WEBMASTER NOTE: This is the unedited transcript of the hedge fund hearings held on May 14-15, 2003, which we received directly from the court reporter. We are posting the transcript in this form to make it available as soon as possible. Staff will review this transcript and will correct any errors that may be contained in it. We will post on our website the corrected transcript, which will also be easier to view and to read, as soon as it is available. (This replaces the file posted May 22, 2003, which had technical defects.) -------------------------------------------------------------------------------------- 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION 2 3 In the Matter of: ) 4 ) File No. 05-007-03 5 HEDGE FUND ROUNDTABLE ) 6 PAGES: 1 through 264 7 PLACE: Securities and Exchange Commission 8 450 Fifth Street, N.W. 9 Washington, D.C. 10 DATE: Thursday, May 15, 2003 11 12 The above-entitled matter came on for hearing, pursuant 13 to notice, at 9:00 a.m. 14 15 BEFORE: 16 17 WILLIAM H. DONALDSON, Chairman 18 PAUL ATKINS, Commissioner 19 RAUL CAMPOS, Commissioner 20 CYNTHIA GLASSMAN, Commissioner 21 HARVEY GOLDSCHMID, Commissioner 22 23 24 Diversified Reporting Services, Inc. 25 (202) 467-9200 1 C O N T E N T S 2 PAGE 3 PANEL 5 - HEDGE FUND STRATEGIES AND MARKET 4 PARTICIPATION 9 5 6 MODERATOR: 7 ANNETTE L. NAZARETH 8 Director, Division of Market Regulation, Securities and 9 Exchange Commission 10 11 PANELISTS: 12 AFSANEH BESCHLOSS 13 CEO and Chief Investment Officer, Carlyle Asset 14 Management Group 15 16 PETER BORISH 17 Senior Managing Director of Business Development, 18 OneChicago, LLC 19 20 PETER BROWN 21 Executive Vice President, Renaissance Technologies 22 Corporation 23 24 JAMES CHANOS 25 President, Kynikos Associates, Ltd. 1 WILLIAM N. GOETZMANN 2 Edwin J. Beinecke Professor of Finance and Management 3 Studies and Director, International Center for Finance, 4 Yale School of Management 5 6 LAWRENCE E. HARRIS 7 Chief Economist and Director, Office of Economic 8 Analysis, Securities and Exchange Commission 9 10 WILLIAM HEYMAN 11 Executive Vice President and Chief Investment Officer, 12 The St. Paul Companies 13 14 ANDREW W. LO 15 Harris & Harris Group, Professor of Finance, Sloan 16 School of Management, Massachusetts Institute of 17 Technology 18 19 ROBERT STEEL 20 Vice Chairman, Goldman Sachs Group 21 22 MARK YUSKO 23 President and CEO, UNC Management Company, Inc. 24 25 1 PANEL 6 - ENFORCEMENT/FRAUD CONCERNS 89 2 3 MODERATOR: 4 CYNTHIA M. FORNELLI 5 Deputy Director, Division of Investment Management, 6 Securities and Exchange Commission 7 8 PANELISTS: 9 SCOTT BERMAN 10 Partner, Brown Rudnick Berlack Israels, LLP 11 12 STEPHEN M. CUTLER 13 Director, Division of Enforcement, Securities and 14 Exchange Commission 15 16 THOMAS FEDOREK 17 Senior Managing Director, Citigate Global Intelligence & 18 Security 19 20 KRISTINA L. KNEIP 21 Senior Staff Attorney/Examination, Supervisor, State of 22 Washington Department of Financial Institutions, 23 Securities Division 24 25 1 PATRICK J. McCARTY 2 General Counsel, Commodity Futures Trading Commission 3 4 PAMELA J. PARIZEK 5 Associate Managing Director, Kroll, Inc. 6 7 LOIS PELTZ 8 President and CEO, Infovest21 9 10 11 PANEL 7 - ASSESSMENT OF THE CURRENT REGULATORY 12 FRAMEWORK 147 13 14 MODERATOR: 15 PAUL F. ROYE 16 Director, Division of Investment Management, Securities 17 and Exchange Commission 18 19 PANELISTS: 20 MARK ANSON 21 Chief Investment Officer, CalPERS 22 23 ALAN BELLER 24 Director, Division of Corporation Finance, Securities 25 and Exchange Commission 1 ARMANDO BELLY 2 General Counsel, Soros Fund Management, LLC. 3 4 IAIN CULLEN 5 General Counsel, Alternative Investment Management 6 Association, partner, Simmons & Simmons 7 8 JEAN-CLAUDE DELESPAUL 9 Secretary General, Commission des Operations de Bourse, 10 France 11 12 JOHN G. GAINE 13 President, Managed Funds Association 14 15 FREDERICK C. "Rick" LAKE 16 Co-Chairman, Lake Partners, Inc. 17 18 SANDRA MANZKE 19 Founder & Co-Chief Executive Officer, Tremont Advisers 20 21 JOHN MARKESE 22 President and CEO, American Associatin of Individual 23 Investors 24 25 1 ANNETTE L. NAZARETH 2 Director, Division of Market Regulation, Securities and 3 Exchange Commission 4 5 ROBERT POZEN 6 John Olin Visiting Professor, Harvard Law School 7 8 PAUL N. ROTH 9 Partner, Schulte Roth & Zabel, LLP 10 11 DOUGLAS SCHEIDT 12 Associate Director and Chief Counsel, Division of 13 Investment Management, Securities and Exchange 14 Commission 15 16 CHRISTINA SINCLAIR 17 Head of Department, Business Standards, Financial 18 Services Authority, United Kingdom 19 20 JANE KANG THORPE 21 Director, Division of Clearing and Intermediary 22 Oversight, Commodity Futures Trading Commission 23 24 25 CLOSING REMARKS - Chairman Donaldson 260 1 P R O C E E D I N G S 2 MR. ROYE: Good morning. My name is Paul Roye, and 3 I'd like to welcome you back to the second day of our 4 roundtable on hedge funds. And I'd also like to welcome 5 those joining us by webcast. 6 As you can see from our agenda, just as yesterday, 7 today we have an impressive group of panelists to discuss a 8 variety of issues, and important issues, related to the hedge 9 fund industry. 10 We have a lot of ground to cover today. We're 11 going to start with the investment strategies and market 12 participation of hedge funds. We're going to talk about 13 enforcement and some fraud concerns that we have in the area, 14 as well as a broad discussion of the assessment of the 15 current regulatory framework that governs hedge funds. 16 So I invite all of you to sit back and enjoy the 17 discussions. We expect another lively set of discussions 18 today. 19 Again, just a few housekeeping matters. If you 20 leave the building, unfortunately you'll have to go through 21 our security procedures again, and we do urge you to turn off 22 your cell phones and we will have breaks during the panels so 23 you can make your phone calls. 24 With that, I'd like to turn over our program to 25 Annette Nazareth, our esteemed director of the division of 1 market regulation who is going to lead a discussion on hedge 2 fund strategies and market participation. 3 And on behalf of the SEC participants on the panel, 4 I'd just like to make the broad disclaimer for today that the 5 views that you hear from the SEC participants are their own 6 views and not necessarily the view of the Commission. 7 And with that, I will turn the program over to 8 Annette and her panel. 9 MS. NAZARETH: Thank you, Paul. Good morning. On 10 behalf of all of my colleagues on the staff, I'd like to 11 thank the panel members for taking the time to participate on 12 this panel dealing with hedge fund trading strategies and 13 market participation. 14 Clearly, this is a very ambitious topic and the 15 amount of time allocated to it is quite short so each of the 16 panelists have agreed to forego an opening statement so that 17 we will have more time for meaningful discussion. 18 First, though, I want to briefly introduce the 19 panel to you. I can only mention the highlights of their 20 very impressive resumes as they relate to the hedge fund 21 industry. Frankly, if I were to describe all of their 22 accomplishments, we'd have no time for discussion at all. 23 First, I'd like to start with Afsaneh Beschloss, 24 who is the chief executive officer and chief investment 25 officer of Caryle Asset Management Group and, prior to 1 joining CAMG, Afsaneh was the treasurer and chief investment 2 officer of the World Bank. 3 Next is Peter Borish, who is a senior managing 4 director of business development at OneChicago. OneChicago 5 is an exchange that trades single stock futures and narrow 6 based index futures, but Peter previously led a team of 7 researchers and traders at Tudor Investment Corporation. 8 Next is Peter Brown. He's executive vice president 9 of Renaissance Technologies Corp. where he develops 10 mathematical models for the financial market. Renaissance 11 Technologies is a general partner and investment advisor of 12 Medallion Funds, which is a hedge fund with approximately $5 13 billion in assets under management. 14 Next we have Jim Chanos, who is president and 15 founder of Kynikos Associates, which provides the investment 16 strategy of profiting from unhedged shortselling of 17 overvalued securities. Kynikos also manages the short 18 portfolios of Beta Hedge and Beta Hedge International for 19 domestic and offshore investors as well as The Opportunity 20 Fund which seeks to identify mispriced securities that are 21 both overvalued and undervalued. 22 Next we have Professor William Goetzmann, who is 23 the Edwin J. Beinecke Professor of finance and management 24 studies and the director of the International Center for 25 Finance at the Yale School of Management. Will is an expert 1 on a diverse range of investments, including stocks, mutual 2 funds, real estate and, even more interesting, paintings. 3 His research topics include global investing, forecasting 4 stock markets, selecting mutual fund managers, housing as 5 investment and the risk and return of art. 6 Next to me is Larry Harris, who is our chief 7 economist here at the Securities and Exchange Commission. 8 He's here on assignment from the Marshall School of Business 9 at the University of Southern California, where he holds the 10 Fred Keenan Chair in Finance. Very fortunate for us, having 11 Larry here. He's an expert on market microstructure, 12 investment management and the uses of transactions data in 13 financial research. 14 Next to Larry is Bill Heyman. He's executive vice 15 president and chief investment officer of The St. Paul 16 Companies, which is a major U.S. property and liability 17 insurance company and he is responsible for all of St. Paul's 18 public and private investment activities. Some highlights of 19 Bill's career -- and there are many -- include he was 20 chairman of CitiGroup Investments, Inc., he was head of the 21 private investment department of Salomon Brothers, Inc. and 22 of course, most impressive of all, he's a former director of 23 the SEC's division of market regulation. 24 Next is Andrew Lo. He's the Harris & Harris Group 25 Professor of Finance at the MIT Sloan School of Management 1 and he's a director of MIT's laboratory for financial 2 engineering. His interests are many. They include empirical 3 validation and implementation of financial asset pricing 4 models, the pricing of options and other derivative 5 securities, financial engineering and risk management, 6 trading technology and market microstructure and hedge fund 7 risk and return dynamics and risk transparency. So clearly 8 he has some very direct knowledge about our topics today. 9 Next to Andrew is Bob Steel. He's a vice chairman 10 of Goldman Sachs, Inc. and he's a member of the management 11 committee. At Goldman, Bob has held many important positions 12 including head of the firm's equities division, head of all 13 institutional equities in the United States and head of the 14 equities division in Europe. Bob is a member of the New York 15 Stock Exchange where he has served on various committees and 16 he's a member of the board of directors of the Securities 17 Industry Association. 18 And last, but not least, we have Mark Yusko. He's 19 chief investment officer of the University of North Carolina 20 at Chapel Hill. He's responsible for the management of 21 financial assets of the university and affiliated foundation 22 funds. Mark and his team founded the UNC Management Company 23 to provide comprehensive investment advisory services to the 24 university, including providing strategic and tactical asset 25 allocation recommendations to the board, investment 1 management selection, manager performance evaluation, 2 spending policy management and performance reporting. 3 And of course we also have again with us today -- 4 we're very fortunate to have all our commissioners and our 5 chairman with us this morning, so we're delighted to have 6 everyone here. 7 I'd like to begin by focusing first on -- directly 8 -- getting right to the topic on hedge fund trading 9 strategies and market impact. Hedge funds engage in a wide 10 variety of trading strategies ranging from strategies that 11 are market-neutral to those that are highly speculative. 12 This raises questions concerning the impact that these 13 strategies have on individual stocks and on the markets as a 14 whole. 15 So I thought I would begin by first calling on 16 Peter Brown to describe generally what these hedge fund 17 trading strategies are for the different types of investments 18 strategies that they engage in. 19 Peter, could we start with you? 20 MR. BROWN: Sure. Let me just say in very general 21 terms what all hedge funds that I know of do. They gather up 22 information and on the basis of this information, form an 23 opinion about what the true value or future value of some 24 financial instrument is. Then they notice if the market has 25 a different opinion and, if it does, they trade. That is 1 generally -- every hedge fund I know about, that's what they 2 do. 3 So, for example, an event-driven hedge fund may 4 think that the probability of some merger occurring is 5 greater than what they see in the market. Say if it's a 6 stock for stock merger, they'll buy the target -- the 7 acquiree and sell the acquirer, thereby driving the spread 8 between the two closer together. 9 Now, if the manager is right, the spread will 10 continue closer together and he'll turn a profit. Take 11 statistical arbitrage. That's the area I'm in. There, the 12 manager will form opinions on the relative value of all kinds 13 of instruments to one another and they will sell the 14 instruments they believe are overvalued relative to other 15 instruments and buy the instruments they believe are 16 undervalued relative to other instruments. 17 Again, look what happens. When they sell the 18 stocks or whatever the instruments are, the price of those 19 instruments will come down and the one they buy will go up. 20 If the manager is right, the stocks will continue to move in 21 the direction that they've nudged the market. 22 So in these cases and all other cases that I know 23 of, the impact of these trades -- I can give other examples. 24 Do you want me to run through a litany of kinds of hedge -- I 25 think it was discussed yesterday, but -- I'll give you one 1 other example. 2 Say convertible bond arbitrage. There, the manager 3 may believe that the volatility of a stock is underpriced so 4 he'll buy the convert which has an implicit option in it. He 5 doesn't want to take a position in the underlying so he'll 6 sell the stock to hedge out that exposure. 7 When he buys the convert, he increases the price 8 the marketplaces on the volatility and if he's right, the 9 same thing happens. He'll make money and the market will 10 continue to move in the direction which he's pushed the 11 price. 12 So in all these examples, what hedge funds do is 13 move the market in a direction that they believe the true 14 value of an instrument or pair of instruments ought to be. 15 And if they're successful, that is, if they make money, then 16 they'll make the market more efficient. 17 So when hedge funds trade in any strategy -- I'm 18 addressing now the market impact and going on to the next 19 issue -- I hope that's okay. When hedge funds trade, what 20 they do in any of these strategies is make the market more 21 efficient. So I think that trading by hedge funds is a good 22 thing. I want to make sure I get that in because I don't 23 know if you're going to call on me again. 24 Do you want me to go on with other strategies or -- 25 MS. NAZARETH: You can go on with a few more 1 strategies. 2 MR. BROWN: Can I instead go on and address other 3 aspects of -- okay, fine. 4 Let's look at volatility. There's been a concern 5 that hedge funds through their trading various strategies 6 affect the volatility of the market. Now, let's decompose 7 volatility into two components. One, that -- innovations in 8 news; in other words, new information coming in, and the 9 other, do -- let's call it noise. I don't necessarily mean 10 white noise but noise. 11 Now, you can't really do anything about innovations 12 in the news and you shouldn't really do anything there. But 13 the noise represents unwarranted risk to -- unnecessary risk 14 to all investors. And what a hedge fund does is trade out 15 the noise. All these strategies they trade out the noise. 16 So for example, if a stock takes a tumble for no 17 apparent reason, some hedge fund will be sitting there 18 waiting and buy the stock, thereby supporting the price and 19 reducing the volatility. So this is another way in which the 20 hedge fund trading is good for the market. 21 And I can go on to liquidity but I think maybe I'll 22 stop because you said talk for two or three minutes. 23 MS. NAZARETH: Bill, can you comment further on 24 both the types of techniques that hedge funds employ and the 25 instruments that are also used in hedge fund strategies? 1 MR. HEYMAN: Well, I could certainly continue the 2 litany of strategies. I don't know if that's productive. I 3 have one general observation that I had in reading these 4 questions which I thought were very good and it's probably 5 better made at the beginning of this discussion than at the 6 end. 7 As I read the press articles on hedge funds, which 8 describe them as unregulated, the exemptions under which they 9 operate are principally in the area of primary markets, 10 selling their own securities. In their secondary market 11 operations, hedge funds are subject to the same restrictions 12 as everybody else. 13 So a discussion of this nature is really less -- by 14 definition, has to be less a discussion of hedge funds than a 15 discussion of various trading strategies and how they affect 16 the market because in theory they could be executed by 17 anyone. 18 Now, as a matter of fact, hedge funds have a de 19 facto monopoly on many of these strategies, with some 20 competition, probably less than there used to be from 21 proprietary trading desks of regulated institutions. But 22 this discussion is to me more delicate than the other four or 23 five panels in that it involves consideration of tampering 24 with secondary markets which is always a delicate matter. 25 About six or seven years ago, in connection with a 1 NASDAQ settlement, the Commission, more or less by fiat, 2 restructured equity markets in the U.S. and only now are 3 people beginning to question certain elements of the scheme 4 that resulted. 5 The other day I recall that Chairman Donaldson 6 questioned whether decimalization was a good thing in all its 7 consequences, a question which would have been sacrilege five 8 years ago. 9 So I would simply say at the outset that as we 10 consider these things, we should understand that we're not 11 talking about entities, we're talking about strategies. 12 MS. NAZARETH: That's an excellent point. Jim, do 13 you have any thoughts that you want to add with respect to 14 techniques or strategies or the types of instruments again 15 that hedge funds employ in their trading strategy? 16 MR. BORISH: Well, I'm going to defer to my 17 colleagues on most of the aspects of variety of strategies. 18 I think I can focus a little bit on one particular strategy 19 which you highlight in your question, which is short selling, 20 market impact on short selling, whether or not it should be 21 regulated more than it already is. 22 I would point out that short selling is one 23 technique used by hedge funds. It's probably subject to the 24 most regulations in terms of needing to borrow shares, the 25 so-called uptick rule which has been in place for 70 years, 1 and a variety of other restrictions. 2 So we would comment that as it relates to that 3 market technique and trading approach, short sellers and 4 hedge fund managers who employ short selling are already 5 regulated more so than other traders or trading strategies. 6 Having said that, I think that it's worth exploring 7 some of the issues that short selling give rise to, and 8 certainly there's been, I know, increased interest, given the 9 last few years with market performance, on what is going on 10 on the short side and any way we can illuminate that would be 11 helpful hopefully for this panel. 12 MS. NAZARETH: I think we will spend a great deal 13 more time talking about short selling in the course of this 14 discussion. Maybe I'll ask Peter and Afsaneh to both see if 15 you can respond to the following question. In terms of risk, 16 can you sort of describe how hedge fund investments and 17 trading strategies differ from more traditional investments 18 through mutual funds and other similar products? 19 MS. BESCHLOSS: Sure. As someone who's been an 20 investor in hedge funds, both at the World Bank currently and 21 in various endowments, I was sort of listening to the other 22 panelists -- I have always looked at hedge funds essentially 23 as any other investable category except much more active, and 24 that has repercussions on what I'm going to say about risk. 25 So hedge funds are nothing but -- you know, some 1 people call them mutual funds on steroids or whatever you 2 want to call them, but essentially it's active strategies and 3 with the exception that they have access to many tools that 4 you do not have in traditional money management. 5 Now, what does that mean in terms of risk 6 management? Because they are much more active, because they 7 use many more tools, the risk management becomes a harder 8 job. Obviously, the risk management and the issues that we 9 may discuss later on transparency are very interrelated. On 10 the one hand, as an investor, you always want more 11 transparency, you want to understand exactly if you put your 12 money in something what's going on. 13 On the other side, there are certain strategies in 14 the hedge fund world in general, in investments, that require 15 some level of proprietary information, at least during 16 certain periods of time. Maybe not in the long run, but over 17 ceratin periods of time. 18 And one solution that we have come up with in the 19 past really four, five years, and it seems to be working, is 20 really working maybe with third parties in some form or other 21 so that the information from hedge fund managers could go to 22 third parties who have absolutely no connection with market 23 makers in any shape or form. They can process the 24 information and then as a user of information, as an 25 investor, you can then get that information in an aggregated 1 form, in a form that makes sense to you. 2 And obviously for some of the -- as I mentioned, 3 you know, some complex fixed income strategies, some complex 4 risk op strategies, it's very difficult to come up with 5 meaningful risk numbers. The second thing that is very 6 difficult is really aggregation of these different strategies 7 and you do have to make certain kinds of adjustments and 8 simplifications to be able to do that. 9 But my assumption has always been more risk 10 management is better than less risk management and if you are 11 -- especially right now as more investors are getting 12 invested in this sector, very important to have the risk 13 management. And obviously we can talk later about the role 14 of prime brokers and other entities in risk management. 15 But it is something I think which is key to both 16 the trading where both people who are trading the strategies 17 should understand the underlying risks of what they're doing 18 and the investors in the business should spend more time on 19 aggregation. 20 I'll just make one other point. The other thing 21 that I think as an investor that is extremely important is 22 hedge funds are generally a part of your portfolio, not the 23 totality of your portfolio. I think another very important 24 task is being able to aggregate the risk of your hedge fund 25 portfolio, whatever strategies are in there, together with 1 the rest of your portfolio which is generally a traditional 2 portfolio and I think that's one of the things that needs 3 more work in this area. 4 MS. NAZARETH: Do you think that this lack of 5 transparency with respect to risk has a negative impact on 6 market efficiency as a whole and do you think that some of 7 the concerns that you read about in the press with respect to 8 the ability of hedge funds to move market sometimes in 9 strange ways in particular products is related to that? 10 MS. BESCHLOSS: I don't necessarily look at it that 11 way. I think you do need -- you know, we need to do risk 12 management. But the question is, do you need the information 13 on a daily basis? I'd say no, because as an investor, what 14 would you do with that information? There's nothing very 15 much you could do. 16 And it's the same thing really for your mutual fund 17 or your public traditional kinds of -- you know, if you got 18 information from your public managers you'd have the same 19 problem. So I don't look at it quite that way. I think 20 hedge funds take advantage of market inefficiencies and as we 21 find in many strategies like merger op, like some others, as 22 the strategies become more common, as people put money, they 23 become more efficient. 24 So hedge funds have -- I've seen them also have -- 25 play role in making certain kinds of markets more efficient 1 than less efficient. But every type of business, whether 2 it's traditional money management or hedge fund management, 3 hedge funds obviously because of lack of transparency, 4 there's room to take advantage in certain ways that none of 5 us would feel comfortable. 6 MS. NAZARETH: Thank you. How about Peter Borish 7 and then I think Peter Brown has some comments. 8 MR. BORISH: Thank you. Well, I think that hedge 9 funds and risk management, a lot of what they do is they take 10 conventional wisdom and you sort of have to turn it upside 11 down. So the normal concept of the greater the risk, the 12 greater the reward is actually the opposite with a hedge 13 fund. 14 A hedge fund is going to look at an opportunity 15 where they look at less risk and they're going to look at the 16 greater the reward, which is they're going to vary their size 17 with respect to the opportunity. So the greater the 18 perceived market inefficiency, the larger they can 19 participate in the marketplace. 20 A normal investment where somebody buys something, 21 the general risk management is time and that -- so in a hedge 22 fund where the difference is every position that is taken, 23 usually before you take that trade you have an exit point. 24 So you have an entry and an exit and you can measure that 25 risk. Most other types of investments that are long only, 1 you get in but you don't have a notion of where you're going 2 to get out. 3 So oftentimes it's perceived that hedge funds may 4 be more risky but the fact that they're taking risk 5 management by actually trading is actually the most effective 6 risk management strategy that there is because in the 7 investment world, if you live, you win. And so the key here 8 is not to have an ego but to say I've tried this position, it 9 hasn't worked, now I'm going to get out. 10 So you want to turn that upside down, versus if I 11 buy something and it goes down 15 or 20 percent, well, I 12 liked it there, it must be better here. That may be true. 13 And that all works great until the one time when it doesn't 14 work and then you lose all your money and then you're not in 15 business. 16 So that's why I say you want to spend your time 17 turning it upside down. 18 MR. BROWN: I think it's useful to compare hedge 19 funds to stocks. There are roughly 6,000 hedge funds and a 20 comparable number of exchange trade stocks. Now, I recently 21 looked at the median volatility of a hedge fund is and the 22 medium volatility of stock. By volatility, referring to 23 standard deviation here. 24 The median volatility of a hedge fund is half the 25 median volatility of a common stock. The volatility of a 1 fund to funds recently is more like a quarter of the 2 volatility of the S&P 500. So just in terms of an objective 3 measure of risk, hedge funds are significantly less risky. 4 They came out of the collapse of the dot com bubble 5 relatively unscathed and this explains why a number of 6 universities, institutions and even retail investors are now 7 eager to get into hedge funds. They've sort of woken up -- 8 back five years ago everybody was making money going long and 9 they've now woken up to the fact that risk matters. 10 And I suppose that's part of the reason there's 11 attention to hedge funds now because so many people want to 12 get into them. There's concern about hedge funds increasing 13 volatility in the market, causing things to be risky through 14 use of derivatives and shorting. 15 But the hedge funds that I know about, they use 16 these derivatives and short selling -- maybe not Jim here -- 17 to control risk and that strikes me as a good thing. 18 I think I'll stop there. 19 MS. NAZARETH: Larry? 20 MR. HARRIS: We've been talking about two different 21 types of risk this morning already. Talking about the risk 22 associated with investment in a hedge fund. We're also 23 talking about the risk associated with the strategies that 24 hedge funds employ and their impact upon the market as a 25 whole. I want to talk about that second type of risk and its 1 relationship to transparency. 2 Our fear -- not the SEC but sort of throughout the 3 economy -- is that there might arise a circumstance when 4 everybody decides to do the same thing but that people are 5 not aware that everybody else is trying to do the same thing. 6 So some circumstance arises where everybody wants 7 to get out of the market at the same time but they don't know 8 that everybody else wants to and that in trying to exercise 9 that strategy without the knowledge that other people are 10 going to do it as well, we're afraid that that would possibly 11 drive the market down in a way that wouldn't be acceptable 12 and certainly would not likely happen if everybody knew about 13 everybody else's strategy, since certainly if everybody knew 14 that everybody else was going to do it they'd realize that 15 they couldn't do it and that therefore they would arrange 16 their affairs differently. 17 That's something similar to the scenario that we 18 saw in the '87 crash and many people believe that that was a 19 significant determinant of the '87 crash. Now, the question 20 is what relation should our fears about that kind of scenario 21 have to do with hedge funds in general and the transparency 22 of their operations. 23 I'll note that the types of mistakes that I just 24 described are not likely made by the most sophisticated 25 traders in the markets. The most sophisticated traders in 1 the market spend a lot of time thinking about what other 2 people do because they profit only when other people make 3 mistakes. 4 And so when they're successful, they're successful 5 not only because they've got a good idea but they have a good 6 understanding about the mistakes that other people make. As 7 a consequence, the more sophisticated traders in the markets 8 try to be as aware as possible of what's happening so that 9 it's unlikely that hedge funds are going to be the ones who 10 are going to collectively fall into the mistake that I've 11 just described. 12 If there are mistakes like this where collective 13 action leads to problems that individuals wouldn't have 14 anticipated because they didn't take into account what other 15 people would do, it's more likely going to happen among 16 people who are less sophisticated. 17 To the extent that these things do happen, though, 18 there are tremendous opportunities to profit from it and the 19 hedge funds, among other sophisticated investors, are going 20 to be the first to stand on the opposite side of it and step 21 in. 22 Just the same, we do have concerns about 23 transparency that if there were only more transparency, it 24 might be easier for other people to see what other people 25 intend to do and then respond to it or plan their affairs 1 accordingly. My -- I'm a little bit concerned about imposing 2 too much transparency on informed traders of any type because 3 the effect of imposing transparency on their operations is to 4 ultimately make their operations less profitable. 5 Now, I'm not particularly interested in the profits 6 of informed traders in the sense that I care about them as 7 traders, but I do care a lot about the research that those 8 profits support. 9 The research that the informed traders undertake to 10 become well informed is the -- provides them with the 11 insights that allow us to -- allow them to understand what 12 valuations should be in the market. And as was described 13 very eloquently by Peter Brown, the acting on those insights 14 is what makes the prices more informative and informative 15 prices are the -- are essential to the efficient operation of 16 our economy. 17 So if we ask for more transparency, we may obtain 18 better control over the systemic risk that we've just talked 19 about, but the control won't be quite as effective as it 20 might be -- that is to say that the systemic risks that we're 21 concerned about have to do with the less informed traders 22 than the better informed, sophisticated traders. 23 But if we ask for too much transparency, we 24 decrease the profits that hedge funds and other sophisticated 25 traders can make. Most of those profits, in one form or 1 another, go to compensating the collection of information and 2 the collection of that information ultimately goes into 3 prices and produces more informative prices that are used 4 throughout economy to better manage the use of our resources 5 and ensure that resources are allocated to their highest use 6 to ensure that CEOs and CFOs are compensated in a way that is 7 proportionate to their contribution to the management process 8 and so forth. 9 That's an overview of some of the systemic issues. 10 MS. NAZARETH: Okay. Thank you. I think I'll call 11 on Bill Heyman next and then I'll Mark Yusko and Andrew Lo to 12 be thinking about whether they can comment both on explaining 13 to us so we can better understand why hedge funds can be less 14 volatile, which is certainly not their -- I think is commonly 15 understood and Andrew maybe you can talk about the risk and 16 return with hedge funds. 17 MR. HEYMAN: Following up on some of the things 18 Larry said, the issue that seems to be posed for this panel 19 is are hedge funds good or bad for the market. I don't like 20 to use words good or bad in describing markets but the press 21 seems to use it. 22 I think that issue can be discussed on a number of 23 levels. The first level I think is are hedge funds users or 24 providers of liquidity. I've seen literature that assumes 25 that anyone participating in a market is a provider of 1 liquidity. In fact, I saw a brief from the Justice 2 Department in the mid-'90s that suggested that traders were 3 providers of liquidity. 4 But in reality, there are two classes of market 5 participants; people who are net providers of liquidity and 6 net users of liquidity. And although it's a generalization, 7 I would say that most of the time for most of their 8 strategies, hedge funds are net providers of liquidity. In 9 merger arbitrage, in investing in distressed securities, they 10 are more or less the only buyers from natural holders of 11 securities which, by virtue of events, pass into those 12 spheres. And, indeed, when hedge funds in those areas turn 13 sellers, there are no natural buyers. 14 So, I recall cocktail parties in the '80s where I 15 tried with a straight face to discuss the social utility of 16 merger arbitrage since that's what I did then but in 17 hindsight, I shouldn't have been so bashful. And as Larry 18 said, if -- transparency can certainly be considered but it 19 will come at a cost and the cost will not rest where 20 regulators suspect it will rest. 21 In the end, providers of liquidity who are saddled 22 with increased costs will attempt to pass them on and they 23 will pass them on to natural investors and that's I think 24 something to consider as one parses through these questions. 25 MS. NAZARETH: Thank you. Mark? 1 MR. YUSKO: Well, I think a number of things 2 related to the whole construct of risk are important to 3 highlight. One is, it depends on your definition of risk how 4 risky these strategies are in a portfolio. If your 5 definition of risk is volatility of returns, then as Peter 6 said and as Andrew I'm sure will comment on, and others have 7 shown, these strategies are significantly less risky if you 8 just take strict volatility of returns. 9 And to me, the way we think about risk is risk is 10 like energy. It can change form but it can't be eliminated 11 so you can't say that there's less risk, per se. You just 12 change the form from market risk or beta risk to stock 13 selection or alpha risk. And when we look at investing -- 14 and roughly 55 percent of our endowment is invested in "hedge 15 funds". 16 I hate the term hedge funds, one, because A.W. 17 Jones had a D on the end, it was called hedged fund when he 18 formed it in 1949 and most managers today -- because -- 19 somebody said there were 6,000 funds. I claim there are 24 20 because we've met all 6,000. They're all in the top quartile 21 so somewhere -- the bad fund's out there but we've never met 22 any. 23 (Laughter.) 24 MR. YUSKO: So the issue is that a lot of the 25 strategies have nothing to do with hedging. They have to do 1 with arbitrage. They have to do with taking advantage of 2 market anomalies. Yet there are some strategies in our 3 portfolio where the exposure is a hedged, with a D, equity 4 exposure that has reduced the volatility and the risk of loss 5 and has allowed our fund to preserve capital over the last 3 6 years where the average endowment fund has lost 8 to 10 7 percent a year for 3 years. 8 So if you think of risk as risk of loss, so going 9 to zero, there is some additional risk in this world of 10 strategies because of another tool that's used, not because 11 of the strategy but because of the tool used of leverage. 12 Leverage can be very good and it can be very useful. And in 13 fact, leverage plus short selling actually reduces risk -- 14 back to A.W. Jones. 15 But leverage in its worst form -- let's take a 16 house today. Housing market. There are loans being made at 17 125 percent of value. Loan to value of 125 percent. Well, 18 if you then lost your job and were forced to sell, you've now 19 used leverage to take away 100 percent of your equity. 20 You've got a hundred percent loss. 21 And that can happen and has happened in this 22 business as funds have blown up, although the number of 23 blowups -- I find this kind of interesting -- compared to the 24 number of funds and the dollars in management is much lower 25 than the wealth that was destroyed by the money that flowed 1 into the mutual fund industry at the peak. 2 My favorite stat is 85 percent of all the money in 3 tech mutual funds came in after January 1, 2000. That's a 4 very bad statistic because it means most of that money was 5 taken away. So it really depends on how you think about 6 risk. We define risk as not being able to provide inter- 7 generational equity between current users of the funds that 8 we spend and future generations. 9 So if we can't earn a real rate of return and if 10 you turn a dollar into 70 cents over the last three years, it 11 will take you decades to get back. If you can preserve 12 capital in the difficult markets by using a hedged strategy, 13 then we think that you're way far ahead. 14 One last piece is that we really believe that this 15 is really just a democratization or a disintermediation of 16 proprietary trading due to technology. The fact that you can 17 take a PC, even a handheld today, and have as much computing 18 power as Wall Street had 20, 30, 40 years ago, you used to 19 have to sit inside a Wall Street proprietary trading desk in 20 order to do these strategies. 21 Goldman Sachs was built around risk for arbitrage a 22 hundred years ago, so this strategy has been going on a long 23 time. It's not new, they're not novel and you have to focus 24 on the exposure as opposed to calling this an asset class. 25 It's the exposure, stocks and bonds and maybe some derivative 1 exposure. 2 MS. NAZARETH: I'll ask Andrew and then Bob Steel 3 to tell us about the Goldman experience. 4 Go ahead, Andrew. 5 MR. LO: I guess I'd like to start by pointing out 6 that there are two aspects of risk that need to be focused on 7 and I think they're distinct aspects. One has to do with 8 risks associated with the hedge fund investments themselves, 9 and I'll talk about that in a minute, and then the second has 10 to do with systemic risks that hedge funds in general impose 11 on the financial system. I think those are different and 12 need to be looked at somewhat separately. 13 With regard to the first kind of risk, I think it's 14 pretty clear from the comments from the other panelists that 15 in fact there are many different kinds of risks, that risk is 16 not a univariate concept. And that's part of the problem 17 with dealing with hedge funds is that there are so many 18 different types of risks. 19 I want to go back to a question that was posed by 20 Commissioner Campos yesterday. He asked I think quite 21 perceptively if it's the case that hedge funds are less risky 22 and have higher returns, why shouldn't we let everybody have 23 access to them? And I don't think that there was an adequate 24 answer given. I think a number of people tried to make 25 arguments about why you might not want to let other retail 1 investors have access, but I think there's a very simple 2 answer. 3 The answer is that hedge funds are more risky. I 4 know that that sounds rather surprising to some but the fact 5 -- if there's one lesson that we've learned from modern 6 financial economics it's that there's usually a relationship 7 between risk and expected return. And we know that hedge 8 funds have yielded higher expected returns than many other 9 investments. As a result, you would expect that they would 10 have higher risk in one form or another. 11 Now, I do agree with Peter and Mark that looking at 12 volatility as a measure of risk, for most hedge funds 13 volatility is quite low. But the same can be said for lots 14 of other things that we would all regard as risky. For 15 example, think about an insurance company that insures 16 earthquakes. If you take a look at the returns on those 17 kinds of companies, you'd find that they have very low 18 volatility, very high sharp ratios except every once in a 19 while, in the parlance of Wall Street, you have your face 20 ripped off. 21 (Laughter.) 22 MR. LO: Now, there's nothing wrong with that kind 23 of risk and there are many investors who are perfectly 24 capable, interested and delighted to take on those risks, 25 thank goodness. But the fact is it's a different kind of 1 risk that's not adequately measured by volatility. 2 And so with all of the various different hedge fund 3 styles that we've spoken about, each one of these styles 4 carries its own unique kind of risk that can't adequately be 5 measured by volatility. Now, if you think about trying to 6 explain that to unsophisticated investors, you quickly see 7 the problem. 8 Most people have a hard time figuring out how to 9 get the blinking 12:00 to stop on their VCRs. 10 (Laughter.) 11 MR. LO: How do you explain to them the various 12 subtle kinds of risks that different kinds of hedge fund 13 strategies pose? I think this is an area where the SEC can 14 actually have a very big impact in the area of risk 15 disclosure and investor education. And one of the main 16 thrusts that I think that the SEC might consider is gathering 17 data. 18 One of the most important aspects of any kind of 19 research effort at understanding risk is to start with the 20 data. One of the reasons that there's been so much academic 21 research over the past few years in hedge funds is because we 22 now relatively recently have had access to hedge fund data. 23 The SEC chief economist Larry Harris's pioneering work on 24 market microstructure would have been impossible without 25 data. 1 And so I think that the SEC is in a unique position 2 to put together a data set that currently doesn't exist, data 3 that will not be generally and publicly available, but data 4 that will allow the SEC to get a much better handle on the 5 kind of risks for each of the hedge fund styles that we see. 6 COMMISSIONER GLASSMAN: Can I interrupt with a 7 question? Yesterday I asked a question about rate of failure 8 and the answer was essentially -- my understanding was there 9 really aren't that many hedge funds that fail. There are a 10 number that close but with no loss of principal. So what I'm 11 hearing you say is there are some spectacular failures. Are 12 there very few of them but they're just spectacular? Is that 13 what's -- 14 MR. LO: Exactly. I think that gets to my second 15 point about the systemic risk that hedge funds pose to the 16 financial system. 17 The fact is that it's true. There are very, very 18 few spectacular failures but then, again, there are very, 19 very few spectacular earthquakes. Each one of them is fairly 20 significant and I think we can learn a great deal from these 21 kinds of failures. 22 So this gets to my next point. I guess when a 23 hedge fund fails -- in fact, in 1998 when LTCM failed, one of 24 my colleagues said well, let's see -- you know, we had a 25 whole bunch of rich investors that lost their money. So 1 what? Who cares? 2 The who cares part is the fact that the failure or 3 the near-collapse of LTCM at least at that time seemed to 4 have threatened the integrity of the financial system and 5 that's an externality that I think the SEC is also in a prime 6 position to address. And I guess what I would suggest maybe, 7 an interesting alternative to the way that these kinds of 8 failures are handled right now, is to take the path that the 9 federal government is taking with respect to airplane 10 crashes. 11 In particular, we have an organization called the 12 National Transportation Safety Board that's charged with 13 responsibility for investigating every crash that occurs. 14 These are the folks that end up at the crash site, they look 15 for the black box, which may be appropriate for hedge funds 16 as well, they collect data, they analyze the data, and 17 ultimately they file a report that describes what happened 18 and makes recommendations as to how to improve the system. 19 Since 1967 when the NTSB started, they've 20 investigated 114,000 incidents in aviation alone. Now, there 21 haven't been 114,000 airplane crashes but any accident they 22 investigate they file a public report. And just to bring 23 home the point, I think many of you are probably aware that 24 icing on the wings of airplanes is not such a good thing. 25 Well, the reason that you know this, the reason 1 that we're aware of this is because on October 31, 1994, an 2 American Eagle flight 4184 crashed and the NTSB filed a 3 report shortly thereafter observing that ice accretion was 4 responsible for the crash. 5 And so the hope is that with systemic risks, 6 although those risks are very rare and not something that 7 fills our daily attention, that's the kind of thing that I 8 think the SEC is prime to be able to collect the data and be 9 able to analyze. 10 MS. NAZARETH: Thank you. Bob? 11 MR. STEEL: Thanks, Annette. It's great to be here 12 in the middle. I've learned that Gus Levy was recognized 13 today as having built our firm on risk arbitrage, which he'd 14 be pleased to know, and also I found out that you can change 15 the 12:00 on your VCR, which I didn't know. 16 (Laughter.) 17 MR. STEEL: I guess, Annette, that there are a 18 couple of things that I'd add to the conversation, I hope. 19 One is that I think something that maybe hasn't been said 20 clearly is that there is risk of the strategy when you invest 21 in hedge funds but by nature the limited partnership has 22 certain characteristics, too, that are of a risk that people 23 choose to accept or not accept. 24 There's less liquidity, there's the potential to 25 lose all your capital, and so that's a different form of 1 risk. Especially someone like Mark who basically is 2 investing in perpetuity as an endowment or he's really 3 investing for future generations and the goal is to protect 4 the purchasing power, but there isn't the near-term liquidity 5 needs. 6 The fact that he can be comfortable putting 55 7 percent of his portfolio, as I understood, into limited 8 partnership-type investing is consistent with his ambition 9 but it isn't for everyone else. And so I think that's a 10 different type of risk that you have to think about. I think 11 it steers into another issue that you'll get to later in 12 terms of appropriateness of investing and I just would like o 13 make that point. 14 To add to something Bill said, I think when you sit 15 inside our firm, what's fascinating to me is when there's a 16 sudden change in the nature of a security, which Bill alluded 17 to. And that is that on Monday a stock closes at 20 and 18 people are valuing it because of the long-term prospects. At 19 4:15, someone makes a bid for the security at 30 and the 20 stock opens on Tuesday morning at a new price. 21 It isn't a stock trading at 20 being valued on its 22 long-term fundamentals. It's a security that's valued at 27 23 where professionals are estimating what the odds of closing 24 are, what the antitrust issues are, and how long it will take 25 and whether you can borrow the security and set up the hedge. 1 And all of a sudden, the nature of investor changes 2 instantly and the arbitrager who comes in provides liquidity 3 to the people who previously owned the security at 20 with a 4 long-term ambition and have stepped into new shoes that have 5 new risks and new characteristics of risks. And that orderly 6 transfer of holders, given the change in the security or the 7 change in the situation, is something that occurs every day 8 and I can't imagine how that would happen -- and that the 9 previous holder would then be assuming risk they weren't 10 qualified or prepared to understand or to take into those 11 shoes. 12 And so I just thought of that and wanted to add 13 that to a point Bill was making. 14 I think to comment maybe briefly on Larry's point 15 -- well, on Andrew's points more, that looking into this 16 issue of systemic risk, at Goldman Sachs we have a business 17 of prime brokerage where we have about $125 billion of hedge 18 fund equity and so we look at this very carefully and we can 19 talk about how we look at it maybe later. 20 But I think that when we look at the amount of 21 different strategies going on and the amount of correlation, 22 I think the thing that is pleasing to us and would be 23 systemically is the fact that it seems as though there's not 24 much and that people are all doing different things, they're 25 all looking at all the different information and pursuing 1 different strategies that we don't see as much correlation as 2 you might think. 3 Andrew is correct that there is that earthquake 4 opportunity that we sure think about when we analyze the 5 securities because those are the equities off which we loan 6 money and we're the first line of defense. I think the issue 7 that Andrew raised -- he mentioned the other day when we were 8 discussing the panel -- of the transportation analogy is a 9 good one and I think that is something that I would encourage 10 us to think about. 11 The idea of a regulator stepping into the shoes to 12 decide and to analyze, quantify and then potentially make 13 decisions about the systemic risk as it builds, ebbs, flows 14 seems to be a tricky slope to start on but I would be 15 interested in other people's comments on that point. 16 MS. NAZARETH: Could I ask you about -- and perhaps 17 others here have some experience as well -- whether you think 18 that the practices in the industry after long-term capital 19 management improved in any way? I mean, obviously there were 20 some lessons learned. 21 We may not have had the kind of post mortem that 22 you would with a plane crash, but there certainly was a fair 23 amount of work done including work by the President's working 24 group and the counter-party risk management policy group I 25 thought had some very important recommendations. 1 Do you think that there have been improvements in 2 risk management by counter-parties since that experience? 3 MR. STEEL: I think the good news is that if you 4 look at the work and the 20 suggestions that came from the 5 counter-party risk management group, that there have been 6 lots of improvements. 7 I think the bad news is that not everybody -- there 8 isn't kind of a way of measuring who is getting in line and 9 who isn't on that and so everybody is applying these things 10 at their own speed in their own way. They are 11 recommendations and so I think from our perspective, I know 12 we sure take them seriously at the different levels where we 13 analyze our risk. 14 But I think the challenge is to -- we sometimes 15 have the tendency, we've seen in lots of situations, where 16 the lowest common denominator seeks a commercial advantage 17 and that would be systemically challenging. 18 So the answer would be successful articulation and 19 some degree of improvement but we could always do more. 20 MS. NAZARETH: I want to call on Will but I also 21 want -- I'm sure you have a number of things to say. One of 22 the things I was curious about as well was, again, following 23 up on something Bob said. 24 You know, when you're managing risk, one of the 25 issues again that I think came up in long-term capital 1 management was the sense that an awful lot of people were 2 sort of on the similar side of the market, there was a sort 3 of -- you worry about this herd mentality and that unwinding 4 positions can sometimes be substantially more difficult than 5 you anticipated if, again, everybody has got the similar 6 hedges and you can have more impact on the market than you 7 may otherwise have expected. 8 So it looks like that remark has inspired some 9 comments so let me call on Will and then I'll ask Bill to 10 respond to that as well. 11 MR. GOETZMANN: I could actually respond briefly to 12 that. You know, we're talking about events, systemic events 13 and so forth maybe caused by opinions, driven by models that 14 value securities but also we should consider systemic events 15 that are related to the institutions themselves. 16 Bob's firm, if it has 125 billion in hedge fund 17 capital flowing through it, is part of a system that can be 18 sensitive to interest rate shocks and the availability of 19 credit and other kinds of things, so that as we have -- as 20 the industry has moved from what almost seems a series of 21 little shops to a broader more -- something with real 22 foundations in the largest financial institutions, we should 23 consider the broader system beyond the hedge funds themselves 24 and the trading itself to the institutions that support them. 25 The point I wanted to make is that hedge funds are 1 absolutely vital to the operation of the markets. You 2 couldn't have markets without people serving in the role that 3 a hedge fund serves in terms of arbitraging these 4 opportunities. But they are marginal in two important 5 senses. 6 Hedge funds will never be the dominant form of 7 investment in a market. Mark's fund will never put 90 8 percent of its investment in what we would think of as a 9 hedge fund that seeks to exploit mis-pricings in a market. 10 As hedge funds have grown, especially because the returns 11 look attractive, we have to ask why these strategies have 12 attracted money and how can they continue to attract money. 13 Hedge funds -- their profits are driven by subtle 14 and fleeting mis-pricings that are captured by really bright 15 people working full-time to build sophisticated models to 16 measure them. And as such, they can't be sustained in a 17 market like ours, which is relatively efficient. 18 So inevitably, hedge funds are going to -- in some 19 sense, they contain the seeds of their own demise, especially 20 strategies such as M&A arbitrage and convertible bond 21 arbitrage where the returns have been a great challenge to 22 sustain over the last few years. 23 I think that's a good thing that this marginal 24 force in the economy has been there to serve us and step in 25 to support prices, step in to assert, if you will, 1 intelligently developed models of what securities should be 2 worth, but also it really shouldn't be considered a large and 3 dominating factor in an investment portfolio. So -- there 4 are limits to scale is the point I guess I'm making. 5 Now, the second sense of the marginality is 6 something that we've also talked about today which is hedge 7 funds being a marginal investor. That is, the investor that 8 effectively sets the price for a security and does so by 9 committing capital to an opinion about what the security is 10 worth. 11 It's very helpful to have a marginal investor that 12 is taking a stand with capital on a belief in the valuation 13 of the security and that's quite helpful to us. But as a 14 marginal investor, if the investor steps back -- if it 15 withdraws capital or has an abrupt change in the opinion of 16 what the value of the security might be, then the price will 17 change. 18 So inevitably, as hedge funds have served us as 19 marginal investors, they are bound to have some relationship 20 to price fluctuations. To the extent that they are trading 21 on important information, they will always move in price and 22 that can be helpful. And the few cases where it will not be 23 helpful are either if all the models are wrong at the same 24 time and everybody is trading on an idea that is just not 25 economically valid or if they're driven by expediency to 1 withdraw capital from a market and -- an example, a credit 2 crunch. 3 So those are the two times when the marginal 4 investor -- having these marginal investors can be a risk -- 5 systemic risk to the economy. 6 MS. NAZARETH: Thank you. 7 MR. HEYMAN: In discussing whether hedge funds make 8 the market a more dangerous or less fair place for other 9 investors, a couple people have alluded to the phenomenon 10 that occasionally everybody gets on the same side of the 11 boat. 12 I think there's a limit to which government ought 13 to worry about that; not that it shouldn't worry at all. 14 When I began in business, information basically seeped into 15 the market on a very unequal and probably an unfair basis, 16 and the result was less volatility and a better balance 17 between people wanting to buy and people wanting to sell. 18 In a fairer and more volatile world of instant 19 news, it is inevitable that there will be many times in which 20 everyone has the same opinion at once and there are quantum 21 shifts in investor preferences. 22 Government should not be concerned when that 23 happens unless it happens with such magnitude that it 24 threatens the systemic seizure and that is generally the 25 result of really outsized exposures which had all parties had 1 information, might not have happened. In the case of long- 2 term capital, what emerged -- and there really was a post 3 mortem in the press. 4 And in fact, in most large hedge fund blowups, 5 there are post mortem in the press. They may not have a 6 uniform style but everyone ends up knowing what happened. In 7 long-term capital, credit was being extended by a number of 8 regulated institutions. I think few knew what the others 9 were doing. The firm itself was able to receive this credit 10 without showing its own hand, something that probably 11 couldn't happen today. 12 So I think government's concern is legitimate at 13 the boundaries but to the extent that people say hedge funds 14 or any market participant make the market more volatile, 15 unless there's some inequity to which one can point, I think 16 government more or less has to watch that. 17 MR. LO: I'd just like to respond to a couple of 18 those points. The first is that I think volatility is a good 19 thing. I mean, in fact, typically when we teach about market 20 efficiency we argue that having a market that's volatile 21 means that there's a lot of price discovery information 22 transmission going on. 23 So the point is not to get rid of volatility. I 24 think that there's a distinction between market volatility 25 and the systemic risks that are posed by very, very large 1 catastrophic failures of a particular financial institution. 2 While I agree with you that there was a very 3 detailed post mortem, the President's working group on LTCM, 4 the fact is that that working group didn't really generate 5 any data for other people to study. It generated a few 6 recommendations, which were only recommendations. And this 7 was an unusual event that generated this kind of a post 8 mortem. There are lots of other events that I don't think 9 generate nearly the amount of post mortem. 10 Getting back to the NTSB example, I think one of 11 the reasons that people are so keen to learn from every 12 airplane crash is because the kind of information that we 13 glean from it has been paid for by the lives of the people 14 that are lost. And if we take that analogy to the financial 15 markets, many investors have given billions of dollars in 16 lost capital for what? I think what we'd like to be able to 17 do is to learn from it. 18 For example, while I think everybody is familiar 19 with LTCM and the facts surrounding that case, how many 20 people in the audience know the facts surrounding Laser 21 Advisors, Gotham Investment Management, Haifuku, Paramount 22 Partners? Each one of these cases contains a lesson and some 23 very important information for improving the financial system 24 and it seems to me that we ought to spend some time focusing 25 on those kinds of issues as well. 1 MR. YUSKO: Annette, one thing that -- I wish I had 2 a dollar for every time long-term capital was used in the 3 same sentence as hedge funds. And it's very frustrating 4 actually because actually I wouldn't have to work if that 5 were true and mostly it's very frustrating because long-term 6 capital was one of thousands of funds. And it was -- if you 7 actually go through the post mortem, 85 percent of the 8 investors in long-term capital made money. Only 15 percent 9 lost money. 10 Had they not given their equity capital back a 11 couple months before the widening of the spreads based on a 12 catastrophic event in Russian default, they would have been 13 able to meet their margin call and we wouldn't be having this 14 discussion. 15 So I think there's this overemphasis, particularly 16 in the financial press, on blowups which, if you actually 17 calculate the number of mutual funds that have gone out of 18 business since January 1, 2000, it's significantly, a 19 multiple of the number of hedge funds that have gone out of 20 business since January 1, 2000. 21 So I think there is this negative bias placed 22 around this industry that's really undeserved and if you keep 23 focusing on that and keep marginalizing the other issues and 24 the other risks -- for example, GE has been called the 25 biggest hedge fund in the world. Ford Motor Credit has 1 issues. GM Credit. There are lots of big European insurance 2 companies right now with much bigger prop books than most 3 hedge funds that are in desperate need of capital or 4 something bad is going to happen. Japanese banking system, 5 if we actually had the mark to market, what kind of mess 6 would that create? 7 So I think the size of this negative part of the 8 hedge fund business gets a disproportionate amount of press 9 and a disproportionate amount of commentary and I wish we 10 could talk about the Lone Pines and the Blue Ridges and the 11 Mavericks of the world instead of talking about long-term 12 capital. 13 COMMISSIONER GOLDSCHMID: Annette, let me ask a 14 question. How important is leverage to the hedge fund 15 strategy today, the various strategies? 16 MS. NAZARETH: Afsaneh? 17 MR. BORISH: I was going to mention another point 18 but on the leverage -- I'm sure others have a lot to say. 19 Really, I think what Peter said earlier, there are so many 20 different strategies -- there are some strategies when I was 21 at the World Bank, for example -- you know, I traded hedge 22 fund strategies myself which were totally unleveraged so you 23 could be trading totally unleveraged. 24 You could have -- there is a fund today which has 25 the same amount of leverage as long-term capital if you want 1 to call it like, you know, 400 times, and fixed income. But 2 it is very, very strategy-specific and also in certain kinds 3 of strategies it makes sense to have a certain level of 4 leverage, once, two times, three times, and others where, you 5 know, this particular fund says it's okay to have 400, 500 6 times. 7 Now, you know, we could debate that but essentially 8 they're saying they're really not leveraged because 9 everything is hedged against some other position. The 10 question is if something goes wrong in the documentation, 11 something goes wrong in the swap documents, well, yeah, the 12 systemic risk issues, which are really not hedge fund issues. 13 They are instrument related -- you know, that's a derivative 14 issue but I'm sure others have a lot more to say on this and 15 then maybe Annette will let me say something else. 16 MS. NAZARETH: You want to talk about the leverage 17 and then we'll get back to Afsaneh? 18 MR. BORISH: I'd like to respond to three speakers 19 briefly, if I might. On leverage, it's very important to 20 look at what you're leverage. I believe that an unleveraged 21 position in almost any dot com is more risky than a highly 22 leveraged position, say, in an indexed arbitrage trade. 23 Now, I also want to agree with Mark Yusko and 24 disagree with Andrew Lo. Too much emphasis is put on the 25 failure. If you look at stocks -- again, let's make the 1 analogy with stocks. Far -- even leaving aside WorldCom and 2 Enron, far more money has been lost in stocks that have gone 3 completely -- where everything has been lost, completely 4 bankrupt, than in hedge fund failures. Any hedge fund with 5 the return profile of the NASDAQ 100 would be out of business 6 today. 7 I also want to support Will Goetzmann where he said 8 that hedge funds contain the seeds of their own destruction. 9 Empirically you can see this. In the 1970s, a trained monkey 10 who happened to know the Black Shoal's formula could have 11 made a fortune betting on the mispriced options. 12 (Laughter.) 13 MR. BORISH: A couple decades ago, anybody who bet 14 that if a commodity goes up today it will go up tomorrow, 15 would have been living on the beach today. Another example 16 is index arbitrage. It's largely traded out. Any of these 17 strategies, very hard to make much money today because the 18 hedge funds and others have traded out these inefficiencies. 19 Today you have to concentrate on much more difficult to find 20 inefficiencies. 21 MS. NAZARETH: Afsaneh? 22 MS. BESCHLOSS: The other points I wanted to make 23 related to some of the things Peter just said and others have 24 said a little earlier. And I think one thing that's actually 25 interesting, we talked about risk, we talked about volatility 1 today. As Peter said earlier, volatility in many hedge fund 2 strategies is actually lower at the hedge fund level and then 3 if you take a fund to fund, which is diversified, even lower. 4 So in fact if you look for investors at the risk -- 5 you know, they went into hedge funds with a certain 6 understanding of how much risk they wanted to take overall in 7 their portfolio. In most cases, you'll find that that risk, 8 if measured by volatility, is actually lower. I think 9 something that is going on, which is interesting in hedge 10 fund industries, hedge fund managers themselves are measuring 11 their own risks better but at the same time maybe becoming 12 risk averse. 13 I mean, it's something that I would throw in this 14 debate. Are hedge fund managers taking the risks that they 15 are paid to take? 16 MR. BORISH: They have their money. 17 MS. BESCHLOSS: Exactly. They have their money, as 18 Peter said, in there. The other thing I think is that again, 19 when we go sort of at the microlevel and we look at risk, 20 you're really looking at -- when you're putting together a 21 portfolio of traditional managers and hedge fund managers and 22 how uncorrelated these hedge fund managers are to the rest of 23 your portfolio, and at the end of the day, most of the 24 portfolios I've been familiar with, hedge funds strategies 25 have reduced risk by being uncorrelated to the stocks and 1 bonds as Peter was saying. 2 The other thing is, again, when we talk 6,000 hedge 3 funds, and you asked are there lots of failures -- are they 4 small failures, I go back again to Peter's example. Just 5 like with stocks, just like with really any other instrument, 6 when we say 6,000, it's sort of a meaningless number because 7 in that data there are a lot of people who come in and out 8 with one or two million, they don't survive, they don't blow 9 up, they don't destroy anyone else's money. They just go in 10 and out of that sample. 11 And when I look at samples, it's more like a 12 thousand -- you know -- between 500 and a thousand that you 13 sort of take seriously in this industry and I think it goes 14 back to the subject which is really being discussed yesterday 15 and today. Investors, especially I think when it gets to 16 retail investors, do they really understand the risks and do 17 they understand the strategies? 18 If you don't understand broadly what the strategies 19 and broadly -- not in great detail -- what the risks are, 20 should you be investing at the retail level, which goes back 21 to the issue of whether you need to be the more sophisticated 22 endowment or public pension fund or sophisticated individual 23 to be able to invest in this. 24 But I think the most important point at least for 25 me is what Robert Steel said. Coming back to the prime 1 broker issue, at the end of the day, if we look at any 2 systemic risk issue, you know, I think a lot of us in this 3 room have gone through all the -- years and years of 4 discussing systemic risks and derivatives. I think there 5 were all the committees, I was involved in them and at some 6 point huge amounts of discussion went into systemic risks of 7 derivatives and how they would block markets and we would, 8 you know, all die. 9 (Laughter.) 10 MS. BESCHLOSS: And I think we're still alive. But 11 the issues go -- I think it would be interesting in the hedge 12 fund industry to look at that issue of systemic risk as we 13 studied it with regard to derivatives and I think when you 14 come down to it, it was the banks who provided credit to, 15 let's say, real estate. Had we done a better job at looking 16 at the risk at the level of prime brokers, I think the LTCM 17 issue might have been handled slightly differently. 18 So I would go back and say, number one, that maybe 19 what we need to be doing, one is what level of government 20 regulation you need but I think more importantly, what should 21 the prime brokers be doing, singly, as individual prime 22 brokers, jointly as a group. 23 And then I would add to that. If we put a lot of 24 extra regulation on U.S. prime brokers, what is that going to 25 do? The business will go offshore over which we have no 1 control. So if there is a way to have some sort of 2 understanding with prime brokers groups not just with U.S. 3 banks but across the board where this -- any kind of risk -- 4 hedge funds are really not particular -- where anything that 5 we want to be looking at is controlled where it should be 6 controlled and is aggregated where it should be aggregated. 7 MR. BORISH: If I could just have one point, 8 talking about risk, most hedge fund documents have a self- 9 preservation criteria in there which is if you lose 50 10 percent of your capital, they close or they stop trading or 11 they give the investors an opportunity to redeem their 12 capital. 13 So unlike a situation where if you buy a stock and 14 you get paralyzed and you don't know what to do and you hold 15 it and then it goes bankrupt or you lose everything, almost 16 hedge fund document I know has a point at which if you lose 17 money they stop trading. And some it's 35, 40 percent but 18 generally it's 50. 19 CHAIRMAN DONALDSON: Annette, I'd like to ask a 20 general question of this particular panel, and it goes 21 something like this. There are, as we all know, well 22 advertised figure of $600 billion of hedge fund money out 23 there. You just have to sit here for a few hours and listen 24 to all the knowledge that is resident and the people that 25 have been talking about it. 1 My question is there's a cost-benefit analysis from 2 the point of view of the SEC as to how much cost do we 3 possibly incur to the hedge fund industry in order to deliver 4 for us the right to go in and continually monitor and follow. 5 Is it worth it? How much cost are we willing to put onto 6 this industry, to a $600 billion industry, in order for us to 7 be able to have the right to go in and continually monitor 8 it? 9 Is there any view on this? Can this industry 10 sustain the cost in order for the greater good of the public 11 knowledge base of this agency? 12 MR. BROWN: I have one brief comment. I believe 13 that the SEC and regulators benefit enormously. If you just 14 look at what hedge funds pay in Section 31 fees, it dwarfs 15 the cost of the regulation. So I think the SEC and the 16 government is coming out way ahead on a cost-benefit 17 analysis. 18 (Laughter.) 19 MR. GOETZMANN: I'd be happy to answer that since I 20 have nothing at stake whatsoever in this issue except as a 21 taxpayer. I think that the process is underway now of 22 generating information and costly information but that 23 process is being separated. The big funds are doing one 24 thing and the small funds are not doing it. 25 And the process involves increasing auditing of the 1 procedures. You know, we talked a little bit about blowups 2 and how safe the hedge fund industry really is, but most of 3 the blowups in the hedge fund industry have been operational 4 catastrophes that probably would have been avoided had there 5 been more auditor attention and auditor ability to 6 investigate the procedures for trading that were used. 7 So I think that that's money well spent. And it 8 may not be money that -- it's certainly money that the major 9 hedge funds are investing in at this point, not just in terms 10 of engaging auditors and in seeking to comply with the 11 requests but also developing statistical systems, however 12 imperfect, to try and gauge their own measures of risk. 13 So I think that one of the dangers for the SEC is 14 that you would achieve rapid and total transparency and you 15 would have truckloads of paper being backed up to the doors 16 here full of all the trades and so forth, so it's a cost both 17 ways, not just for the funds but for us to go through and try 18 to reconstruct the activities. 19 But relying on this intermediary, the accounting 20 profession to provide some risk control measures without 21 disclosure of strategies to the public I think is a helpful 22 direction to go in. 23 COMMISSIONER CAMPOS: Moreover, we were told 24 yesterday that 70 percent of hedge fund managers are already 25 registered investment advisors so we already have a large 1 stake, apparently. Granted, that doesn't give us all the 2 compliance and examination that we might otherwise but it 3 seems to me we as an agency are already well into that and we 4 were told that that's attractive to be a registered 5 investment advisor if you want institutional moneys as a 6 manager. 7 So there's already an economic incentive at least 8 to exceed and to allow a certain amount of regulation. 9 Now, I have another question if we're in a position 10 to go forward on that, and we can come back to it. 11 It seems to me that -- we've had a tremendously 12 sophisticated discussion about risk and alphas and betas and 13 the moving -- the opportunity costs and all that. And then 14 there seems to be a gee, you know, sort of patting ourselves 15 on the back where we're the smart people of the world and 16 it's really difficult for those out there on Main Street to 17 understand risk and understand how complicated all this is. 18 And, you know, it's easy to do that when we get 19 together with highly educated people and people who 20 understand their professions that well. But I ask myself -- 21 and in terms of the risk aspects of it, how clear is it to 22 the retail investor the risk that they're taking when they go 23 long and naked without any amount of -- I mean, is that risk 24 being appropriately communicated and indicated to people? 25 And instead, what we have is we seem to have a two 1 class system. We seem to have those who have access to your 2 intelligence, your professional research and so forth, who at 3 least hedge or have hedged situations as was said a minute 4 ago. And we have the retail public that doesn't seem to have 5 access to these sorts of strategies, whether it be through 6 your industry or through existing mutual fund industry. 7 So, as an agency, should we care about that? I 8 mean, is it simply a caveat emptor world, and let the guy who 9 doesn't know any better be long on a big cap fund and 10 whatever happens happens? And even if they apply the 11 existing mantras of diversification in these last three 12 years, they're still going to lose because, you know, they're 13 30 percent in equities and you're 70 percent in fixed income 14 and you're losing 30 percent in your equities, you're not 15 going to make money, you know. 16 And then there's a time cycle. There's not enough 17 time for some of these people to come back and ride whenever 18 the next bull market comes. 19 MR. HEYMAN: Can I try that one? First, whether 20 it's clear to -- whether the risks of going along are clear 21 to retail investors, I'm sure they're a lot clearer than they 22 were a few years ago. 23 (Laughter.) 24 MR. HEYMAN: With respect to the second question, I 25 think it's a very simple question to the debate before this 1 two-day session. Certainly hedge fund strategies, again, 2 generalizing, over the last four or five years in which a lot 3 of equity values were destroyed, delivered on a significant 4 part of their promise and that was the promise that they 5 could preserve capital in poor climates for financial assets. 6 Obviously, some in the industry would support going 7 in the direction of raising the bar in terms of 8 qualifications of investments as a tradeoff against less 9 regulation. On the other hand, that does have the effect of 10 government saying to investors who can't meet that bar, the 11 new bar or the previous bar, that we're going to make it more 12 difficult or perhaps even impossible for you to accomplish 13 something that would have provided you with great protection. 14 Now, who knows going forward how true any of that 15 will be? We always fight the last war but in terms of 16 equity, for the conclusion to be reached that the solution -- 17 if there's a problem that needs a solution, which can be 18 debated -- is to simply prevent hedge fund strategies from 19 being accessible at lower ends of the food chain is probably 20 not a fair result. 21 MR. ROYE: I couldn't agree more. In fact, this is 22 one of the central issues that we think about all the time 23 and we've been approached by our alumni, by others who look 24 at the performance of the fund, particularly the low 25 volatility of the fund are attracted to it. 1 And I hope that this is not too offensive to too 2 many wealthy people but wealth is not an indicator of 3 investment intelligence. Usually that wealth was created in 4 many other capacities and I find it very frustrating as an 5 individual investor who just barely made it to qualified 6 status a couple years ago -- 7 (Laughter.) 8 MR. HEYMAN: Still there? 9 MR. ROYE: Yeah, still there. Cash. Cash is a 10 good thing. 11 (Laughter.) 12 MR. ROYE: And it's been very frustrating to watch 13 the best strategies, the best managers, who have migrated out 14 of the traditional world. Real story. Group at Putnam, 15 Putnam International Voyager, had an investment in there, in 16 a 403(b), was doing great. Last August it started to go 17 down, didn't think much of it, everything was going down. 18 So I met these two guys at a hedge fund conference 19 in January and we got chatting and they talked about what 20 they were doing, starting a hedge fund and where were you, 21 we're at Putnam, well, what did you manage? We managed the 22 Putnam International Voyager Fund. When did you leave? In 23 August. Who replaced you? A 29-year-old that had worked for 24 them for a couple years. And nothing against 29-year-olds; I 25 was one not too long ago. 1 (Laughter.) 2 MR. ROYE: It really does matter to me, I think, 3 that the perception of risk has blocked access to the people 4 who need it most. The perception was if you had a lot of 5 money, you could afford to be in risky strategies where 6 there's risk of loss. What I think we've seen now in the 7 bear market is that it's the exact opposite. If you don't 8 have time to get that money back, that you're in real 9 trouble. 10 And making these strategies accessible to others I 11 think will be very, very positive. In fact, if you look at 12 Richard Thayler's work, the problem in investing, 13 particularly in the defined contribution area which is 14 another whole bottle of worms or can of worms I don't want to 15 open up too much, but it's awful. 16 If there are seven options in your 401(k) or 17 403(b), five are stock and two are bond. The average 18 investor will have five-sevenths in stocks and two-sevenths 19 in bonds. If it's five bond and two stocks, they'll have 20 five-sevenths in bonds. And the elections they make on the 21 day they sign up in the HR office with nobody giving them any 22 advice are the same options they'll have forever. They don't 23 change. 24 So if you could have an arbitrage strategy which is 25 lower volatility, if you could have a long/short strategy 1 which is going to provide good upside in good markets and 2 protection in down markets, you'll decrease the volatility of 3 the overall portfolio. 4 And there's a great slide that I use with all of 5 our constitutes which shows that if you took the return on 6 the market of the last 30 years, about 13.2 percent, with 16 7 percent volatility, it turns a dollar into about four-and-a- 8 half dollars. 9 If you just reduce the volatility, don't increase 10 the return but take that volatility from 16 down to 8, you 11 end up with 7 in cumulative wealth. The reduction of 12 volatility is what matters, not increasing return. And these 13 strategies are all about getting rich slowly and compounding 14 wealth. So pushing that down as far as we can get it, 15 particularly because of the diversification benefits of a 16 thing like a fund to funds I think is critical. 17 MS. NAZARETH: Jim, do you have a comment? 18 MR. CHANOS: Yeah. I'd like to interject into this 19 argument the observation from my vantage point, running a 20 fund primarily from the short side gives a sort of unique 21 perspective to see people who are coming in to try to hedge 22 their portfolios. 23 And what I could respond to Commissioner Campos's 24 question, it really is almost a blunt answer but investors 25 almost, no matter what their sophistication, chase returns. 1 That has been our experience. We can talk a lot about risk 2 management, lowered volatility. I've seen it all and heard 3 it all from investors coming into my shop for 20 years. 4 But they chase returns and they will justify 5 putting money with you based on whatever model they want to 6 use. And I think to some extent retail investors have chased 7 returns more than perhaps more sophisticated investors, but 8 I've seen a lot of bonehead moves from sophisticated 9 investors at the top and bottoms of markets from our 10 perspective. So we're not going to save people from 11 themselves when fear and greed run rampant at various market 12 turning points. 13 Having said that, we recently have seen a number of 14 mutual fund companies come into our shop and talk to us about 15 partnering up, perhaps doing a joint venture. And I think 16 the interest is there and growing now to try to avail 17 themselves to various different techniques to hedge 18 portfolios. I'm not so sure it's going to be successful. 19 My sense is that one of their concerns is the PR 20 factor, for example, of taking short positions. We haven't 21 touched upon that in this panel yet but, you know, there are 22 some uneconomic arguments that people make about 23 shortselling, whether it's index arbitrage, whether it's 24 directional shortselling, whether it's fundamental 25 shortselling, that I think is keeping back some people in the 1 mutual funds complex from aggressively pursuing this or 2 rolling out products that are hedged. And maybe rightly so. 3 I don't know. We haven't discussed it yet. 4 But the point is that I think that intellectually 5 there is a sense afoot in that community that it needs to do 6 more and perhaps should do more with different strategies. I 7 think it's just beginning, however, and they're a little 8 uncertain. 9 MS. NAZARETH: Mike? 10 MR. LO: I just want to follow up on a couple of 11 comments that Mark made. I think it was a few years ago that 12 the former Treasury Secretary, Larry Summers, was giving a 13 lecture and somebody in the audience said if you're so smart, 14 how come you're not rich? And Larry retorted in his usual 15 way, if you're so rich, how come you're not smart? 16 (Laughter.) 17 MR. LO: And I think that -- so I would agree with 18 Mark that there really -- there isn't necessarily a 19 correlation between having a high net worth and having 20 investment intelligence. But the reason that high net worth 21 is part of the qualified investor's criterion is because if 22 you have a high net worth you can afford to lose a fair 23 amount of money. 24 So I guess what I would suggest, getting back to 25 Commissioner Campos's point, is that in changing the 1 suitability requirements, we might consider, in addition to 2 the high net worth criterion, to have some kind of an 3 educational criterion where investor education is I think the 4 ultimate answer. 5 I agree that it's important to have these kinds of 6 hedged products available to individuals, particularly for 7 retirement planning and building long-term wealth a little 8 bit at a time is exactly the right thing to do but getting 9 individual investors to do that and to feel good about doing 10 that is a very difficult task where investor education I 11 think comes in. So I think that's a really important issue. 12 MR. HARRIS: There's no question that there's an 13 element of paternalism associated with the qualified investor 14 status and that raises some philosophic problems. On the one 15 hand we say that, gee, who are we to be paternal? Let people 16 decide for themselves and they'll learn. On the other hand, 17 the history of this agency is one that P.T. Barnum would have 18 appreciated. Our commissioners every day, or twice or three 19 times a week, sit in enforcement meetings hearing cases of 20 situations that Jesse Livermore recognized from the turn of 21 the century. 22 How do we reconcile that? One way to reconcile is 23 to recognize that learning is very expensive and if we're to 24 say that people can go out and learn by themselves from 25 experience, that that's all we need to properly regulate the 1 market, so they get burned once, that's fine, that runs 2 counter to the notion that, gee, after you've learned, at 3 some point you're going to end up dying and your children are 4 not going to figure this out except by themselves. 5 And so I think there is some room for -- I don't 6 want to use the word paternalism but for benevolent care to 7 recognize that the cost of learning is very high. Now, 8 Andy's suggestion is very good but we want to do everything 9 we can to lower the cost of learning. 10 Let me give you an example of a very simple 11 situation that comes up in hedge funds that requires a fair 12 amount of sophistication to understand and folks that are 13 chasing returns, as Jim suggested, are not likely to have it. 14 So here's a problem that we learned yesterday. 15 We learned yesterday that the management and 16 contract in hedge funds is extremely important for aligning 17 people's interest. It rewards them for performing well. 18 There's 20 percent. 19 Many of you know -- and if you don't, you do need 20 to know this -- that if the manager of the hedge fund doesn't 21 have his own finger in the guillotine in the presence of 22 these contracts -- by finger in the guillotine I mean co- 23 participation -- that the optimal strategy for the manager, 24 who is not particularly concerned about the -- running down 25 their reputation -- the optimal strategy is to take as much 1 leverage possible because leverage produces volatility and 2 volatility gives you a 50/50 chance with these compensation 3 contracts of getting extraordinarily rich or walking away a 4 loser. 5 Now, if you're in a business that P.T. Barnum 6 recognizes and understands that there's a sucker born every 7 minute and that people will not be able to follow your 8 reputation if you're a good marketing person, then what we've 9 created is a situation that's very, very unattractive. So 10 the important message that people need to know is that it's 11 not acceptable to have these types of management contracts 12 without the co-participation. 13 So that was explained very clearly yesterday, but I 14 venture to say that if you grab people at random among the 15 investing population, very few people will first of all 16 recognize that the management contract will get us fantastic 17 incentives to take leverage to increase volatility in the 18 absence of the co-participation and that -- and very few 19 people -- even if they recognize that, very few people will 20 recognize the importance of co-participation. 21 So we have to educate people to this issue. But in 22 the end, we get back to the fact that as cheap as we make 23 education, it's still very expensive and do we want to live 24 in a world where we can allow a fringe to develop where 25 people who have great marketing skills can have access to a 1 sucker who is born every minute. And those are the types of 2 issues that the Commission undoubtedly will consider. 3 MS. NAZARETH: Harvey, did you have a comment? 4 COMMISSIONER GOLDSCHMID: Yeah, I -- following up 5 on that a bit, though, enlarging it, one concern about risk 6 for me in this area is the premise of hedge funds, if I 7 understand them, the unifying premise is to find market mis- 8 pricing, there have got to be only a limited number of 9 targets of opportunity. 10 As the Chairman indicated, as you've grown to 600 11 billion with maybe more coming, the targets of opportunity 12 have got to be limited, and is there risk that you're going 13 to reach too far in order to keep producing numbers you've 14 produced in a world where you just won't have the 15 opportunities out there? 16 MS. NAZARETH: Peter, do you have an answer? 17 MR. BORISH: Well, one point when people talk about 18 the growth of assets, and if you look at the relative amount 19 of assets in the hedge fund world relative to the long only 20 world and you look at targets of opportunity, you can make 21 the same argument that part of the reason was that there was 22 so much money coming into the long only strategy that there 23 was very few targets of opportunities and they were trying to 24 put a lot of money into that funnel. 25 So I find that over time growth in almost every 1 strategy continues to take place and that you will have good 2 managers and you will have bad managers, and that certain 3 strategies, as arbitrage and technology becomes more 4 efficient, the mean return will decline and that will 5 naturally take assets out of that strategy and move it into 6 another strategy. 7 But I think as the U.S. economy continues to grow 8 and the long only strategies continue to grow and fixed 9 income grows and real estate, there's much, much more 10 opportunity for this realm to grow as well. It's only a 11 problem if this area grows and every other area does not. 12 MR. HARRIS: Commissioner Goldschmid, the profits 13 that the hedge fund industry can make are limited as you 14 mentioned. They come from two sources. The first source is 15 the profits that they can make as well-informed speculators. 16 Those profits are determined by the mistakes that other 17 speculators and investors make and by the demands that other 18 people make on liquidity. And those are finite and of course 19 those are decreasing as people become better educated. The 20 good news for the hedge fund managers again are that there 21 are new people in the market all the time who are not as well 22 educated. 23 They are also limited by the extent to which people 24 can fall into bad products, as I just described, and 25 hopefully want to limit it. 1 The Chairman asked what's the capacity of this 2 industry for carrying regulation and the answer is given that 3 the -- if you ignore the profits that are associated with 4 exploiting foolish people and only look at the profits 5 associated with the stated line of business, any costs 6 imposed upon this industry will reduce those profits because 7 they're finite and they're limited. 8 And the reduction of those profits ultimately will 9 have some impact, not necessarily measurable or identifiable, 10 on market efficiency. And so we weigh those costs against -- 11 in doing the cost benefit analysis, we'll weigh those costs 12 against the benefits of trying to -- of taking a paternal 13 line in some sense for investors and also possibly the 14 benefits associated with systematic risks, of which frankly 15 I'm not particularly concerned but I do think that we do have 16 to pay close attention to them. 17 MS. NAZARETH: Bill? 18 MR. HEYMAN: If I may, your question may be even 19 more pertinent than you know, although the answer may not be 20 a matter for regulatory notice. 21 There was a recent piece written by Steven 22 Galbraith at Morgan Stanley, with which I have no 23 affiliation, in which he gave the results of a study of the 24 performance of equities over the last four or five years. 25 And he concluded that in the last year or so, the difference 1 between the best performing equities and the mean and the 2 worst performing equities and the mean had narrowed. And it 3 is that difference which is the alpha that all these 4 long/short funds, which are the principal new entrants into 5 the field, is seeking to capture. 6 So there is a phenomenon out there with a 7 geometrically increasing number of participants with more and 8 more capital trying to capture a pie of alpha, which appears 9 form all statistical evidence to be shrinking. I don't know 10 whether -- that may be a market condition that government 11 simply can't recognize, but it is out there. 12 COMMISSIONER GOLDSCHMID: I take it one way of 13 trying to keep up in this world would be to leverage and that 14 may create its own problems. 15 MR. HEYMAN: That's possible. 16 MS. NAZARETH: I'd like to ask one more question on 17 risk, following up on a number of points that people made and 18 then, if possible, quickly move on to short selling because I 19 know that's always of great interest. 20 Again, following up on a number of thoughts, we've 21 talked about managing both individual counter-party exposures 22 as well as concerns about systemic risk and it seems to me 23 that there were a couple of points made. 24 One was Afsaneh's suggestion that there's an 25 importance in having gatekeepers such as prime brokers, which 1 I'm sure Bob could talk about, they have the window of 2 knowledge with respect to what these hedge funds are doing 3 and what role can they play in ensuring some market integrity 4 here. 5 And also, the Chairman asked about the greater 6 regulation -- some have suggested that simply greater 7 transparency of some sort may again be better for the 8 markets. Others have suggested that that again could inhibit 9 the ability of hedge funds to effectively trade. 10 So I'd like people to if you can quickly address 11 those issues. Bob, do you want to address the prime 12 brokerage question? 13 MR. STEEL: Sure, I can start and I think maybe 14 some of my comments will