Hedge Fund Regulation, Performance, and Risk-Taking: Re-Examining the Effect of the Dodd-Frank Act

Abstract

This paper examines the effect of the Dodd-Frank Act (“Dodd-Frank”) on the profits and risk-taking of the hedge fund industry. Dodd-Frank subjects most hedge funds to government inspections, requires them to register with the Securities and Exchange Commission (“SEC”), and imposes a number of disclosure and compliance obligations. According to the SEC and other authorities, these measures were intended to protect investors from misrepresentation of fund performance and increase the control of systemic risk; but the industry opposed the law, claiming that compliance costs would substantially affect the profitability of the industry and that the new obligations were unnecessary given the relatively sophisticated nature of hedge fund investors. The empirical evidence on the effect of Dodd Frank on profitability and risk-taking, however, is limited. This paper, therefore, contributes to filling this gap. The results show that, relative to a control group of funds that were already regulated or largely exempted from regulation, the newly regulated funds experienced a significant decrease in reported profits but not in risk (as proxied by volatility). The funds that became subject to the obligation to file Form PF (a new form created as part of the implementation of Dodd-Frank, which focuses on performance and volatility data) actually experienced a decrease in risk, but this result should only be interpreted as suggestive given some limitations of the data. In addition, the analysis suggests that the decline in reported profits among the newly regulated funds was not driven by compliance costs, as predicted by the industry. Rather, the results indicate that the decline can be reasonably attributed to greater conservativism in financial reporting. Taken together, the results contradict some commentators’ suggestion that the reduction in reported returns following Dodd-Frank represents a “partial government failure.”