Hedging Their Bets, How Hedge Funds Can Curb Critics and Avoid Regulation

Date: Monday, November 24, 2008
Author: knowledge@wharton, Riskcenter.com

Hedge fund managers oversee $1.9 trillion in assets, but no one knows what they invest in or even what those assets are actually worth. That's because hedge funds are not regulated and consequently aren't required to make the same detailed financial disclosures that are required of publicly traded companies. This mystery product comes with a Rolex price-tag. Hedge fund managers generally keep 2% of invested assets and 20% of the profits, known as the "two and twenty rule."

The combination of potentially huge financial rewards and lack of transparency may foster ethical lapses, Thomas Donaldson, Wharton professor of legal studies and business ethics, said during a recent talk on hedge fund ethics. "Remember, some of these are hard-to-value assets, like collateralized debt obligations and credit-default swaps. When you're growing mushrooms in the dark, you might be tempted to paint a rosier picture."

For the week that ended on November 7, hedge fund selling contributed heavily to steep stock market declines. Several prominent hedge funds are facing the double-whammy of demands for cash from both investors and lenders. Those demands force selling of stocks but also are keeping about $400 billion of cash on the sidelines as fund managers brace for the worst.

Donaldson defines hedge funds as "privately owned financial firms that raise money from large investors, including individuals, pension funds and charities, for the purpose of increasing the value of the investment." The definition is broad, he said, because hedge funds are subject to so few limits. "The term 'hedge funds' is a loose-fitting blanket that covers a bewildering array of financial strategies," he noted in a paper that was the basis of his talk. "They are capable of doing just about anything to achieve their ends. They can go long. They can go short. They can hedge currencies."

Hedge fund success depends on thisveil of secrecy, Donaldson said. "Hedge funds systematically deny information to their own investors and to governments in order to protect their competitive advantage." They are not required to file reports with the U.S. Securities and Exchange Commission, although a few have chosen to do so. Most of those voluntary reports, however, are little more than a way of letting regulators know that the fund is in business.

Investors not only do not know what a manager will do with their money, they can't get it out easily. Hedge funds usually impose lock-up periods that require investors to commit their money for a certain amount of time. Lock-ups allow managers to invest in less-liquid assets without worrying that a client will want money back before those assets have matured. Most funds have lock-up periods of one to two years, according to Donaldson.

Lock-ups do not apply to funds of funds, which pool assets to invest in several funds at once. Funds of funds often pool money from smaller investors who can't meet the minimum-asset requirements that individual hedge funds demand. When a hedge fund lock-up ends, investors who want to withdraw their money often can get only part of it. Many hedge funds have gating provisions dictating what percentage a client can take out. A typical gate might say that if redemptions -- investors' demands for their money -- exceed 20%, investors can no longer take money out. Gate provisions are aimed at heading off runs on a fund, which could put it out of business by forcing it to sell assets at fire-sale prices to meet redemption demands.

Missing out on $57 Billion in Fees

Hedge funds operate in private, but they often affect the public. Many market-watchers believe that hedge fund managers -- nervous about holding on to assets overnight -- sold stocks in such massive amounts that they caused the recentsteep declines in the Dow Jones industrial average that haveoccurred repeatedlyjust before the market closed. "It probably does explain the volatility. People have guns to their heads," Donaldson said.

Hedge funds have become such a huge force that they have attracted many critics, including some who complain that hedge fund managers pay too little in taxes. Indeed, they are taxed at the 15% capital gains rate rather than at the 35% income tax rate because most of their income is in the form of capital gains. The huge sums these managers have earned have further fueled the public's outrage, Donaldson said. Stephen Schwarzman, head of Blackstone Group, a private equity firm whose executives are taxed in the same way as hedge fund managers, earned twice the pay of the top five Wall Street executives combined in 2007. "Secretaries at hedge funds often pay taxes at a higher rate than managers," Donaldson said. "It's not a bad business to be in." (That's because secretaries pay income tax rates, which start at 10%, increase to 25% for people earning more than $32,550, and scale up to 35% as incomes rise further.)

Studies show that most hedge fund managers don't have their own money in their hedge funds, raising even more questions about whether they deserve their high pay and lower tax rates. The debate over taxes is so intense that when Donaldson suggested on CNBC that the tax treatment was unfair, the show's producers tagged him as "against prosperity."

Critics have also said that hedge funds "dupe investors with false or misleading claims," Donaldson said, especially about performance. Hedge fund managers woo investors by promising outsized returns, but research suggests that hedge funds as a group don't perform better than other kinds of investments. Donaldson believes few investors hear about such research, but are bombarded with stories of hedge fund managers who take home hundreds of millions in pay when they place winning bets. Even when a hedge fund loses money, the manager still keeps 2% of invested assets, about double the fee charged by a mutual fund. Prominent investor Warren Buffett, in a recent letter to Berkshire Hathaway shareowners, called hedge fund fees "grotesque" and warned shareholders not to expect high returns. Many investors may be unaware of how deeply fees eat into their returns. One study showed that if Buffett had charged hedge fund-style fees during his period as head of Berkshire Hathaway, he would have reaped $57 billion in fees, reducing the return to his investors by 90%.

Some members of Donaldson's audience questioned his use of the word "dupe." One asked whether it's a fair word to use when hedge fund investors don't seem interested in knowing how a manager makes money. Another asked whether it was necessary to worry about risks taken by hedge fund investors, who typically are wealthy enough to withstand large losses. And someone else pointed out that even public companies that were required to report the value of their portfolios often were unable or unwilling to do so, as the recent failures of Lehman Brothers and Bear Stearns show.

Donaldson acknowledged those points and said he would consider changing the word duping to something like "pressures to mislead." He also said that he, too, has few concerns about "a billionaire losing money." But hedge fund activities can ripple throughout the economy. "Hedge funds are alleged to aggravate social crises and cause significant social harm," Donaldson suggested. Many middle-income Americans are exposed to hedge funds through their pension funds, which invest in them. Banks also lend to hedge funds, which may compound risk in the financial system. "There is still a lot of noise buzzing around now that in addition to collateralized debt obligations and credit default swaps, banks may also have on their books [hedge fund] loans they don't know much about."

When the Long Term Capital Management hedge fund failed in 1999, the Federal Reserve was forced to cobble together a multibillion dollar bailout to head off the threat of economic collapse, for example. The meltdown of two Bear Stearns hedge funds in the summer of 2007 also helped trigger a broader financial panic. But it was clear long before then that the funds were on the verge of disaster. According to Donaldson, the economist and New York Times columnist Paul Krugman reported that the Bear Stearns funds "borrowed huge amounts, and invested the proceeds in questionable mortgage-backed securities ... and more than 60% of their net worth was tied up in exotic securities whose reported value was estimated by [the manager's] own team." In April 2008, the federal government bailed out the entire Bear Stearns firm just a few days after the company's chief executive had expressed confidence about its financial health. Federal Reserve chairman Ben Bernanke has worried that the complex web of relationships between banks and hedge funds may cloud the judgment and ability of either side to measure risk accurately.

A 'Microsocial Contract'

Regulation forcing disclosure at hedge funds may seem like an obvious solution, but Donaldson believes it wouldn't work for two reasons that he refers to as "regulatory recalcitrance." First, regulations tend to kill innovation. In the case of hedge funds, the negative effect may be so strong that it destroys most incentives for operating a hedge fund. When investing strategies become public, others copy them, reducing or eliminating the chance to generate big gains. "I want to suggest that there is something to the idea that smart people can create novel strategies, and that this is something to be protected. This is a social good."  Similarly, most societies have stopped trying to regulate the arts because such a move stifles creativity. "Soviet-era governments that attempted to do so paid a high price in the deterioration of artistic quality," Donaldson said.

The second reason: The data-gathering and monitoring required to force hedge fund disclosure would be too expensive and impossible to do effectively. The government would need data, not just from hedge funds, but from most large market participants. And once the government had the data, how would it gauge liquidity risks quickly and accurately? Most societies have abandoned trying to regulate sexual behavior for similar reasons, he said. "I'm not a raving rightist, but I do not want to prevent capitalistic acts between consenting adults." Many economic behaviors, such as bribery, are also difficult to prosecute because they are easily disguised, he said. Cash can be hidden in envelopes. Bribery can take the form of a job given to a relative.

That doesn't mean Donaldson thinks the risks related to hedge fund transparency are unsolvable. He proposes a solution he refers to as a "microsocial contract," an industry standard. In his paper, he said Nike and others in the apparel industry had worked with nonprofit groups and host-country governments to create codes of conduct that improved treatment of workers at suppliers in countries such as China. Another example: The Financial Industry Regulatory Authority oversees securities firms and is composed of industry members, not government. Hedge funds might agree to disclose how much leverage they have, for example. "Industries have been wonderfully adept at designing cooperative arrangements that boost value to industry and to customers and clients."

Some financial firms may worry that if they discuss such changes with competitors, the government will accuse them of antitrust violations. The government could allay this fear by reassuring companies that such discussions will not result in antitrust action, Donaldson noted, adding that as an incentive to talk, hedge funds should realize that avoiding discussions could instead result in restrictive legislation.