The Law and Economics of Hedge Funds: Financial Innovation and Investor Protection

Abstract

A persistent theme underlying contemporary debates about financial regulation is how to protect investors from the growing complexity of financial markets, new risks, and other changes brought about by financial innovation. Increasingly relevant to this debate are the leading innovators of complex investment strategies known as hedge funds. A hedge fund is a private investment pool not subject to the full range of restrictions on investment activities and disclosure obligations imposed by the federal securities laws, that compensates management in part with an annual performance fee, and typically engages in the active trading of financial instruments. Hedge funds engage in financial innovation by pursuing novel investment strategies that lower market risk (beta) and may increase returns attributable to manager skill (alpha). Despite the funds’ unique costs and risk properties, the historical performance of hedge funds suggests that the ultimate result of hedge fund innovation is to help investors reduce economic losses during market downturns. In 2008, as losses from the U.S. mortgage market transformed to an international financial crisis, global equities dropped 42 percent while hedge funds worldwide lost a comparatively smaller 19 percent for their investors. By increasing investors’ ability to maximize risk-adjusted returns, hedge funds advance the same goal that federal investor protection regulation seeks to advance. This Article shows that the economic outcomes attained by hedge funds are in part attributable to the legal regime under which they operate. The hedge fund legal regime includes not only federal securities law but also the entity and contract law provisions governing the fund, its manager, and investors. Federal law applicable to hedge funds enables the funds to pursue innovative investment strategies employing the trifecta of leverage, short sales, and derivatives. The entity and contract law governance of hedge funds provides high-powered incentives for fund managers to engage in and capture the gains from financial innovation while maintaining a relatively healthy balance between risk taking and risk management. A general lesson from the law and economics of hedge funds is that when a legal regime permits financial intermediaries to be flexible in their investment strategies and aligns the incentives of investors and innovators through performance fees and co-investment by managers, financial innovation is likely to complement investor protection without wideranging regulation. The role of the funds in advancing the same goal as investor protection suggests that they should legally be available to a broader class of investors.