Speech by SEC Staff:
Securities and Exchange Commission (Chief Economist) and Carnegie Mellon University. This was prepared for a Panel Discussion on "Demystifying Hedge Funds" on July 26, 2005 at the American Enterprise Institute in Washington, D.C. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This presentation expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
It's a pleasure to speak as part of this afternoon's panel on hedge funds hosted at the American Enterprise Institute as hedge funds are such an important topic of broad interest in our capital markets. I'd like to thank Adam, whom I have known for several years at Carnegie Mellon, for the invitation to participate in today's panel. I should emphasize at the onset of my remarks that these do not necessarily reflect the views of the Commissioners of the Securities and Exchange (SEC) or my colleagues on the staff of the Commission. I further wish to emphasize that I am not going to address the registration requirements for hedge funds adopted by the SEC or related implementation issues. Instead, as an economist who happens to hold a senior position with the SEC, I want to offer an economic perspective on the role of hedge funds in our capital markets and also comment on why there are policy issues associated with hedge funds.
I wish to first emphasize the importance of the efficiency of America's capital markets. The relatively efficient price signals that prevail in the marketplace are important for enhancing productive efficiency and economic growth through superior capital allocation and facilitating the ability of relatively uninformed investors to make suitable portfolio choices.1 Consequently, these uninformed investors benefit from the arbitrage process and enhanced competition in the financial markets. While the asset valuations in our marketplace reflect considerable information, at the same time it is important for there to be strong incentives to engage in the costly analytic and trading activities that result in such information being embodied in prices. In my view, the high-powered incentives possessed by many hedge fund managers serve to enhance the quality of asset valuations by encouraging such activities. While economists tend to focus upon the efficiency of the marketplace and the competitive paradigm, in recent years there has been more attention paid to the limits to arbitrage,2 emphasizing the role of arbitrageurs and hedge fund investors with high-powered incentives. Even my own experience as an academic economist has pointed to potential violations of efficient markets pricing.3
A key ingredient in producing relatively efficient prices is the competitive market forces of large investment pools and the tremendous sums of capital in the marketplace. The ability of "hedge funds" to operate across different market sectors makes hedge funds useful for ensuring the fairness of prices across different market contexts and various margins for pricing.
While the competitive pricing paradigm is a very useful and powerful one in financial economics, hedge funds and arbitrage capital play a crucial role in the process through which relatively efficient prices emerge. High-powered incentives are crucial to ensuring sufficient search and analysis to limit the extent of mis-pricing prevailing in the marketplace. Indeed, to the extent that there are some sophisticated asset managers that can predictability earn superior risk-adjusted returns, those managers should be able to earn much of the associated economic rents. An interesting theoretical analysis that focuses upon (mutual) fund flows, competition in the managerial labor market and the ability of managers to capture the rents from superior skills was recently offered in the Journal of Political Economy.4 In practice, the structure of hedge fund compensation allows the general partner to share significantly in the economic rents that it creates.
One of the factors that limits in practice the ability of managers to collect the economic rents from their strategies is the difficulty of determining and documenting truly superior risk-adjusted performance. As a result of the considerable variability (noise) in the cross section of fund returns it is well known in some contexts, such as for mutual fund investing, that it is difficult to detect truly superior performance-in technical parlance, there is insufficient "power" to distinguish superior performance.5 To a degree this limits the ability of a manager to appropriate his past track record-does the superior historic track record simply reflect chance variation?6 The discussion of statistical power and historic track records also emphasizes the importance of "selection" and "survivorship" effects in interpreting historic returns. Empirical estimates of historical hedge fund returns substantially overstate prospective investible returns as a result of such effects. A similar theme is emphasized in the column by Malkiel and Saha on the editorial page of today's Wall Street Journal. The precise magnitude of such biases depends upon how returns are being measured and the underlying data generation process, but this does suggest, even apart from the importance of properly adjusting for risk, the need for caution in interpreting historical returns. This conclusion complements the observation in a paper by Getmansky, Lo and Makarov (2003) that liquidity issues in the underlying holdings of hedge funds tend to smooth their returns and consequently, understate their risk and overstate their attractiveness.
One of the important reasons for concern about hedge funds by some policymakers is the presence of a variety of incentive conflicts in which the incentives of the principal and the agent who acts on his behalf diverge. Of course, only in certain instances does the resulting behavior violate acceptable norms and become problematic. There are several natural illustrations of the divergence in incentives and the principal-agent conflict that seem relevant in the case of hedge funds.7 For example, the asset manager receives option-like payoffs (he shares in the upside above a basic contractual return, but not the downside) and in that sense has incentives to assume relatively more risk than limited partners (and perhaps too much incentive); of course, this helps overcome the manager's natural risk aversion. Given the investment adviser's interest in the fees that he might receive over time, many advisers are quite naturally very interested in growing their businesses, possibly beyond the size that their investment ideas might support.8 Along related lines, financial economists have often observed that the relationship between investment flows and therefore, also both the size of a mutual fund and the total fees paid by a fund, are convex in the investment performance (e.g., Chevalier and Ellison (1997) and Sirri and Tufano (1998)). In other words, the marginal benefit and payoffs to a mutual fund adviser of improved performance is especially great when the base level of a manager's performance is already strong.
However, a strong implication of this perspective is that advisers may possess incentives to substantially add to the risks that their funds bear if those risks are not fully understood or detected in the marketplace. This reflects the value in the competitive marketplace for new investments and assignments to those whose performance wins the tournament among funds of various types. It also illustrates the importance and value of trying to create "track records" for new products, why some advisers discard less successful ones and why the track record of products being evaluated by institutional clients often exceeds substantially the subsequent realized performance.9
An additional dimension to the agency problem with fund management is that in some contexts the fund adviser, i.e., the agent, works for many principals at the same time. In particular, there often is an allocation problem when the same securities are being purchased or could be purchased for many different vehicles. In a situation with separate accounts this can arise as a byproduct of the separate account structure if the accounts are not treated equivalently. However, in some contexts, such as the example of a fund manager working for a variety of products in the same fund family there can be situations in which there are different sensitivities to various accounts due to such factors as incentive compensation, differential management fee rates as in the case of a manager investing for both a hedge fund and traditional mutual fund, the effect of past performance within a particular product and the convexity of the flow for performance relationship, and spillovers from "Star" funds. In such circumstances I feel that it is very important for the manager to have an objective and well-defined as well as a fair process for allocating positions, because the potential for problematic conflicts of interest is considerable.
At the same time I want to emphasize that it may be very appropriate for the manager to have multiple clients or work with multiple funds. There are natural scale economics in the generation of information and in portfolio decision-making.10 This is basic economics and business. The issue in my mind is the role of the manager's self interest in such decisions across clients. To the extent that academics have identified situations, even at times in the aggregate, in which the agent's self interest appears to drive decisions does give one concern.
A forthcoming academic paper in the Journal of Finance documents strategic cross-fund subsidization of "high family value" funds compared to lower value ones within a mutual fund family.11 This study links the differential performance within a fund complex to both preferential allocation of IPOs and the extent of cross-trading within a complex. Of course, there are other illustrations of potential types of incentive conflicts in asset trading. For example, even on an ex ante basis the early trades in a program will tend to obtain more favorable executions and less price impact. Perhaps more fundamentally, it is important for managers to avoid exploiting the (illegal) "look back" option they possess in trade assignment and instead make contemporaneous assignment to avoid inherent conflicts of interest.
While in the second portion of my remarks I have focused upon issues associated with conflicts of interest, systemic risk or the possibility of correlated defaults across the economy is another facet of why hedge funds have received attention from policy makers.12 Many hedge fund managers often invest on the same side of a position (e.g., they tend to be on the long side of the credit spread across markets). As the example of Long-Term Capital illustrates, there can be strong external effects across hedge fund investors due to price effects when a major player needs to liquidate significant positions.
As I conclude, I want to observe that the preferences of the general partner and limited partners about additional monitoring can diverge. The limited partners would bear much of the cost and derive much of the benefit for monitoring focused upon conflicts in incentives between the general and limited partners. Such monitoring might be attractive to the limited partners to the extent the associated monitoring costs are below the costs of the conflicts of interest that are avoided. Of course, other reasons for enhanced monitoring, such as the externalities associated with the systemic effects, could make enhanced monitoring desirable from a policy perspective without the limited partners, who ultimately bear much of the cost, being favorably inclined.
Berk, J. and R. Green, 2004, "Mutual Fund Flows and Performance in Rational Markets," Journal of Political Economy 112, 1269-1294.
Biais, B., P. Bossaerts and C. Spatt, revised 2005, "Equilibrium Asset Pricing and Portfolio Choice under Asymmetric Information," unpublished manuscript.
Chan, N., M. Getmansky, S. Haas and A. Lo, 2005, "Systemic Risk and Hedge Funds," unpublished manuscript.
Chevalier, J. and G. Ellison, 1997, "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy105, 1167-1200.
Dammon, R., K. Dunn and C. Spatt, 1993, "The Relative Pricing of High-Yield Debt: The Case of RJR Nabisco Holdings Capital Corporation," American Economic Review 83, 1090-1111.
Getmansky, M., A. Lo and I. Makarov, 2003, "An Econometric Model of Serial Correlation and Illiquidity in Hedge Fund Returns," unpublished manuscript.
Harris, L., 2003, Trading and Exchanges: Market Microstructure for Practitioners, Oxford University Press: New York.
Malkiel, B. and A. Saha, July 26, 2005, "Caveat Emptor," Wall Street Journal, p. 24.
Massa, M., Matos, P., and J. Gaspar, 2005, "Favoritism in Mutual Fund Families? Evidence on Strategic Cross-Fund Subsidization," Journal of Finance, forthcoming.
Shleifer, A. and R. Vishny, 1997, "The Limits of Arbitrage," Journal of Finance 52, 35-55.
Sirri, E. and P. Tufano, 1998, "Costly Search and Mutual Fund Flows," Journal of Finance 53, 1589-1622.
Spatt, C., 2005, "Conflicts of Interest in Asset Management," Keynote Address at Hedge Fund Compliance and Regulation Conference. http://www.sec.gov/news/speech/spch051205css.htm
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