Is there a case for supervision of alternative investment funds? A new working paper

by Tarun 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 The 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 request 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.