Hedge Fund Registration: Risky Business
by Peter Schwartz
President of Knowledge Mosaic LLC
n February 10, the SEC rule governing hedge fund registration took effect. There has been much hue and cry about the Commission hastening down the slippery slope toward hyper-regulation of complex markets that it can barely fathom, much less manage. The reality, of course, is that this is a much-needed modernization of the Investment Advisers Act of 1940. The new rule takes only the modest and entirely reasonable steps of understanding the contours of, and establishing very basic disclosure requirements for, a hidden financial universe populated by thousands of hedge funds managing assets of nearly $1 trillion.
What are Hedge Funds?
Hedge funds are unregulated investment pools that for the past 30 years have catered primarily to wealthy individuals and investment institutions such as pension funds, endowments, and foundations—entities of sophistication that do not need the protection of the securities regulations blanketing publicly traded companies and mutual funds. Making use of sophisticated trading instruments and markets (e.g., currency, managed futures, complex derivatives, and arbitrage), the stated purpose of hedge funds is to manage and diversify risk. Hedge funds are also distinguished by fee structures in which hedge fund managers receive a percentage of a fund's capital gains and asset appreciation.
Commission goals for hedge fund registration include collecting vital data on the size and scope of hedge fund activities, preventing hedge fund-related fraud, and managing the emergence of retail markets for hedge funds. Opponents of the new rule, led by dissenting commissioners Cynthia Glassman and Paul Atkins, argue that hedge fund investments are a tiny fraction of the total pool of investment money, hedge fund investors can look after their own interests, the Commission does not possess the resources or expertise to manage this effort, and hedge funds themselves should not bear the cost burden of the new rule.
Given the political direction of the Commission—with Harvey Goldschmid stepping down, William Donaldson perhaps not far behind, and any new Bush appointees likely to favor market-driven solutions over federal regulation—the half-life of the hedge fund registration rule may not exceed a few months. However, with emerging questions about the true performance of these funds, with hedge funds at the heart of late trading and marketing timing scandals, with hedge funds implicated in charges of rigged energy trading markets, and with the haunting story of the big Daddy of hedge funds—Long Term Capital Management—lurking in the background, the issue of regulation is not likely to fade away soon.
Hedge Fund Ecosystems
Hedge funds exist in a financial ecosystem that draws resources from the most powerful players of the international banking system For this reason alone, the influence of hedge funds vastly dwarfs their literal size as measured in assets (although one could hardly call $1 trillion peanuts). Hedge funds work closely with prime brokers, investment banks, and commercial banks, which provide both the extensive back-office support these funds need and the leverage that fuels their performance. The players in this nexus prize their relationships with hedge funds because these funds are largely unregulated, and can therefore operate under a shroud of secrecy the world of high finance desires, and because the relationships are incredibly lucrative vehicles for all parties involved. Recent scandals involving hedge funds have exposed the turning wheels and gears of this financial universe.
Hedge Fund Performance
Princeton professor Burton Malkiel, of the Random Walk Down Wall Street, recently published a study indicating that hedge fund indexes do not accurately indicate the industry's investment performance. Misleading performance figures may be drawing too much money into the funds. There is no meaningful framework for obtaining and verifying information used in hedge fund performance numbers. Performance data are selected arbitrarily, and no performance numbers are included for funds that have gone out of business during a reporting period. The lack of clear reporting standards also reinforces conflicts of interest for managers whose compensation depends upon fund performance numbers.
Measures of fund risk are apparently also skewed, Malkiel suggests, with betas roughly double what the industry reports. He observes that the $1 trillion asset figure commonly assigned to hedge funds—about 4 percent of the total amount of US-based managed assets—also doesn't take into account the extensive use of leverage by these funds. According to Malkiel, hedge funds often dominate trading on the New York Stock Exchange. Although there may be a subclass of hedge fund managers who deserve their outsized fees, Malkiel can find no consistent performance for fund managers over time, and so manager selection risk itself is extremely high. The point to all of these data? Hedge funds, marketed as risk-mitigating investment vehicles, actually rest themselves on a mountain of leveraged risk.
Hedge Fund Scandals
Given their penchant for secrecy, hedge funds have drawn substantial attention to themselves in the past year. Eliot Spitzer's fund investigations turned up hedge funds as players in virtually every market timing and late trading scandal investigated. Investment companies bent the trading rules for hedge funds in exchange for guaranteed business from these funds.
More recently, hedge funds have also been implicated in energy trading scandals, with (unsubstantiated) charges that these funds have manipulated futures markets to generate wide swings in natural gas prices. Even without proof of market manipulation, investigators estimate that speculating hedge funds account for nearly 10 percent of the trades in the natural gas futures market. These instances of special treatment, manipulative behavior, and speculative mania in fragile markets underscore the pervasive and disproportionate influence of many of these unregulated entities.
The Shadow of Long Term Capital Management
The collapse of the famous hedge fund Long Term Capital Management in 1998 reverberates in the background of the current debate about the behavior of hedge funds, and hence the proper way to regulate them. Founded in 1994 by legendary Salomon Brothers bond trader, John Meriwether, along with Nobel laureates Myron Scholes and Robert Merton, LTCM promised to transform the staid world of managed risk by blending the techniques of arbitrage and short-term trading with computer models and massive positions in the markets it played, sustained by phenomenal amounts of leverage (as much as 30x asset levels).
LTCM imploded in 1998, following the devaluation of the Russian ruble and a stampede to higher ground in the global currency markets. In the aftermath, with alarm bells ringing about the potential for a global financial meltdown, a consortium of major financial institutions and investors, guided by the Federal Reserve Bank of NY, assembled a $3.5 billion rescue package for LTCM. The assumption among the participants in this rescue effort, that LTCM was “too big to fail,” speaks to the contingency of the commitment to free markets within the hedge fund ecosystem. It also underscores the unmanageability of the risk that hedge funds assume.
Hedge Funds and Risk
Ultimately, the SEC's modest hedge fund registration initiative rests on an altogether unremarkable insight. Hedge funds market themselves as risk management instruments. In reality, hedge funds embrace risk. The uses of leverage, arcane trading techniques, complex networks of influence within the regulated securities markets, and incomplete and inaccurate performance information heighten risk. The conflicts of interest for managers who must report performance data that affects their compensation heightens risk. Each of these reasons, by itself, is sufficient to justify the SEC's initiative. Those within the hedge fund ecosystem experiencing heartburn about hedge fund registration may want to consider, not the mote in their brother's eye, but the beam in their own.
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Peter Schwartz is President of Knowledge Mosaic LLC, a publisher of regulatory and compliance information websites and news services, including Securities Mosaic, Communications Mosaic, and Energy Mosaic.
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