Hedge Fund Disclosure Rules Favors Hedge Funds

The Securities and Exchange Commission nicely illustrates a big problem with regulation: capture. Under the pretext of justice or fairness, the SEC routinely hurts the unorganized plebians vs. the insiders. Consider that it’s first commissioner was Joe Kennedy, who made his first fortune off then-legal bucket shop trading tactics. The SEC then sat on a monopoly on equity trading, and mandated commission rates for decades, as well as preventing all sorts of competition. You might remember the SEC in penalizing famous frauds like Madoff, Bayou, and Wood River–after they were exposed as frauds by their own investors. These are the police who show up after you’ve tackled and hog-tied your intruder, and then take credit for putting him in jail.

SEC rules prohibit hedge funds from mentioning their returns because the rubes who read newspapers and the interweb include ‘nonqualified investors’ (those making less that $200k per year and are not worth $1MM). This only helps the fraudsters and inhibits competition, and makes investing more complicated. If people knew about Madoff’s record many would have highlighted its patent impossibility: you simply could not have generated that kind of return record doing what he said he was doing, and many an assistant professor would have loved demonstrating this.

What are the returns to hedge funds? Who knows, because currently discussing it is not merely discouraged, but illegal! This supposedly helps the widow who might be tempted by the siren song of hedge fund jingles, but any stripper knows that coy concealment titillates much more than brazen reality. Fund X made 100% in 2008? I must find out! The fund’s insiders abet the misinformation as required by law by making no comment. The rules are designed to encourage rumor-driven investing. The hedge fund indices themselves have repeatedly been found to contain survivorship bias (see here and here), which makes total sense. Any hedge fund index is more beholden to hedge funds than potential clients, because the funds are not obligated to give them their returns. You don’t become an expert in something, without being an advocate in some way, just as all those socialist economics professors pre-1989 generally preferred socialism. Is it surprising they neglect various subsidiary funds of an entity when it fails, because that really wasn’t a ‘fund’, and it wasn’t really part of X?

Consider instead if funds could mention their performance. Lying about returns would still be illegal, so, truth telling by those with good returns would be a dominant strategy, and silent firms would look bad because they probably aren’t talking for a reason. This would give investors more information about the risks and opportunities available to them.

Current SEC chairman Mary Schapiro came from the NASD, the group that helped keep the exchanged in monopolistic control over order flow well into the internet age. She has always jumped on conspicuous peccadilloes to divert attention from what she should be doing: encouraging vigorous competition. For example, in 2005 she shined the light on Wall Street gift boxes, as if the occasional bottle of wine or golf bag is a big priority. The SEC is involved in the complex ‘flash crash’ on March 6 2010, when systems were failing, and arcane institutional restrictions on how market trades must be routed ended up in chaos. Her preferred solution: restrict what competitors can offer customers. Brilliant!

About Eric Falkenstein 136 Articles

Eric Falkenstein is an economist who specializes in quantitative issues in finance: risk management, long/short equity investing, default modeling, etc.

Eric received his Ph.D. in Economics from Northwestern University , 1994 and his B.A. in Economics from Washington University in St. Louis, 1987

He is the author of the 2009 book Finding Alpha.

Visit: Eric Falkenstein's Website

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