	Hedge Funds Generally Are Subject to Limited Direct Oversight and the Federal Government Does Not Specifically Limit or Monitor Private Sector Plans’ Investments in Hedge Funds

SEC’s ability to directly oversee hedge fund advisers is limited to those  that are required to register or voluntarily register with SEC as investment  advisers. On the basis of the results, FRBNY noted  that the banks generally had strengthened practices for managing risk  exposures to hedge funds, but the banks could further enhance firmwide  risk management systems and practices, including expanded stress testing. Plan fiduciaries are expected to meet general standards  of prudent investing and no specific restrictions on investments in hedge  funds or private equity have been established. Updates to the surveys indicated that  institutional investors plan to continue to invest in hedge funds. Several pension plan officials  told us that they sought to obtain returns greater than the returns of the  overall stock market through at least some of their hedge fund  investments. In  addition to investment challenges, hedge funds pose additional challenges,  including: (1) limited information on a hedge fund’s underlying assets and  valuation (limited transparency); (2) contract provisions which limit an  investor’s ability to redeem an investment in a hedge fund for a defined  period of time (limited liquidity); and (3) the possibility that a hedge fund’s  active or risky trading activity will result in losses due to operational  failure such as trading errors or outright fraud (operational risk). Pension plans that invest in hedge funds take various steps to mitigate the  risks and challenges posed by hedge fund investing, including developing a  specific investment purpose and strategy, negotiating important  investment terms, conducting due diligence, and investing through funds  of funds. According to market participants  doing business with larger hedge funds, hedge fund advisers have  improved disclosure and become more transparent about their operations,  including risk management practices, partly as a result of recent increases  in investments by institutional investors with fiduciary responsibilities,  such as pension plans, and guidance provided by regulators and industry  groups. The creditors and  counterparties we interviewed said that they have exercised market  discipline by tightening their credit standards for hedge funds and  demanding greater disclosure. However, regulators and market participants also identified issues that  limit the effectiveness of market discipline or illustrate failures to properly  exercise it. In  addition, the actions of creditors and counterparties may not fully prevent  hedge funds from taking excessive risk if these creditors’ and  counterparties’ risk controls are inadequate. These factors can  contribute to conditions that create the potential for systemic risk if  breakdowns in market discipline and the risk controls of creditors and  counterparties are sufficiently severe that losses by hedge funds in turn  cause significant losses at key intermediaries or instability in financial  markets. Regulators View Hedge Fund Activities as Potential Sources of Systemic Risk and Are Taking Measures to Enhance Market Discipline and Prepare for Financial Disruptions

Although financial regulators and market participants recognize that the  enhanced efforts by investors, creditors, and counterparties since LTCM  impose greater market discipline on hedge funds, some remain concerned  that hedge funds’ activities are a potential source of systemic risk. Some regulators regard counterparty credit risk as the primary channel for  potentially creating systemic risk. At the time of our work in 2007,  financial regulators said that the market discipline imposed by investors,  creditors, and counterparties is the most effective mechanism for limiting  the systemic risk from the activities of hedge funds (and other private  pools of capital). For instance, they have examined particular hedge fund activities  across regulated entities, mainly through international multilateral efforts. Finally, in September 2007, the PWG formed two  private sector committees comprising hedge fund advisers and investors  to address investor protection and systemic risk concerns, including  counterparty credit risk management issues.
Why GAO Did This Study

In 2008, GAO issued two reports on hedge funds--pooled investment vehicles that are privately managed and often engage in active trading of various types of securities and commodity futures and options contracts--highlighting the need for continued regulatory attention and for guidance to better inform pension plans on the risks and challenges of hedge fund investments. Hedge funds generally qualified for exemption from certain securities laws and regulations, including the requirement to register as an investment company. Hedge funds have been deeply affected by the recent financial turmoil. But an industry survey of institutional investors suggests that these investors are still committed to investing in hedge funds in the long term. For the first time hedge funds are allowed to borrow from the Federal Reserve under the Term-Asset Backed Loan Facility. As such, the regulatory oversight issues and investment challenges raised by the 2008 reports still remain relevant. This testimony discusses: (1) federal regulators' oversight of hedge fund-related activities; (2) potential benefits, risks, and challenges pension plans face in investing in hedge funds; (3) the measures investors, creditors, and counterparties have taken to impose market discipline on hedge funds; and (4) the potential for systemic risk from hedge fund-related activities. To do this work we relied upon our issued reports and updated data where possible

What GAO Found

Under the existing regulatory structure, the Securities and Exchange Commission and Commodity Futures Trading Commission can provide direct oversight of registered hedge fund advisers, and along with federal bank regulators, they monitor hedge fund-related activities conducted at their regulated entities. Although some examinations found that banks generally have strengthened practices for managing risk exposures to hedge funds, regulators recommended that they enhance firmwide risk management systems and practices, including expanded stress testing. The federal government does not specifically limit or monitor private sector plan investment in hedge funds. Under federal law, fiduciaries must comply with a standard of prudence, but no explicit restrictions on hedge funds exist. Pension plans invest in hedge funds to obtain a number of potential benefits, such as returns greater than the stock market and stable returns on investment. However, hedge funds also pose challenges and risks beyond those posed by traditional investments. For example, some investors may have little information on funds' underlying assets and their values, which limits the opportunity for oversight. Plan representatives said they take steps to mitigate these and other challenges, but doing so requires resources beyond the means of some plans. According to market participants, hedge fund advisers have improved disclosures and transparency about their operations as a result of industry guidance issued and pressure from investors and creditors and counterparties. Regulators and market participants said that creditors and counterparties have generally conducted more due diligence and tightened their credit standards for hedge funds. However, several factors may limit the effectiveness of market discipline or illustrate failures to properly exercise it. Further, if the risk controls of creditors and counterparties are inadequate, their actions may not prevent hedge funds from taking excessive risk and can contribute to conditions that create systemic risk if breakdowns in market discipline and risk controls are sufficiently severe that losses by hedge funds in turn cause significant losses at key intermediaries or in financial markets. Financial regulators and industry observers remain concerned about the adequacy of counterparty credit risk management at major financial institutions because it is a key factor in controlling the potential for hedge funds to become a source of systemic risk. Although hedge funds generally add liquidity to many markets, including distressed asset markets, in some circumstances hedge funds' activities can strain liquidity and contribute to financial distress. In response to their concerns regarding the adequacy of counterparty credit risk, a group of regulators had collaborated to examine particular hedge fund-related activities across entities they regulate, and the President's Working Group on Financial Markets (PWG). The PWG also established two private sector committees that recently released guidelines to address systemic risk and investor protection.