Key Issues for Policymakers
As hedge funds grow in size and importance, regulators and legislators are examining: the funds’ impact on systemic risks; transparency; the quality of measurement used to determine performance and value the funds’ holdings; and, the funds’ governance structure. A new regulatory approach for hedge funds is part of a larger effort by the Obama Administration and Congress to develop a comprehensive reform of financial regulation, including the establishment of a systemic risk regulator to monitor and mitigate risks to capital markets and their participants.
Hedge Funds, the Global Financial Crisis, and Systemic Risk
The worldwide financial crisis called into question the role that various market participants played in creating systemic risks in the U.S. and global financial systems. “Systemic risk” describes “the risk that an economic shock, such as market or institutional failure, triggers (through a panic or otherwise) either the failure of a chain of markets or institutions or a chain of significant losses to financial institutions, resulting in increases in the cost of capital or decreases in its availability, often evidenced by substantial financial-market price volatility.”91 Such events could arise from a loss of liquidity (inability to convert securities into cash), credit (loan defaults), leverage (over-extended in debt), concentration of risk (due to adoption of similar trading strategies), or technology and operational failures.
Several reports published in 2009 examined the causes for the financial crisis, including one led by Lord Adair Turner, chairman of the U.K. Financial Services Authority, and another by the de Larosière Group. These reports emphasized the roles played by macro-economic imbalances, the pace of financial innovation exceeding regulatory capabilities in facilitating excessive leverage, and an irrational exuberance perpetuated by an unsustainable rise in securities and real estate values.92 In this context, as Treasury Secretary Tim Geithner outlined in testimony in March 2009 before the House Financial Services Committee, “Regulated institutions held too little capital relative to the risks to which they were exposed. And the combined effects of the requirements for capital, reserves and liquidity amplified rather than dampened financial cycles. This worked to intensify the boom and magnify the bust. Supervision and regulation failed to prevent these problems. There were failures where regulation was extensive and failures where it was absent.“93
What role did hedge funds play? The emerging consensus is that the “recent financial crisis is not actually a ‘hedge fund crisis,’” as summarized by the Technical Committee of the International Organization of Securities Commissions.94 They note, too, that “many of the financial firms that failed or required governmental intervention were already subject to a high degree of regulatory oversight.”
(See page 15 of the Hedge Funds Primer)
The total amount of assets managed by the hedge fund industry, even at an estimate of $1.43 trillion under management as of June 2009, is dwarfed by almost any other class of asset manager, from mutual funds to investment banks to life insurance companies. The largest hedge fund is a fraction of the size of leading financial institutions.95
(See “Relative Size of Hedge Funds” on page 4 Hedge Funds Primer)
Regulators and policy makers have expressed concerns about the potential impact of the failure of one or more large funds as a triggering event in which counterparties would be at risk.
An approach that addresses this concern should be coupled with a modernized financial regulatory system—one that addresses overall risk to the financial system and regulates market participants performing the same functions in a consistent manner. This approach does not prevent losses from occurring, but rather works to diminish the risk that such losses by individual market participants would adversely impact the broader financial system. Further, regulators and market participants should continue monitoring the extent to which hedge fund risks are concentrated in too few positions.
Greater Transparency, Better Reporting
Hedge funds, like other market participants, must comply with a variety of reporting requirements, such as: SEC portfolio reporting (requiring investment managers with investment discretion with respect to more than $100 million in equity securities to periodically report position information); SEC reports of ownership of five percent of a class of equity securities (which must be reported within 10 days of acquiring five percent); reporting to the Treasury large positions in to-be-issued or recently issued Treasury securities and positions in foreign exchange; and large position reporting (for hedge funds that trade in U.S. futures markets) to the CFTC.
There has been a steady improvement in the amount of data available to investors about hedge funds. “Hedge fund advisers have responded to the requirements of these clients by providing disclosure that allows them to meet fiduciary responsibilities,” according to the GAO.96 That said, though, a July 2008 survey of senior executives in the global fund and investment management business showed that the vast majority of respondents want investment banks to improve the risk transparency of their hedge fund products.97
In addition, there are some simple, common-sense disclosures that private investment funds could be required to make before they accept an investment. Legislation could reinforce those disclosure obligations by requiring private investment funds to:
- Create, update, and provide investors with a private placement memorandum disclosing all material information regarding the fund, including any disciplinary history or litigation;
- Disclose their fees and expense structures, as well their use of commissions to pay broker-dealers for research (i.e., “soft dollars”);
- Disclose their methodologies for valuation of assets and liabilities;
- Disclose side-letters and side-arrangements;
- Disclose conflicts of interest and material financial arrangements with interested parties, including investment managers, custodians, portfolio brokers, and placement agents;
- Disclose policies as to investment and trade allocations;
- Provide investors with audited annual financial statements and quarterly unaudited financial statements; and,
- Disclose the portion of income and losses that the fund derives from Financial Accounting Standard (FAS) 157 Level 1, 2, and 3 assets.98
The Asset Managers’ Committee has specifically recommended many of these disclosures, but Congress could give the recommendations legal effect through a new statute tailored for private investment companies, or through amendments to the Investment Advisers Act of 1940.100
However, requiring hedge funds to make public disclosure of certain positions and trading strategies would have severely negative consequences. CPIC previously commented on this issue in 2008 in the context of a proposal by the SEC to require public reporting of short sale positions—a proposal the SEC later pared back to a requirement that disclosure be made only to the SEC for staff use in monitoring short sale activity.101 CPIC strongly supported the SEC’s right to obtain this information for regulatory and enforcement purposes, but argued that public disclosure of information relating to investment managers’ positions in securities would unfairly penalize investment managers and their investors and potentially expose them to retaliation. In April 2009, CPIC made similar arguments to the UK Financial Services Authority in response to their proposal requiring short sellers to publicly report their individual positions in specific securities when certain thresholds are met.
If certain positions and strategies were subject to such disclosure, trade secrets and proprietary information would be divulged, which is contrary to long-standing market practices, federal law, and the rules of numerous other federal agencies. These practices, laws, and rules recognize the need to protect businesses from the economic and competitive disadvantages that would result from public disclosure of such information.102
Fund managers often conduct rigorous, costly financial analyses that focus on an issuer’s business plan, and the quality, integrity, and potential growth of their earnings. They gather information from a wide array of sources and review the businesses of competitors, affiliates, and counterparties to significant transactions. Some managers employ accountants, researchers, and financial analysts. Their analytical techniques may have been developed over years of experience and at great expense. Disclosure of investment positions allows other traders to be “free riders,” benefiting themselves while reducing the gains that should accrue to those that actually did the research. Public disclosure of short positions may also confuse investors. Short selling in a company’s stock can occur for many reasons and not necessarily because the short seller has a negative view of a company’s outlook; for example, a financial institution may take a short position to lock in a spread or hedge an investment in convertible bonds. In these cases, public disclosure of a short position, especially by a prominent investor, may mislead investors and trigger panicky selling. Finally, public disclosure of trading positions and investment strategies could expose investment managers to retaliation, such as a “short squeeze” campaign. Likewise, issuers may cut off communications with funds who report short positions in the issuers’ securities. This type of retaliation prejudices institutional investment managers, their clients, and, more broadly, the process of price discovery.
CPIC supports public transparency in other areas that will benefit investors, as outlined in legislation CPIC proposed to Congress (See page 23 of the Hedge Funds Primer). CPIC believes hedge funds and other privately offered pooled investment vehicles should be required to file with the SEC, and keep current, an online publicly-available registration statement. Disclosures should include: the fund’s name and principal place of business, the year of formation and the year in which operations commenced; the investment manager of the fund, its principal place of business, and its contact information; names and descriptions of the officers and portfolio managers of the fund, as well as its trustees or directors; the name and address of the public accounting firm that serves as the fund’s auditor; the fund’s yearly gross and net asset values since inception; the number of investors as of the most recent calendar year-end; and, a brief description of its investment strategy.
Valuation, Performance Reporting
Proper valuation of fund assets is an extremely important component of investor protection. These valuations are used to determine the value of a fund’s units so that an investor knows what his or her investment is worth at a given point in time. These measurements also determine the price at which new units are issued and existing ones are redeemed. To avoid dilution and unfairness, these calculations must be accurate, using an unbiased, consistent, and transparent method.
The consistency and uniformity of performance reporting goes to the heart of an investor’s ability to choose wisely among a myriad of financial and investment products, giving the investor an “apples vs. apples” choice—a true comparison. A February 2009 survey of institutional investors by State Street Corporation shows that “concern over accurate hedge fund valuation has increased, most likely due to growing complexity in investment strategies.” This concern rose, survey participants said, because, among the challenges arising from the recent market volatility has been the difficulty in “accurately valuating derivatives and other complex financial instruments [held by hedge funds].”103
U.S.-based hedge funds are subject both to GAAP (Generally Accepted Accounting Principles) accounting standards and to federal and state anti-fraud restrictions in their performance reporting.
The Asset Managers and Investors Committees of the President’s Working Group on Financial Markets outlined best practices to govern the valuation processes funds should use to assess investment positions and the valuation policy and procedures investors should adopt.104
In their view, fund managers “should establish a comprehensive and integrated valuation framework to provide for clear, consistent valuations of all the investment positions in the fund’s portfolio, while minimizing potential conflicts that may arise in the valuation process.” Specific components of this framework should include a governance structure, well-documented valuation policies, and independent personnel who are extremely knowledgeable about valuation methodologies. The valuation policy’s elements should cover methodologies (including sources of prices for different types of investment positions), internal documentation procedures to support valuations, and a delineation of the circumstances that permit a manager to rely upon models.105
Investors must “understand the processes and controls related to deriving valuation, and that [they] evaluat[e] and monito[r] these on an ongoing basis,” the Investors Committee of the President’s Working Group advised in its best practices in January 2009. Investors should verify that a fund’s manager has a written statement of valuation policies and procedures, a governance process to ensure consistent and appropriate application of valuation methodologies, rigorous data collection that includes secondary sources whenever possible, and the use of third party, independent administrators.106
The SEC provides guidance on the valuation of securities, derivatives, and other assets lacking readily available market quotations, which requires the use of good faith estimates but does not provide a clear, uniform methodology. This guidance, though, warrants updating.
Professional investors rely on short selling strategies to accomplish their investment goals. A short sale is any sale of a security the seller does not own or a sale that is completed by delivery of a borrowed security. As financial detectives, short sellers look for securities that are overpriced. Through their prime broker, the short seller promises the lender to replace the borrowed shares in the future, and pays certain costs until the borrowed shares are returned. Short sellers receive a credit rebate on sales proceeds that come into the prime broker’s account. (Visit
www.financialdetectives.org to learn more and download a primer on short selling.)
Short selling is an integral part of the workings of capital markets, providing liquidity, driving down overpriced securities, and increasing efficiency. In equity markets, there are many types of short sellers. The vast majority are market neutral, where the seller has no view of a particular company’s outlook. As the SEC noted, “short selling provides the market with two important benefits: market liquidity and pricing efficiency.”109
The short sellers’ detective work helps to align securities’ prices with fundamental values. “Virtually every piece of empirical evidence in every journal article ever published in finance concludes that without short sellers, prices are wrong.”110
Researchers have shown that short selling:
- Identifies overvalued stocks and acts as a safety value in bringing the prices of overvalued companies’ shares back to alignment with prices those companies’ fundamentals would justify111
- Increases the information flowing to investors, improving efficiency in securities pricing and lowering investors’ transaction costs112
- Focuses investors’ attention on companies’ fundamentals by focusing investors’ attention on misperceptions about those fundamentals113
- Improves market quality by deepening liquidity114
Researchers have called short sellers “canaries in the mine,” “investors’ heroes,” “an antidote to overly optimist CEOs,” and investors’ “first line of defense.”117
Constraints on short selling have been found to undermine market quality, thereby harming investors’ interests. “Markets which prevent or do not practice short sales are characterized by poor information diffusion and price discovery. . . . Market efficiency and the ability to hedge investments are attractive factors to sophisticated global investors,” according to the Financial Times.118
Engaging in short selling entails risks and costs. One danger is the theoretical possibility of an unlimited loss. In comparison to a “long” purchase of shares, where the investor can only lose the amount of money he or she originally invested (plus fees), there is no maximum to the loss that a short seller could incur. In other words, there is no cap on how high a share price could go; the higher the share price, the greater the loss.
The governance of hedge funds needs to be viewed from a different perspective than that for mutual funds and other types of asset managers. The exemptions from regulation under the Investment Advisers Act of 1940 and the Investment Company Act of 1940 for hedge funds and their advisers are designed to encourage tremendous flexibility in the range of investment strategies and products these funds can use. That capability has enabled them, as the Federal Reserve, the SEC, and academics have shown, to play a key role in stabilizing markets by providing liquidity. (See pages 3–7 of the Hedge Funds Primer)
Finance Professor Bruce N. Lehmann observes that “governance issues associated with hedge funds are best understood by looking at other limited partnerships or public firms that are similar in terms of assets or liabilities.”119
In his view, if the regulatory structure for hedge funds changes dramatically, hedge funds will not be able to operate as efficiently as they do now.
Lehmann observes that “the governance structure of hedge funds improves on that of public companies with regard to moral hazard in three ways. First, hedge-fund managers receive a more refined performance-based fee. . . . Second, managerial wealth is managed inside the fund. Third, managers are bound to the fund to some extent via exit restrictions.” As a result, the incentives in a typical hedge fund governance structure are “far stronger” than those at public corporations.
Hedge Fund Valuation: Counsel from the CFA Institute Centre for Financial Integrity
Valuation of Liabilities
- Position: Investment funds should value the instruments on their balance sheets that create leverage.
- Rationale: The valuation of traditional investment fund holdings essentially relies solely upon a valuation of the asset side of the balance sheet because such funds do not carry debt. Hedge funds, however, use a variety of leverage instruments to boost their returns. Unless these liabilities are valued, it would create a mismatch for the net asset value of the fund by marking the asset side of the balance sheet to market but leaving the liabilities at cost.
- Position: Valuation of hedge fund portfolios should use a hierarchy of valuation techniques, with the use of public price quotes as the preferred method. For instruments which have no publicly available quotes, valuations should first rely upon widely accepted valuation techniques and models, and only in rare circumstances rely upon proprietary valuation models.
- Rationale: Reliance on quoted prices for transactions involving liquid securities provides the most reliable proxy for the valuation of instruments where such prices are available. Widely accepted valuation models are the next preferred technique due to their acceptance and the general understanding by investors. Only in rare circumstances involving one-of-a-kind, complex, and structured instruments should the valuation look to the use of proprietary valuation models because of the potential for manipulation.
- Position: Valuation of hedge fund holdings whose prices are not publicly available should fully disclose to hedge fund investors information about the models used to value such instruments and the assumptions used in the valuation process, and should describe both the instrument being valued and the structure underlying the instrument.
- Rationale: Investors need to know what valuation models and assumptions are used to determine whether they are realistic. They also need to understand the instrument being valued and the structure underlying the instrument to determine whether the valuation method is appropriate.
Hierarchy of Valuation Methods
Disclosure of Valuation Models
- Regulation must be based upon activities, not actors, and it should be scaled to size and complexity.
- All companies that perform systemically significant functions should be regulated.
- Regulators should have the authority to follow the activities of systemically important entities regardless of where in the entity that activity takes place.
- As complexity of corporate structures and financial products intensifies, so, too, should regulatory scrutiny.
- There should be greater scrutiny based upon the “Triple Play”—being an originator, underwriter/securitizer and investor in the same asset.
- The systemic risk regulator must enforce transparency and practice it.
“Short selling . . . can contribute to the pricing efficiency of the markets. . . . When a short seller speculates on . . . a downward movement in a security, the transaction is a mirror image of the person who purchases the security based upon speculation that the security’s price will rise. . . . Market participants who believe a stock is overvalued may engage in short sales in an attempt to profit from a perceived divergence of prices from true economic values. Such short sellers add to stock pricing efficiency because their transactions inform the market of their evaluation of future stock price performance. This evaluation is reflected in the resulting market price of the security.”
SEC Staff Report September 2003107
“In my current view, hedge funds deserve a narrowly tailored regulatory treatment.”
Rep. Paul Kanjorski
May 7, 200990
“Placing the onus on market participants to provide discipline makes good economic sense. . . . [But] [d]irect regulation may be justified when market discipline is ineffective at constraining excessive leverage and risk-taking.”
Federal Reserve Board
Chairman Ben Bernanke,
May 16, 200699
“More institutions are looking for better ways to measure and manage risk, and many place equal emphasis on qualitative and quantitative analysis when monitoring hedge fund performance.”
State Street Corporation
“There’s a valuable role that’s played by short-selling. It brings information into the marketplace that’s incredibly useful and valuable.”
SEC Chairman Mary Schapiro
May 14, 2009115
"Alternative investments. . . play an important role in the European economy. They are an alternative source of capital for European companies. This is particularly significant at the present time when banks are restricting lending.”
EU Internal Market Commissioner Charlie McCreevy
April 29, 2009116