Last summer, we told you about an academic article on hedge fund regulation by Houman Shadab of George Mason University, just outside of Washington D.C. Shadab’s cogent and balanced analysis of hedge fund regulation stood in stark contrast to calls to prevent most investors from purchasing hedge funds. He argued that “financial sophistication” and wealth level are not synonymous and that wealth-based investing limits actually hurt, not helped, most truly “sophisticated” investors.
Today (Thursday) Shadab testified in front of the US Congress’ Committee on Oversight and Government Reform along with George Soros, Ken Griffin, John Paulson, Andrew Lo, Jim Simons and other hedge fund industry participants.
Anyone involved with the hedge fund industry needs to read Shadab’s written testimony or watch the video of his verbal remarks. He has brought together over two years of research to address a variety of topical issues such as the extent to which hedge funds were actually involved with CDSs and CDOs, systemic risk and even hedge fund compensation. We’d also recommend you check out his working paper to be published next year in the Berkeley Business Law Journal called “The Law and Economics of Hedge Funds: Financial Innovation and Investor Protection” (available here).
We spoke with Shadab after the hearing today and asked him to elaborate on a few of the points raised in his testimony.
AAA: As you pointed out in your testimony, hurdle rates and high water marks act as a governor on manager compensation – a feature that traditional executive compensation schemes may lack. But isn’t a performance fee still asymmetrical in the manager’s favor? Or is that even a problem?
Shadab: Given how competitive the hedge fund industry is, I’m not sure the asymmetric nature of the performance fee is a problem. There is strong pressure on managers to deliver results satisfactory for investors, meaning: perhaps managers’ greatest incentive to strike the right balance between risk-taking and risk management is preventing investor redemptions down the road. As we are currently witnessing, hedge fund investors aren’t satisfied to simply do less bad than the market. If the hedge fund manager can’t weather the storm, redemptions will follow.
AAA: Did hedge funds start (or at least act as a catalyst for) the mortgage crisis?
Shadab: Hedge funds only started really investing in securities whose value was in some way related to mortgages by sometime in 2004, according to the numbers I have seen. By that time, the housing bubble was in full swing, and interest rates were quite low by historical standards. Even when hedge funds did arrive on the mortgage-related security scene, they limited themselves primarily to the equity tranche, or riskiest slice, of security issued in a typical collateralized debt obligation deal. This type of activity didn’t fuel the credit crisis, since the primary purpose of such deals to get investment grade tranches issued that paid higher yields than bonds having same rating. It was pensions, money market funds, insurance companies, and banks fueling these deals, not hedge funds.
AAA: You describe short sellers as “watch dogs” over public companies. But is it possible for these watch dogs to ever bite their owners? In other words, have short sellers ever caused a company to fail?
Shadab: I have not read about a case where an otherwise healthy company was forced into bankruptcy merely because their stock was repeatedly sold short. Remember, its not like short-selling has the power to move stocks, at least not without massive fraud in the form of abusive naked shorting. Short-selling by itself riskier than going long, because the short-seller will have to cover at some point, which could in principle cause far more losses than the initial investment. And if a trader keeps shorting a healthy company, they keep exposing themselves to more risk: the farther a stock drops, the higher it could potentially come back, which would be ruinous for a short-seller.
AAA: In your view, what are regulators’ top 3 biggest misconceptions about hedge funds?
Shadab: One: Hedge funds are “risky.” Risk is the most important concept in all of finance. Unfortunately, its one of those concepts used far more than its understood. Regulators think that hedge funds are risky because they’re non-traditional. But traditional, long only buy-and-hold investments are more risky, because, as we all should know, they are undiversified, not with respect to companies in which they invest, but with respect to strategy. Hedge funds’ non-traditional investment strategies are less risky, at least in principle, because they do not necessarily commit the manager to one single way of making gains for investors, and one way of thinking about markets. When viewed from the perspective to outcomes, and not hypotheticals, hedge funds are less risky than traditional investments.
Two: Transparency will reduce risk. Too many seem to believe that hedge funds can simply disclose their leverage and investment positions, and from that information we will know all we need to know about the risks that hedge funds pose. That’s just too simplistic. To get an accurate picture of hedge fund risk, we would need confidential information from virtually every financial institution, and on a daily basis, at least. Two questions arise: what regulator has the expertise to process that information? and what is the appropriate response to discovering that a fund or group of funds has a risk exposure deemed too great? It’s just not clear that regulators will have sufficient manpower and expertise in finance to make sound judgments about what risks hedge funds pose, to whom, to what extent, when, and what should be done when the response itself could cause a financial disruption. I worry that increasing transparency will decrease due diligence, and lull parties into complacency. This financial crisis is partially a crisis of complacency: too many parties relied on ratings agencies to evaluate credit risk, and the Securities and Exchange Commission to keep an eye on investment banks. It would be a shame if hedge fund investors, prime brokers, counterparties, or creditors began to relax their oversight and instead relied upon, for example, the Federal Reserve to make calls about which funds are too risky. If anything, we need more market discipline, not the opposite. The solution, however, is not to “do nothing.” Rather, policymakers should look at some of the underlying causes of assets bubbles, such as monetary policy, bank supervision and capital requirements, off balance-sheet and mark-to-market accounting, the power of ratings agencies in credit markets, and how restrictions permitting mutual funds to pursue alternative investments may bring additional volatility-dampening strategies to markets.
Three: Hedge funds are “highly leveraged”: Although many hedge funds do employ large amounts of leverage, as high as 10 or 15 to 1, high leverage is not a defining feature of hedge fund industry. The latest estimation I have found is that hedge funds in 2007 were leveraged up to 3.9 times assets, and this includes all types of leverage, whether from borrowings or through shorting or derivatives exposure. Indeed, hedge fund leverage seems to primarily come from using derivatives, not borrowings. I think that is important, because leverage obtained through derivatives seems to be of the type that is used to reduce and manage risk, not increase it.
AAA: You warn that “changing how hedge funds are regulated could actually undermine the interests of investors and increase economic instability.” Can you give us an example of a form of regulation that has the potential to do this? If hedge funds have nothing to hide, why do they resist regulation?
Shadab: Hedge funds don’t have anything to hide, but certainly do have something to protect: their intellectual property, in the form of investment positions and trading strategies. This is not to say that every hedge fund manager is sitting on the equivalent of the formula to Coca-Cola. Many hedge fund investment strategies are in fact quite mundane, and investors must be sure they are paying their manager for genuine value. So, for example, by employing leverage to benefit from very small spreads between two different debt instruments, a fixed-income arbitrage hedge fund can help all market participants realize the true credit risks to which they are exposed. In this sense, hedge funds reduce bad surprises for other parties. Now, if limitations on leverage are placed upon hedge funds, the ability of such funds to make these types of revelations to the marketplace–so that others can make better investment decisions that relate to credit quality–may be hampered.
AAA: If you’ll permit me to ask a self-interested question, I see you cited AllAboutAlpha.com in your written testimony. How long have you been a reader? Why do you read it?
Shadab: How long? Not long enough! It’s now my one-stop-shop for keeping up on the developments and ideas driving the world of hedge funds.
AAA: That’s great to hear. Thank you for your time.
There are plenty more observations and statistics in the 26-page paper Shadab submitted to the committee yesterday. Let’s hope that this type of dispassionate discussion catches on as regulators perform the post mortum on the recent financial chaos. (Note to Italian and German hedge fund managers fighting for their regulatory lives: Shadab’s contact information is on his website…)