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

Houman B. Shadab
2009
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
more » ... deral 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.
doi:10.15779/z387s20 fatcat:u2ehbu2iobhrllgmg3kfwe6x24