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Home > Hedge Funds Serve Very Little Useful Purpose Except to Make a Few
People Very Rich
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Hedge Funds Serve Very Little Useful Purpose Except to Make a Few People
Very Rich
By David Dayen [1] / The American Prospect [2]
May 3, 2016
In the pilot episode of the Showtime drama Billions, a CNBC host grills
Bobby Axelrod (Damian Lewis), founder of the hedge fund Axe Capital, at a
public forum. "How do you respond to the criticism that hedge funds are the
scavengers of the financial sector, and that a select few have undue
influence on the markets?"
"We're not scavengers," Axelrod replies. "We're white blood cells scrubbing
out bad companies, earning for our investors, preventing bubbles. A hedge
fund like mine is a market regulator."
This claim invites an important debate: Do hedge funds represent an asset to
the larger economy, or a menace? Do they really help make markets more
efficient and transparent, or do they just exploit opportunities at the
expense of other investors?
There are roughly 11,000 such funds-investment vehicles that control a mix
of client dollars and borrowed money, with a corporate structure that
exempts them from most investment-company regulations. We know that hedge
funds have made a small subset of financial titans fabulously wealthy. The
top hedge fund executives make a billion dollars a year or more. Hillary
Clinton and Bernie Sanders are fond of saying on the campaign trail that the
top 25 hedge fund managers earn more than all of America's kindergarten
teachers combined. But does this orgy of wealth create value, or merely
extract value, at the expense of workers, companies, and other investors?
A fictional television show with revenge plots and emotional tumult and the
usual allotment of Showtime-mandated soft-core pornography has more pressing
concerns than these. It's beyond the show's scope to explain how hedge funds
became such a disruptive force in our economy and our politics, or to
distinguish them from other investment firms, rather than using them as a
signifier for "Wall Street jerk." In fact, amid the twists and turns,
Billions barely even begins to explain what a hedge fund does.
Hedge funds actually sprang from the widening of a small loophole in New
Deal reforms meant to stop companies that trade on behalf of investors from
ripping off their clients and threatening economic stability. The Investment
Company and Investment Advisers Acts of 1940 prohibited firms operating with
pools of investor money from engaging in risky practices like short sales
(bets that a stock will go down instead of up), leverage (investing with
borrowed funds to amplify returns and heighten risk), and corporate
takeovers. Meanwhile, investment companies had to register with the
Securities and Exchange Commission (SEC), disclosing their portfolios and
their corporate structures. The 1940 laws also restricted certain types of
fund manager compensation. The purpose was to eliminate the kind of
speculative risks with pools of capital that generated the Great Depression.
The plot of Billions closely resembles the investigation of SAC Capital's
Steve Cohen for illegal trading activity. Here, U.S. Attorney for the
Southern District of New York Preet Bharara speaks on the case during a news
conference, Thursday, July 25, 2013 in New York.
These rules remain in place for the $30 trillion mutual-fund industry, which
also invests large pools of client funds. But wealthy families secured a
loophole in the 1940 Acts for their own private investment managers. The law
exempted advisors with fewer than 100 clients who didn't offer services to
the general public from complying with the regulations. Policymakers
justified this by reckoning that "sophisticated investors" can handle the
risks, while retail investors-"widows and orphans"-needed to be protected
more stringently.
It took less than a decade for Alfred Winslow Jones, a former Fortune
magazine scribe, to capitalize on the exemption, creating the first-ever
hedge fund. A.W. Jones & Co., a limited partnership, employed two
strategies, both explicitly banned by the 1940 Acts: leveraged purchases of
certain stocks with borrowed money, and short sales of other stocks. Jones
believed that these two techniques in tandem created a conservative,
"hedged" portfolio, one that didn't simply go up or down based on the
vicissitudes of the market. "Hedge funds originally were all long/short
equity," says Rob Johnson, president of the Institute for New Economic
Thinking and a former managing director at George Soros's hedge fund. "You
own equities, but the long ones are balanced by the short ones. There's no
net exposure to equities."
Jones also invented the compensation structure used by modern hedge funds:
an annual fee of 2 percent of all assets under management, and a 20 percent
take of all profits above a certain threshold. Jones claimed he came to this
figure because Phoenician sea captains paid themselves one-fifth of the
profits after a successful voyage. In reality, that was a fiction to cover a
tax dodge; by taking a share of investment profits, Jones could justify the
earned income as capital gains, which had a far lower tax rate in 1949 (the
top rate on capital gains then was 25 percent; the top marginal income tax
rate was 82.13 percent). Today, the same dodge still operates, allowing
hedge fund income to be taxed at lower capital gains rates.
Hedge funds claim to be able to beat the market-to achieve above-average
returns, known in financial jargon as "alpha." The fee structure, termed
"two and twenty," theoretically incentivizes and rewards hedge funds for
attaining alpha.
The experimental A.W. Jones fund created a new class of money managers
outside the regulatory restrictions of the 1940 Acts, with no requirement to
disclose positions, even to its own investors. But this largely remained a
privilege for the ultra-rich. Over the first 50 years of existence, hedge
funds grew slowly; according to research firm BarclayHedge, by 1997 hedge
funds only held $118 billion in worldwide assets under management.
But institutional investors, like university endowments and pension funds,
wanted to get in on the action. They were attracted by the prospect of
earning alpha, and they saw value in alternative investments uncorrelated
with market performance. If hedge funds can go up even when the market
drops, it diversifies their portfolios.
In 1996, President Bill Clinton signed the National Securities Markets
Improvement Act (NSMIA), which overhauled state and federal responsibility
for securities market oversight. It was part of a series of market
deregulations in the Clinton era, advanced with broad Wall Street support
and almost no resistance in Congress: After bipartisan agreement, the House
and Senate finalized NSMIA with a voice vote. "We bring the financial
markets of this country into the 21st century," said lead bill sponsor
Representative Jack Fields, who shortly thereafter left Congress to found a
corporate lobbying shop.
Section 209 of NSMIA, largely unnoticed at the time, expanded the number of
clients hedge funds could handle while escaping the 1940 Acts' rules, from
99 to an unlimited number of "qualified purchasers." This included
individuals with $5 million in investments, and more important,
institutional investors with assets of $25 million or more. While the SEC
wanted to raise that threshold, Congress "believed that investor protections
could be maintained" at $25 million, according to a statement from conferee
Representative John Dingell. Clinton didn't even refer to this part of the
law in his signing statement. But hedge funds salivated at the prospect of
an entirely new funding source, including tens of billions in retirement
savings from ordinary workers.
After NSMIA passed, hedge fund assets increased ten-fold to $1.2 trillion
within seven years, and they have doubled again since then. One out of every
five university endowment dollars are now invested in hedge funds, according
to the National Association of College and University Business Officers.
BarclayHedge now estimates hedge fund assets under management in the third
quarter of 2015 at $2.7 trillion. And that doesn't count the borrowed money
also invested by the same firms.
Meanwhile, a close cousin of the hedge fund industry, private equity firms,
also proliferated. These outfits, previously called leveraged buyout firms
(LBOs) until they rebranded after several celebrated scandals in the 1980s,
use borrowed money to take control of companies, transform them, and spin
them back out. There is overlap in what some hedge funds and some private
equity companies do; both can benefit from stripping corporate assets, for
example. But in general terms, private equity takes companies private, while
equity hedge funds seek trading profits through the purchase and sale of
public stock.
What the two have in common is that they live on exemptions from New Deal
regulations. With hedge funds, these loopholes sprang from legislation.
Private equity firms took advantage of pliant regulators who ignored actions
that would not have been tolerated in an earlier era. Though they control
companies and sell shares to investors (known as limited partners), private
equity firms need not comply with SEC public-company disclosure
requirements, because the offerings are considered private. Therefore, in
different ways, a large subset of investment companies are exempt from rules
requiring disclosures and prohibiting speculative plays-regulations that
were created for very good reasons.
This expansion of unregulated investment companies-and the rise of "funds of
funds" that allow institutional investors to place money into collections of
hedge funds-put at risk the retirement savings of teachers, firefighters,
and police officers, and rendered all but meaningless the "limited investor"
rule to qualify for regulatory forbearance. As a consequence, hedge funds
are among the largest storehouses of aggregated wealth in the financial
system. These loopholes also facilitated an expansion in hedge fund
investing strategies, where long/short equity became just one technique
among many. Most hedge funds no longer hedge; at least, that is not their
net investment strategy. On the contrary, most take big risks in pursuit of
big rewards. And this transformation underscores how hedge funds stopped
being a relatively conservative element of a niche investment strategy and
started bigfooting the entire economy.
Hedge fund manager traffic in myths, all of which fall apart on close
examination. The first myth is that they make financial markets more
efficient by betting against unsustainable or anomalous trends. A related
claim is that they play a kind of regulatory function by policing markets
and by putting salutary pressure on corporate executives. For the most part
this is nonsense.
For example, in the movie and book The Big Short, the heroes are hedge fund
guys who perceived before others did that the housing market, pumped up by
subprime loans, was a bubble that would soon burst. The protagonists made a
lot of money by betting on a crash before others did. But did this make
markets more efficient? The bubble kept inflating and the crash was still
horrific. In fact, by creating a market in credit default swaps of housing
bonds, hedge funds magnified the impact of the collapse to the financial
sector, elevating it from a localized event to a global credit crunch.
Or take the case of William Ackman, whose Pershing Square hedge fund has
waged a public battle with the Herbalife Corporation. Ackman contends that
Herbalife, a direct marketing company of nutritional supplements, is a
pyramid scheme. He has made massive bets against Herbalife, and has spent a
small fortune trying to discredit the company so that his bet pays off. So
far, the loser has been Ackman. But if Herbalife really is a pyramid scheme,
shouldn't regulators rather than speculators with conflicts of interest be
the ones to investigate that allegation? Indeed, there's a fine line between
hedge fund managers disciplining markets and manipulating them; the FBI is
investigating whether Ackman made false statements to deliberately tank
Herbalife's stock.
Hedge funds are able to carry out self-fulfilling prophecies. By making big
bets against a healthy company's stock, they can take that company down-as a
side effect of the speculation. So the claim that hedge funds function as
quasi-regulators, or that this should be an acceptable delegation of
responsibility, is preposterous. It's the opposite of what they do.
Hedge fund managers also argue that they earn super-normal returns through
superior knowledge of the global economy, creating the "secret sauce" that
allows them to outpace the market. In addition to deciding which companies
will succeed or fail, they discover market inefficiencies and identify
global trends. They use this knowledge to bet on changes in sovereign bonds,
spreads on a country's corporate bonds, currency fluctuations, or commodity
prices like oil. If they see trouble ahead for Asia, they'll short anything
with export exposure to Asian countries. If they think the Eurozone will
take off, they'll make moves there.
Some hedge fund managers do make a lot of money by exploiting such
knowledge. For example, George Soros once made more than a billion dollars
by crashing the British pound, accurately sensing that it was overvalued.
And the business press has bought into the idea of superior insight,
treating every pronouncement by hedge fund superstars like Ray Dalio or
David Einhorn with the same reverence of a Treasury secretary or finance
minister.
But often, the trading edge can come not from immersive study but simply by
speaking to the right source. A number of hedge funds have been cited for
illegal trading on inside information; the plot of Billions closely
resembles the investigation of SAC Capital's Steve Cohen for illegal trading
activity. Recent court rulings threaten to make insider trading putatively
legal, but do reveal that, for all the assumptions about deep economic
knowledge inside hedge funds, they often get by with tips and rumors.
Most of the other hedge fund money-making strategies involve pure financial
engineering: using tax laws, speculative plays, regulatory forbearance, or
opportunistic legal maneuvers to hoover up profits from almost anywhere.
For example, distressed-debt hedge funds specialize in finding corporations
or sovereign entities in trouble and scooping up their bonds at a discount,
and then pursuing aggressive courtroom strategies with the hope that they
will be repaid at par, enjoying a huge payday. So-called "vulture" funds
like Aurelius Capital Management and NML Capital have moved from Greece to
Argentina to Detroit to Puerto Rico, picking at the carrion along the way.
This creates huge rewards: In his holdout play in Argentina, Paul Singer of
NML won 369 percent of principal on bonds he purchased for pennies on the
dollar. Bracebridge Capital did even better, securing eight times the
principal value. And winning for the vulture funds equals losing for
citizens and workers, who must deal with austerity budgets and public
employee layoffs as debt repayment takes precedence.
A handful of hedge funds use high-frequency trading to gain minuscule timing
advantages over the market and convert them into profits. An SEC report from
last October identified close to four dozen funds employing high-frequency
trading, with 28 using it exclusively. These pure arbitrage plays, involving
massive cancellations of orders and trades within a microsecond, create
little value than placing fractions of a penny into hedge fund accounts
millions of times a day. Under the New Deal regulatory schema, this is a
modern-day version of a venerable and illegal abuse known as trading ahead
of markets. It merely produces profits for the high-frequency traders at the
expense of ordinary investors.
So-called "activist" hedge funds accumulate stock in poorly performing
companies (or companies with large cash surpluses) to dictate strategies to
boards of directors and corporate management that will increase the stock
price. Activists have become so feared that just making public statements
about management can boost shares, on the assumption that the board will
cave. "It's closer to intimidation by the Mafia than sophisticated business
theories," said Michael Kink, executive director of the union-backed Strong
Economy for All Coalition. "Make us rich or we're going to throw you out the
window."
This is a funhouse-mirror version of the work of private equity companies,
which load up operating companies with tax-deductible debt and make their
money by extracting dividends, often at the expense of workers or pensioners
or investments that the company needs. Activist hedge funds keep the company
public, but encourage the board to undertake similar schemes. Hedge funds
forced General Motors to buy back $5 billion in stock last year, leaking
money to investors instead of improving the company. Activist fund Starboard
Value wants to break Yahoo into pieces to extract value. Last year, they
forced Darden Restaurants, which owns Olive Garden and other chains, into a
sale/leaseback scheme to monetize the value of the company's real-estate
holdings-and hand them to investors.
Exerting pressure on firms to improve management and boost the stock price
might seem like a mutually beneficial strategy for investors and companies
alike. But higher stock returns, while enriching hedge fund investors, don't
necessarily yield rewards for a company or its workers. When activist hedge
funds counsel closing an unprofitable factory, outsourcing to a country with
lower labor costs, increasing dividends, or buying back shares, they suck
out future earnings. Companies must then cut back on the very strategies
that make them healthy for the future-investment, R&D, job creation. A
recent study from three international researchers finds that activist
campaigns decrease the long-term value of the firms they target.
But here is the most revealing false claim of all. Despite all these
methods, and despite all the money pouring into the industry, the stark
truth about hedge funds is this: On average, most of them don't beat the
market. Their net alpha is zero, or less.
It's hard to precisely quantify this reality, because hedge funds don't have
stringent disclosure requirements, making it hard to be sure about average
performance. For example, the HFR index, designed to track hedge fund
performance, likely overstates returns because reporting is voluntary,
meaning underperformers could simply opt to hide their numbers. Hedge funds
that lose money and close don't report results either. So the statistics are
often skewed in favor of winners. But look at these estimates for last year,
provided by LCH Investments. The top 20 hedge funds-out of 11,000-made $15
billion. The rest of the industry lost $99 billion. Even bigshots like
Pershing Square's Bill Ackman lost money in 2015. And this year has begun
even more disastrously.
If you go outside the top 20 super-managers, you find that hedge funds
underperform in the S&P 500, index funds with a diversified mix of
companies, balanced mutual funds, and, according to a Cambridge University
study, a collection of stocks picked at random by monkeys. According to
other estimates, in 2014, hedge funds overall returned 3 percent; the S&P
returned 11 percent. The spread was even worse in 2013.
In fact, hedge funds have lagged the S&P index and other benchmark
portfolios going back to the early 2000s. Many investors and even hedge fund
managers have acknowledged this for years. And there are analysts who
believe that, if you adjust for leverage (the ability to use borrowed money
to magnify returns), you can explain virtually all the alpha going back to
the original hedge funds in the 1940s. And of course, leverage magnifies the
downside as much as the upside. "During the financial crisis a lot of hedge
funds went out of business," says Josh Pollet, associate professor of
finance at the University of Illinois. "That tells us a lot about their
exposure to risk."
If most hedge funds don't outperform the market averages, why do they
continue to grow? Why do investors and institutions around the world
continue to pay higher fees for lower performance, making a handful of
managers notoriously rich?
Practically every expert whom I asked that question had a different
rationale. Some chalked it up to investor inertia, a refusal to reckon with
the lack of alpha. Related to that is investors' "reach for yield" in a
low-interest-rate environment, where they will sign up with anyone promoting
high returns, regardless of the veracity of the claims.
Others believe that even sophisticated investors can be seduced by
eye-popping returns at the very top. Large university endowments like
Harvard and Yale, for example, have invested in hedge funds for decades,
reporting double-digit increases. But that longevity, and the size of their
investments, gives them access to top funds like Bracebridge Capital, Yale's
secretive trading firm, and special fee rates available to longtime
investors. Other endowments have to settle for smaller shops, and unlike
Lake Wobegon, all hedge funds are not above average. A study of the
University of California's endowment shows that their hedge fund investments
underperformed the rest of their assets in 10 out of 12 years, costing the
university $783 million. Even the Ivies should worry about hedge fund
exposure to risk; for all of Harvard's endowment success, it lost 27 percent
in 2009.
Other theories are more sinister. The actual returns from individual hedge
funds remain maddeningly opaque, making it hard for investors to know whom
to trust.
A picture that reads in Spanish: "VIP Vulture" hangs on a fence outside
Congress where lawmakers debate a deal with U.S. creditors in Buenos Aires,
Argentina, Wednesday, March 30, 2016. Under the deal, Argentina would pay to
resolve all related debt claims, including those from a group led by hedge
fund manager Paul Singer's group in New York.
The sales job extends to third-party investment consultants, who have
business relationships with the hedge funds to which they funnel investors.
The International Business Times has reported on Angeles Investment Advisors
counseling the pension fund of San Francisco to invest in hedge funds, when
they reserve the right to collect additional fees if the pension fund
agrees. Callan Associates, another adviser, has been sued by the retirement
fund of Beaumont, Texas, by a private pension fund in New York State, and by
others for receiving undisclosed annual payments from the investment funds
they pitched to clients. In 2009, Consulting Services Group recommended that
the pension fund of Shelby County, Tennessee, invest in a hedge fund that
they ran themselves. The most recent disclosure brochure from Lyxor Asset
Management, another adviser, states openly that they have a conflict of
interest, from a 0.35 percent fee they charge pension funds when they invest
in affiliated managers.
Other strategies to rake in public investment capital resemble pay-to-play
schemes. "Say I'm an elected official or an appointed official like a
pension fiduciary, who needs campaign contributions to prevail in an
election," says INET's Rob Johnson. "The hedge fund guys say, if you arrange
for me to manage $200 million from your pension pool, I'll put a good
portion of the fees into your campaign war chest." Republican New Jersey
Governor Chris Christie passed hundreds of millions in state pension money
to hedge funds, and received millions in donations for his gubernatorial and
presidential campaigns. As state treasurer of Rhode Island, Democrat Gina
Raimondo performed the same trick with over a billion in state resources,
using hedge fund donations to help become governor.
Simply projecting outsized returns for hedge fund investments allows a
cash-strapped state to provide fewer resources for pensions. Rhode Island
can plan to put less into its pension fund if they assume a 10 percent
return rather than 5 percent. If they miss the target, that's the next
governor's problem; what matters is making a projection in the short term
that allows them to shortchange public employees. So workers and teachers
lose pension money they're owed so they can make billionaires richer.
The two-decade explosion of hedge funds translates into manager triumphs
regardless of returns: 2 percent off the top of the $2.7 trillion invested
in 2015 is $54 billion. As author Les Leopold puts it, top managers
routinely make a million dollars an hour. A bit of that wealth goes into
philanthropy, and plenty more into ostentatious shows of privilege-mansions,
yachts, private jets. But significant amounts get poured into the political
system, much of it to retain a lax regulatory environment and build a force
field around those profits.
Despite a decade of bipartisan support-from Donald Trump to Hillary
Clinton-for ending "carried interest," the term for the maneuver that allows
hedge fund managers to take their 20 percent share of profits above
benchmark as capital gains instead of earned income, saving billions of
dollars in taxes, the loophole remains intact. Various trade organizations
and individual hedge funds have spent millions to ensure that. They've
similarly fought to protect a separate tax loophole for their 2 percent
management fees, which involves cycling money through offshore shell
companies pretending to sell specialized insurance.
The actions of so-called "activist" hedge funds more closely resemble
"intimidation by the Mafia than sophisticated business theories," said
Michael Kink, executive director for The Strong Economy for All coalition.
Overall, hedge funds spent $7.34 million in lobbying last year, according to
the Center for Responsive Politics. In addition to tax rules, hedge funds
have been active in pressing to weaken regulations on derivatives, one of
their key trading instruments. Defending the industry from disclosure
requirements and limits on activities allows them to gouge their clients
with hidden fees. Incredibly, most major institutional investors do not know
precisely how much hedge funds charge them. A report from the Roosevelt
Institute and the American Federation of Teachers looking at 11 pension
funds' hedge fund investments found that they paid 57 cents in fees for
every dollar in net return.
Campaign contributions by hedge funds dwarf their lobbying outlays, as fund
managers have become some of the most reliable mega-donors in America. Hedge
funds delivered $52 million to candidates during the 2014 midterms, and have
already eclipsed that in this cycle. Political reporters herald hedge fund
managers siding with presidential candidates, like the $11 million from
Renaissance Technologies' Robert Mercer to support Ted Cruz or the millions
Elliott Management's Paul Singer raised for Marco Rubio, as if they were
blue-chip prospects in the NFL Draft. Hedge funds also bankroll think tanks
and dark-money groups that seek to privatize public education, among other
aims. "They are wildly distorting democratic governmental processes for
their own benefit," says Michael Kink of Strong Economy for All.
All of this would be hard enough to take if hedge funds didn't also
represent a systemic risk. The funneling of massive amounts of wealth to a
small collection of billionaires boosts inequality, and activist funds'
extraction of value out of companies hobbles communities and destroys jobs.
But for the University of Illinois's Josh Pollet, it's hedge funds' ability
to use leverage that hooks them into the broader system, potentially
producing a negative shock. While the Dodd-Frank Act did reduce direct
sponsorship of hedge funds by big banks, it didn't limit the ability of
hedge funds to borrow capital from banks and engage in risky trades. "If a
bunch of hedge funds try the same strategy at the same time, the concern is
that hedge funds will do badly, pull down the banks, and the banks are vital
for other activity," Pollet says. Regulators take pride in their efforts to
limit leverage by banks. But simultaneously allowing leverage to build in
outside investment companies is like boasting about the new lock on the
front door while leaving the back door wide open.
Hedge funds have pushed into so many aspects of American life that solutions
for minimizing their risk have proliferated in parallel. Dodd-Frank forced
hedge funds to register with the SEC, but virtually nobody believes that
having them give their name, rank, and serial number will make much of a
difference. "The SEC doesn't have the manpower or the technology to regulate
hedge funds or any other part of the markets," says Rob Johnson. Even with
registration, hedge fund disclosure is minimal, and their activities, many
of which would be banned under the Investment Company Act, can continue
freely.
Senator Tammy Baldwin recently introduced legislation that specifically
targets activist hedge funds. For more than 50 years, investors have had to
disclose to the public when they acquire 5 percent of a company (known as a
13D disclosure). But they can wait up to ten days to disclose. The Baldwin
bill would shrink that to two days, limiting the ability for the activist to
tip off allies to rush into the fund at a lower stock price, profiting from
the spike when the 13D disclosure goes public. This was supposed to be
updated as part of Dodd-Frank, but the SEC has dragged its feet.
The bill would also restrict "wolf packs" of activist funds from
individually buying just under the 5 percent threshold to skirt disclosure
rules. If the wolf pack works together, Baldwin's bill would count them as a
single group and trigger disclosure. Finally, the bill would crack down on
how hedge funds use derivatives to mirror their position in a stock,
allowing them to amass larger stakes in companies and intimidate management.
Often activists will create a "net short" position in a stock, designed to
depress the price and expand the windfall. The legislation would put these
derivatives under the auspices of the 13D law, forcing disclosure sooner.
Tax reform and tighter controls on high-frequency trading, while broader
fights, would attack elements of the hedge fund industry. Reformers like
Hedge Clippers, the anti-hedge fund coalition formed last year, also support
banning placement agents that cajole investors into funds with which they
have a mutual arrangement.
States and municipalities, particularly those with pension investments in
hedge funds, can drive change. Last October, Scott Evans, the chief
investment officer of the New York City Retirement Systems, demanded full
fee disclosure for its hedge fund investments as a condition for future
business. Fee disclosure can accelerate a trend of hedge funds cutting fees
for investors to limit exits during the current downward cycle; "two and
twenty" has increasingly become "one and fifteen." Hedge Clippers has also
called for a cap on exposure to hedge funds and other alternative
investments for pension funds and university endowments.
A more radical strategy is to force fiduciaries for institutional investors,
bound to operate in the best interest of their clients, to rethink the
entire purpose of the hedge fund investment. Currently, most fiduciaries
still have this idea that so-called alternative investments like hedge funds
enable them to diversify their portfolios and hedge risk, as well as
increase yields. But as we've seen, hedge funds don't really hedge anymore.
More important, research from analysts as varied as Morgan Stanley, the
French business school IPAG, and even the hedge fund AQR shows that hedge
fund returns increasingly correlate with the broader market, particularly
since the 2008 financial crisis.
If hedge funds go up and down alongside the market, and all but the top
performers don't even beat the market, the rationale for investing in them
vanishes. A fiduciary recognizing this would have a duty to investors to
step away from hedge funds. That's already starting: The California Public
Employees' Retirement System, the nation's largest, pulled out of hedge
funds in September 2014, followed by a Dutch health-care workers' fund the
next year.
The quickest way to eliminate the risk to the economy associated with hedge
funds is to reclassify them under the 1940 Acts. Their emergence was an
accident of history, a gift to wealthy families. But the by-product of that
gift has now grown to outsized proportions and shoved itself into
practically every aspect of economic life. Putting hedge funds under the
1940 Acts would mandate disclosure, alter fee structures, and eliminate the
use of leverage. It would extend the regulatory perimeter in a far sharper
way than Hillary Clinton, whose campaign has vowed to rein in "shadow banks"
like hedge funds, has so far promised. In effect, putting hedge funds under
the wise regulatory structure adopted in 1940 would put them out of
business.
Though market forces take a very long time to correct damaging mistakes,
sometimes they purge malefactors. For close to a decade, quantitative
analysts have built computer programs that mimic hedge fund alpha
strategies, generating similar returns through passive rather than active
investment, with far lower fees. These have grown to $50 billion in assets,
a pittance compared to the hedge fund industry but a 25-fold increase since
2010. Robo-traders come with their own potential abuses and require careful
study. But maybe in a few years, outsourced factory workers and hedge fund
managers can hold hands in solidarity and demand an end to having their jobs
taken away by robots.
Clarification: David Dayen's article on hedge funds included a sentence that
Callan Associates was sued by two pension funds for receiving undisclosed
fees from investment funds that Callan promoted. This is accurate as
written, but the investment funds were not in fact hedge funds.
David Dayen is the author of author of Chain of Title: How Three Ordinary
Americans Uncovered Wall Street's Great Foreclosure Fraud [3], releasing May
17.
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Home > Hedge Funds Serve Very Little Useful Purpose Except to Make a Few
People Very Rich
Hedge Funds Serve Very Little Useful Purpose Except to Make a Few People
Very Rich
By David Dayen [1] / The American Prospect [2]
May 3, 2016
In the pilot episode of the Showtime drama Billions, a CNBC host grills
Bobby Axelrod (Damian Lewis), founder of the hedge fund Axe Capital, at a
public forum. "How do you respond to the criticism that hedge funds are the
scavengers of the financial sector, and that a select few have undue
influence on the markets?"
"We're not scavengers," Axelrod replies. "We're white blood cells scrubbing
out bad companies, earning for our investors, preventing bubbles. A hedge
fund like mine is a market regulator."
This claim invites an important debate: Do hedge funds represent an asset to
the larger economy, or a menace? Do they really help make markets more
efficient and transparent, or do they just exploit opportunities at the
expense of other investors?
There are roughly 11,000 such funds-investment vehicles that control a mix
of client dollars and borrowed money, with a corporate structure that
exempts them from most investment-company regulations. We know that hedge
funds have made a small subset of financial titans fabulously wealthy. The
top hedge fund executives make a billion dollars a year or more. Hillary
Clinton and Bernie Sanders are fond of saying on the campaign trail that the
top 25 hedge fund managers earn more than all of America's kindergarten
teachers combined. But does this orgy of wealth create value, or merely
extract value, at the expense of workers, companies, and other investors?
A fictional television show with revenge plots and emotional tumult and the
usual allotment of Showtime-mandated soft-core pornography has more pressing
concerns than these. It's beyond the show's scope to explain how hedge funds
became such a disruptive force in our economy and our politics, or to
distinguish them from other investment firms, rather than using them as a
signifier for "Wall Street jerk." In fact, amid the twists and turns,
Billions barely even begins to explain what a hedge fund does.
Hedge funds actually sprang from the widening of a small loophole in New
Deal reforms meant to stop companies that trade on behalf of investors from
ripping off their clients and threatening economic stability. The Investment
Company and Investment Advisers Acts of 1940 prohibited firms operating with
pools of investor money from engaging in risky practices like short sales
(bets that a stock will go down instead of up), leverage (investing with
borrowed funds to amplify returns and heighten risk), and corporate
takeovers. Meanwhile, investment companies had to register with the
Securities and Exchange Commission (SEC), disclosing their portfolios and
their corporate structures. The 1940 laws also restricted certain types of
fund manager compensation. The purpose was to eliminate the kind of
speculative risks with pools of capital that generated the Great Depression.
The plot of Billions closely resembles the investigation of SAC Capital's
Steve Cohen for illegal trading activity. Here, U.S. Attorney for the
Southern District of New York Preet Bharara speaks on the case during a news
conference, Thursday, July 25, 2013 in New York.
These rules remain in place for the $30 trillion mutual-fund industry, which
also invests large pools of client funds. But wealthy families secured a
loophole in the 1940 Acts for their own private investment managers. The law
exempted advisors with fewer than 100 clients who didn't offer services to
the general public from complying with the regulations. Policymakers
justified this by reckoning that "sophisticated investors" can handle the
risks, while retail investors-"widows and orphans"-needed to be protected
more stringently.
It took less than a decade for Alfred Winslow Jones, a former Fortune
magazine scribe, to capitalize on the exemption, creating the first-ever
hedge fund. A.W. Jones & Co., a limited partnership, employed two
strategies, both explicitly banned by the 1940 Acts: leveraged purchases of
certain stocks with borrowed money, and short sales of other stocks. Jones
believed that these two techniques in tandem created a conservative,
"hedged" portfolio, one that didn't simply go up or down based on the
vicissitudes of the market. "Hedge funds originally were all long/short
equity," says Rob Johnson, president of the Institute for New Economic
Thinking and a former managing director at George Soros's hedge fund. "You
own equities, but the long ones are balanced by the short ones. There's no
net exposure to equities."
Jones also invented the compensation structure used by modern hedge funds:
an annual fee of 2 percent of all assets under management, and a 20 percent
take of all profits above a certain threshold. Jones claimed he came to this
figure because Phoenician sea captains paid themselves one-fifth of the
profits after a successful voyage. In reality, that was a fiction to cover a
tax dodge; by taking a share of investment profits, Jones could justify the
earned income as capital gains, which had a far lower tax rate in 1949 (the
top rate on capital gains then was 25 percent; the top marginal income tax
rate was 82.13 percent). Today, the same dodge still operates, allowing
hedge fund income to be taxed at lower capital gains rates.
Hedge funds claim to be able to beat the market-to achieve above-average
returns, known in financial jargon as "alpha." The fee structure, termed
"two and twenty," theoretically incentivizes and rewards hedge funds for
attaining alpha.
The experimental A.W. Jones fund created a new class of money managers
outside the regulatory restrictions of the 1940 Acts, with no requirement to
disclose positions, even to its own investors. But this largely remained a
privilege for the ultra-rich. Over the first 50 years of existence, hedge
funds grew slowly; according to research firm BarclayHedge, by 1997 hedge
funds only held $118 billion in worldwide assets under management.
But institutional investors, like university endowments and pension funds,
wanted to get in on the action. They were attracted by the prospect of
earning alpha, and they saw value in alternative investments uncorrelated
with market performance. If hedge funds can go up even when the market
drops, it diversifies their portfolios.
In 1996, President Bill Clinton signed the National Securities Markets
Improvement Act (NSMIA), which overhauled state and federal responsibility
for securities market oversight. It was part of a series of market
deregulations in the Clinton era, advanced with broad Wall Street support
and almost no resistance in Congress: After bipartisan agreement, the House
and Senate finalized NSMIA with a voice vote. "We bring the financial
markets of this country into the 21st century," said lead bill sponsor
Representative Jack Fields, who shortly thereafter left Congress to found a
corporate lobbying shop.
Section 209 of NSMIA, largely unnoticed at the time, expanded the number of
clients hedge funds could handle while escaping the 1940 Acts' rules, from
99 to an unlimited number of "qualified purchasers." This included
individuals with $5 million in investments, and more important,
institutional investors with assets of $25 million or more. While the SEC
wanted to raise that threshold, Congress "believed that investor protections
could be maintained" at $25 million, according to a statement from conferee
Representative John Dingell. Clinton didn't even refer to this part of the
law in his signing statement. But hedge funds salivated at the prospect of
an entirely new funding source, including tens of billions in retirement
savings from ordinary workers.
After NSMIA passed, hedge fund assets increased ten-fold to $1.2 trillion
within seven years, and they have doubled again since then. One out of every
five university endowment dollars are now invested in hedge funds, according
to the National Association of College and University Business Officers.
BarclayHedge now estimates hedge fund assets under management in the third
quarter of 2015 at $2.7 trillion. And that doesn't count the borrowed money
also invested by the same firms.
Meanwhile, a close cousin of the hedge fund industry, private equity firms,
also proliferated. These outfits, previously called leveraged buyout firms
(LBOs) until they rebranded after several celebrated scandals in the 1980s,
use borrowed money to take control of companies, transform them, and spin
them back out. There is overlap in what some hedge funds and some private
equity companies do; both can benefit from stripping corporate assets, for
example. But in general terms, private equity takes companies private, while
equity hedge funds seek trading profits through the purchase and sale of
public stock.
What the two have in common is that they live on exemptions from New Deal
regulations. With hedge funds, these loopholes sprang from legislation.
Private equity firms took advantage of pliant regulators who ignored actions
that would not have been tolerated in an earlier era. Though they control
companies and sell shares to investors (known as limited partners), private
equity firms need not comply with SEC public-company disclosure
requirements, because the offerings are considered private. Therefore, in
different ways, a large subset of investment companies are exempt from rules
requiring disclosures and prohibiting speculative plays-regulations that
were created for very good reasons.
This expansion of unregulated investment companies-and the rise of "funds of
funds" that allow institutional investors to place money into collections of
hedge funds-put at risk the retirement savings of teachers, firefighters,
and police officers, and rendered all but meaningless the "limited investor"
rule to qualify for regulatory forbearance. As a consequence, hedge funds
are among the largest storehouses of aggregated wealth in the financial
system. These loopholes also facilitated an expansion in hedge fund
investing strategies, where long/short equity became just one technique
among many. Most hedge funds no longer hedge; at least, that is not their
net investment strategy. On the contrary, most take big risks in pursuit of
big rewards. And this transformation underscores how hedge funds stopped
being a relatively conservative element of a niche investment strategy and
started bigfooting the entire economy.
Hedge fund manager traffic in myths, all of which fall apart on close
examination. The first myth is that they make financial markets more
efficient by betting against unsustainable or anomalous trends. A related
claim is that they play a kind of regulatory function by policing markets
and by putting salutary pressure on corporate executives. For the most part
this is nonsense.
For example, in the movie and book The Big Short, the heroes are hedge fund
guys who perceived before others did that the housing market, pumped up by
subprime loans, was a bubble that would soon burst. The protagonists made a
lot of money by betting on a crash before others did. But did this make
markets more efficient? The bubble kept inflating and the crash was still
horrific. In fact, by creating a market in credit default swaps of housing
bonds, hedge funds magnified the impact of the collapse to the financial
sector, elevating it from a localized event to a global credit crunch.
Or take the case of William Ackman, whose Pershing Square hedge fund has
waged a public battle with the Herbalife Corporation. Ackman contends that
Herbalife, a direct marketing company of nutritional supplements, is a
pyramid scheme. He has made massive bets against Herbalife, and has spent a
small fortune trying to discredit the company so that his bet pays off. So
far, the loser has been Ackman. But if Herbalife really is a pyramid scheme,
shouldn't regulators rather than speculators with conflicts of interest be
the ones to investigate that allegation? Indeed, there's a fine line between
hedge fund managers disciplining markets and manipulating them; the FBI is
investigating whether Ackman made false statements to deliberately tank
Herbalife's stock.
Hedge funds are able to carry out self-fulfilling prophecies. By making big
bets against a healthy company's stock, they can take that company down-as a
side effect of the speculation. So the claim that hedge funds function as
quasi-regulators, or that this should be an acceptable delegation of
responsibility, is preposterous. It's the opposite of what they do.
Hedge fund managers also argue that they earn super-normal returns through
superior knowledge of the global economy, creating the "secret sauce" that
allows them to outpace the market. In addition to deciding which companies
will succeed or fail, they discover market inefficiencies and identify
global trends. They use this knowledge to bet on changes in sovereign bonds,
spreads on a country's corporate bonds, currency fluctuations, or commodity
prices like oil. If they see trouble ahead for Asia, they'll short anything
with export exposure to Asian countries. If they think the Eurozone will
take off, they'll make moves there.
Some hedge fund managers do make a lot of money by exploiting such
knowledge. For example, George Soros once made more than a billion dollars
by crashing the British pound, accurately sensing that it was overvalued.
And the business press has bought into the idea of superior insight,
treating every pronouncement by hedge fund superstars like Ray Dalio or
David Einhorn with the same reverence of a Treasury secretary or finance
minister.
But often, the trading edge can come not from immersive study but simply by
speaking to the right source. A number of hedge funds have been cited for
illegal trading on inside information; the plot of Billions closely
resembles the investigation of SAC Capital's Steve Cohen for illegal trading
activity. Recent court rulings threaten to make insider trading putatively
legal, but do reveal that, for all the assumptions about deep economic
knowledge inside hedge funds, they often get by with tips and rumors.
Most of the other hedge fund money-making strategies involve pure financial
engineering: using tax laws, speculative plays, regulatory forbearance, or
opportunistic legal maneuvers to hoover up profits from almost anywhere.
For example, distressed-debt hedge funds specialize in finding corporations
or sovereign entities in trouble and scooping up their bonds at a discount,
and then pursuing aggressive courtroom strategies with the hope that they
will be repaid at par, enjoying a huge payday. So-called "vulture" funds
like Aurelius Capital Management and NML Capital have moved from Greece to
Argentina to Detroit to Puerto Rico, picking at the carrion along the way.
This creates huge rewards: In his holdout play in Argentina, Paul Singer of
NML won 369 percent of principal on bonds he purchased for pennies on the
dollar. Bracebridge Capital did even better, securing eight times the
principal value. And winning for the vulture funds equals losing for
citizens and workers, who must deal with austerity budgets and public
employee layoffs as debt repayment takes precedence.
A handful of hedge funds use high-frequency trading to gain minuscule timing
advantages over the market and convert them into profits. An SEC report from
last October identified close to four dozen funds employing high-frequency
trading, with 28 using it exclusively. These pure arbitrage plays, involving
massive cancellations of orders and trades within a microsecond, create
little value than placing fractions of a penny into hedge fund accounts
millions of times a day. Under the New Deal regulatory schema, this is a
modern-day version of a venerable and illegal abuse known as trading ahead
of markets. It merely produces profits for the high-frequency traders at the
expense of ordinary investors.
So-called "activist" hedge funds accumulate stock in poorly performing
companies (or companies with large cash surpluses) to dictate strategies to
boards of directors and corporate management that will increase the stock
price. Activists have become so feared that just making public statements
about management can boost shares, on the assumption that the board will
cave. "It's closer to intimidation by the Mafia than sophisticated business
theories," said Michael Kink, executive director of the union-backed Strong
Economy for All Coalition. "Make us rich or we're going to throw you out the
window."
This is a funhouse-mirror version of the work of private equity companies,
which load up operating companies with tax-deductible debt and make their
money by extracting dividends, often at the expense of workers or pensioners
or investments that the company needs. Activist hedge funds keep the company
public, but encourage the board to undertake similar schemes. Hedge funds
forced General Motors to buy back $5 billion in stock last year, leaking
money to investors instead of improving the company. Activist fund Starboard
Value wants to break Yahoo into pieces to extract value. Last year, they
forced Darden Restaurants, which owns Olive Garden and other chains, into a
sale/leaseback scheme to monetize the value of the company's real-estate
holdings-and hand them to investors.
Exerting pressure on firms to improve management and boost the stock price
might seem like a mutually beneficial strategy for investors and companies
alike. But higher stock returns, while enriching hedge fund investors, don't
necessarily yield rewards for a company or its workers. When activist hedge
funds counsel closing an unprofitable factory, outsourcing to a country with
lower labor costs, increasing dividends, or buying back shares, they suck
out future earnings. Companies must then cut back on the very strategies
that make them healthy for the future-investment, R&D, job creation. A
recent study from three international researchers finds that activist
campaigns decrease the long-term value of the firms they target.
But here is the most revealing false claim of all. Despite all these
methods, and despite all the money pouring into the industry, the stark
truth about hedge funds is this: On average, most of them don't beat the
market. Their net alpha is zero, or less.
It's hard to precisely quantify this reality, because hedge funds don't have
stringent disclosure requirements, making it hard to be sure about average
performance. For example, the HFR index, designed to track hedge fund
performance, likely overstates returns because reporting is voluntary,
meaning underperformers could simply opt to hide their numbers. Hedge funds
that lose money and close don't report results either. So the statistics are
often skewed in favor of winners. But look at these estimates for last year,
provided by LCH Investments. The top 20 hedge funds-out of 11,000-made $15
billion. The rest of the industry lost $99 billion. Even bigshots like
Pershing Square's Bill Ackman lost money in 2015. And this year has begun
even more disastrously.
If you go outside the top 20 super-managers, you find that hedge funds
underperform in the S&P 500, index funds with a diversified mix of
companies, balanced mutual funds, and, according to a Cambridge University
study, a collection of stocks picked at random by monkeys. According to
other estimates, in 2014, hedge funds overall returned 3 percent; the S&P
returned 11 percent. The spread was even worse in 2013.
In fact, hedge funds have lagged the S&P index and other benchmark
portfolios going back to the early 2000s. Many investors and even hedge fund
managers have acknowledged this for years. And there are analysts who
believe that, if you adjust for leverage (the ability to use borrowed money
to magnify returns), you can explain virtually all the alpha going back to
the original hedge funds in the 1940s. And of course, leverage magnifies the
downside as much as the upside. "During the financial crisis a lot of hedge
funds went out of business," says Josh Pollet, associate professor of
finance at the University of Illinois. "That tells us a lot about their
exposure to risk."
If most hedge funds don't outperform the market averages, why do they
continue to grow? Why do investors and institutions around the world
continue to pay higher fees for lower performance, making a handful of
managers notoriously rich?
Practically every expert whom I asked that question had a different
rationale. Some chalked it up to investor inertia, a refusal to reckon with
the lack of alpha. Related to that is investors' "reach for yield" in a
low-interest-rate environment, where they will sign up with anyone promoting
high returns, regardless of the veracity of the claims.
Others believe that even sophisticated investors can be seduced by
eye-popping returns at the very top. Large university endowments like
Harvard and Yale, for example, have invested in hedge funds for decades,
reporting double-digit increases. But that longevity, and the size of their
investments, gives them access to top funds like Bracebridge Capital, Yale's
secretive trading firm, and special fee rates available to longtime
investors. Other endowments have to settle for smaller shops, and unlike
Lake Wobegon, all hedge funds are not above average. A study of the
University of California's endowment shows that their hedge fund investments
underperformed the rest of their assets in 10 out of 12 years, costing the
university $783 million. Even the Ivies should worry about hedge fund
exposure to risk; for all of Harvard's endowment success, it lost 27 percent
in 2009.
Other theories are more sinister. The actual returns from individual hedge
funds remain maddeningly opaque, making it hard for investors to know whom
to trust.
A picture that reads in Spanish: "VIP Vulture" hangs on a fence outside
Congress where lawmakers debate a deal with U.S. creditors in Buenos Aires,
Argentina, Wednesday, March 30, 2016. Under the deal, Argentina would pay to
resolve all related debt claims, including those from a group led by hedge
fund manager Paul Singer's group in New York.
The sales job extends to third-party investment consultants, who have
business relationships with the hedge funds to which they funnel investors.
The International Business Times has reported on Angeles Investment Advisors
counseling the pension fund of San Francisco to invest in hedge funds, when
they reserve the right to collect additional fees if the pension fund
agrees. Callan Associates, another adviser, has been sued by the retirement
fund of Beaumont, Texas, by a private pension fund in New York State, and by
others for receiving undisclosed annual payments from the investment funds
they pitched to clients. In 2009, Consulting Services Group recommended that
the pension fund of Shelby County, Tennessee, invest in a hedge fund that
they ran themselves. The most recent disclosure brochure from Lyxor Asset
Management, another adviser, states openly that they have a conflict of
interest, from a 0.35 percent fee they charge pension funds when they invest
in affiliated managers.
Other strategies to rake in public investment capital resemble pay-to-play
schemes. "Say I'm an elected official or an appointed official like a
pension fiduciary, who needs campaign contributions to prevail in an
election," says INET's Rob Johnson. "The hedge fund guys say, if you arrange
for me to manage $200 million from your pension pool, I'll put a good
portion of the fees into your campaign war chest." Republican New Jersey
Governor Chris Christie passed hundreds of millions in state pension money
to hedge funds, and received millions in donations for his gubernatorial and
presidential campaigns. As state treasurer of Rhode Island, Democrat Gina
Raimondo performed the same trick with over a billion in state resources,
using hedge fund donations to help become governor.
Simply projecting outsized returns for hedge fund investments allows a
cash-strapped state to provide fewer resources for pensions. Rhode Island
can plan to put less into its pension fund if they assume a 10 percent
return rather than 5 percent. If they miss the target, that's the next
governor's problem; what matters is making a projection in the short term
that allows them to shortchange public employees. So workers and teachers
lose pension money they're owed so they can make billionaires richer.
The two-decade explosion of hedge funds translates into manager triumphs
regardless of returns: 2 percent off the top of the $2.7 trillion invested
in 2015 is $54 billion. As author Les Leopold puts it, top managers
routinely make a million dollars an hour. A bit of that wealth goes into
philanthropy, and plenty more into ostentatious shows of privilege-mansions,
yachts, private jets. But significant amounts get poured into the political
system, much of it to retain a lax regulatory environment and build a force
field around those profits.
Despite a decade of bipartisan support-from Donald Trump to Hillary
Clinton-for ending "carried interest," the term for the maneuver that allows
hedge fund managers to take their 20 percent share of profits above
benchmark as capital gains instead of earned income, saving billions of
dollars in taxes, the loophole remains intact. Various trade organizations
and individual hedge funds have spent millions to ensure that. They've
similarly fought to protect a separate tax loophole for their 2 percent
management fees, which involves cycling money through offshore shell
companies pretending to sell specialized insurance.
The actions of so-called "activist" hedge funds more closely resemble
"intimidation by the Mafia than sophisticated business theories," said
Michael Kink, executive director for The Strong Economy for All coalition.
Overall, hedge funds spent $7.34 million in lobbying last year, according to
the Center for Responsive Politics. In addition to tax rules, hedge funds
have been active in pressing to weaken regulations on derivatives, one of
their key trading instruments. Defending the industry from disclosure
requirements and limits on activities allows them to gouge their clients
with hidden fees. Incredibly, most major institutional investors do not know
precisely how much hedge funds charge them. A report from the Roosevelt
Institute and the American Federation of Teachers looking at 11 pension
funds' hedge fund investments found that they paid 57 cents in fees for
every dollar in net return.
Campaign contributions by hedge funds dwarf their lobbying outlays, as fund
managers have become some of the most reliable mega-donors in America. Hedge
funds delivered $52 million to candidates during the 2014 midterms, and have
already eclipsed that in this cycle. Political reporters herald hedge fund
managers siding with presidential candidates, like the $11 million from
Renaissance Technologies' Robert Mercer to support Ted Cruz or the millions
Elliott Management's Paul Singer raised for Marco Rubio, as if they were
blue-chip prospects in the NFL Draft. Hedge funds also bankroll think tanks
and dark-money groups that seek to privatize public education, among other
aims. "They are wildly distorting democratic governmental processes for
their own benefit," says Michael Kink of Strong Economy for All.
All of this would be hard enough to take if hedge funds didn't also
represent a systemic risk. The funneling of massive amounts of wealth to a
small collection of billionaires boosts inequality, and activist funds'
extraction of value out of companies hobbles communities and destroys jobs.
But for the University of Illinois's Josh Pollet, it's hedge funds' ability
to use leverage that hooks them into the broader system, potentially
producing a negative shock. While the Dodd-Frank Act did reduce direct
sponsorship of hedge funds by big banks, it didn't limit the ability of
hedge funds to borrow capital from banks and engage in risky trades. "If a
bunch of hedge funds try the same strategy at the same time, the concern is
that hedge funds will do badly, pull down the banks, and the banks are vital
for other activity," Pollet says. Regulators take pride in their efforts to
limit leverage by banks. But simultaneously allowing leverage to build in
outside investment companies is like boasting about the new lock on the
front door while leaving the back door wide open.
Hedge funds have pushed into so many aspects of American life that solutions
for minimizing their risk have proliferated in parallel. Dodd-Frank forced
hedge funds to register with the SEC, but virtually nobody believes that
having them give their name, rank, and serial number will make much of a
difference. "The SEC doesn't have the manpower or the technology to regulate
hedge funds or any other part of the markets," says Rob Johnson. Even with
registration, hedge fund disclosure is minimal, and their activities, many
of which would be banned under the Investment Company Act, can continue
freely.
Senator Tammy Baldwin recently introduced legislation that specifically
targets activist hedge funds. For more than 50 years, investors have had to
disclose to the public when they acquire 5 percent of a company (known as a
13D disclosure). But they can wait up to ten days to disclose. The Baldwin
bill would shrink that to two days, limiting the ability for the activist to
tip off allies to rush into the fund at a lower stock price, profiting from
the spike when the 13D disclosure goes public. This was supposed to be
updated as part of Dodd-Frank, but the SEC has dragged its feet.
The bill would also restrict "wolf packs" of activist funds from
individually buying just under the 5 percent threshold to skirt disclosure
rules. If the wolf pack works together, Baldwin's bill would count them as a
single group and trigger disclosure. Finally, the bill would crack down on
how hedge funds use derivatives to mirror their position in a stock,
allowing them to amass larger stakes in companies and intimidate management.
Often activists will create a "net short" position in a stock, designed to
depress the price and expand the windfall. The legislation would put these
derivatives under the auspices of the 13D law, forcing disclosure sooner.
Tax reform and tighter controls on high-frequency trading, while broader
fights, would attack elements of the hedge fund industry. Reformers like
Hedge Clippers, the anti-hedge fund coalition formed last year, also support
banning placement agents that cajole investors into funds with which they
have a mutual arrangement.
States and municipalities, particularly those with pension investments in
hedge funds, can drive change. Last October, Scott Evans, the chief
investment officer of the New York City Retirement Systems, demanded full
fee disclosure for its hedge fund investments as a condition for future
business. Fee disclosure can accelerate a trend of hedge funds cutting fees
for investors to limit exits during the current downward cycle; "two and
twenty" has increasingly become "one and fifteen." Hedge Clippers has also
called for a cap on exposure to hedge funds and other alternative
investments for pension funds and university endowments.
A more radical strategy is to force fiduciaries for institutional investors,
bound to operate in the best interest of their clients, to rethink the
entire purpose of the hedge fund investment. Currently, most fiduciaries
still have this idea that so-called alternative investments like hedge funds
enable them to diversify their portfolios and hedge risk, as well as
increase yields. But as we've seen, hedge funds don't really hedge anymore.
More important, research from analysts as varied as Morgan Stanley, the
French business school IPAG, and even the hedge fund AQR shows that hedge
fund returns increasingly correlate with the broader market, particularly
since the 2008 financial crisis.
If hedge funds go up and down alongside the market, and all but the top
performers don't even beat the market, the rationale for investing in them
vanishes. A fiduciary recognizing this would have a duty to investors to
step away from hedge funds. That's already starting: The California Public
Employees' Retirement System, the nation's largest, pulled out of hedge
funds in September 2014, followed by a Dutch health-care workers' fund the
next year.
The quickest way to eliminate the risk to the economy associated with hedge
funds is to reclassify them under the 1940 Acts. Their emergence was an
accident of history, a gift to wealthy families. But the by-product of that
gift has now grown to outsized proportions and shoved itself into
practically every aspect of economic life. Putting hedge funds under the
1940 Acts would mandate disclosure, alter fee structures, and eliminate the
use of leverage. It would extend the regulatory perimeter in a far sharper
way than Hillary Clinton, whose campaign has vowed to rein in "shadow banks"
like hedge funds, has so far promised. In effect, putting hedge funds under
the wise regulatory structure adopted in 1940 would put them out of
business.
Though market forces take a very long time to correct damaging mistakes,
sometimes they purge malefactors. For close to a decade, quantitative
analysts have built computer programs that mimic hedge fund alpha
strategies, generating similar returns through passive rather than active
investment, with far lower fees. These have grown to $50 billion in assets,
a pittance compared to the hedge fund industry but a 25-fold increase since
2010. Robo-traders come with their own potential abuses and require careful
study. But maybe in a few years, outsourced factory workers and hedge fund
managers can hold hands in solidarity and demand an end to having their jobs
taken away by robots.
Clarification: David Dayen's article on hedge funds included a sentence that
Callan Associates was sued by two pension funds for receiving undisclosed
fees from investment funds that Callan promoted. This is accurate as
written, but the investment funds were not in fact hedge funds.
David Dayen is the author of author of Chain of Title: How Three Ordinary
Americans Uncovered Wall Street's Great Foreclosure Fraud [3], releasing May
17.
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http://www.alternet.org/economy/hedge-funds-serve-very-little-useful-purpose
-except-make-few-people-very-rich
Links:
[1] http://www.alternet.org/authors/david-dayen
[2] http://www.prospect.org/
[3]
http://www.amazon.com/gp/product/1620971585/ref=as_li_tl?ie=UTF8&camp=17
89&creative=9325&creativeASIN=1620971585&linkCode=as2&tag=dd
a0d-20&linkId=XXB24AGPRVZMHYIK
[4] mailto:corrections@xxxxxxxxxxxx?Subject=Typo on Hedge Funds Serve Very
Little Useful Purpose Except to Make a Few People Very Rich
[5] http://www.alternet.org/
[6] http://www.alternet.org/%2Bnew_src%2B
