Editor’s Letter : Trimming the Hedges

Over the past few months calls for regulation of the booming hedge funds industry have been becoming louder. Some are looking to regulate the industry directly, others, such as the New York Federal Reserve, are focusing their attention on the banks that service the hedge funds industry. In a recent speech, for excample, the head of the New York Fed, Timothy F. Geithner, urged banks not to relax their credit terms or ease up on their due diligence in their rush to win hedge fund business (see Milestone, page 8.)

While their proposed solutions may differ, their concerns are based on the same fact: Investing in hedge funds has become wildly popular recently. Frustrated by the recent lackluster performance of equities, investors, from individuals to giant public pension funds, are hungry for the fat returns for which hedge funds have become famous.

The potential problem is that many investors who are buying into hedge funds appear to have little conception of the sorts of risks they might be takingpartly because relatively few people really understand how hedge funds work. It is hardly surprising, then, that the regulators are taking an interest in this fast-growing and confusing sector.

Given that the regulators role is to protect investors, they are absolutely right to want to clamp down on irresponsible behavior. The dilemma they face is how to tighten their control without strangling the industry. Hedge funds, by their very nature, rely on being lightly regulated in order to turn in the extraordinary returns for which they have become known.Tighten up the regulations and the funds become less nimble and, almost certainly, less successful.

In light of this, the New York Feds approach is spot on. Of course, banks should be extremely careful in their dealings with hedge funds. And of course, in their excitement to jump on a multi-billion dollar bandwagon, some will be tempted to let their standards slip rather than risk missing out on a potentially juicy piece of business. By shaking up the banks, the Fed may be heading off a potential disaster that no amount of regulation of the hedge funds would avert. Geithner should be congratulated for devising a sensible solution to a thorny problem.

Until next month,

Dan Keeler