Do Hedge Funds Give Rise to Externalities?

As mentioned in several earlier blog posts, I have very strong opinions on the issue of hedge fund regulation. As discussed in Wednesday's New York Times, Christopher Cox, Chairman of the SEC, made several particularly interesting comments during Tuesday's Senate hearings:

“I am concerned that the current definition, which is decades old, is not only out of date but wholly inadequate to protect unsophisticated investors from the complex risks of investment in most hedge funds,” he[Cox] said.

...

The commission has the authority to investigate any kind of fraud it suspects, but the court’s decision to throw out the registration requirement limits its ability to conduct routine exams and improve its understanding of the industry.

...

The Treasury Department, meanwhile, has formed a group to examine potential risks in the industry, including the exposure that many large banks could have to certain trades. The group, which first met a few weeks ago, will work with members of the hedge fund industry and the banks who manage their accounts. 

...

[Randal K. Quarles, under secretary for domestic finance at the Treasury Department] said one risk he saw was embedded leverage, or bets that hedge funds have taken with derivatives that are less apparent on the balance sheet. 

Now I could sit here and address Mr. Cox's comments one by one, but I think the entire issue here can be addressed through a single word, a powerful economic concept called externalities. Per Wikipedia:

In economics, an externality is the effect of a transaction between two parties on a third party who is not involved in the carrying out of that transaction. Externalities can be either positive, when an external benefit is generated, or negative, when an external cost is generated from a market transaction.

An externality occurs when a decision causes costs or benefits to stakeholders other than the person making the decision, often, though not necessarily, from the use of common goods (for example, a decision which results in pollution of the atmosphere would involve an externality). In other words, the decision-maker does not bear all of the costs or reap all of the gains from his or her action. As a result, in a competitive market too much or too little of the good will be consumed from the point of view of society. If the world around the person making the decision benefits more than he does, such as in areas of education, or safety, then the good will be underprovided; if the costs to the world exceed the costs to the individual making the choice in areas such as pollution or crime then the good will be overprovided from society's point of view.

So, to me the real question is - "Does the hedge fund industry give rise to externalities that warrant government regulation?" Tom Evslin, himself a free-marketeer, recently had a great post on externalities and provided classic economic arguments for where government regulation might be warranted (even for those in favor of free markets).

For externalities to be present in the hedge fund industry, the crux of the argument has to revolve around those who are impacted by hedge funds but themselves are not directly involved in hedge funds. This would seem to break down into two core constituencies:

1. non-accredited investors who are indirectly invested in hedge funds through pension plans and other pooled investment vehicles; and


2. market participants of all types who are potentially effected by the trading activities of hedge funds and its impact on the global financial markets.

Interestingly enough, I would say that these two constituencies are generally the focus of the more rational arguments I’ve seen for regulating hedge funds, and I’ll briefly explain my views on each.

Non-accredited investors : Chairman Cox raises the issue of protecting the individual (read: unsophisticated and non-accredited) investor. I buy this argument as long as we are talking about what constitutes an unsophisticated investor. The accreditation requirements go a long way towards separating those for whom investing in hedge funds is appropriate and those for whom it is not, and it probably does make sense to raise the net worth and income thresholds. Ok, now what? Most of the arguments I've seen have to do with non-accredited investors indirectly investing in hedge funds through their holdings in pension plans, which themselves invest in hedge funds.

Ah, now we're getting somewhere. This could be an externality, right? But wait, pensions fund managers, they are, what is that word, fiduciaries. Hmmm, maybe it is their responsibility to make sure that their investments are being managed properly and their constituencies are being protected. And they are sophisticated, right? They either have large in-house investment teams or smaller teams that leverage the work of “skilled” pension consultants like Mercer, Hewitt, Hennessee, Cambridge Associates, etc.

So is there really an externality here? My answer - NO. Why use regulation to protect people who themselves are protected through the accreditation standards, and whose agency involvement (via indirect investment through pension funds) is being represented by those who are legally responsible for looking after their best interests? Seems like overkill to me.

Market participants: The above article addresses a number of issues relating to hedge funds’ impact on the financial markets, which clearly effects investors everywhere whether or not they are invested in hedge funds. The article mentions the SEC’s power to investigate fraud (and, in fact, other concerns) in the absence of explicit regulation, as well as the Treasury Department’s newly-formed group “… to examine potential risks in the industry, including the exposure that many large banks could have to certain trades.” This group will also include hedge funds. I saw this first-hand in my earlier career in derivatives and trading, where both the SEC and Treasury interviewed myself and several of my colleagues (in trading, structuring and prime brokerage) to ask questions, investigate issues and collect data on hot-button issues, i.e., concentration of risk, number of unconfirmed trades, KYC/AML procedures, etc. Let me tell you, this kind of tacit regulation and review works like a charm. It is not “check the box” regulation – it is sitting eye-to-eye with someone who has the power to make your life very, very painful. When your internal counsel gets a call from the SEC, Treasury or the OCC, you hop to it, get your ducks in a row and prepare to be grilled. This is a healthy process and keeps people on their toes, knowing that they can get a call at any time.

And the interesting thing is that while hedge funds themselves might not be “regulated” in the classic sense (though in my earlier post about regulation, I argue that hedge funds are, in fact, effectively regulated), their key trading counterparties and liquidity providers – the banks and prime brokers – are. Further, the principal engine of growth in hedge fund AUM – pension funds and endowments – are fiduciaries, who themselves are legally on the hook for protecting their constituencies. So I really don’t see how those with the power, authority and responsibility for protecting and preserving the integrity of U.S.-based institutions’ impact on the financial markets don’t already have the requisite tools at their disposal. So is this a true externality? I don’t think so.

One final comment on this issue of regulation to protect investors from bad behavior: Through legislation, the SEC filing process and coordination with the FASB (the body which promulgates financial accounting rules), the government has already taken extensive steps to regulate public companies and mutual funds (presumably, the argument being that individual investors themselves can't influence what happens inside a corporation or a mutual fund and, therefore, needs to be protected). Let's take a quick look at their record in using regulation to address perceived externalities in the financial markets: (1) Enron; (2) WorldCom; (3) Cendant; (4) Every company ensnared in the options-backdating scandal; (5) and about 5,000 other examples.

Oh, and let's not forget the issues with Directors' conflicts in mutual funds, the mutual fund market timing scandal, just to name a few. How often have we read statements to the effect of, "Hedge funds have an unfair advantage over mutual funds because they are less transparent."  I'll tell you - a lot, and this contention is a bunch of baloney. Time and time again it has been proven that "regulation by filling in forms" works poorly. The simple act of filling in a form doesn't ensure honesty, integrity or presentation of substance over form.

It is time that people both inside and outside the Beltway wake up to the fact that regulations, while appropriate where externalities exist, are not a panacea and should not be solely relied upon to ensure good behavior. Investors themselves need to do their homework, and those in the position of fiduciary responsibility need to be held accountable for doing the homework on behalf of their less sophisticated constituents. Further, the government already has very powerful and effective tools at their disposal outside of formal regulation, and from personal experience I can tell you that this process – periodic meetings with members from the SEC and Treasury, similar to that used by the FSA in the UK – is very effective. Let’s focus on the goal here, folks, and not simply create another opportunity for ill-conceived and costly legislation to dampen an essential and vibrant marketplace.

Comments

[Jack Doueck, Stillwater Capital]

Roger,
I don't think the accredited investor rules are trying to ensure that an investor can withstand a loss. They are trying to ensure that the investor is experienced enough not to be taken advantage of in a high-risk investment. So I believe my example still holds.
Jack Doueck
Stillwater Asset Backed Strategies
Stillwater Capital

[Roger]

Jack, you make an excellent point. While my posts indicate my preference for self-regulation, the accredited investor standard is one element which I firmly believe has to exist and, to your point, has to work and make sense. The fact that your case study easily punches a hole in the current rules and is not terribly uncommon (at least as far as Robert is concerned) is reason enough for the SEC to re-vamp the accredited investor rules. I guess the key question is, notwithstanding Robert's level of business knowledge, if his net worth is sufficiently large to protect him against potential losses from poor hedge fund investments. I am sure your answer would be, "He could lose money investing in a long-only portfolio of common stocks as well." My answer to you would be "good point." I don't have the answer but I really like the question.

[Jack Doueck, Stillwater Capital]

Does being an Accredited Investor actually make you a Sophisticated
Investor?

Robert Smith is 41, well educated having gone to Harvard and then Yale for
his masters. Lives in Minneapolis with his wife and two kids. Owns is
home, makes $150,000 a year and works hard as an analyst for a mutual fund.
Has $750,000 in savings, reads the Wall Street Journal every morning and
watches CNBC all day.

Jenny Burns is 21, skipped collage to pursue her "acting" career. Lives in
California, loves MTV and VH1, rents her apartment, watches Charmed and The
OC. Has never taken a business class, never read a business magazine or
paper and doesn't understand the difference between an equity and
bond.thinks the stock market is like Costco. Last month she inherited $1.1
million dollars from her grandmother.

Guess who the "Sophisticated Investor" is under the law??? You got
it: JENNY.

Under the current "Accredited Investor" rules, Jenny is considered the
Sophisticated Investor and can invest in some of the best and brightest
hedge funds around, while Robert can not. For some strange reason the
government is under the impression that just because someone has money, it means that they must be able to understand and analyze investment choices!
There should clearly be an updating of the current rules and regulations
that more realistically reflects the true definition of a "sophisticated
investor" and takes into account knowledge, intelligence and education.

Jack Doueck
Stillwater Asset Backed Lending Division