Are Hedge Funds Regulated? The Answer May Surprise You...

I have often seen headlines for incredible gains and shocking losses in the hedge fund industry. Not only that, but sometimes there are multi-billion-dollar scams, like the Bernie Madoff Ponzi scheme in 2008. All of this is enough to make you wonder, are hedge funds regulated?

Hedge funds are regulated, but the regulations are less strict than what we see with other public listings. Hedge funds must abide by certain rules laid out in a handful of investing acts to maintain certain freedoms that are not afforded other investment vehicles like mutual funds. Some of these rules include limits on the types of investors a hedge fund can recruit; others stipulate the number of investors a private listing can have.

Even though funds are regulated, it will still take a savvy investor to decide which hedge fund is a winner and which is a loser, as the disparity between hedge fund gains can be massive. That said, let us get into some laws that define the hedge fund industry.

What Are the Hedge Fund Regulations?

Hedge fund regulation can be complex with some of the oldest rules dating back to the 1930s. On the other hand, the Dodd-Frank act of 2010 has led to some of the most significant regulations in the Hedge Fund space in recent memory. These acts regulate not only the hedge fund industry but alter the way the entire investing market works. In essence, hedge funds are afforded more flexibility than other listings because they are formed around exceptions to the laws.

Investment Company Act of 1940

The Investment Company Act of 1940 came as a response to the Wall Street Crash of 1929. The first mutual fund was established in 1924 and the investment vehicle was massively popular. The ensuing crash that followed this spike in investing led to the worst economic depression in American history. Unfortunately, a lot of the regulations that we have now that mandate the disclosure of financial information from financial companies was not law at the time.

At its core, the act defines what an investment company is, and mandates that those companies disclose information. The act applies to all kinds of investment vehicles, and it helped mold the formation of the modern Securities and Exchange Commission. The act does not just apply to public listing, but also private equity, and even hedge funds.

Under the act, hedge funds must abide by certain rules to be exempted from disclosing financial information. One of the important areas of the law comes from section 3(c)(1). This section exempts hedge funds from being labeled as an investment company. It states that a fund is exempt from the Investment Company Act if it is held by fewer than 100 people.

This is an important exemption from the law because it could impact whether you can buy into a particular fund. Some hedge funds will market themselves as a section 3(c)(1) fund.

Section 3(c)(7) is another key area of the law, and like 3(c)(1), this exemption also limits the number of investors that a hedge fund can have. It also restricts the type of people that can buy into the fund to “accredited investors” and “qualified purchasers.”

Qualified Purchasers

A “qualified purchaser” is someone who has more than $5,000,00 in investments. A company that has more than $5,000,00 in investments and is owned by 2 or more people who are related. Or, importantly, as section 3(c)(51)(A)(iv) states, “A person acting for its own account or the accounts of other qualified purchasers, who in aggregate owns and invests on a discretionary basis, not less than $25,000,00 in investments.”

While some hedge funds limit their investors to “accredited investors,” a qualified purchaser is another way to narrow down who can buy-in. The added restrictions intend to limit those who can buy into a fund to only people that can sustain significant losses.

Accredited Investors

Hedge funds do not face much of the same regulation as other public offerings even if they are similar in investing style; however, they are still monitored by government agencies and subject to some of the same laws. In the US, hedge funds are not allowed to advertise to the general public, instead, they limit the type of people who can sign up to “accredited investors.” Accredited investors are simply individuals that the Security and Exchange Commission deems sophisticated enough to invest in private offers, given the individual’s financial prowess. This normally just means an investor who has a lot of money, like a qualified purchaser, can realistically sustain greater losses.

Not only are accredited investors able to tap into the hedge fund market, but they can also participate in riskier financial machines overall such as angel investing, venture capital investing, and private equity. These vehicles aren’t available to the average investor.

Securities act of 1933 and Securities Exchange act of 1934

The Securities Act of 1933 and the Securities Exchange act of 1934, like many other regulations in the public-facing financial sector, mandates certain reporting standards. However, these standards are circumvented if a hedge fund abides by some restrictions. One such restriction is to sell to accredited investors. While certain types of hedge funds are limited to the number of investors they can have, some can have unlimited investors as long as they are all accredited.

Regulation D Securities act of 1933

Regulation D is where the lifeblood of hedge funds come from. It is the act that allows companies to buy and sell assets without the need to register with the SEC.

While the SEC allows companies to buy and sell without registering with them, those companies are still held to record-keeping standards that help prevent fraud. Companies must provide investors with enough information to avoid fraudulent listings. If a fund provides misleading information, it can face legal action.

The Dodd-Frank Act

In 2015, the Dodd-Frank act allowed the SEC to evaluate what and who was able to register with a hedge fund. The act allowed for meaningful review and led to the adjustment of what was defined as an accredited investor. More than that, under the act, the SEC can continue to review and update the definition for who can invest in these vehicles. These changes have a huge impact on how much capital a hedge fund can generate from investors.

Another important change that the Dodd-Frank Act brought was to eliminate certain exemptions under the Advisors Act. The Dodd-Frank act changes how advisors register. The registration status depends on Asset Under Management (AUM) thresholds. For investment advisors with less than $25 million in assets under management, the advisor will have to be licensed by regulatory agencies in the state they operate in.

If an advisor is only working for a private fund with assets under management of less than $150 million then they will be exempt from registering the SEC. The Dodd-Frank Act increases the threshold from what used to only be $30 million in AUM.

Who Monitors the Hedge Fund Industry?

There are a handful of authorities that watch over hedge funds and monitor for fraud and misleading information. The main agencies are the Commodities Future Trading Commission, the Commodity Pool Operators, and the Commodity Trading Advisory.

The Commodities Future Trading Commission can fine individuals that breach rules around hedge fund management. Recently, the CFTC fined a portfolio manager $700,000 for lying to investors. While hefty fines like this are rare, they are essential in maintaining a safe marketplace for investors who are often left to fend for themselves.

Why Are Hedge Funds Loosely Regulated?

As we’ve discussed, hedge funds are less well regulated than public listing because the types of investors have more funds which insulate them better from significant losses. These hedge funds can participate in riskier behaviors that aren’t available to mutual funds or index funds. Some of these strategies involve increased leverage, debt investing, higher fee structures.

What Are the Benefits?

Hedge funds allow investors to increase overall diversity in their portfolios
Some funds have above-average gains
They can be a great way to have a passively managed portfolio

What Are the Risks?

Less financial information available
Can have very high fee structures that eat into potential gains
Less regulation means that investors need to be more discerning of which funds are quality

Hedge funds are regulated, but the regulations are wildly different from the rest of the investment market. If you can invest in a hedge fund, then you should research the qualifications of fund managers thoroughly. Furthermore, the future of the hedge fund industry is always subject to change.

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Andrew Hutchinson

Andrew Hutchinson is a writer and editor. He is an active investor and is passionate about personal finance. When he isn’t working, Andrew spends his time reading bad sci-fi novels.