Trillium News

Strategic View: Can there be a socially responsible hedge fund?(A)

Hedge funds are a mystery to most people, starting with the name. A “hedge” sounds like something to reduce risk. Yet some hedge funds make headlines for providing exceptional returns, and it is an iron law of finance that high returns have a dark side: high risk. This was notoriously demonstrated “when genius failed” at the Long Term Capital Management (LTCM) hedge fund in 1998 – almost bringing the entire global economy down with it.[1]

The term hedge fund goes back over fifty years, and originally related to selling “short” some stocks while buying others, and thus reducing the risk of market exposure. Now the term is used for all sorts of unregulated investment funds, usually in partnership form, that are lightly regulated and invest using unconventional strategies. Thus the first challenge of hedge fund investing is that it can mean almost anything, as there is no consistency as to the underlying strategies. The activities of hedge funds remain murky, as funds can escape the usual level of U.S. Securities and Exchange Commission (SEC) scrutiny by restricting their customers to “accredited investors.” These include institutions and individuals that meet certain financial requirements. For example, a charitable organization or trust must have assets exceeding $5 million, while an individual or couple must have financial net worth exceeding $1 million, or a high level of annual income. [2]

What are the ethical problems with hedge funds? Oh, where to begin! Probably with over-promising and under-delivering. The lure of hedge funds is that they will provide “all-weather” high returns that avoid the cyclical losses common to stock-market investing. While the industry publishes very attractive return statistics, academic studies cite widespread problems with “backfilling” data and “survivorship bias.” Managers that have a good run with their family and friends’ money stick around and provide backfilled data to the index providers. Funds that do badly disappear and are removed from the data sets or never show up. For example, in 2004 over 250 funds closed down. Only one-quarter of the funds reporting data in 1996 still existed in early 2005. One academic paper found that these pervasive data problems inflate hedge fund index returns by as much as 8-9% per year. LTCM lost 92% of its capital, but didn’t report the disaster to database providers, and has now been expunged from the indices.

The second problem with hedge funds is the financial terms. Skeptics say a hedge fund is “a compensation scheme masquerading as an asset class.”[3] The typical fund charges 1-2% of assets plus takes 20% of the return. Some hedge fund managers make over $100 million per year, and the trading strategies are generating huge revenues for brokerage houses as well.

Problem three is some of the strategies themselves. Esoteric, clever and undisclosed strategies have a good chance of providing high returns. Shining a bright light on investments often puts the squeeze on excess returns, as the herd begins to share the wealth with the smart money. The problem is that the very lack of scrutiny of hedge funds provides plenty of room for dodgy behavior. Take just the latest example from the headlines, Millennium Partners, which has reported 17% annualized returns since 1990. Without acknowledging any wrongdoing, the firm has agreed to a $180 million settlement over an elaborate scheme it had developed to trade in and out of mutual funds.

To make a sleazy story short, this hedge fund figured out a way to avoid the usual restrictions on mutual fund trading by creating more than 100 shell companies that were used to open 1,000 accounts at 39 different firms processing the trades. The long-term, largely middle class investors in the mutual funds subsidized Millennium’s profits, as inflows and outflows from the strategy created transaction costs borne by mutual fund shareholders. The strategy was esoteric, secretive and apparently profitable. I also think it was inherently unethical, a wealth transfer from the middle class to the fund’s more affluent “accredited investors.”

In theory, it would be possible to provide a responsible hedge fund, but for me this would require going well beyond the basics of what companies were placed in the portfolio. First, the fund should have a transparent strategy that involves no unethical conduct. Second, its fee structure should make a radical break with the norm in the industry. If profits are going to be shared, then the basic fee should be reduced. Also, substantial profit sharing should only be for that portion of returns that relates directly to the manager’s skill, in excess of a risk-free cash rate or any net exposure to the stock and bond markets. Generating returns from holding cash and market exposure shouldn’t require handing over 20% of gains to the manager, on top of a 1-2% fee on assets.

Hedge fund investing requires significant due diligence, and the general lack of regulatory scrutiny means that much of this work has to be done by the investors themselves. A “fund of hedge funds” offered by an established provider is one way to diversify risk and provide an additional layer of fiduciary oversight. There are now over 7,000 hedge funds, with assets over $1 trillion. The number of funds and their profitability now rival the entire mutual fund industry. Caveat emptor!

[1] I’m referencing here Roger Lowenstein’s entertaining account of this disaster, When Genius Failed. The title refers to the fact that LTCM’s team included two Nobel prizewinners in economics.

[2] Changes are afoot as starting in early 2006 hedge funds will have to acknowledge their existence to the SEC, and submit to inspections of their books and records.

[3] Much of the data in this article (and this quote) comes from “The new money men,”, February 17, 2005.