Monday, June 25, 2007
We're Breaking the Law, therefore You Should Change it
by Ken Houghton
Suppose I declare publicly that I'm robbing pension funds. (Just to be clear, I'm not.) And suppose there are several pension fund managers who are helping me? (Just to be clear, they're not helping me.)
You would assume that I would be arrested, no? Or at least forced to talk with George Mitchell. And that people would try to stop me from doing it. And, when they found out about it, they would (rightly) object that it was done, probably noting that the pension fund managers (if not I) have a "fiduciary responsibility." (This, by the way, dovetails to the answer I would give to this post by Brad DeLong: absolutely, since the integrity of the system is otherwise compromised; reputational risk didn't used to be something with which firms took chances.)
The last thing anyone would expect would be to find people argue that, since I was robbing pension funds, robbing pension funds should be made legal.
Ladies and gentlemen, I give you Tyler Cowen (as noted previously, via DeLong):
Follow the pieces:
(Note also that any time an economist says "of course," he's unlikely to be telling the strict truth, as with [5] above. The general rule of "2 and 20" links the hedge fund managers compensation to the amount of funds invested [2% of assets] and the gain of the fund [20% of the profits]. HOWEVER, the gain of the fund will be proportionate to the assets invested. If your "hedge fund" has $100, you can make a $200 or $500 "bet," but not a $2,000 one. In all cases, the maximum return of this portion of compensation is limited by the initial investment. So, in both cases, the hedge fund manager is realistically being compensated for the Assets Under Management, just as the PM is.**)
So mutual funds are attempting to imitate hedge fund strategies. Or, in some cases, investing in hedge funds. Now, since the MF has more than 15 clients, one would assume that the hedge fund would have to report. One would likely be incorrect.
In such an atmosphere—with your pension funds and mine being invested in a manner that is not reported, not conducive to easy access, and (to be direct) not legal, all for an unpredictable relative return, but with higher upfront costs—one would think that a sane economist would consider the "prudent investor" rule*** and decry this activity.
Ladies and gentlemen, Tyler Cowen:
"Not necessarily beneficial." Which part is that: the part that requires investor access, the part that requires investor consent, or the part that requires reported returns with enough information that the investor can make the first two decisions?
*This is not to suggest that Vanguard, Fidelity, et al. don't try to hide their lesser/loser funds. But those were reported, so at the very least an analyst or an economist could tell that they existed and don't any more, and report that accordingly.
**This ignores the so-called "real estate agent" problem.
***This used to be known as the "prudent man" rule, iirc.
UPDATED with DD links.
Suppose I declare publicly that I'm robbing pension funds. (Just to be clear, I'm not.) And suppose there are several pension fund managers who are helping me? (Just to be clear, they're not helping me.)
You would assume that I would be arrested, no? Or at least forced to talk with George Mitchell. And that people would try to stop me from doing it. And, when they found out about it, they would (rightly) object that it was done, probably noting that the pension fund managers (if not I) have a "fiduciary responsibility." (This, by the way, dovetails to the answer I would give to this post by Brad DeLong: absolutely, since the integrity of the system is otherwise compromised; reputational risk didn't used to be something with which firms took chances.)
The last thing anyone would expect would be to find people argue that, since I was robbing pension funds, robbing pension funds should be made legal.
Ladies and gentlemen, I give you Tyler Cowen (as noted previously, via DeLong):
2. Hedge funds exist because mutual funds do not deliver "complex investment strategies." In part this is because mutual funds are regulated.
4. Investment advisors with fewer than 15 clients do not have to register with the SEC.
5. Regulations restrict the compensation of mutual fund advisors in various ways, typically requiring symmetric treatment of gains and losses (if a dollar of profit leads to a bonus, a dollar of loss must lead to a penalty). That is why mutual fund managers are compensated in proportion to the size of their funds, not their performance. This is not obviously efficient, and of course hedge funds pay for performance.
6. Hedge funds don't have to disclose information to investors, other than by contractual agreement.
7. Diversification and redemption requirements make it harder for mutual funds to exploit some profit opportunities, or to hedge in particular manners.
8. The number of mutual funds that try to replicate hedge fund strategies is growing rapidly.
9. Available data on hedge fund returns are nearly worthless.
Follow the pieces:
- (2) mutual funds are regulated and part of that regulation minimizes (restricts) their attempting "complex investment strategies."
- Also (7) the ability of people to manage their own money (be able to move it from one fund to another, subject to regulation) limits the ability of mutual fund managers to take some risks while hedge funds.
- Hedge funds do not necessarily answer to their investors (6), and where said investors generally are required to commit their funds for a defined period of time. (LTCM was five years; most hedge funds require at least one.), and
- We don't know that hedge funds outperform mutual funds.* Indeed, it's not the way to bet, since (by dd's rules, especially Good ideas do not need lots of lies told about them in order to gain public acceptance and Fibbers' forecasts are worthless.) if they did, they would all be advertising their performance, not (9) keeping it quiet—especially when the regulators start sniffing.
(Note also that any time an economist says "of course," he's unlikely to be telling the strict truth, as with [5] above. The general rule of "2 and 20" links the hedge fund managers compensation to the amount of funds invested [2% of assets] and the gain of the fund [20% of the profits]. HOWEVER, the gain of the fund will be proportionate to the assets invested. If your "hedge fund" has $100, you can make a $200 or $500 "bet," but not a $2,000 one. In all cases, the maximum return of this portion of compensation is limited by the initial investment. So, in both cases, the hedge fund manager is realistically being compensated for the Assets Under Management, just as the PM is.**)
So mutual funds are attempting to imitate hedge fund strategies. Or, in some cases, investing in hedge funds. Now, since the MF has more than 15 clients, one would assume that the hedge fund would have to report. One would likely be incorrect.
In such an atmosphere—with your pension funds and mine being invested in a manner that is not reported, not conducive to easy access, and (to be direct) not legal, all for an unpredictable relative return, but with higher upfront costs—one would think that a sane economist would consider the "prudent investor" rule*** and decry this activity.
Ladies and gentlemen, Tyler Cowen:
Overall I was struck by how much hedge fund activity is an artifact of regulations, and not necessarily beneficial regulations. Deregulating some aspects of mutual funds may be an alternative to regulation of hedge funds.
"Not necessarily beneficial." Which part is that: the part that requires investor access, the part that requires investor consent, or the part that requires reported returns with enough information that the investor can make the first two decisions?
*This is not to suggest that Vanguard, Fidelity, et al. don't try to hide their lesser/loser funds. But those were reported, so at the very least an analyst or an economist could tell that they existed and don't any more, and report that accordingly.
**This ignores the so-called "real estate agent" problem.
***This used to be known as the "prudent man" rule, iirc.
Labels: Econbrowser, hedge funds, Market Failures, Tyler Cowen
Comments:
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You present this arguement as though investors whose assets are inested in pension pools and composed simply of long stocks through mutual funds are at less risk than if they were invested in say a principle protected alternative investment vehicle known as a hedge fund.
Talk about prudence. I agree that some fiduciary managers are likely to be violating their charge, but this occurs without regard to the vehicles for investment.It is not the hedge fund itself that creates imprudence but rather the decisions and due diligence of the manager.
mgr1929
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Talk about prudence. I agree that some fiduciary managers are likely to be violating their charge, but this occurs without regard to the vehicles for investment.It is not the hedge fund itself that creates imprudence but rather the decisions and due diligence of the manager.
mgr1929
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