Thursday, August 26, 2010

Hedge Fund Disclosure Rules Favors Hedge Funds

The Securities and Exchange Commission nicely illustrates a big problem with regulation: capture. Under the pretext of justice or fairness, the SEC routinely hurts the unorganized plebians vs. the insiders. Consider that it's first commissioner was Joe Kennedy, who made his first fortune off then-legal bucket shop trading tactics. The SEC then sat on a monopoly on equity trading, and mandated commission rates for decades, as well as preventing all sorts of competition. You might remember the SEC in penalizing famous frauds like Madoff, Bayou, and Wood River--after they were exposed as frauds by their own investors. These are the police who show up after you've tackled and hog-tied your intruder, and then take credit for putting him in jail.

SEC rules prohibit hedge funds from mentioning their returns because the rubes who read newspapers and the interweb include 'nonqualified investors' (those making less that $200k per year and are not worth $1MM). This only helps the fraudsters and inhibits competition, and makes investing more complicated. If people knew about Madoff's record many would have highlighted its patent impossibility: you simply could not have generated that kind of return record doing what he said he was doing, and many an assistant professor would have loved demonstrating this.

What are the returns to hedge funds? Who knows, because currently discussing it is not merely discouraged, but illegal! This supposedly helps the widow who might be tempted by the siren song of hedge fund jingles, but any stripper knows that coy concealment titillates much more than brazen reality. Fund X made 100% in 2008? I must find out! The fund's insiders abet the misinformation as required by law by making no comment. The rules are designed to encourage rumor-driven investing. The hedge fund indices themselves have repeatedly been found to contain survivorship bias (see here and here), which makes total sense. Any hedge fund index is more beholden to hedge funds than potential clients, because the funds are not obligated to give them their returns. You don't become an expert in something, without being an advocate in some way, just as all those socialist economics professors pre-1989 generally preferred socialism. Is it surprising they neglect various subsidiary funds of an entity when it fails, because that really wasn't a 'fund', and it wasn't really part of X?

Consider instead if funds could mention their performance. Lying about returns would still be illegal, so, truth telling by those with good returns would be a dominant strategy, and silent firms would look bad because they probably aren't talking for a reason. This would give investors more information about the risks and opportunities available to them.

Current SEC chairman Mary Schapiro came from the NASD, the group that helped keep the exchanged in monopolistic control over order flow well into the internet age. She has always jumped on conspicuous peccadilloes to divert attention from what she should be doing: encouraging vigorous competition. For example, in 2005 she shined the light on Wall Street gift boxes, as if the occasional bottle of wine or golf bag is a big priority. The SEC is involved in the complex 'flash crash' on March 6 2010, when systems were failing, and arcane institutional restrictions on how market trades must be routed ended up in chaos. Her preferred solution: restrict what competitors can offer customers. Brilliant!


Paul said...

Its no wonder we see such little innovation in financial markets. just higher and higher regulatory barriers to entry.

Aaron said...

I agree that hedge fund disclosure restrictions are silly, and not in investor interest. However, I don't think Joe Kennedy had anything to do with bucket shops, and there is nothing wrong with bucket shops. The anti-bucket shop publicity (including silly disgusting stories about the etymology of the name) was spread by their competitors--exchanges--aided by newspapers which derived a lot of business from price listing and advertising.

From 1919 to 1930, Joe Kennedy engaged in stock manipulation, fraud and insider trading. Although that is often described as "legal at the time," it wasn't. There were no specific statutes against it, but it could have been prosecuted under general fraud and conversion principles. No one did that, however.

That activity was not how Joe Kennedy made his first fortune, he did that through business, not finance. It's also not how he made his main fortune, which was from buying real estate during the Depression. Wall Street got Joe from $25 million to $50 million, the real estate brought him up to $200 million (multiply by 10 or 15 for approximate current values).

Anonymous said...

She's just acting on incentives - the more the SEC screws up, the more money it gets.

michael webster said...

You have to understand the history of the disclosure regulations, the due diligence defence, and the growth of the secondary market for securities.

The secondary market for securities would not exist unless the reseller of a security is not liable for the issuer's misrepresentations to the public.

The legal solution to this was to give the reseller a due diligence defence - which required some public disclosure so that there was evidence of the due diligence.

As long as the broker/dealer did the required due diligence, then they were not liable for whatever they failed to turn up, even if it was material to the public.

But there were exemptions to this: a broker/dealer could sell to a "sophisticated party", if the person was the sort that the regulator thought could and ought to perform his/her own pre-purchase investigation. In exchange for this exemption, the broker/dealer agrees to say nothing "to create a public market" for the product.

It would be easy to review these exemptions, find that there is no rational basis for them, and get rid of them.

But, exemptions to the public disclosure rules are what create the need for hedge funds, so they are going lobby anytime soon for the ability to "create a public market" for their products.

Eric Falkenstein said...

michael: I'd agree there's a value to making people accountable for misrepresentation, but as funds can't talk about their returns at all, I don't see how this helps anyone except hedge funds. After all, the crappy funds love this rule.