Hedge Funds Should Be 'Regulated Out of Existence'? Time for a Reality Check 14 comments
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A lot of commentators - particularly in the mass media - have blamed hedge funds for the financial crisis. But unfortunately, their rhetoric is often very knee-jerk and lacks the necessary detail to actually make their arguments convincing. So in our yearning for a cogent argument against hedge funds, we were very excited to read this column yesterday by Kiplinger.com contributing columnist Steven Goldberg called “Ban Hedge Funds?”
But alas, Goldberg’s arguments don’t wash. In fact, they’re so stained with apparent indignation toward hedge funds that we felt a need to document the fallacies and half-truths raised in the piece. As players in financial markets, hedge funds - like mutual funds, banks, pension funds, and individual investors - are all accomplices to the calamities. But the cause? I guess that you can find research to prove anything. But here’s our take on the arguments raised by Goldberg…
Claim: “Much of the demand for what Warren Buffett years ago termed ‘financial weapons of mass destruction’ came from hedge funds.”
Reality Check: Depends on what you mean by “much”. According to this 2006 table from the British Bankers Association (cited by academic Houman Shadab in this paper), hedge funds were responsible for less than a third of the CDS market. (see related post)
Claim: “The funds typically charge annual fees of 2%, plus 20% of all fund gains.”
Reality Check: Just this week, the Economist cited HFR data showing the average hedge fund management fee was really only 1.55% (about the same as a mutual fund). Data firm, Barclayhedge recently produced this chart that shows less than a third of hedge funds charge 2% or more in management fees (see related post). [click to enlarge chart]
Claim: “To make those huge profits, many hedge funds use leverage, sometimes to the tune of 20 to 1 or even 30 to 1…”
Reality Check: Goldberg is careful with his wording here, writing that “some” hedge funds use high leverage and that it has recently dropped. But there is no hiding from his thesis that (all) “hedge funds should be banned.” So let’s revisit overall hedge fund leverage. In this post, we included several charts showing hedge fund industry leverage, including this one from Morgan Stanley showing that leverage was closer to 2:1 even in the halcyon days for the hedge fund industry (some estimates have it as high as 3:1 overall).
Claim: “When the market began to drop in earnest last fall, hedge funds often sold blue chips — because the managers could sell them without disrupting their prices as much as they would affect the prices of less-liquid investments had they sold them.”
Reality Check: This is also true for countless other investors. Harvard, for example, reduced its equity allocation by 80% in Q4. Blaming hedge funds sold liquid securities before illiquid ones is like blaming individual investors for not selling their real estate holdings before their large cap equities. In addition, long/short equity funds - the largest single category of funds - tend to be long small caps and short large caps. So when they closed out their positions, they would have also had to buy-back significant amounts of blue chip stocks.
Claim: “It was Lehman’s bankruptcy that brought on the worst financial crisis since the Great Depression. Hedge funds are enormous participants in short sales.”
Reality Check: Again, Goldberg has done his homework and points out that short selling “keeps markets honest.” But once again, he uses a specific transgression - naked shorting that he associates with Lehman’s demise - as an argument that (all) “hedge funds should be banned.” Like his leverage argument above, this amounts to cherry picking. Using Goldberg’s own logic “hedge funds are enormous participants in…(a process that)…keeps markets honest.”
Claim: “Those who are well-connected enough to invest in the few good ones can, indeed, profit from hedge funds — and diversify their investments. But most of the hedge funds available to common folk aren’t worth nearly what they charge.”
Reality Check: While is does appear that Goldberg thinks hedge funds deliver both profit and diversification, he seems to suggest that those in a more accessible regulatory wrapper (a long/short mutual fund for example) are too expensive. But as mutual funds, these vehicles charge no performance fee and have management fees that are generally in line with the mutual fund industry. If he is suggesting that “common folk” can only invest in lower quality hedge funds than the well-connected, then he must surely be an advocate of opening up the industry to retail investors, allowing broader marketing and making “good” hedge funds part of his clients’ portfolios.
Claim: “…people in the mutual fund business have done pretty well for themselves without helping to bring the global economy to its knees.”
Reality Check: Not so fast. While it’s true that hedge funds punch above their weight in capital markets due to higher portfolio turnover, to suggest that mutual funds have not had any role in the financial calamity is disingenuous. Of course they have. According to a report by the Investment Company Institute, net outflows from equity and balanced funds in Q3 and Q4 of last year was around US $350 billion.
According to Morgan Stanley and HFR data cited by Pensions & Investments (see related post), net hedge fund outflow over this period was a comparable US $390 billion. Sure, hedge funds were levered up more than mutual funds. But clearly - as financial markets players - mutual funds and hedge funds both played a role in the market mayhem of the past year.
None of these “reality checks” is bullet proof. Far from it. But after reading Goldberg’s column, we were left a lingering desire for someone to take on hedge funds using real data and facts, not opinion and conjecture often reinforced by the echo chamber of the mainstream media.
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This article has 14 comments:
But they stand in serious need of regulation to ensure that their activities do not conflict with the public interest. Further, a comprehensive investigation of naked short-selling, CDS manipulation and rumor-mongering is long overdue. If such an investigation is performed, hedge funds will be prominent among the offenders.
The proposed changes in the regulation of OTC derivatives, to include record keeping and audit trails, is a promising beginning.
it is generally true that hedge funds deliver profits in up markets. so do the stocks i own. so when does the next up market arrive?
'comprehensive investigation of naked short selling, CDS manipulation & rumor mongering is needed' - agreed.
'hedge funds need regulation to ensure that their activities are not inimical to the public interest' - agreed.
nuff said.
> jack
If you regulate naked shorts, you should regulate naked longs. It takes a lot more guts to go short. Something must be wrong. In fact, Lehman would have collapsed without the hedge funds selling. Hedge funds just saw the gambling at Lehman for what it was.
Hedge funds provide capital for emerging markets abroad and here at home, because of the intelligence, high motovation, and less risk aversion of their subscribers.
Its dead wrong to even talk about "banninig" hedge funds. They are an engine of growth, and thjose which are defectove simply disappear as being market inappropriate. The government has little business dictating the public interest. The public interest requires that such capital be readily available, not stymied by Obama's ideas of "wealth redistribution" as opposed to "wealth creation."
The Hedge Fund spin of the federal morality police reminds me of the prohibition era. Water was no subsitute for wine, and its time to start pointing that out to the fools who think otherwise, or America is about to take up parallel station with Zimbabwe in terms of future living standards, and this recession will last for 40 years instead of 5.
Enough of this Nationalist Socialist ideology in terms of redesigning our capital markets. This foolishness needs to be met head on and "wrassled" down.
Cheers,
C7
Hedge Funds, Naked Shorts, and outrageous Exec pay and severance packages for horribly shoddy and often immoral "work" has gone way too far. Stocks that we bought for long term holdings, such as C&S National Bank and Barnett Bank, rock solid, conservative, turned into Bank of America, high risk gambles in markets real bankers never ventured.
You will say "we" (the disgusted American investors, not gamblers) want to throw the baby out with the bath water. Yes, if that baby is soaked in the bath water filth of greed and deception, yes, throw the baby and Mama from the good old American train of morality, honesty and good will to all. Hokey, but better than the alternative, the "ME First" generation of wild hedgers and naked short sellers. Wall Street is not about gambling and investing should not be gambling.
Good Bye, from Goody Two Shoes, a Marine Corps Captain.
Capital is like water in that it flows along the least obstructed path to its desired end. Just as boulders in a stream force water to find a new path, money will always flow away from and around regulation. And the bigger the stream [money], the more it crashes and cuts against anything in its way. If it isn't "hedge funds" it will be some other river bed and form of gravity that carries this greed to its desired end. Soooo….
Let's stay focused on the real problem and that is a constantly outdated regulatory system and that systems seeming inability to un-tether itself from the political process as well as the political and financial elite. Because, after all, if we really wanted to solve the problem it would be as easy as defining the (smaller) playing field and tossing-in a few simple rules that even allow for murder and (financial) suicide. Make all the money you want, continue to slit your collective wrists (which they would), just don't step off the field of play or break the simple rules to win. My first rule would be, if you want to remain unregulated, unaudited… then you do not have access to our (regulated and orderly) financial markets. It is access, after all, that makes them 'too big to fail.'
But here are a few suggestions for starters:
* We're bringing back Glass-Stegall, separating the banking system from the 'shadow' banking system. Period. One we protect, one we don't. Everyone in attendance (like banks) must decide on which side of the white line they want to be, player or spectator, but not both.
* Deal with outside investor money? Then we're forcing you to register and submit to the same regulation and oversight as broker/dealers do. Period. You know, the stuff we would all desperately love to avoid (like margin requirements, suitability, FINRA audits, net capital rules, Reg T, compliance departments, the ridiculous arbitration process….).
* We're bringing back trading curbs, (a stronger) 'up tick' rule and tighter margin requirements. OK, so maybe they really didn't work and it's not that we don't trust you, but….
* Unlike today (e.g., Maddoff), all operational processes must be outside and arms length to include clearing, trustee and accounting. Just like an individual account at a B/D, customers will receive no less than quarterly statements from an outside clearing firm.
* And then there's that whole audit process (or lack thereof). Any firm over $100MM will be required to have outside AUDITED annual financials as well as audited return calculation. We all know there is huge error in average industry return calculations (as a result of, e.g., survivor bias and hit or miss reporting).
And those are just a good start. Call yourself a "hedge fund," long/short, quant, buy/write… it's just a name. But you want access? You want to step outside your limited field of play? Then you play by a tougher set of rules. Sorry about that.
Partners are welcome and encouraged to contact any of these independent sources for more detail and answers to any questions or concerns they may have.
All we do is trade. Full disclosure solves the fraud problems.
But then banks became "invest-banks!" And like the investment firms that housed them, they took on a whole new carnival atmosphere! We were now convinced ( or at least that's what the billion-dollar Madison Avenue ad-heads tried to convince us) that money could be " created." A whole world of creations sprang forth in such an array alphabetic abbreviations(IPO,CDS,... descriptionnd predication. Only those that concocted the charades understood the charades. Although in retro-spect,maybe even the panderers felt duped.
Where the hedge funds the top perpetrators? Whocares? They were one more perp among many.Let's get rid of allPonzischeme and shell-gamers. If this leaves half of Wall Street empty, so what?We can start with congress next. These people are not the "creatorsof wealth," the are the destroyers of lives!
> jack
Shorting keeps markets honest. But what does naked shorting do? The above quote conflates regular shorting and naked shorting as though they were the same thing.
I think it would be terrible to ban hedge funds or even over regulate them. But I also think that the SEC should put a VERY tight leash on naked shorting. My favorite solution is to require a 1 hour delivery of shares sold short, with immediate cover & stiff fines for failures to meet the 1 hour deadline.