Speech by SEC Commissioner:
Remarks before the SIA-Hedge Fund Conference
Commissioner Roel C. Campos
U.S. Securities and Exchange Commission
New York, NY
September 14, 2005
Good afternoon. First, I'd like to thank the SIA for inviting me to join you today. As you may know, I am a firm supporter of the hedge fund regulatory scheme we have adopted in the U.S. I believe that, at this light level of regulation, the US regulatory structure is a tool for enhancing the regulator's and investors' knowledge regarding hedge funds, a way of increasing transparency in an industry comprised of 8000 funds and over a trillion dollars, and a way to let the sun shine in without interfering with the operations that are exposed. However, I also strongly believe that in developing the proper inspection and examination regime within this disclosure format, it is essential for the SEC to interact meaningfully with the industry on a regular basis. For this reason, I am pleased to be speaking with you today and plan to continue my active involvement in this arena as we move through the implementation phase and into the compliance period, which begins February 1, and for which funds likely will need to file no later than December of this year.
Before I begin, I must remind you that the views I express here are my own and do not necessarily represent those of the SEC, the staff or my fellow Commissioners.
Today I'd like to jump right into the topic of hedge funds, detailing a little current history before posing some concerns that I hope you will think about. Interestingly, I find that each time I have spoken about hedge funds in the last few months, there has been some new development in the industry. Hedge funds are truly the water of the investment industry, flowing this way and that as they encounter obstacles in their path to high returns.
I think we can agree that the term "hedge fund" is a misnomer given the breadth of funds and investment strategies under discussion. In an effort to keep us all on the same page, I am going to use the term focusing on those investment funds that would fall within the definition outlined in the SEC's adopting release. I noticed that the MFA's 2005 Sound Practices for Hedge Fund Managers, published last month, takes the same approach. I think it is a good one.
Even within this defined universe, it is useful to note that many of the numbers I will use today are, at best, guestimates from various sources attempting to compile statistics on hedge funds based on available information. Therein lies one of the problems with this segment of the industry: opacity. Nobody-- neither regulators, industry groups, competing hedge funds, investment banks, nor investors -- has a complete picture of the industry. Quite simply, the gaps in the available data regarding hedge funds as a group or even individual hedge funds provide an inadequate basis upon which an investor may evaluate the risk of an investment in such products. And that doesn't begin to address the issue of transparency of information with respect to the regulator's role, if any, in identifying and assessing the systemic and operational risks associated with hedge funds. But I'll speak of this more later in my remarks.
Every day we read about the growing size, influence, market impact and incredible reach of these investment funds. Hedge funds are attractive largely because of the perceived higher returns and the investment alternatives that are not correlated with the stock markets. Pension funds and institutional investors began to look to hedge funds to beat benchmarks. The number of hedge funds worldwide has increased from approximately 600 funds with $38 billion in assets in 1990 to more than 8000 funds with $1 trillion in assets in 2004.
Part of this growth stems from the expansion of hedge funds into other business activities and investment strategies that offer profits - activities and strategies that put them in direct competition with investment banks, SROs, mutual funds, and others. Some hedge funds have become clients of the big firms, expecting royal treatment for their large commission payments - in a questionable symbiosis of order flow for information. Others have entered the money lending business, offering quicker access to funds than investment banks. They also account for much of the recent surge in credit-derivatives activity, wherein banks welcome the funds as trading partners, but the funds sometimes move out of the trades, assigning them to others, without telling the bank that their counterparty has changed.
Their trading strategies constantly expand to new areas too. Some hedge funds recently have focused on relative-value trading, in which long-term stock positions are balanced by negative bets on different companies in the same sector, either at home or abroad. Others are involved in the nondeliverable forward, or NDF, market, which enables them to bet on currencies whose fluctuations are restricted by government fiat. Many are operating long-only investment strategies. Interestingly, such long-only funds hardly differ from an actively managed mutual fund, except that the hedge fund may be more aggressive and charge higher fees. And, there is no question that hedge funds have piled into the futures market, causing it to triple in size over the past five years, while the supply of bonds cheaply available to fulfill these contracts has dwindled.
Hedge funds are active not only in the capital arena but also in the corporate arena. This past year, we have seen innumerable examples of their influence on the management and direction of companies in which they hold an interest. The most publicized may have been the ouster of the management of the Duetsche Bourse. This of course has raised the question of whether such short-time investors should be entitled to shareholder rights in outright conflict with long-term investors. We also have seen hedge funds combining their involvement in both the capital and the corporate arena. Just last month, Citadel purchased a 10% ownership right in the Philadelphia stock exchange and signed a 10-year contract with Accenture to manage large quantities of trading data.
This growth in the number of hedge funds has taken place despite, or should I say as a result of, the lack of transparency in the industry. As I mentioned earlier, there is marked inability to assess accurate and full information regarding the risk associated with individual hedge funds, much less any type of comparable information to analyze competing investment options. In addition, there is no explanation for the data that is provided, so that investors can understand the scope of its usefulness. The information available on hedge funds falls into the category of: you can make the numbers say anything. For example, the returns indexes -- relied on as one of the few sources of information for investors -- are skewed because they are based on partial information. Hedge funds are not required to report periodic audited returns but only information as they desire. Sometimes, backfilled returns are averaged into databases, providing an elevated performance level. Interestingly, one study I read indicated that the average hedge fund return over the past decade turns out to be more than three percentage points lower than those available from many database providers.
In fact, even the experts seem to question the value of available information in the hedge fund industry. Dr. Sharpe, a retired professor from Stanford University, created the Sharpe Ratio for calculating measuring the return that investors should expect for the level of volatility they are accepting. He notes that investment consultants and companies that compile hedge-fund data commonly misuse the formula for promotional purposes. Moreover, he suggests that, "past average experience may be a terrible predictor of future performance," because the complex strategies used by hedge funds are vulnerable to surprise events and elude any simple formula for measuring risk. Scot Evans, chief investment officer at TIAA-CREF seconded that notion, recently stating that if people were getting into hedge funds now because of past performance, that was almost always a bad idea. I'll bet you've never see that comment in any marketing materials!
But seriously, the range of performance in hedge funds appears to be broader than in mutual funds. Accordingly, investors must be extremely wary that the universe of high performing funds is small compared with the entire universe of investment opportunities. This is why transparency is vital: to permit investors to analyze the risks inherent in this industry. In recognition of this need, some of the more sophisticated investors have created demand for a new business for modern day gumshoes. In an effort to learn about particular funds and the adviser running them, investigative firms are charging anywhere from $1000 to tens of thousands of dollars to produce in-depth detailed reports. Reportedly, these sleuths are increasing used in the case of international hedge funds or managers with nontraditional backgrounds. Some of the reports analyze whether assets reported to investors as well as the methods used to value those assets are accurate.
Consultants have also developed a niche in the hedge fund industry, advertising an ability to divine what can't be seen because of the inadequacy of available information. These consultants typically charge up to 20% of management fees and 20% of the profits made by the fund. These fees can rise if the fund performs well. Some of these consultants earn a percent annually of assets brought into the fund, for as long as the assets remain in the funds. In at least one case, managers have paid those fees in the form of brokerage commissions, channeled through a brokerage with which the consultant has a relationship. Independent of any conflict or disclosure issues this relationship may spark, the transparency issue for the consultants is mind-boggling. The consultants also are limited in their access to data and thus, their predictions may not be much better than the rest of us. Yet, Hennessee Group, Aris Partners and Altegris and Consulting Services Group for example, raised tens of millions of dollars for Bayou Group (the fund you've all been reading about in the paper), earning as high as 3% on the money they brought in.
But let's momentarily return to that conflict of interest issue. If a consultant itself is affiliated with a fund of hedge funds that makes a pitch to an investor, shouldn't that raise alarms? Is there any difference, however, from a consultant not being affiliated with a hedge fund but accepting a fee for marketing? Shouldn't these potential conflicts be disclosed to the investor who is relying on the consultant to provide her with information she cannot find in the public domain? As you know, the Commission staff recently released a report documenting conflicts involving pension-fund consultants and pay to play arrangements. Let me be quick to say that the Commission staff's focus in the report was on disclosure. I wonder if similar disclosure may be warranted in the hedge fund consultant arena. Ah, but I digress.
Returning to the discussion before us, what is the consequence of this growth in hedge funds but continuing lack of information about these products? I would suggest that the result is twofold. First, there may be too much liquidity chasing too few deals (a sentiment recently echoed by Alan Greenspan) and second, there may be too much uniformed or insufficiently informed investor money at risk.
We've already discussed one of the costs of this combination and that is the expansion of hedge funds into new areas of investment and the development of new trading strategies. As the funds experience overcrowding in one area, they may move into the next area because their ability to profit is minimized in the first area. A prime example of this is in the sector of managed futures and convertible arbitrage, where hedge funds have become the markets and therefore cannot exploit the inefficiencies of these markets by standing on the sidelines. They directly feel the ups and downs. Overpopulation of hedge funds also may result in increased leveraging, to magnify small returns, of assets by the funds and the accompanying increase in risk, should lenders call on those funds or markets move quickly and unexpectedly. Yet this development and expansion in the industry is unaccompanied by a like increase in the information available to investors.
According to Professor Lo of the MIT Sloan School of Management, in his recent article, "Systemic Risk and Hedge Funds", the smooth returns of hedge funds may be a warning sign for the industry. Mr. Lo's measures indicate that hedge fund investments are less liquid now than they have been in 20 years. He points to the April downturn that hit almost all categories of hedge funds. He then suggests that the losses of 1998 in Long Term Capital Management were preceded by a noticeable series of months of mediocre performance. With the increased leveraging exhibited by many funds today and the mediocre performance results, Mr. Lo suggests another crisis is likely. His ultimate parade of terribles is a series of collapses of highly leveraged hedge funds that bring down the major banks or brokerage firms that lend to them. Based on these predictions, I would suggest that investors are entitled to more information about hedge funds sooner rather than later.
This call for transparency is even more important as hedge funds and other products cross traditional lines, creating more room for investor confusion. Private-equity funds, for example, are competing with hedge funds to be the alternative investment of choice for individuals seeking higher returns. By August of this year, private equity funds had raised $711 billion in assets versus the nearly $1 trillion in hedge funds. Moreover, private equity firms are purchasing hedge funds, take for example Summit Partners purchase of Coast Asset Management. But they are not alone. Investment banks and asset management firms are buying stakes in or entire hedge fund firms. Lehman Brothers, for example, purchased 20% of Ospraie Management.
Plus, a few mutual funds have beaten the market by acting like hedge funds. Long/short funds, for example, aim to deliver decent returns while protecting investors from the full force of a stock-market tumble. Some three dozen other mutual funds are adopting the traditional hedge fund strategy of engaging in short-selling, without the perils of hedge funds: steep minimum investments, withdrawal restrictions and limited transparency. Again, the need for disclosure is paramount in this environment.
Another cost of this combination of growth in the hedge fund industry and in the availability of uninformed money is that hedge fund fraud has been on the rise. This year the Commission has brought 11 cases against hedge funds directly and another 4 cases against broker-dealers tied to hedge funds. And there are several more cases in the pipeline. (Last year, the Commission brought 19 cases.) While most people are familiar with the Bayou Group case from the press of the last few weeks, I'll take a moment to mention the hedge fund case brought by the Commission in late July against Barry Bingham and Bingham Capital Management Corporation.
Bingham created and managed Bingham Growth Partners, a hedge fund, through Bingham Capital Management, an unregistered adviser. Over the lifetime of Growth Partners, Bingham offered and sold at least $1,800,000 of shares in the hedge fund - denoted as limited partnership interests - to at least 22 investors. Of this amount, approximately $460,000 of the hedge fund's shares were offered and sold on the basis of Bingham's misrepresentations about the hedge fund's past returns. Specifically, Bingham prepared and distributed to investors false periodic earning statements and other documents representing that Growth Partners was achieving substantial, positive returns over various time periods, when in fact the hedge fund was consistently losing money. In addition, Bingham misappropriated some of the hedge fund's assets, including some in the form of "soft dollar credits" generated from the hedge fund's trading commissions. By the end of the tale, Bingham had wholly depleted the hedge fund through his trading losses and misappropriations.
I know that some will argue the rising numbers are proportionate to the increase in the number of hedge funds, and thus regulatory concerns are overblown. Well, try to explain that to the increasing number of affected investors, especially in light of the movement to offer retail versions of hedge funds. I do not think they'll be appeased by that argument. The bottom line is that increasing numbers of hedge funds means increasing pressure on hedge funds to perform and increasing numbers of investors susceptible to fraud. The acts of a few can cause severe reputational damage and drive investors suddenly to the sidelines, causing a "run on the bank."
This is why the Commission stepped into the fray. And I might add rather cautiously and moderately. The new SEC rules, slated to go into effect in February require funds larger than $25 million and with more than 15 investors to file as registered investment advisors. The rules affect funds with a lock up of under two years and require appointment of chief compliance officers.
The Commission pursued registration only after an in-depth study of the available information on hedge funds conducted through a staff study and Commission roundtable. The trends uncovered during the staff's analysis of hedge funds raise the same concerns worldwide about the risk associated with these funds, including the rapid growth of an opaque industry of which no government agency has reliable data, the potential for systemic risk to the markets due to hedge funds influence, broader investor exposure (both retail and pension/retirement fund), their fee structure, the absence of uniform performance reporting and valuation - not to mention disclosure and transparency generally, and the growth in hedge fund fraud. If the regulator can't tell what's going on in the industry, how is the investor supposed to do so? Compounded by the lack of available data and transparency, the inability to examine hedge fund advisers makes it difficult to uncover fraud and other misconduct.
The concept of registration under the Advisers Act was selected because of its minimalist approach in both regulatory burden and in cost but extensive benefits of census information, deterrence of fraud (through inspections), barring unfit persons from the industry, adoption of compliance controls, and limits on retailization. The registration requirement neither requires an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments, in order to protect the resilience and flexibility of the markets. Moreover, the Commission carefully crafted the registration requirements to allow exemption for, among other things, private-equity pools, grandfathering existing clients and addressing foreign components of the hedge fund industry. In other words, our regulatory approach has been to leave the success or failure of hedge funds to market forces.
I'd like to try to assuage some of your concerns regarding the Commission's examination oversight for this group of new registrants. As promised in the open meeting adopting the registration requirements, the Commission has focused intently on the examination component of the new rules. Communication has been a two-way street between the industry and our Offices of Risk Assessment, and Compliance Inspections and Examinations (or "OCIE"), and the Division of Investment Management, among others. I too have attended several meetings, calls, and conferences - like today's event - in an attempt to fulfill my personal pledge to find the right balance in approaching this issue. The outcome of everyone's efforts has been that in conjunction with the numerous meetings, conferences and phone calls with the industry, OCIE has developed a rigorous training program for examination staff in all offices. The bi-monthly training sessions extend over an eight month period, and cover the follow topics, at a minimum: the product (including structure, objectives, strategies and style, investment tools and financial instruments), the business (including portfolio management, risk management and controls concerning credit, leverage and operations, tax-driven behavior, and use of administrators and outside auditors), trading practices, valuation techniques, distribution activities and communications with investors.
Speakers will include representatives from trade organizations, representatives from accounting firms and third-party administrators, outside counsel, academics and Commission staff. The sessions will be interactive, allowing the examination staff to ask questions via videoconference and through other electronic means. In addition, staff has been provided with training through the certificate programs sponsored by the Chartered Alternative Investment Analyst Association. Let me just add that the training initiative is not a one-time exercise. As the Commission staff assumes its examination role with respect to these registrants, the staff will continue to develop its procedures and policies to address the particular nuances of the hedge fund industry.
We know that the industry understands that our mission in examinations is to detect fraud and abuse. And, we heard loud and clear from industry representatives that they support this goal. After all, all firms suffer from the reputational loss of confidence caused by fraudsters in the industry. Our efforts to detect fraud will be bolstered by a robust examination process, and one that is informed about the hedge fund industry, its operations and practices. We will continue to seek feedback from the industry as we go forward.
In fact, already, the staff is considering the appropriateness of and best approach to any additional accommodations for offshore advisers. The Commission granted a number of accommodations to foreign advisers after receiving comments during the notice and comment period. However, we have heard new and additional difficulties faced by third-party offshore subadvisers who manage less than 15% of a fund's assets. Accordingly, the staff is reviewing the appropriateness of and best approach to further accommodations. My point in sharing this discussion, which is in the very early stages, is to emphasize the fact that our regulation of hedge funds will be on-going and fluid process, as well as a two-way street.
In addition, over the last year, OCIE has switched to a risk-based review process as opposed to a regular top-to-bottom, rotating review of registrants. What does this mean for you? It means that you, to some degree, will control the frequency with which the staff visits. Fund managers who fall within the high risk categories, as developed by the staff, likely will fall into the pool of more frequently reviewed advisers. Also, using sweep exams, OCIE will focus on high risk or questionable practices at advisers instead of all activity at an adviser. As trends in the industry change, so will the analysis of risk factors and thus the pool of inspected funds.
For example, if we look at the cases which have been brought over the last two years, are there any commonalities? Have the hedge funds involved in fraud primarily had affiliated broker-dealers executing their transactions? Bayou Group, for example, did not charge a management fee but it did profit via commissions for trading through its own brokerage arm, as well as other fees. Do the auditors have questionable ties to the company; were they independent? Again, looking at Bayou Group, the fact that the auditor was essentially a fictitious entity should have been a large red flag. Has there been a recent phenomenon of smaller hedge funds painting the tape to boost performance figures at the end of the month, during this period of overpopulation among funds and lower returns? Questions like these will guide our staff in its risk-based analysis and ultimate decision of which advisers to inspect.
At this point, we have over 9000 registrants, not including all of the new registering hedge fund advisers. I can say with certainty that the bottom line is this: you should not expect to see us on a daily or even yearly basis. More importantly, when you do see us, our inspections will be limited. Throughout the process of deliberation resulting in the registration requirements, the Agency has never contemplated a review of the strategies employed by hedge funds.
I am not suggesting that we will catch all hedge fund fraud. I believe, however, that regulation will act as a deterrent to those who currently see no barriers to fraud. It also will sift out the dregs from the industry, providing a minimum baseline for the advisers running the funds. Investors need a cop on the beat when it comes to hedge funds, and the SEC is here to be that watchdog. In fact, the staff also is examining whether there is some universe of data that would be submitted regularly and electronically to the SEC to aid in the review process. Yet investors must remember that common sense and due diligence lie in their domain. We cannot do the investing for them.
I'm not alone in this belief. Last week, Jane Buchan, CEO of Pacific Alternative Asset Management Co, which invests $7.5 billion for pension funds and other clients, stated that she believes the Commission's new rules will cut down on fraud committed by managers who start with real strategies, get into trouble, and hope they can hide the evidence from their clients by fiddling with the books before trying to make the money back. Remember the story I just shared regarding Bingham Growth Partners: perhaps if the adviser had been required to register, he would have thought twice about creating phony documents and misrepresenting returns.
My remarks would be incomplete without at quick comment on the international front. As with in the US, there is consensus that not enough information is available regarding these investments. Other than this baseline pronouncement, there currently is no set approach to regulation of the funds at this time. In June, the FSA published two discussion papers on hedge funds, one of which specifically outlined various risk of hedge funds and possible mitigation strategies. The FSA requested public comment on the reports, including as to whether regulatory action was necessary and what would be the optimal areas of regulation and methods of regulation.
In July, German Deputy Finance Minister, Caio Koch-Weser, expressed concerns regarding the strong growth of the hedge funds sector and the possible implications for financial stability. He suggested keeping it in the forefront of the agendas for the FSF meeting, held last week, as well as the March 2006 meeting in Australia. The International Organization of Securities Commissions, or IOSCO, also is exploring the question of whether a code of conduct should be developed for valuation of hedge funds. In addition, the Joint Forum issued a report in August reviewing, among other risk related topics, regulated firms' exposure to and interaction with hedge funds and the market dynamics associated with the downgrade of GM/Ford debt earlier this spring
I do not want to be misunderstood in my support of the Commission's hedge fund regulation. There is no doubt that hedge funds are an extremely useful investment tool for many types of investors. For example, healthy competition to traditional banking can provide nimble capital and liquidity. My greatest concern, however, is that investors at all levels of experience be able to access comparable information regarding the investment options with which they are faced. Currently, the transparency available in most of the hedge fund industry has been likened to a black hole or dark cloud, while the marketing of these investments is stupendous. Therein lies the problem. I'd like to end with a recent report from KPMG, as noted in Barrons, in which the conclusions in the executive summary were as follows: Hedge funds: (1) face a slowdown in asset growth; (2) will encounter "significant head winds" that will bring down returns; (3) have plenty of "has-beens" and "wannabees" managing the funds; and (4) are playing a zero-sum game in which there are winners and losers. The message: the rose-colored glasses are off.
Again, regulatory goals are modest. We will concentrate on detecting and deterring fraud, increasing transparency and encouraging accurate books and records and reporting. Industry has much to gain in the protection of its valuable reputation. I will continue to support an open continuous dialogue with industry and its associations. Wise regulation can only occur with active participation between the regulator, business and industry.
Thank you. I'd be happy to answer any questions you may have.