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- Title
The Law and Economics of Hedge Funds: Financial Innovation and Investor Protection.
- Authors
Shadab, Houman B.
- 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 company that is not subject to the full range of restrictions on investment activities and disclosure obligations imposed by federal securities laws, that compensates management in part with a fee based on annual profits, 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, their historical performance 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. subprime mortgage market transformed into an international financial crisis, the value of 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 argues that the beneficial outcomes hedge funds attain for their investors are largely 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 its investors. Applicable federal laws enable the funds to pursue innovative investment strategies by 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.
- Publication
Berkeley Business Law Journal, 2009, Vol 6, Issue 1, p240
- ISSN
1548-7067
- Publication type
Article