From: Michael Lorenzen
Securities Exchange Commission Proposed Rule Comment File S7-25-06
I disagree with this proposed rule change and offer the following comments.
Certain levels of sophistication are required to invest in unregistered private offerings. This is a field I work in, and I can confirm that hedge funds are not for unsophisticated investors. They can be quite complex and involve different sets of risks than other types of investments.
I also think it is philosophically wrong to limit the choices of investors based simply upon assets. The rich have advantage enough without limiting the choices of those with fewer assets. One might ask how it is that someone who worked a blue collar job, had never invested in the stock market, but won the lottery of multiple millions, is overnight considered to be “sophisticated” enough for a hedge fund now? It should be noted that in England there are no real net-worth requirements for investing in hedge funds. Investment advisors are required to determine the sophistication and suitability of potential investors regardless of net worth.
There are some U.S. hedge funds that will take a limited number of smaller investors, but frankly not many. So, for all practical purposes, raising the limit does not have that much of an affect on the opportunities for most investors, as there are sadly not enough opportunities available under the current rules.
Also, the SEC proposal specifically exempts private equity funds, as they provide a great deal of the funding for new business in the US. Why do they get an exemption? It should also be noted that private equity funds are in general more volatile and harder to understand than most hedge funds.
It is my contention that the positive values that hedge funds offer to rich investors should also be offered to everyone, within a proper regulatory structure. The current two-class structure (rich or not rich) limits the investment choices of average Americans and makes the pursuit of affordable retirement more difficult than it should be. The rich have a considerable advantage in growing assets for retirement, in that they simply have more assets to begin with. They should not also have an advantage in better investment choices.
Why should 95% (or maybe soon to be 99% if this proposal goes through!) of Americans, simply because they have less than $1,000,000 (or $2,500,000?), be precluded from the same choices available to the rich? Why do we assume those with less than $1,000,000 to be sophisticated enough to understand the risks in stocks (which have lost trillions of investor dollars), stock options (the vast majority of which expire worthless), futures (where 95 % of retail investors lose money), mutual funds (80% of which underperformed the market), and a whole host of very high-risk investments, yet deem them to be incapable of understanding the risks in hedge funds? One might ask how it is that someone who worked a blue collar job, had never invested in the stock market, but won the lottery of multiple millions, is overnight considered to be “sophisticated” enough for a hedge fund now?
The SEC should pursue a rule change that opens the hedge fund field to the individual smaller investor. If you create a situation where they can access appropriate sophisticated advisors, they will do so. Indeed, they attempt to do so now. There are tens of thousands of advisors and brokers who offer investment services to the public. They simply do not have hedge funds as a choice.
To say that there are thousands of funds who are seeking money is not an exaggeration. The problem today is that they must do so privately and only to high-net-worth investors and institutions. The current rules do not allow them to do so, and so they do not. It is not the desire of the industry to be secretive, it is the requirements of the law. Most hedge fund managers would have no personal bias against small investors. The reason hedge funds avoid small investors is primarily legal. The large majority of managers simply want an appropriate amount of money to manage. If the rules allowed for appropriate and knowledgeable investing by smaller investors, they would adjust their programs to accept them.
The decision whether to allow smaller investors the same rights as larger investors should be made in the light of three questions:
1. Is it appropriate?
The premise of Modern Portfolio Theory is that you can smooth out the returns and decrease the risk of an investment portfolio by adding noncorrelated investment asset classes, even if those individual classes are individually highly volatile. Many hedge funds' styles, by any reasonable assessment, are highly uncorrelated with the stock and bond markets. High-net-worth individuals and institutions are taking advantage of this fact by diversifying a part of their portfolios into hedge funds. This reasonable diversification should be made available to smaller investors as well.
No one would suggest that all or even a significant proportion of an investor's portfolio should be in hedge funds. But a reasonable diversification is appropriate.
There is no real reason to believe that smaller investors cannot understand hedge fund strategies, if properly explained. If investors can be assumed to understand the risks involved with individual US stocks, foreign stocks, commodity futures, currencies, options, mutual funds, and real estate, not to mention a host of Reg D limited partnerships, then how can anyone suggest that hedge fund strategies are beyond the ability of investors?
I would suggest that investors can understand quite readily the logic and value of hedging the interest-rate directional risk from a bond fund, or pairing undervalued and overvalued stocks, or hedging a convertible bond. While management competence is the real issue investors should focus on, how difficult is it to understand the concept behind buying undervalued assets in a distressed debt fund?
A hedge fund is a business, generally with a straightforward premise. It is no more, and often far less, difficult to understand than the business risks and plans of typical US-based company (to say nothing of a bio-tech or high-tech firm or international company) than the risks and concepts of a typical hedge fund.
2. Is it the right thing to do?
Most hedge funds have an offshore version with lower minimums. The reality is that investors from Botswana have more and better investment choices than do average US citizens from Boston, Massachusetts.
If you ask the brokers and investment advisors on the front lines of serving the public whether they wish they had access to hedge funds on behalf of their clients during the difficult stock markets of 2000-2002, the answer would be a resounding yes. If you ask investors whether they should be able to make their own decisions - to have the same choices as the rich - the answer would also be yes.
The only people who benefit from limiting investor choice are those who have a vested interest in not facing the competition from hedge funds. As they seek to protect their turf, they have lost sight of the interests of those they should be serving.
Those who oppose allowing average investors to have the same choices as the rich should tell us why lower-net-worth investors are less intelligent or are deserving of fewer options than the rich. They should show why average investors should only be allowed funds which are one-way bets on an uncertain future.
I believe that investors would tell you that not allowing them the same choices as the rich is the type of government protection they do not need.
3. Is it fair and just?
With all the proper regulatory scrutiny being devoted to hedge funds, with the concern of hedge funds that such activities could restrict their investment options and business, it would behoove us to remember the small investor, who is not even allowed a hedge fund crumb from the rich man's table. The focus of future regulation should be to make sure there is an honest game on an even playing field, not to exclude certain classes of citizens.
If you were to tell investors that they would be discriminated against because of their gender or race or sexual preference, there would be an outcry. To put it simply: it is a matter of Choice. It is a matter of Equal Access. It is a matter of Equal Opportunity. Congress should change the rules and allow all investors to be truly equal, at least as to opportunity.
I believe it is time to change a system where 95% (and maybe soon to be almost 99% if this proposal goes through) of Americans are relegated to second-class status based solely on their income and wealth and not on their abilities. This proposal is not the way to make this change. It is simply wrong to deny a person equal opportunity and access to what many feel are the best managers in the world, based upon old rules designed for a different time and different purpose. Perhaps the day is now upon us that the SEC and Congress will see to it that small sophisticated investors are invited to sit at the table as equals with the moneyed crowd instead of moving the table away from them as this proposal would do.