Ad Wars: The SEC Is Turning Hedge Funds Into the New Ginsu Knife
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Fresh from having declined to constrain money market funds, the Securities and Exchange Commission has moved to loosen marketing constraints on hedge funds.
Two weeks ago, the agency threw up its hands and said it would not be able to defend millions of investors from money market funds that do things like invest in dodgy European bank bonds yet proclaim themselves to be perfectly safe.
Instead, the S.E.C. — mandated by Congress through its misnamed and harmful JOBS Act — proposed rules last week to lift advertising restrictions for hedge funds and other kinds of private investment offerings. The rules haven’t been finalized, but we can look forward to an ad featuring a wizened couple in matching tubs overlooking a sunset, holding hands and talking about how they just put money with the next George Soros.
The old rules for hedge funds make little sense. Surely, hedge funds should be able to pitch investors with data about their returns and methods. But there’s a problem: The S.E.C. does not have any new resources and has not implemented any policies to police these pitches.
Letting slip the dogs of advertising comes as some professional investors and academics doubt that the industry can continue to produce outsize investment returns — if, in fact, it ever did. As they get bigger, hedge funds struggle to score good results. As investments have become increasingly correlated and interrelated, it gets harder to execute safer and unique strategies.
In a perfect world, hedge fund advertising would improve the world of investing. Hedge funds, after all, are wildly misunderstood. A good hedge fund seeks steady returns in good markets and bad. Many of the best-managed funds aren’t actually trying to beat the market in its best years. And many of the good funds seek uncorrelated results, so that the returns don’t move in lock step with the stock market.
And, honestly, few things could be worse than mutual funds, which in aggregate underperform the stock market and charge too much to do it.
The problem is that the way this loosening looks on paper and the way it will play out in the real world are a tad different.
If Groucho Marx were alive today, he’d say that he would never want to invest in a hedge fund that would have him as a limited partner. One doesn’t see Le Bernardin and Château Lafite filling the airwaves during N.F.L. games. The ban on law firms advertising was lifted in the 1970s. Today, Jacoby & Meyers advertises on television; Sullivan & Cromwell does not. Drug ads have wrought a parade of patients demanding new (high-margin) medicines from their doctors that often offer few benefits over the old (off-patent) ones.
Even professionals have a problem in evaluating hedge fund performance, because distinguishing skill from luck and excessive risk-taking is extremely difficult. For instance, funds often don’t even let their own employees know how much leverage they are taking.
Take the case of John Paulson, who is famous for having shorted the housing bubble, making billions. The result is that many, surely including Mr. Paulson, were convinced of his brilliance.
Before his world-renowned score, he was a grinder, eking out decent returns with a relatively small fund. Afterward, his fund grew exponentially to tens of billions under management.
Then his returns nose-dived. His main fund plunged 36 percent last year and has dropped another 13 percent this year, according to The Wall Street Journal.
Last week, after Citigroup’s private bank pulled out of his fund, Mr. Paulson convened a conference call with Bank of America investment advisers and their clients to explain what was going so horribly wrong with his funds.
It turns out that Mr. Paulson was like the Old Man in the Hemingway novel: He happened to be the guy, through some skill and some luck, to land the biggest fish in the world. How much of each did he have? No one can know.
Another lesson from Mr. Paulson’s experience is that even if a fund manager is smart, people who put their money into them are dumb. Citigroup and Bank of America look as if they were typical. Average investors chase performance, putting in money after the great years. Then they panic, pulling their money out at the bottom.
Look for this to be replicated frequently when hedge funds start advertising. Simon Lack, in an important recent book "The Hedge Fund Mirage" (Wiley), argues that hedge funds have been great for hedge fund managers and not so great for their investors. The managers get huge fees. Investors would have been better off investing in Treasury securities, he says.
The hedge fund trade group says that Mr. Lack has it all wrong. Their logic, however, hasn’t been persuasive. Felix Salmon, a blogger for Reuters, wrote that the hedge fund group’s complaints have "convinced me of the deep truth of Lack’s book in a way that the book itself never could."
At least hedge funds specialize in separating people from their money through excessive fees. Other types of offerings prefer to do so through less savory means. The opening of hedge fund advertising has garnered much of the attention, because of the tantalizing idea that we will all soon be able to invest with the best minds on the planet. But the S.E.C. is also lifting rules on other kinds of securities offerings from small companies. Many of these will require less disclosure and will be particularly ripe for fraud.
So the best-case scenario from the agency’s move is a bunch of Paulsons, while the worst-case is a bunch of Madoffs. It doesn’t seem like a great bargain.
The S.E.C. declares in a fact sheet that it will keep the rules about who can invest. Yet the victims of Bernard L. Madoff, who orchestrated the largest Ponzi scheme in history, were accredited investors. The agency does not plan to mandate any new process to ensure that investors are accredited, or whether their investments are appropriate for them.
This all harks back to a precrisis specialty: get rid of supposedly outdated regulation, but create no new limits or powers to keep things from blowing up.