Hedge funds have seen their share of debate and controversy
over the years, but none so much as after the year 1998. That was when
Long-Term Capital Management, a speculative hedge fund in Connecticut, failed and
required bailout from other financial companies and institutions. The failure
of LTCM, which had been using absolute return strategies, shook up the
financial industry, and many were gravely concerned about the future of hedge
funds. When information about LTCM’s practices, including evidence of tax
avoidance, became public knowledge, the media, the general public, and even
some of the financial sector were up in arms about ramifications to the hedge
fund industry.
Some saw the collapse of Long-Term Capital Management, and
their alleged illegal activities, as a sign of pending doom for many other
hedge funds. The bailout, which was under the supervision of the Federal
Reserve, ended up costing financial institutions over three and a half billion
dollars – and it was a desperate measure to stop the rest of the financial
market from experiencing difficulties. The ultimate losses of LTCM cost around
four and a half billion dollars, and the hedge fund eventually went under in
2000. With such a huge scare, and such a huge bailout, there was great concern
about systemic risk (the whole financial system failing). Any hedge funds who
acted similarly to LTCM were considered, by some, to be at risk of failure.
Multiple hedge funds requiring bailout to stave off systemic risk was a very
real possibility at the time. However, LTCM was the major failure and the
biggest bailout to date, and there has not been any systemic failure before or
after LTCM.
The fear of systemic risk is far from the only criticism
that hedge funds have seen. A major concern with critics is the fact that there
is so little transparency required in hedge funds. For one, it makes it
difficult to track average performance of hedge funds when so few
comprehensively disclose information. For another, a lack of transparency can
mean a bigger opportunity for fraud, and there have been several big cases of
fraud in the last several years that critics cite as evidence that there should
be more disclosure and more regulation. However, hedge funds remain private
investments, and are not – in most circumstances – required to divulge
information to a third party. There is also a concern of conflict of interest
in cases where Americans do not use third parties to act as custodians or
administrators of their funds; in some such cases of proven conflict of
interest, there have been allegations of fraud and securities violations.
Hedge funds may be debated in the public realm, and may be
occasionally subjected to new rules and regulations, but it remains fairly unregulated
compared to other investment types. Unless hedge funds are some day no longer
considered private investments, there is no sign of this changing in a major
way. The SEC does investigate allegations of insider trading and other
fraudulent activities when it can, but it is not as involved with hedge funds
as many would prefer.
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