Posted by: Aaron Pressman on June 5, 2007
Can the Securities and Exchange Commission save us from ourselves and do we want to be saved? Sadly when it comes to hedge funds, the answer on both counts is no. The agency is in the middle of imposing a dramatic new limit on investing in hedge funds, at the time when the public is ever increasingly forced to rely on its own investing acumen to pay for retirement, health care and college tuition. It’s like banning ark building just before the flood or restricting diabetics access to healthy foods.
We’ve got to manage our 401(k)s, IRAs, 529s, HCFSAs and on and on because the government and industry stepped back from responsibilities they once handled entirely or in large part. Now the SEC’s view is we should have fewer tools to do so, even for wealthy and sophisticated investors. And this from the agency that allowed brokers to call themselves financial advisors, continues to allow mutual funds to pay for marketing expenses from fund assets and generally did nothing about conflicts of interest on Wall Street until state attorneys general got in the game.
The new restriction is contained in an SEC rule (PDF) proposed last December (two days after Christmas!) that would add another qualification to the current “accredited investor” restriction on buying hedge funds. First put in place in 1982, current hedge fund investor restrictions require that a person have an individual or joint net worth exceeding $1 million or income exceeding $200,000 ($300,000 jointly) in the two most recent years. Those figures have never been adjusted for inflation. That $1 million in 1982 is worth about $1.9 million in today’s dollars according to the SEC. So while only 1.87% of Americans qualified in 1982, now about 8.47% qualify. Of course, it’s not just inflation – it’s the mega growth in America’s upper classes that has enlarged the pool. More people qualify because more people have a lot of money and need more sophisticated investment plans. And along with massive growth in hedge fund assets has come growth in information resources on the Internet and a huge increase in the usage of financial advisers. Has anyone at the SEC noticed that Morningstar has added a whole section on hedge funds including all kinds of info on fees and risks? I’d argue that more—not fewer – people ought to be allowed to invest in hedge funds as a result of the changes to the economic landscape.
But the SEC is going the other way, proposing a new requirement that a person have at least $2.5 million in investments excluding primary real estate to get in a hedge fund. Under that restriction, only 1.3% -- a 30% cut from 1982 and an 85% cut from today – would qualify. What’s the rationale? “We believe that this result is appropriate given the increasing complexity of financial products, in general, and hedge funds, in particular, over the last decade,” the agency writes. The SEC has cause and effect backwards. Financial products have gotten more complex because more people (and institutions) need more complex products to meet their needs.
There are two main objections I frequently hear when talking of hedge funds, neither very convincing. The first one is of course that they’re too risky and too complicated for ordinary folk. Surely you’ve heard about the hedge fund that blew up because it borrowed too much or bet the wrong way on some market? Conveniently ignored of course are all the examples of mutual fund blow ups, and not just little ones. I used to have the Putnam Voyager Fund in my 401(k), for example. The fund, which once held tens of billions of dollars, lost more than half its value in the 2000 to 2002 bear market. And while there are examples of busted hedge funds, you are actually less likely to lose money in one than in a stock mutual fund. And p.s. hedge funds aren’t the only products getting more complex. What about variable insurance annuities, guaranteed investment contracts, long-term disability policies and even good old exchange-traded funds?
The other objection you hear, and it actually contradicts the first, is that hedge funds haven’t beaten the S&P 500 in recent years despite all the fees they’ve collected. But it’s almost completely beside the point, a fact that becomes obvious when you see that flows into hedge funds from sophisticated investors have been increasing despite this supposed underperformance. The main draw of most hedge funds is better risk-adjusted performance, not simple outperformance. If the performance is dramatically less volatile than stocks and the returns are almost as good, that’s very valuable. Ask anyone who retired and stopped contributing to their 401(k) in 2001 or 2002. Further, if the returns aren’t correlated with the stock and bond funds that we all already own, there’s an added diversification benefit. Perhaps the toughest-ever review of hedge fund performance, published by Princeton professor and finance legend Burton Malkiel in 2005 (PDF), found that the industry had over three-quarters of the gains of the S&P 500 per month with less than half as much volatility. And that’s after Malkiel adjusted for survivorship bias, incubated returns other issues with common reports of hedge fund performance. It’s on the CFA Institute’s web site here.
As a footnote, there are other securities laws that restrict participation in hedge funds. Larger funds, so-called 3(c)7 funds, require a minimum net worth of $5 million. And investment advisers are not supposed to charge performance fees unless their investors have a net worth of $1.5 million. And don't forget the various and sundry mutual fund and other products that act like hedge funds mentioned here lately.