From: Craig A. Matson
Good morning. This letter serves as a comment and response to the SEC’s proposed File # S7-25-06.
The SEC’s proposed rule changes are targeted at two areas: first, strengthening anti-fraud provisions of the existing regulations and secondly, increasing net worth requirements prior to investment in hedge funds or other performance-based pools of investor capital.
Laws to protect investors against fraud or deceptive business practices are necessary to facilitate legitimate commerce. All are in agreement that full and complete advisor disclosure about investment risks is critical for a full evaluation prior to investment.
My remarks are targeted primarily at the second proposed SEC rule change regarding investor net worth requirements for hedge funds.
The SEC has concluded that enacting laws with high minimum net worth thresholds protects those who are unable to evaluate the investment risks of hedge funds or other performance-based pools of investor money. I believe this premise is fundamentally flawed.
I am unconvinced there is a causal relationship between net worth and financial acumen. In my experience, the investor of normal means has both the ability and willingness to evaluate non-traditional strategies used by sophisticated managers. In many cases the investor of average means will use more realistic definitions of ‘risk’ than do academically-inclined institutional managers and consultants.
It is interesting that many of the country’s wealthiest institutional and private investors were caught as investors in the Long Term Capital Management and Amaranth debacles. If there is a relationship between high net worth and strong financial acumen, how is it demonstrated in these instances? The answer is there is no relationship between net worth and financial savvy.
In truth, the average investor (which includes me) will do exactly what the wealthy investor does prior to investment: ask whatever questions he/she considers to be pertinent. Then the investor will make their investment decision based upon their evaluation. I am not an accredited investor using today’s definition. Yet, I have worked as a proprietary trader for two different investment banks, and believe that I can evaluate investment risks reasonably well. However, I am prevented from investing with the best hedge fund managers because my net worth is insufficient in the SEC’s view.
Many of the world’s finest money managers run hedge funds or charge performance-based compensation. Thus, the SEC’s desire to increase net worth requirements will ensure that only the wealthiest investors have access to the best investment minds. The net worth barriers will not allow the average person the access the wealthy currently enjoy.
Taken as a whole, the performance-based hedge fund industry has produced higher net returns to the investor with much lower account volatility than has the more traditional mutual fund industry. Because these risk-adjusted returns have been superior to those produced by the mutual fund industry, it can rightly be asked ‘why are we erecting barriers to a product that is inherently less-risky? While it is true there have been spectacular failures of highly publicized hedge funds, it is also true there have been equally spectacular failures of long-only mutual funds.
Most investors understand the important of diversifying their portfolio. Since a portfolio of well-chosen hedge funds is producing superior risk-adjusted returns (particularly in down markets), erecting net worth barriers only ensures the average investor will be unable to access the best funds and managers. Because hedge fund managers have more tools and strategies at their disposal, they tend to outperform traditional long-only strategies in bear markets. If the average investor does not have access to hedge funds during these difficult markets, it is likely they will suffer unnecessary losses in long-only funds.
Additionally, because so few investors meet the strident net worth requirements required by the SEC, new business formation by new advisors is impeded. Because only a small percentage of investors currently qualify to invest, many emerging hedge fund managers with talent and innovative, productive strategies are simply unable to attract a sufficient base of clients in a timely way. Unfortunately, many new hedge fund managers leave the industry NOT as a result of deficient performance but for a lack of clients. Eliminating unnecessary investor restrictions and barriers to entry will ensure a stream of innovative new managers entering an industry the investing public has clearly embraced.
The SEC’s intent to ensure truthful and accurate statements and representations should be supported. However, the causal link between personal net worth and financial acumen doesn’t exist and should be abandoned. The investing public has made it clear they want greater access to these managers and strategies. The SEC should assist the investor in its quest to access these managers and not impede it.
In summary, the Investment Advisers Act of 1940 should be sufficiently altered to eliminate unnecessary barriers to entry into performance-based pools of investor capital. As a result, we will see product innovation, the emergence of outstanding new managers, and the justifiable demise of underperforming managers offering non-competitive products. Any attempts to raise the net worth thresholds should be summarily dismissed.
Thank you for taking time to consider my comments on these proposed rule changes.
Craig A. Matson