A call to embrace tougher standards

Hedge funds may complain, but the Securities and Exchange Commission is on the right track in considering whether to tighten the definition of the so-called qualified investor.
At present, an investor must have an income of $200,000 a year ($300,000 a year for a couple) or investible assets of $1 million to be deemed “qualified” and therefore eligible to seek the high returns promised by hedge funds.
The assumption is that investors who meet these standards are sophisticated enough to understand the risks involved in putting their money into a hedge fund and have the financial wherewithal to recover from any setback that might occur if a fund’s investment strategy fails.
It also assumes that qualified investors understand the complex investing strategies often pursued by hedge funds and are well aware that risk and return generally are bound tightly together.
However, these standards were set in 1982 and haven’t been revised since. Someone earning $200,000 a year in 1982 was doing very well indeed.
Likewise, someone who had investible assets of $1 million was very wealthy.
In fact, in 1982 just 1.3% of households could meet one of these tests. In 2003, 8.4% of households had investible assets of $1 million or more, and the percentage no doubt is higher today.
Simply adjusted for inflation, that $1 million standard should be more than $2 million, while the income standard should be more than $400,000 for a single earner.
In other words, a million dollars isn’t what it used to be. In fact, it has become so commonplace that it is no longer prima facie evidence of investment sophistication.
Furthermore, the definition of a hedge fund has broadened over the past two decades.
Today some so-called hedge funds don’t hedge their risk and, in fact, leverage them. The poster child for what can go wrong in a hedge fund, Long-Term Capital Management LP of Greenwich, Conn., was leveraged to the hilt.
The hedge fund industry may well object to a tightening of the standards. Some will argue that raising the bar will make it more difficult for small hedge funds to get started.
But small hedge funds were started successfully when the current standards were set in place — the successful ones have grown up to be the large hedge funds of today.
It is difficult to see why it would be any more difficult for hedge fund startups today if the standard were inflation adjusted. In fact, the proposed SEC standard of $2.5 million in investible assets can be met by about 1.3% of households — the same percentage as in 1982.
It should be easier to start a hedge fund today than it was in 1982, as hedge funds are far better known now because of all the publicity they have received in recent years. In addition, virtually all large pension funds, endowments and foundations are clamoring to put money into hedge funds.
The hedge fund industry should be lobbying for safeguards to ensure that those who invest in hedge funds fully understand what they are investing in and the possibility that those investments may carry unusual amounts of risk.
It should want to keep out unsophisticated investors or those who can’t truly accept any losses that may occur from investing with hedge funds.
The surest way to attract the attention of Congress and to bring about federal legislation tightening the regulation of hedge funds — the last thing the hedge fund industry should want — is for a hedge fund implosion to wipe out the savings of investors who couldn’t afford the losses and who could credibly claim that they didn’t fully understand what they were getting into.
The SEC has asked for comments on its proposal for raising the definition of “accredited investor.”
Members of the hedge fund industry should think very carefully before they oppose any changes too strongly.
Meanwhile, financial planners and investment advisers also should make their voices heard on the issue. They should let the SEC know if they think their clients are truly sophisticated enough, and have enough resources, to invest in hedge funds.