“Is a puzzlement,” the king of Siam said to Anna in “The King and I.”
He might as well have been talking about how the Securities and Exchange Commission should go about protecting inexperienced investors from esoteric alternative investments, especially hedge funds and private-equity funds.
The first part of the “puzzlement” is whether, in fact, the SEC should take steps to protect the naive investor.
Some will argue that wealthy individuals generally are sophisticated enough to make their own decisions, and don’t need the protection of regulators.
Likely to seek advice
Others will argue that wealthy individuals, who might be tempted to invest in unusual vehicles, are smart enough to find expert help. They generally learned, in the process of becoming wealthy, to get advice from people who were expert in areas where they were not.
Therefore, they most likely will seek expert advice before plunging into
hedge fund or private-equity deals.
On the other hand, some professionals and small-business owners become rich through hard work or luck, or a combination of both, and they remain financially unsophisticated.
Some families that become wealthy through inheritance, and farmers who become liquid when they sell their property to agribusiness companies, often remain naive in term of investing.
All may be tempted to try investing in hedge funds and other instruments that appear to promise better returns than mutual funds, with less risk. Look how many fall victim each year to Ponzi schemes and other scams.
Those arguing in favor of new SEC standards, and defining which investors are qualified to invest in esoteric but well-publicized hedge, private-equity and leveraged-buyout funds, say these groups need protection from themselves and from the less scrupulous members of the financial community.
That is especially true because the price of entry into these investments may be a significant part of their overall wealth, precluding meaningful diversification.
Congress expects the SEC to make rules to protect the average investor — from themselves, as well as from others.
It is unlikely, therefore, that the SEC will walk away from suitability standards. To do so would invite Congress, especially a Democratic Congress, to step into the void with legislation.
The “puzzlement” then becomes: How does it define a suitable investor for hedge funds and other private investments?
Current SEC rules define a suitable investor for a private-investment pool, including hedge funds, based on wealth or annual income.
The definition depends on whether the fund is registered or unregistered and whether it charges a performance fee.
Basically, an investor must have a net worth of at least $1 million, including the value of their home, or an annual income of more than $200,000.
These standards have remained unchanged since 1982. If they were simply adjusted for inflation, the standards would be a net worth of almost $2 million and $400,000 of income. That might be the simplest way to go.
But in addition, the SEC might waive these minimums for investors who work with registered investment advisers. These RIAs would be required to certify that the investors understand their risk-return profile, the nature of the investments in which they are interested and the possible effect of these investments on their financial situation.
The advisers also would certify that the investors were not risking too much of their net worth.
Such a solution would raise a roadblock against inexperienced or unsophisticated investors of modest wealth who might be tempted to plunge into potentially high-risk investments without professional guidance.
Also, it would give them an incentive to seek such guidance.
At the same time, it would leave open the option of their investing in hedge funds and other investments that may have returns with low correlations to the stock and bond markets.
This solution might not be perfect — brokers might complain because they might not be able to sell these investments without registering as investment advisers — but it is better than the current situation.
