative mutual funds offer hedge-fund-like options for retail investors. However, research published in the Journal of Financial and Quantitative Analysis finds they are inferior in wealth creation given higher regulatory burdens and weaker incentives.

The sophistication argument for keeping off retail investors does not hold. These instruments are just as complicated as hedge funds and are readily available. “The true impact of wealth-based qualifications is to prevent retail investors who have a sufficient understanding of hedge funds from reducing risk and maximizing their investment returns,” writes finance law professor Houman Shadab for the Mercatus Center at George Mason University.

Enabling those with proven education or experience in investment, such as registered brokers and investment advisers, to become accredited investors would be a good first step. The JOBS and Investor Confidence Act of 2018 planned to do that, but both houses of Congress could not agree in time on the text, and the bill died. Expanding access further, through a financial literacy test, should be explored.

Companies also need access to capital markets without giving up all their stakes to a few private-equity players. Crowdfunding through online platforms has allowed startups to raise funds in a more democratic fashion.

In 2016, the SEC relaxed rules so non-accredited investors could participate in equity crowdfunding campaigns that start as low as $1,000. However, firms must do so through a SEC-registered intermediary and can only raise $1 million in a year. Retail investors remain tightly limited: someone with a net worth of $105,000 and an annual income of $30,000 can only invest $2,200.

These limits have boosted the rise of fundraising schemes that circumvent regulated capital markets altogether. Initial Coin Offerings (ICOs), Initial Exchange Offerings (IEOs), and Security Token Offerings (STOs) let entrepreneurs sell cryptocurrency directly to retail investors that they can later trade or redeem for company goods and services.

Another worrying trend is that startups are delaying IPOs and remaining private for several years. Many never go public at all. They prefer to compete for the private-equity money up for grabs—$2 trillion. Founders also opt for exit sales rather than jump through SEC hoops and face public scrutiny.

“The number of listed companies peaked in the late 1990s, before the dot-com bust, plummeting 52 percent by 2016,” the New York Times reported in 2018. This means that a tiny slice of investors, arguably those in less need, get to reap the benefits from the meteoric rise of startups.

As the economy evolves, regulations must keep up with the times. Online trading platforms and widely available financial education are lowering the intellectual barriers to participation in private equity. There is no justification for preventing working-class Americans from enjoying the full benefits of capital markets and getting advice from the brightest financial talents.

Fergus Hodgson is the founder and executive editor of Latin American intelligence publication Antigua Report. He is also the roving editor of Gold Newsletter and a research associate with the Frontier Centre for Public Policy.

Daniel Duarte contributed to this article.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.

Fergus Hodgson
Fergus Hodgson
Fergus Hodgson is the founder and executive editor of Latin American intelligence publication Econ Americas. He is also the roving editor of Gold Newsletter and a research associate with the Frontier Centre for Public Policy.