Ethics in the hedge fund industry is a frequent topic. The reputation of hedge funds is not something that would tip the scales in their favor. But, to be able to discuss are hedge funds evil, they should know what fund tricks and strategies are employed to gain returns. Is it borderline unlawful or morally unsound?
The bad perception of hedge funds comes from their questionable strategies. They often ended up with major financial crises. But, to perceive hedge funds as evil is subjective. They bring their share of good to the financial sector. To put all hedge funds as some financial buggy man can do only a person that does not have the necessary information.
The perception of evil, amoral, or unethical is subjective and it depends on the individual. Someone will look at a certain action and perceive that someone just used the tools available to him. But, to someone else, that is straight unethical. To better understand this topic, we will go into details, so stay with us.
Understanding Hedge Fund Operations and Ethics
To understand hedge funds operations and the ethics behind them it is important to consider two factors. One must understand how the hedge fund works, and what are the principles of their operations. Second, it is crucial to understand the ethical considerations that are behind their tactics and operations.
Hedge funds are structured as limited partnerships (LP) or as a limited liability company (LLC). Those forms of organizations protect hedge fund manager’s personal property from business debts and liability. This is already for someone a sign of amorality. But, investors just as managers are responsible for investing.
The hedge fund fee structure is based on two components. One is a management fee, and the other is a performance fee. A performance fee is the one that pushes managers an extra mile. Ridiculously high-performance fees were the cause of some unlawful actions in the past. However, hedge funds employ high-risk strategies. And those bonuses are a reward for winning in a difficult environment.
Hedge funds offer a wide diversification of the investment portfolio. That is one of the reasons for the input of large amounts of money from investors. Hedge funds are through their tactics and strategies offering high returns. Although some of them may seem unethical, these strategies are within the bounds of the law.
Hedge funds need to tackle high risk by employing risk management strategies. One of these strategies is short selling. This strategy is considered to be controversial for a long time. Short selling has come under further scrutiny by the U.S. Congress in 2021.
Liquidity in hedge funds is a frequently discussed topic. Although hedge funds approach liquidity differently, they are known for their lock-up periods. This means in practice that the investors cannot redeem their investment when they wish. This is a tactic used by hedge funds to protect the investment portfolio. If a significant portion of the investors tried to pull out their investment at the same time, that would cause liquidity issues with the hedge fund.
The lock-up period and redemption timings are often defined by the strategy the fund uses. Long-term strategies demand patience from investors. They cannot harvest any returns from the investments until they come with reasonable returns.
Controversy Surrounding Hedge Funds
Hedge funds are frequently under scrutiny from the public and regulatory bodies. This is due to controversies surrounding their operations. Some of the controversies that became well-known are:
- High levels of risk, and use of leverage.
To amplify their returns hedge funds often use leverage strategy. This borrowed money can bring major returns but can also raise the concern of a systemic risk. - Higher fees when compared to other investment vehicles.
Hedge funds charge a two-component fee. While a management fee is not a problem, frequently a moral dilemma is raised concerning the performance fee. Hedge fund charges for all investments that bring extra returns. This is an incentive for managers to invest in riskier index options. Also, some managers exploit controversial tactics to gain an advantage in the market. From these deals, managers come as extremely wealthy individuals. - Taking higher risks.
To measure a level of acceptable risk is a personal preference. In investment, business managers should determine these boundaries with clients. There are cases when managers do not disclose the risk information to the client. Also, they tend to cross the boundaries that were defined earlier. - Conflict of interest.
There are instances when hedge fund managers manage their investment portfolios. This is a clear conflict of interest in case they are taking advantage of a client on their behalf. Also, exploiting good relations with other financial institutions is a conflict of interest. - Market manipulation tendencies.
There were cases when managers were caused by market manipulation. Rigging markets by insider trading, price manipulation, and collusion among market participants is a common market manipulation. Another approach to market manipulation is front-running. It is also known as pre-hedging or pre-positioning. A manager in that situation gets information from a broker about a forthcoming order on a financial instrument that is going to hit the market. The pump and dump scheme is another example of the unethical influence on the market. This scheme relies on spreading false information about a specific security. The goal is to create a hysteria regarding a security that will pump its price up. Then the managers sell their share of the security at an inflated price. All mentioned market manipulation strategies harm both the market and other investors. - Lack of transparency.
Hedge funds are not heavily regulated like mutual funds. Their managers have enough gray areas to manipulate into. Unlike other types of funds, they usually do not need to disclose their investment strategies or holdings to the public. Furthermore, they are not under the same obligation regarding reporting requirements. - Different and often lower levels of regulatory oversight.
Hedge funds are differently regulated all over the globe. The power of hedge funds is amplified in certain locations due to a lack of regulatory scrutiny. The hedge funds are gladly exploiting those possibilities without considering any ethical or moral dilemmas. Critics of these decisions often point out a lack of regulation as a possible cause of financial instability. - Short selling controversy.
This is a well-known and frequently used investment strategy. Still, it is drawing controversies from investors, regulators, and the general public. The first controversy is the investment approach itself. The investors in hedge funds are betting against the security. This is considered to be contraindicative to traditional investors. They argue that investing in the long-term growth of security is a way to support a company’s growth. Short-selling large shares of stocks of the company can have an impact on the reputation of the company. There were cases where this practice hindered the company’s attempts to raise capital. This is also considered as a way to manipulate the stock market. Short selling can also raise market volatility. This can happen in case the stocks rise, the short-sellers will have to sell them at large losses. Massive short-selling can also cause a conflict with retail investors. These investors can perceive short-selling as undermining the companies that they invested in and causing disruption to the broader market. - Insider trading practices.
Insider trading is a type of trading practice where public company stocks or other securities are traded based on nonpublic information about the company. In some countries, including the U.S. it is illegal to conduct insider trading. In the U.S. there are exemptions, which are based on the SEC guidelines. Nonetheless, insider trading is considered to be unethical. The prime reason is that the investor is using data that are not available to other investors. This practice is granting them a head start.
Take a Look at What Exactly Are Hedge Funds (And Why Are They Always Causing Problems)?:
Ethical Considerations
Legality vs. Morality of Hedge Fund Practices
Legality and morality are two different concepts that are often entwined. When something is legal, that means that it is permitted by the law. Morality objects is a certain action deemed right or wrong. Defining and separating right from wrong has been done since the dawn of time. Still today, this issue is not closer to being resolved.
Another issue that comes in this dilemma is that the law sometimes permits actions that are considered amoral and straightforward wrong. That is why it is difficult to judge the practices of hedge funds. Management in hedge funds is not made from perfect people. There are different sorts of people in all professions.
However, there are instances where hedge funds practices are generally considered to be unethical but lawful. Depending on the fund and the manager they may exploit it or may refrain from doing so. These practices include:
- High-frequency trading (HFT).
This is an investment strategy where hedge funds employ sophisticated algorithms. With them, they are executing a high volume of trades at very high speeds. This can cause shifts in market trends. Other investors can find it difficult to compete in those conditions. It is not deemed illegal, but it is often in the focus. The main reasons are that it causes market manipulation, and is perceived as an unfair advantage. - Short-selling.
As we mentioned, this strategy is legal but can cause numerous problems. They can result in market shifts and companies getting a bad reputation. This frequently creates conflicts with other investors.
Ethical Dilemmas in Investment Strategies
Ethical dilemmas are frequent in the investment industry. Investors and professionals are often faced with decisions that can have both moral and ethical implications. The main propulsion force for those decisions is the pursuit of bigger profits. While chasing profits, professionals often forget about social and environmental factors.
When focusing on the investment strategies, these are the most common ethical dilemmas:
- Investing in controversial industries.
These industries include those with questionable labor practices or bad environmental records. Investing in these companies can cause harm both to the environment and to the employees. Managers of hedge funds often choose to unsee those factors and put profits in the first place - Utilizing short-term strategies for maximizing profits.
The managers use these strategies to earn excessive funds on small price fluctuations. This can have a major bad impact on the company. It can discourage investors from investing in the long-term - Abusing insider information to get an unfair advantage.
Insider information is heavily regulated and forbidden. However, greed for profit is still finding its way to use these tactics. Using insider trading is both against the law and deeply unethical. Conducting it undermines the integrity of the market, and harms other investors - Presenting and marketing complex investment strategies to unsophisticated investors.
Offering complex strategies like derivatives, futures, and activist investments to investors who lack knowledge and experience is unethical. Since no one is forcing anyone into something it is not illegal. Those investors are in most cases unfamiliar with the risks. And those risks can strip them of all their investment money - Choosing to prioritize personal interests ahead of the interest of the client.
Hedge fund professionals have a fiduciary duty to work and act in the best interest of the client. But, when a conflict of interest arises, managers often choose to follow their interests. This is usually the case when a manager has a chance to earn a significant performance bonus. Then he will recommend to the client to conduct an investment that is not always aligned with his best interest. The client will be unaware of this hedge fund trick, which makes this an even larger moral and ethical issue.
To address and resolve these ethical dilemmas one must use a multi-point approach. It includes devising clear rules that are unbiasedly enforced. Also, self-regulation from the industry itself. On the list are education of the investors, transparency, and corporate social responsibility.
Regulatory bodies need to establish a set of rules that will be enforced on everyone. The rules should be developed to deter unethical behavior from hedge fund operators. The U.S. regulatory bodies already implemented several rules. Those are in regard to inside trading, and front-running.
Industry organizations can create a code of conduct. It would aim to prevent amoral and unethical practices for their members. A good example is the CFA Institute which has a code of ethics. It outlines the principles for ethical behavior for investment professionals.
Many hedge funds have already developed a good practice of educating their investors. That helps them in dealing with shifty people that could lead them to making bad deals. The more the investors know, they will be better protected from fraud. Also, that helps them to get higher rates of return money through investing.
Regulatory bodies already introduced stricter regulations regarding investment disclosure and regular reporting. Hedge fund companies should not wait for regulatory bodies to increase their transparency. This approach to business should be accepted in the whole sector. It is an overall good step for the business. Managers should inform investors about possible conflicts of interest. With that, they should explain investment approaches and risks.
If investment companies want to address the problem of investing in controversial companies, they should employ corporate social responsibility actions. These actions would address environmental, social, and governance issues. That way the companies that have those values on their list of priorities will be more attractive for investment.
Regulation and Transparency
Role of SEC in Regulating Hedge Funds
The U.S. Securities and Exchange Commission (SEC) has a major role in maintaining the integrity of the market and protecting investors. The SEC’s reach over hedge funds is wide. It encompasses different aspects of their operations. The most important are registration, reporting, trading practices, and possible conflicts of interest.
- Registration and reporting.
Hedge funds that manage over $150 million in assets under management must register with the SEC as an investment advisor. This is regulated under the Investment Advisers Act of 1940. Hedge funds must file an ADV form. In it is detailed information about business practices, key personnel, and potential conflicts of interest. Registration with the SEC also improves transparency. They are requesting funds to disclose essential information to investors and the public. Based on that information the investors can make informed decisions. The hedge fund is also required to file a Form PV with the SEC. This form encompasses additional information about the fund’s leverage, counterparty credit risk, and other systemic risk factors. Along with the PV form, the fund also has to regularly send reports to the SEC. There are quarterly and annual reports that provide updates on their financial condition, investment activities, and potential conflicts of interest - Inspections and examinations.
The SEC conducts routine periodical checks of financial advisors. The goal is to assess their compliance with the securities laws. These inspections include checking through the fund’s books and records and assessing internal controls. The inspection should show the fund’s compliance with the regulations. If they are not there are repercussion measures. - Monitoring trading practices and preventing market manipulation.
One of the SEC’s functions is to enforce rules against market manipulation and insider trading. These are often attributed to hedge funds and their risky, and aggressive tactics. SEC aims to allow all investors to have the same starting position. The SEC has already conducted numerous actions against hedge funds that were caught in these prohibited practices. The end goal is to create fair market conditions for everyone - Establishing, implementing, and maintaining written compliance policies.
The SEC compliance rule requires hedge funds to establish, implement, and maintain written policies and procedures. These are designed to prevent violations of securities laws. Hedge funds are under obligation to periodically review their compliance programs and adjust them in pursuit of effectiveness - Conducting market surveillance and systematic risk monitoring.
The SEC regularly monitors the market. Their goal is to identify and tackle possible risks that can arise due to fund misbehavior. The SEC is corroborating with other regulatory bodies to improve the overseeing of the markets.
Secrecy Advantage and Its Implications for Market Fairness
The secrecy advantage refers to information that hedge funds have due to their access to non-public information or the use of sophisticated analysis. This advantage can be viewed as a reward for informed investors. Also, it raises concerns regarding fairness and transparency.
Hedge funds often operate with a higher level of informational asymmetry when compared to other investors. This can lead to uneven investment conditions. Hedge funds have access to data, research, and insights that are not available to the wider market. This gives hedge funds a better starting position for making informed investment decisions.
Hedge funds can also employ complex strategies. Those can be combined with the lack of transparency and disclosure. This makes it difficult for the investment competition to anticipate or understand their moves.
This is a case when there is a combination of leverage and limited disclosure. These factors can have an impact on the systemic risk. These strategies can also affect the stability and integrity of the whole financial system. That was already the case when hedge funds partake in a major financial crisis.
The secrecy advantage is making it more difficult for the regulatory bodies to monitor the work of hedge funds. That makes it hard to identify the misbehavior of hedge funds. This results in the inability to control the fairness of the market conditions.
Maybe the biggest risks that come with secrecy advantage are ethical considerations of hedge funds and their operation. This comes with a lack of confidence in the market. With the secrecy advantage, there is no clear responsibility of hedge funds to operate while following transparency and ethical approaches. This raises the question of confidence in market fairness. This can lead to reduced interest in market participation. That factor can have an impact on liquidity and market dynamics.
Investment Strategies and Market Impact
Short Selling: Strategic Genius or Market Manipulation?
Looking at a short selling strategy it can look both like a move of a strategic genius or like a market manipulation. What it will look to an individual will differ from the view angle of this strategy.
Short selling can look like a legitimate investment technique that the fund managers use to manage risk. Short selling allows them to make a profit from declining assets. With it, they are providing a form of risk mitigation in a diversified portfolio.
This technique can also be regarded as a way to increase market efficiency. This is explained by facilitating price discovery. Managers who use this tactic have information about overvalued assets. With them, they correct their value by bringing it closer to its real level.
When looking at short selling as a market manipulation one can argue that it has potential for market abuse. When hedge funds take large short positions, and combine it with spreading false rumors can lead to panic selling. When large amounts of assets are quickly sold that can take a toll on market volatility.
Besides market manipulation, short selling is also attributed to ethical issues. This can be the case when the companies that are the target of massive short-selling are in distress. When they are pressured with these actions, this can only put them into new problems like attracting new investors. Short selling and other aggressive tactics can also harm other market participants.
Short selling has several times had a destabilizing effect on the market. If the market is already in decline it can further amplify it during a financial crisis.
So, how the short selling is perceived is mainly a result of the way this technique is used. The only way to ensure that short selling is employed positively is that it is regulatory overseen, followed by transparency and ethical considerations.
Effects of Hedge Fund Activities on the Economy
Hedge funds have a major impact on the global economy. They influence financial markets, allocation of capital, and economic trends. Hedge fund actions can have both positive and negative effects on the economy.
Positive impacts of hedge funds on the economy include:
- Market liquidity and price discovery.
Hedge funds participate in market liquidity by buying and selling different asset classes. This liquidity helps with trading in the broader financial markets. Hedge funds with their practice of extensive research and analysis help with price discovery. Their investment strategies can reflect their assessments of asset values. Hedge funds this way can lead to more precise pricing in the market - Capital allocation and risk management.
Hedge funds invest in different asset classes and industries. That way they are helping with capital allocation across the economy. This influence on businesses that have the potential to grow can contribute to economic development. Since hedge funds often focus on risky investments they pay additional attention to risk management. While they are employing different risk management strategies, they are contributing to the overall market stability. These strategies also help minimize systemic risk - Job creation and economic growth.
When hedge funds are investing in companies they are providing assets for their development. The infusion of new capital can help these companies create economic growth and with it create new jobs.
When we mentioned the negative impact of hedge funds we were focused on these factors:
- Market volatility and market manipulation.
Certain hedge fund investment strategies like high-frequency trading or speculative strategies can raise market volatility. Major market swings are often the result of hedge funds’ tactics that include rapid trading and taking large positions. They can also pursue marketing manipulation tactics to influence prices for personal gain - Herding and systemic risk.
A combined use of leverage and interconnectedness of markets can contribute to the rise of systemic risk. If several hedge funds employ similar investment strategies that can create a herding behavior. That can affect market movements causing major financial crises - Social and environmental impact.
Hedge funds often do not research the social and environmental practices of the companies that they invest in. These companies often take advantage of people and the environment. When investing in them, hedge funds are implying that they do not care how they make money. They just want to make as much profit as they can, without regard to moral or ethical views.
Controversies and Scandals
High-Profile Scandals and Their Consequences
Hedge funds have been involved in several high-profile scandals over the years. Those often resulted in major global financial crises and forced regulatory bodies to take action. These scandals brought a bad reputation to hedge funds. They also put into question the industry’s transparency, ethical conduct, and risks to investors.
Some of the well-known hedge fund scandals are:
- Long Term Capital Management (LTCM) crisis (1998).
LTCM was a highly leveraged hedge fund. It used complex mathematical models to exploit market inefficiencies. The Russian financial crisis showed that their strategy is deeply flawed. The crisis triggered a global market downturn that caused major losses to the LTCM. This further triggered the destabilization of the financial system. The Federal Reserve had to jump in and conduct bailing out of the fund. This crisis showed how a combination of high leverage and mathematical models can be dangerous as a basis for investment decisions. - Bayou Hedge Fund Group (2005).
This Connecticat-based hedge fund was identified as a Ponzi scheme. The fund’s managers forged large investment returns and defrauded investors for hundreds of millions of dollars. The founders of the fund were convicted of fraud. This case showed the importance of due diligence for investors. It also triggered regulatory bodies to increase regulatory scrutiny of hedge funds - Amaranth Advisors Scandal (2006).
The Amaranth Advisors were a hedge fund that focused on energy trading. It suffered massive losses in 2006 as a result of poor trading decisions and a bad assessment of the dynamics of the natural gas markets. The collapse of a hedge fund resulted in a $6.6 billion loss for the investors. This hedge fund failure pointed to a risk that comes from concentrated positions and complex derivatives trading. - Bear Stearns High-Grade Structured Credit Strategies Collapse (2007).
At the center of this scandal were two hedge funds managed by Bear Stearns. They were heavily invested in mortgage-backed securities. They collapsed due to exposure to subprime mortgages. The failure of these funds contributed to the onset of the 2008 economic crisis. The collapse of these funds resulted in changes in risk management practices - Bernard Madoff Ponzi Scheme(2008).
Bernard Madoff was a hedge fund manager who ran a Ponzi scheme for over a decade. He created fake trading records and defrauded investors for a total of $65 billion. He used money from new investors to pay off the returns of the earlier investors. Bernard Madoff was consequently charged and convicted for investment advisor fraud. The penalty was 150 years in prison and forfeiture of $17.179 billion - Galleon Group Insider Trading Scandal (2009).
The founder of Galleon Group Raj Rajaratnam and his associates were charged for inside trading. They were allegedly obtaining information not available to the public to gain profitable trades. Raj Rajaratnam was sentenced to 11 years in jail, which was the highest penalty for insider trading. His 13 coconspirators were also sentenced to an average of 3 years in prison. This case propelled the SEC to pay additional attention to insider trading. This led to further scrutiny of hedge funds on this bases - SAC Capital Insider Trading Case (2013). Another major case of insider trading was with the SAC Capital hedge fund. Its owner Steven Cohen was charged with inside trading. The hedge fund agreed to pay a $1.8 billion settlement. Additionally, Cohen was barred from handling investments for outsiders
- Archegos Capital Management Blowup (2021).
This management company was functioning as a family office but used many of the tactics that are a signature for hedge funds. Bill Hwang the owner of the fund used leveraged money to invest in stocks of Chinese companies. When the fund collapsed that caused a series of margin calls and forced sales of its holdings. That further led to losses for several major banks and a major impact on the market volatility.
These and other major hedge fund scandals had several consequences. Hedge funds were facing more regulatory scrutiny from regulatory bodies. They imposed heightened oversight and stricter disclosure requirements.
Hedge funds also had to adapt and change their investment strategies. The goal is to avoid mistakes from the past and lower investment risks. These scandals put a dent in the hedge fund’s reputation, which led to increased caution among investors. They demanded increased transparency and accountability from the managers and the industry overall.
Hedge fund managers also placed a higher emphasis on ethical conduct. Also, investment practices were updated for additional responsibility.
Influence of Hedge Funds on Global Financial Stability
Hedge funds can have a major impact on the global financial stability. This is due to the hedge fund’s substantial size, connections with global markets, and variety of investment strategies. They can have a positive impact on the global scale by boosting market liquidity and efficiency. On the other hand, they can also pose a threat to a broader financial system.
Role of Hedge Funds in the Financial System
Benefits and Risks of Hedge Fund Investments
Investing with hedge funds comes with benefits and risks. They are a result of investment strategies, risk management, and overall operation approach. Before investors choose a hedge fund to invest in, they should practice due diligence. They should understand what strategies the fund uses, and understand what risks and benefits those can bring.
Investing in hedge funds is best suitable for investors who have a high tolerance for risk, and can sustain losses. Also, suitable investors are those that do not count on fast investment returns. Often hedge funds use long-term strategies that demand longer time to bring returns.
Benefits of Hedge Fund Investments
- Diversification of the investment portfolio.
Hedge funds invest in different asset classes using a wide spectrum of investment strategies. That is resulting in a highly diverse investment portfolio - The goal of absolute return.
This can be a good and a bad thing due to the risks that come with it. Hedge fund managers aim to bring returns regardless of the market conditions. This is called an absolute return. This approach to investing is acceptable to investors who search for consistently high performance even during periods of market volatility - Using sophisticated risk management techniques.
Since hedge funds use risky investment strategies, they must also employ risk management techniques. Some of these include using derivatives for hedging and leveraging - Active management approach that uses flexibility in investing.
Fund managers have a wide array of investment strategies they can use. They are also using an active management approach which allows them to act in an instant. This combination provides hedge funds an opportunity to capitalize on different market conditions - Fund managers performance-based fees.
Like with absolute returns, this can be viewed from a good and bad perspective. Incentivizing managers to deliver better results is a sound strategy, and it pushes managers to prove themselves. But, this approach can lead to greed and looking first at personal interests. That is why it is good to research a company before investing - Working with top professionals.
Hedge fund managers are top-tier professionals in their line of work. To be a successful hedge fund manager you must have a top education, a lot of experience, and a mindset that is pointed to success. These managers use their knowledge and experience to create the best investment strategies that are not commonly found in mutual fund managers - Diversification through non-correlation.
Some hedge funds aim to bring returns that are not correlated with traditional asset classes. This feature can further diversify the portfolio and lower the investment risk.
Risks of Hedge Fund Investments
- Lack of transparency.
When compared to other investment vehicles like pension funds, ETFs, and mutual funds, a hedge fund’s transparency level is nothing to brag about. This lack of transparency can be a limiting factor for investors. This is due to limited information about funds holdings, and risk exposures - Liquidity risk.
Hedge fund often utilizes investment strategies that involve investing in illiquid or less liquid assets. This is particularly the case when using activist strategies, or when investing in debt. This results in often long lock-up periods when investors cannot redeem their investments. This can be a challenge, especially during market downturns - Heavy reliance on leverage.
Using leveraged money is a frequently used investment approach. With it, managers amplify their investments. This technique can bring massive returns, but it can also result in big investment losses - Difficulty in comprehending the fund’s strategy.
In case investors are novices in the investment world, they can find it overwhelming to comprehend all the complex strategies. This lack of understanding can lead to rushing into unplanned high risks - High manager performance fees.
Mutual fund advisers earn significantly less when compared to hedge fund managers. This is due to performance fees that the hedge fund managers charge when their investments are overachievers - High minimum investments.
To invest in hedge funds an investor must have a high annual income and high net worth. But, besides that minimum investments are often so high that they are limited only to the wealthiest investors. Hedge funds explain this measure by minimizing risk for individuals who cannot withstand possible losses - Fluctuating performance.
Yes, hedge funds come with promises of frequent massive returns. But, in reality, investors do not so often lose their investment or have low returns. Not everything can be attributed to a manager’s mistake. In some cases, the sudden shift in the market can result in once safe investment becoming a loss.
Hedge Funds’ Contribution to Economic Growth
FAQs
Why Are People Against Hedge Funds?
People who are against hedge funds base their opinion on the bad reputation that these funds have in public. A bad reputation is a result of a combination of factors including ethical concerns, economic considerations, and examples of controversial behavior.
These are the most common sentiments for disliking hedge funds:
- Perceived greed and unfairness.
Hedge funds are regarded as greedy because their often sole aim is to maximize returns at the expense of other investors, and the society as a whole. In achieving it they sometimes do not choose ethical means. The high fees that they charge for their services fit into this narrative - Their contribution to inequality.
The sentiment for this accusation individuals often point out that hedge funds work only with very wealthy people. They are helping them to become even richer, broadening the gap between classes - Lack of transparency.
When compared to other investment vehicles, hedge funds have very limited transparency. They do not have to report in detail or provide investors with complex information about their investments and strategies. The lack of transparency can lead to issues like conflict of interest - Potential for destabilization and manipulation of the market.
Hedge funds use large amounts of money through sophisticated investment strategies. In the past, they caused several destabilization of the market through their abuse of the law and ethical principles - Their liability is limited. The organizational structure of the hedge funds in many instances protects them from their own mistakes. This makes it difficult for the investors to hold the funds accountable for their actions
- Their profits are often perceived as unearned.
Critics note that hedge funds would rather be exploiting market inefficiencies for profits than adding value through productive economic activity.
It is important to note that although the hedge fund industry has a bad reputation as a whole, that doesn’t mean that all hedge funds deserve it. Most hedge funds follow the law and uphold ethical and moral standards. The loud minority, like almost always in life, makes life difficult for everybody.
Are Hedge Funds Illegal?
Hedge funds in most jurisdictions are not illegal. They are regulated and their work is overseen to ensure that hedge funds operate responsibly and ethically. Regarding the U.S. the primary regulatory body for hedge funds is the Securities and Exchange Commission (SEC).
In addition to the SEC, there are several self-regulatory organizations (SROs) that govern the hedge fund industry. Some of them, like the Alternative Investment Management Association (AIMA) and the Managed Funds Association (MFA), developed their ethical codes. With them, they enforce the ethical conduct of the fund managers.
Final Considerations
The perception of hedge funds as evil is based on major scandals in the past that impacted the global economy. Since then the way that they conduct business has been under strict scrutiny from regulatory bodies. The goal is to prevent market manipulation and investment fraud.
Hedge funds as an investment playground for the rich is not that easy to understand. Before an individual decides to make a judgement they should have all the facts in place. When that is the case, it is easy to see not only the bad impact but also all the positive influence that these funds have on the economy. Hedge funds are a legitimate investment vehicle, and their purpose is well-defined. Calling it evil is only a prejudice.
