Hedge Funds Disclosure: More Bark Than Bite

Other than the money, it’s a rough time to be a hedge fund manager these days, what with high profile failures like Amaranth, billion dollar paychecks making the front page of the New York Times and panic on the street and in the media about their role in the recent financial crisis. Life was so much better when nobody knew who they were or exactly how they made their money.

Now comes a fresh round of criticism for the latest efforts to improve disclosure and governance. Given the the Bush administration’s laissez-faire approach to financial regulation, it’s par for the course that the President’s Working Group on Financial Regulation gave the job to the hedge fund industry itself. So it should come as no surprise that the recommendations, while laudable, have few teeth and are presented more as recommendations than requirements.

In essence, the group urges that funds disclose hard-to-value assets and provide comprehensive investor disclosure similar to public companies. Full details of the recommendations are available here.

Depending on one’s point of view, the recommendations are either inadequate or an onerous and unnecessary burden on the beleaguered hedge funds.

The guidelines were attacked as a “virtual farce” by Richard Blumenthal, attorney general of Connecticut. He criticized them for “creating a dangerous illusion of oversight” when they are optional, the Financial Times reports.

The pro-hedge fund blog AllAboutAlpha observes that the word “transparency” does not appear once in the document.

The big question now seems to be “will hedge funds adopt the recommendations?” The report leaves little doubt that its proposals are guidelines only. In fact, the word “should” appears 245 times in the report, while the word “must” appears only 11 times.

AllAboutAlpha also cites via Seeking Alpha a defense of hedge funds, based in large part on columns by Sebastian Mallaby of the Council on Foreign Relations, who is writing a book on hedge funds.

Thoughtful people–including one prominent hedge-fund manager I know–believe that regulators should cap permissible leverage in hedge funds, because the temptation to borrow excessively in order to boost returns will otherwise be irresistible.

While hedge funds certainly have fared better than many more traditional financial institutions during the credit crisis, their collective size and lack of transparency is seen by some as destabilizing, even if that is not the intent. A popular Research Recap post on the topic, argued that hedge funds can inadvertently exacerbate risk. According to Randall Dood of the International Monetary Fund, “That is because hedge funds, which invest in largely high-risk ventures, are not transparent entities—their assets, liabilities, and trading activities are not disclosed publicly—and they are sometimes highly leveraged, using derivatives or borrowing large amounts to invest. So other investors and regulators knew little of hedge funds’ activities, while, as FitchRatings put it, because of their leverage, their “impact in the global credit markets is greater than their assets under management would indicate.”

Still, the industry’s problems are hardly slowing them down: The Wall Street Journal reports that hedge funds world-wide had $2.65 trillion in assets under management at the beginning of 2008, up 27% from a year earlier, according to new research compiled by publisher HedgeFund Intelligence.