The Un-Democracy of Hedge Fund Investing

Australia and Switzerland do it. So do Hong Kong and Singapore. Even Ireland's into it.

What exactly is it?

Allowing individual investors to invest in hedge funds.

But in the U.S., the movement is in the opposite direction with the S.E.C. contemplating an increase in the net worth requirement for hedge fund investment from $1 million to $2.5 million. This would reduce the number households eligible to invest in hedge funds from 8.5 percent to under 1.3 percent.

Houman Shadab, a research fellow at George Mason University, thinks that's the wrong move. If anything, knowledgeable retail (i.e. individual) investors should be given more access to hedge funds, he argues.

The S.E.C. created the gate around hedge funds to protect individual investors from the unique risks associated with hedge fund investment such as trading in derivatives and currencies and leveraging to magnify returns. But to a sophisticated -- but not wealthy -- investor, access to these strategies would help in diversification and would actually reduce portfolio risk, says Shadab.

There's also a bit of hypocrisy in the way investors are being "protected": How much difference is there between opaque behemoths like Citigroup and General Electric and your average hedge fund? The information necessary for a seasoned investor to make decisions (availability of data on past performance, the correlation of returns with the larger market, net asset value) is largely available.

And while hedge fund-like investment vehicles like hedged mutual funds and clones are available to individual investors, none of them offer all of the characteristics of hedge funds under one roof.

So how to remedy the situation?

Shadab proposes a fund of hedge funds open only to sophisticated investors. This fund would be listed on a private exchange like those recently introduced by Goldman Sachs and Nasdaq. The fund would charge performance fees, use substantial amounts of leverage, keep significant flexibility in trading strategies, and place limitations on the ability of investors to redeem capital.

For all intents and purposes, the S.E.C. defines a sophisticated investor as a wealthy one -- a person who has the financial wherewithal to "fend for themselves." That rule should be tweaked, argues Shadab, so that any investor, after filling out an application stating that they understand the risks involved, could trade on the private exchange.

It is extremely unlikely that an investor without a sufficient understanding of hedge fund investments would go through the trouble to register for a retail hedge fund trading platform.

Shadab also proposes increasing the 499-entity limit for private investment vehicles to ensure that trading in this fund of hedge funds would be sufficiently liquid.

You can read the more nuanced portions of his proposal here.

What do you think? How long before we live in a world where Renaissance, Citdadel and SAC are as unsexy as Vanguard, Fidelity and Janus?