April 12, 2007
Hedge fund regulation
Fed Chair Ben Bernanke yesterday explained why he sees no need for increased regulation of hedge funds.
Quoting from Bernanke's speech:
[M]ost small retail investors are ill-equipped to provide effective market discipline because monitoring complex financial activities demands considerable time, effort, and sophistication. In the case of hedge funds, securities laws effectively allow only institutions and high-wealth individuals to invest in them. These investors generally have the resources and sophistication, as well as the incentive, to monitor the activities of the hedge funds. Large investors are not only well equipped to assess the management, strategies, performance, risk-management practices, and fee structures of individual hedge funds but they also have the clout to demand the information they need to make their evaluations....
Thus far, the market-based approach to the regulation of hedge funds seems to have worked well, although many improvements can still be made (Bernanke, 2006). In particular, risk-management techniques have become considerably more sophisticated and comprehensive over the past decade. To be clear, market discipline does not prevent hedge funds from taking risks, suffering losses, or even failing--nor should it. If hedge funds did not take risks, their social benefits--the provision of market liquidity, improved risk-sharing, and support for financial and economic innovation, among others--would largely disappear.
I agree with Bernanke that direct regulation of hedge funds could be counterproductive. But I am a little more worried than he is about whether the incentives for investors in those funds are working out correctly. In particular, I have raised the concern that some pension fund managers could conceivably want a negative-expected-return portfolio, if this comes in the form of a high probability of above-normal returns and a low probability of severe losses. Bernanke downplays this possibility, asserting
[M]anagers of pension funds and similar institutions generally have a fiduciary duty to their investors to research and understand their investments and to ensure that their overall risk profile is appropriate for their clientele. In practice, most pension funds have only a small exposure to hedge funds.
I assume that Bernanke has some good data to back up that last claim, though I'd be interested to know what it is. I have only looked at one pension fund in detail, the San Diego County Employees Retirement Association, and found that its hedge fund exposure amounts to at least 20% of its assets, and possibly considerably more.
Certainly when we are talking about pensions for government employees, restricting hedge fund participation is not intrusive government regulation, but simply a question of sound fiscal management. I would also make the further argument that corporate pension funds have the political potential to become public liabilities, and could have similar incentive concerns arising from the possibility of corporate bankruptcy.
I therefore repeat a suggestion I have made before. If one defines a "hedge fund" as any institution whose detailed assets and liabilities are not publicly disclosed and regularly audited, I would favor a statutory limit on the total notional exposure (in which I include investments, overlays, pledges of collateral, swaps, options, derivatives, guarantees, whatever) of any pension fund to hedge fund risk of no more than 10% of its total assets.
If Bernanke is right, this would be unnecessary because it would only affect a limited number of institutions. But that doesn't strike me as a good reason not to do it.
Posted by James Hamilton at April 12, 2007 08:31 AMdigg this | reddit
I am not certain what the best regulatory approach here is, but the other issue that Bernanke does not address, and perhaps he cannot address it, even though his initial academic research was on financial fragility, is exactly that: financial fragility.
Thus, it is possible that we are in a situation much like the ecologist C.S. Holling describes, where there is a tradeoff between "stability" and "resilience." Thus, the hedge funds are using ever more sopisticated devices to achieve efficiency and stability, including an explosion of ever higher order derivatives (have not seen more recent numbers, but I know that in the first four months of 2006 there was a 50% increase in forex deriviates). However, this increase may be being bought at the risk of a systemic breakdown or crash affecting all, or most, securities, much like what nearly happened in 1998.
Posted by: Barkley Rosser at April 12, 2007 10:12 AM
I really question Bernanke's assumption that "large investors" are really more sophisticated than "small investors". Many "hedge funds" (at this point, a misnomer if there ever were one) employ strategies that require PhD in Mathematics to understand, and I doubt it is exactly the expertise available at the top of pension funds' management.
Having said that, I agree with both Bernanke and Professor that regulating these private partnerships is a bad idea; moreover, John Mauldin makes an excellent case for scrapping the mandatory wealth restrictions altogether.
Small Investor Chronicles
Posted by: Alex Khenkin at April 12, 2007 10:34 AM
JDH, your definition will prohibit pension fund holdings in private equity. Is this your intention?
Posted by: James I. Hymas at April 12, 2007 10:57 AM
I can tell you for sure that most hedge funds are NOT sophisticated. They make 80% of their decisions by sentiment, NOT mathematics. Many of them does not have technical nor economic backgrounds. I thought the same way as Benanke before I entered the financial industry. I was surprised too...
Posted by: Insider at April 12, 2007 03:58 PM
James Hymas, I wouldn't prohibit such holdings, only limit them to 10% total.
Posted by: JDH at April 12, 2007 09:21 PM
James Hymas - If my pension fund decided that 144(a)s were a better choice than the rather-more-liquid stock market or corporate/government debentures, I would be very worried about more than just my pension.
For all Bernanke's noble talk of "fiduciary duty," the penalties for lax investment monitoring and controls are rather low. Given that, a concentration on liquidity and transparency seems as if it would benefit the pensioners and (if they are doing their jobs) not at all impair the pension fund managers.
Therefore, JDH's propoal is also Pareto-optimal, in the world as described by Bernanke.
Posted by: Ken Houghton at April 13, 2007 10:18 AM
JDH - sorry, my error. I should have said "restrict", not "prohibit".
Ken Houghton - I can understand arguments against over-exposure to private equity based on transparency and the potential for (shall we say) overly-optimistic valuations, but have a bit more difficulty with "liquidity" being the prime concern.
Liquidity costs money; the very long duration of pension liabilities and their relative ease of forecasting imply that liquidity, in and of itself, is not a major concern.
Did you really mean "liquidity"?
Posted by: James I. Hymas at April 13, 2007 11:18 AM
And actually, JDH, I have yet another question regarding your proposal: what about private equity that does publish audited financials, but is not subject to Sarbanes-Oxley? And, for good measure, how about a private equity fund for which the fund itself publishes audited financials, but for which audited financials for the underlying investments are not made public?
Posted by: James I. Hymas at April 13, 2007 01:40 PM
From a societal point of view Bernankes comments seem already out of date.
A combination of market forces and market interference created the developing subprime/mortgage problem, and no doubt many other financial crisis scenarios.
Via successive interferences the guy getting the loan is so far removed from the guy taking the risk that only a person who imagines:
1. A junior clerk following a set of rules can make the same judgments as a seasoned bank manager selected by his ability to produce performing loans
2. Such a junior clerk based system can be reduced down to a set of rules inside a computer to replace a bank manager interview for loan suitability where the person talking to the borrower has no interest at all in this being a performing loan and instead every interest to ensure that somehow the loan goes ahead.
Is this kind of 'sophistication' behind the feds confidence in hedge funds?
Would you want to be the counterparty to my bet you are dead wrong to think this can end well?
Would i want to be the counterparty to your liability to pay me in full when my bet comes true and i am already committed to paying other counterparties a lesser amount if my bet comes true (ie my hedge)
The whole system seems based on burning down the house to collect the insurance and yet nobody seems to see that when all houses are burnt down there will be no house insurer able to pay even if he did have investments in houses.
And yet when people talk about the music stopping or the tide going out we are led to believe we just dont understand how sophisticated these schemes are!
It would be funny if it were not worrying me half to death!
Posted by: Worried at April 14, 2007 03:59 AM
James Hymas, transparency for me is the #1 issue, so I have no problem with equity in an audited privately-held firm. But I see that you are raising a valid issue of investment in what is in effect an audited holding company for unaudited hedge funds. We would need language to count such investments against the 10% limit. What do you or others think might be the best way to word that?
Posted by: JDH at April 14, 2007 08:15 AM
When you say 'audited' can you explain how this would help?
Hedge funds typically have greater than 100% turnover per year in their portfolios.
An audit is a 'snapshot' of one point in the year. It really doesn't tell you anything about the risk you are running in holding an investment in a fund.
In a world where alternative assets (commodities, hedge funds, private equity, timber, real estate etc.) are becoming 30-40% of the average pension fund or endowment (the levels being reached by the likes of Harvard and Yale) then it's difficult to see a '10%' rule working.
However I agree with you about the risks, and the absence of transparency.
I don't, in my own mind, have an obvious solution to the problem.
Just a general observation that there are too many hedge funds, out there, right now, and they don't create enough value, after fees, for most investors.
Posted by: Valuethinker at April 14, 2007 08:56 AM
JDH, I'm not sure that any wording that you are seeking exists - which is why I've always argued against your prescriptive rules-based approach and argued instead for forceful application of the prudent-man rule.
I share insider's sentiments regarding the investment industry in general: there are many smart people in the business, but there are also a lot of ... um ... not quite as smart people. Performance is not as crucial as one might think in attracting assets - it's all about telling a story and making a sale.
There is currently mass adulation directed towards Centaurus Energy's John Arnold for being the guy who profited immensely by betting against Amaranth. I'm not impressed. One assassination, pipeline blow-out or flap of a butterfly wing different and Amaranth wins big and Centaurus is the goat. But I'm sure that Centaurus is now turning away client money. But that's just an aside.
You could, if you wanted, include language in your proposal to define a "qualified investment" - being one that meets the audit & transparency rules. As part of the disclosure, all holding companies would have to disclose their percentage exposure to non-qualified investments, with exposure being carried through the calculations, through all the levels of holding vehicles to the ultimate investor.
But there are always ways around those rules! You don't need a securities license in Canada to take bank deposits - but you do need one to sell equity investments. But bank tellers and insurance agents want to sell exciting high-margin investments - so many banks now offer index-linked notes, fully guaranteed by the bank, with the returns based on equities, commodities - you name it. These qualify as bank deposits. The precise status of the regulations at the moment is beyond my expertise, but that's the sort of thing that happens.
Which is why I say: concentrate on a principles-based prudent-man rule and allow pension beneficiaries to sue based on this rule. Valuethinker's objections to the efficiacy of relying on an audit can be addressed under such a system by examination of the mandate: Allow 5-times notional exposure to gas prices, and you're OK. Give your manager a mandate to lever up to 100-times exposure ... better get ready to justify that as prudent.
Perhaps one way to address the issue is to demand publication of the mandates?
Posted by: James I. Hymas at April 14, 2007 11:55 AM