by
Ramadorai.
The task of financial regulation can be broken up into consumer
protection (where we worry about small consumers being cheated by
financial firms), prudential regulation (where we worry about the
possibility of bankruptcy of one financial firm) and systemic risk
regulation (where we worry about the procyclicality of financial
regulation). Everything that we do in financial regulation must be
motivated by one of these three issues.
In the class of fund management mechanisms, there is one
interesting special case: the `alternative investment management
mechanisms' which include hedge funds, private equity funds, venture
capital, etc. The defining feature of these is that each customer
places a large sum of money under the control of the fund manager. A
typical value for the minimum ticket size is $1 million.
Once this is done, it is no longer possible to argue that the
investor is a small consumer who might be cheated by the fund
manager. A person who places atleast $1 million with a fund manager
has the capability and resources to protect his own interests. Hence,
the mainstream strategy utilised all over the world has been to leave
these fund managers completely unregulated.
Indeed, there has been a healthy competitive tension between these
investment vehicles (which are unregulated) versus mutual funds (which
are regulated). Large customers have the choice between going with
mutual funds, where the cost of regulation is suffered, or going to an
alternative investment mechanism where this cost is not suffered. If
these customers feel the gains from regulation are not justified, they
have the choice of walking away and not incurring the costs.
The world over, there are debates brewing about the need for hedge
funds to begin disclosing regular information on performance,
positions and counterparties to regulatory authorities. For example,
the SEC recently proposed a rule requiring U.S.-based hedge funds to
report such information to a new financial stability panel established
under the Dodd-Frank Act. Unsurprisingly, hedge funds argued against
this proposal, citing concerns that the government regulator
responsible for collecting the reports could not guarantee that their
contents would not eventually be made public.
In a recent paper, my coauthors Andrew J. Patton and Michael
Streatfield and I examine one element of the relationship between a
hedge fund and its customers: disclosure about returns. The paper is
titled
reliability of voluntary disclosures: Evidence from hedge
funds.
Hedge funds are
notoriously protective of their proprietary trading models and
positions, and generally disclose only limited information, even to
their own investors. However they do voluntarily report their monthly
returns and assets under management to a wider audience through one or
more publicly available databases. These databases are widely used by
researchers, current and prospective investors, and the media.
Our paper examines the reliability of these voluntary disclosures
by hedge funds, by tracking snapshots of these hedge fund databases
captured at different points in time between 2007 and 2011. In each
vintage of these databases, hedge funds provide their entire
historical records (rather than just the new performance information
since the previous vintage). Using these data, we detect that older
performance records of hedge funds are revised as a matter of course.
Nearly 40% of the 18,000 or so hedge funds in our sample revise their
previous returns at least once over the vintages that we consider.
We then categorize hedge funds in real-time into revising and
non-revising funds, and find that on average revising funds
significantly underperform non-revising funds, and have a higher risk
of experiencing large negative returns. This suggests that mandatory,
audited disclosures by hedge funds, such as those proposed by the SEC
earlier this year, would be beneficial to investors and help to
prevent such negative outcomes.
SEBI has recently put out a
for comments on a proposed strategy for regulation and
supervision of alternative investment vehicles. Our paper can help in
thinking about the issues faced in this field on the consumer
protection, and analysing the policy choices faced there. While there
is much merit to the mainstream strategy of leaving this industry
unregulated, our paper suggests that a small dose of supervision,
focusing on basic hygiene and motivated by consumer protection, may
help.
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