The issues with hedge funds

May 17, 2016 03:00 PM

[node:field_image:alt]

 

Since I first began writing about hedge funds more than 15 years ago there has always been a conflict within the space. Hedge funds had always been viewed as secretive investment vehicles. This had to do with innovative investment managers being reluctant to reveal their secrets and a media environment where it was difficult to explain such complex material. 

This outlook was not wrong but only told half the story. The hedge fund community had basically worked out a deal with regulators — what we have referred to as a “faustian bargain” — where they would be free from  registration and some of the more intrusive regulatory requirements of mutual funds and in return they agreed to only offer their products to a narrow group of sophisticated investors and not hold themselves out as investment advisors. 

Over the years business media has often referred to the shadowy nature of hedge funds without acknowledging (or perhaps even knowing) that hedge funds where restricted from revealing more with the threat of losing their regulatory exemption. 

And the industry hasn’t always helped itself. While complaining about the unfair nature of their treatment in the press it did little to tell their broader story, restricting media from forums and events and generally adding to the negative perception. 

That is why we were so happy that Anthony Scaramucci agreed to speak with Contributing Editor Steven Lord for our hedge fund issue. In “SkyBridge CEO on investment themes, manager screens & regulatory regimes” (page 18) Scaramucci discusses the state of the hedge fund industry. For a deeper dive into his thoughts on politics, baseball (he is a part owner of the New York Mets) and why he resurrected Wall Street Week, see 
“A random walk with Scaramucci” (page 34). 

Hedge funds are more complex — though not necessarily more risky — than most traditional investment styles, which is one reason it gets its secretive reputation. This means that investing in hedge funds requires more work and research than traditional investment vehicles. In “Trade secrets — due diligence beyond the tear sheer” (page 22) Eloise Yellen Clark, founder of OmniQuest Capital, breaks down the process of performing due diligence on a promising hedge fund strategy. Everyone considering making an allocation to a fund should read this carefully, as Lord describes the process Clark goes through before making an investment into a hedge fund. 

Hedge funds have always been more of a structure than a strategy. The structure was created to avoid certain regulatory requirements, but many of the strategies involved are not inherently more risky. 

The tragic thing about the way the regulatory structure has evolved is that numerous alternative strategies that would serve the diversification needs of the broader retail investing universe are unavailable to them. The growth of liquid alternatives is an attempt to rectify this. In “GSAM’s Papagiannis on liquid alternatives” (page 26) we interview the head of Goldman Sachs’ liquid alternative unit to discuss developments in the liquid alts space.

Why is it important for the hedge fund industry to tell its story? Look no further than Features Editor Garrett Baldwin’s piece “Dems’ antidote to the evils of activist investing” (page 28). Baldwin describes the recently proposed Brokaw Act, which attempts to restrict activist investing that its sponsors claim led to the closure of a paper mill in Wisconsin and more broadly to the focus on short-term (quarterly) profits at the expense of investing in our communities. Like many such narrowly focused bills there are a host of potential unintended consequences that can occur as a result. While I don’t want to speak specifically to the law (though Baldwin certainly does), it is clear that a better understanding by lawmakers of what hedge funds do would lead to better legislation. 

A case in point are efforts by the New Jersey chapter of the AFL-CIO to cut back allocations to hedge funds (see “New Jersey to hedge funds: Stop making us money” page 82). Apparently they think the fees are too high. Yet, the performance beat that of traditional allocations, net of fees. There is an obvious disconnect here. One union official even derided Wall Street billionaires and suggested a traditional allocation to stocks and bonds. Where does he think those traditional brokers work, as opposed to hedge fund managers? 

This is the definition of cutting off your nose to spite your face.

 
 

 

Daniel P. Collins
Editor-in-Chief, Modern Trader
@moderntradered

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.