Hedge Funds Can't Reveal Secrets and Do Business

Date: Wednesday, October 17, 2007
Author: Matthew Lynn, Bloomberg.com

Oct. 17 (Bloomberg) -- Transparency is the aspirin of the political and regulatory worlds: Whatever the problem, one small dose of disclosure will often fix it.

The latest patient? Hedge funds, those lightly regulated private pools of capital whose power and influence have ballooned in financial markets over the past few years.

Amid a clamor for more rules governing the funds, if regulators and trade groups in the U.K. get their way, we may soon find out more about how the funds work. We'll know their strategies and the companies they are investing in.

But hold on. Is that really fair, or wise? After all, a certain amount of secrecy may well be what made hedge funds so successful. If you get rid of that, you will either drive the whole industry offshore or kill it.

That won't stop people from trying.

In the U.K., the second-most-important center for the hedge- fund industry after the U.S., the Hedge Fund Working Group was set up by some leading firms. Its members include Man Group Plc and RAB Capital Plc, and the chairman is Andrew Large, a former deputy governor of the Bank of England. Last week, it published a draft voluntary code of conduct for the industry.

Hedge funds need to provide more information on how they value their assets, the risks they take, and also the strategies they are following, according to the group. ``Disclosure is at the root of all our recommendations,'' it says. ``Managers should ensure appropriate levels of disclosure and explanation in the funds' offering document about its investment policy.''

Duty of Disclosure

They aren't the only ones who think the funds should be telling the world more about what they are doing. According to a report in the Financial Times, the U.K.'s Financial Services Authority, which regulates the nation's financial industry, may allow companies to force disclosure from hedge funds that have built up a stake in the business, even if they have done so through derivatives contracts rather than by buying shares.

Likewise, German Finance Minister Peer Steinbrueck has been trying to get the Group of Seven industrialized nations to demand more transparency from the funds. And, in September, Joseph Yam, chairman of the Hong Kong Monetary Authority, said in a lecture he was unhappy with the levels of disclosure from the funds.

That is about as close to a consensus that the financial regulators get. But is it really right that hedge-fund managers should have to disclose more and more of what they are up to? After all, politicians and celebrities claim a right to some privacy. Why not hedge funds as well?

No Cure-All

There are good reasons why transparency may not be the cure- all it is portrayed as.

First, asking a hedge fund to reveal its ``strategy,'' as the voluntary code does, is like asking Coca-Cola Co. to reveal its formula, or Microsoft Corp. to unveil its code. It isn't incidental to their business: It is central to it.

Of course, the funds might simply be forced to put up some meaningless twaddle on a Web site: something like ``We are committed to outperforming our benchmark index'' or ``Our vision is to deliver consistent alpha.'' If they say anything meaningful, however, they are surely giving away genuinely competitive information. Why should they be forced to do that? It's the only thing they have that makes them special.

Next, investors are already required to disclose shareholdings in companies. Now hedge funds may be forced to disclose when they have bought a stake using derivatives. But won't that just move the whole problem back a stage? Before long, investment bankers will be offering derivatives of derivatives, and then putting an option on them.

Tell the World

The truth is, sometimes investors want to acquire a block of shares in secret. If Rapacious Hedge Fund LLP thinks shares in Conglomerated Widgets are undervalued, why should it tell the whole world it is buying them? Isn't that giving the game away?

Lastly, too much emphasis on transparency may crush innovation. It is difficult to try out new ideas when you are constantly under the spotlight and open to attack. Away from the limelight is usually where new things happen. Why should they reveal more than, say, commercial banks, which don't advertise whom they have lent money to or how much?

For all the criticism they face, there is no real evidence that hedge funds have made the markets less stable. The facts point in the opposite direction: As the funds grow in power, the markets become more stable, not less. In August, when stock prices dropped on concern that U.S. subprime lending was leading to a credit squeeze, it was the heavily regulated banks that got into the most trouble. With a few exceptions, the ``risky'' hedge funds weathered the storm a lot better.

What problem exactly is all this disclosure trying to fix? Hedge funds have encouraged innovation and diversity. Too many demands for more transparency may threaten the very qualities that made them worth having in the first place.

To contact the writer of this column: Matthew Lynn in London at matthewlynn@bloomberg.net .