Hedge Fund Clamp-down? Research Says Investors Can Watch Out for Themselves

Regulators and some members of Congress want to clamp down on the nearly $3 trillion hedge fund industry, worried that big risks taken by these barely regulated investment pools could hurt innocent bystanders. But the hedge fund industry, arguing that it had little to do with the current financial crisis, says funds already have plenty of incentive to be careful.

How do those incentives function in the real world?

New research by Wharton accounting professor Gavin Cassar and Joseph Gerakos, an accounting professor at the University of Chicago Business School, shows that even though hedge funds give their managers virtual autonomy in investment strategy, investors can successfully demand effective internal controls to discourage fraud, including misstatements of asset values.

While the research does not address the systemic-risk issues that concern many regulators and lawmakers, it does indicate that, even in the absence of regulation, hedge fund managers can be reined in by market forces. Managers are more responsible than their critics contend, according to the paper.

Wharton professor Gavin Cassar discusses incentives hedge funds have in place to avoid excessive risk

Among the findings: Funds based outside the U.S. tend to have stronger internal controls than those based in the U.S., even though securities rules tend to be less rigorous elsewhere. Typical controls include requiring multiple signatures for the transfer of funds, and the hiring of third parties to handle such key functions as assessing values for fund assets and auditing books. Strong controls assure investors that money is not being misused, and that their holdings are really worth what the managers say they are. Research by others has shown that internal-control shortcomings are a chief cause of fund collapses.

“It was surprising to us that, generally, offshore funds have better controls than onshore funds,” Cassar said in an interview. He and Gerakos note in their paper, “Determinants of Hedge Fund Internal Controls and Fees,” that investors demand these stronger measures to offset worries about lax offshore regulation. Also, investors know they can use the U.S. legal system to redress fraud and financial misstatement in U.S. funds, but feel they need tougher internal controls for overseas funds because foreign legal systems often aren’t as strong.

Similarly, the researchers found that younger funds and those that use greater leverage tend to have stronger controls, again to address investors’ worries about short track records and greater risk. Managers tend to earn larger fees when they use stronger controls, like hiring strong auditing firms and using outsiders to assess the value of funds’ holdings. A typical arrangement gives managers annual fees of 2% of fund assets plus 20% of profits, but terms can vary considerably.

U.S. regulations restrict hedge fund investing to well-to-do investors. On the assumption these individuals and institutions understand the risks they are taking, the rules allow hedge fund managers far more leeway than is given mutual fund managers catering to small investors. Hedge funds, for example, can borrow money to make bigger bets, and they can engage in short selling and invest in exotic derivatives. Mutual fund managers are barred from all these activities and must adhere to strategies they describe in public disclosures.

Hedge funds are also allowed to operate in greater secrecy, and most make only sketchy disclosures on investment strategies. Critics say this latitude and leverage can enable hedge funds to amass large, risky positions that can roil the markets when things go wrong. The classic example is the 1998 collapse of the Long-Term Capital Management Fund, which threatened to spark a bond-selling spree that could have upended the financial markets. The hazard was considered so severe the Federal Reserve organized a bailout funded by major financial institutions.

But most experts agree that hedge funds were not major culprits in the current financial crisis that began with the subprime mortgage meltdown in 2007. The lingering question for the future: Barring tougher regulation, what kinds of incentives do hedge funds have to avert excessive risk on their own?

Controls Are Costly

While it seems obvious that any honest fund manager would want strong internal controls to attract investors and avert problems, top-quality auditors and outside asset evaluators can be expensive, Cassar said. “Also, there are hidden costs, like signature authority to move money around.” Requiring checks and balances, such as approval from two or three people for a transaction, can be cumbersome, he noted. “A lot of trading is highly dependent on timing, and on acting quickly.”

Many hedge funds place bets that are so large they can affect the prices of assets involved by changing the balance of supply and demand, and hedge fund managers worry that outsiders who know a fund’s strategy can profit through maneuvers like short squeezes and front running — basically, placing bets with advance knowledge of how prices are likely to move. “They don’t want any chance that third parties know their trading strategies or their present positions,” Cassar said, explaining how the emphasis on secrecy can discourage use of controls like employing outsiders for administrative chores.

He and Gerakos looked at 427 hedge funds run by 358 managers from 2003 to 2007, using data from HedgeFundDueDiligence.com, a firm that examines hedge fund practices for clients such as institutional investors that invest in hedge funds. The data showed investors, through their willingness or resistance to investing in a fund, can effectively protect their interests by influencing fees and demanding better fraud controls when they sense the potential for greater risk.

“A lot of investors do … some due diligence,” Cassar noted. “They hire a firm to interview the partners, talk to auditors, do background checks…. They hire someone with an expertise in looking for red flags.”

Youthful Self-control

As the researchers had expected, the data shows that managers of younger funds and those based outside the U.S. tend to have stronger controls. Young funds have to put in strong controls because they have not had time to establish reputations for honesty and good performance, while established funds can attract investors despite weaker controls because they have successful track records, he said. “Ones that survive a long time have … demonstrated that they have skill. You could still cheat, but why would you cheat if you are investing well?”

Use of stronger controls for offshore funds is illustrated by the data on funds based in the U.S. versus those in the Cayman Islands, where financial regulation is less stringent. In the U.S., nearly 77% of funds require only one or two signatures from fund employees to authorize money transfers. For the Cayman Island funds, that figure is about 43%. In the Caymans, nearly 57% of funds have the tougher requirements, such as needing signatures from non-employees to authorize money transfers. In the U.S., only 23% of funds go that far. Cayman funds are also more likely to require that outside administrators, rather than fund managers, place values on assets. They tend to use auditing firms and outside administrators that have higher industry rankings. Use of more stringent controls is simply a business necessity, Cassar said. “The bottom line is that if the hedge fund doesn’t want to invest in controls that might be important, the investor doesn’t invest.”

The research also showed that investors, by paying higher fees, tend to reward managers who adopt strong internal controls. “Investors are cognizant of how internal controls may affect the accuracy of the net-asset-value statement,” Cassar noted.

In their paper, he and Gerakos write: “We argue that when considering an investment in a hedge fund, investors estimate the probability of fraud and financial misstatements, and this probability decreases [as internal controls get stronger]. Consequently, we posit that managers of funds with more stringent internal controls can charge higher fees and have greater sensitivity between their fees and the funds’ reported performance.”

Investors tend to punish managers who commit offenses like incorrectly reporting fund values. “We find funds that have restated performance receive a significantly lower percentage of assets under management for managing the fund. This result is consistent with investors protecting against the risk of future misstatements by paying lower fees,” the authors write.

Funds that use higher leverage — borrowing more dollars relative to those put up by investors — tend to be riskier. Investors and lenders therefore demand strong internal controls, the authors find.

Cassar noted that the research does not address the systemic-risk issues that concern many critics of the hedge fund industry. Lax internal controls and fraud are not a necessary component of systemic risk, which could occur when one or more hedge funds build positions large enough to spark a vicious cycle of selling if bets go wrong. “Even if you had good internal controls, funds can still fail if they make bad bets,” he concluded.

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