Is there a case for supervision of alternative investment funds? A new working paper

By Ajay Shah, on October 4th, 2011

The task of financial regulation can be broken up into consumer protection (where we worry about small consumers being cheated by
financial firms), prudential regulation (where we worry about the possibility of bankruptcy of one financial firm) and systemic risk
regulation (where we worry about the procyclicality of financial regulation). Everything that we do in financial regulation must be
motivated by one of these three issues.

In the class of fund management mechanisms, there is one interesting special case: the `alternative investment management
mechanisms’ which include hedge funds, private equity funds, venture capital, etc. The defining feature of these is that each customer
places a large sum of money under the control of the fund manager. A typical value for the minimum ticket size is $1 million.

Once this is done, it is no longer possible to argue that the investor is a small consumer who might be cheated by the fund
manager. A person who places atleast $1 million with a fund manager has the capability and resources to protect his own interests. Hence, the mainstream strategy utilised all over the world has been to leave these fund managers completely unregulated.

Indeed, there has been a healthy competitive tension between these investment vehicles (which are unregulated) versus mutual funds (which are regulated). Large customers have the choice between going with mutual funds, where the cost of regulation is suffered, or going to an alternative investment mechanism where this cost is not suffered. If these customers feel the gains from regulation are not justified, they have the choice of walking away and not incurring the costs.

The world over, there are debates brewing about the need for hedge funds to begin disclosing regular information on performance,
positions and counterparties to regulatory authorities. For example, the SEC recently proposed a rule requiring U.S.-based hedge funds to report such information to a new financial stability panel established under the Dodd-Frank Act. Unsurprisingly, hedge funds argued against this proposal, citing concerns that the government regulator responsible for collecting the reports could not guarantee that their contents would not eventually be made public.

In a recent paper, my coauthors Andrew J. Patton and Michael Streatfield and I examine one element of the relationship between a
hedge fund and its customers: disclosure about returns. The paper is titled The reliability of voluntary disclosures: Evidence from hedge funds.

Hedge funds are notoriously protective of their proprietary trading models and positions, and generally disclose only limited information, even to their own investors. However they do voluntarily report their monthly returns and assets under management to a wider audience through one or more publicly available databases. These databases are widely used by researchers, current and prospective investors, and the media.

Our paper examines the reliability of these voluntary disclosures by hedge funds, by tracking snapshots of these hedge fund databases captured at different points in time between 2007 and 2011. In each vintage of these databases, hedge funds provide their entire historical records (rather than just the new performance information since the previous vintage). Using these data, we detect that older performance records of hedge funds are revised as a matter of course. Nearly 40% of the 18,000 or so hedge funds in our sample revise their previous returns at least once over the vintages that we consider.

We then categorize hedge funds in real-time into revising and non-revising funds, and find that on average revising funds significantly underperform non-revising funds, and have a higher risk of experiencing large negative returns. This suggests that mandatory, audited disclosures by hedge funds, such as those proposed by the SEC earlier this year, would be beneficial to investors and help to
prevent such negative outcomes.

SEBI has recently put out a request for comments on a proposed strategy for regulation and supervision of alternative investment vehicles. Our paper can help in thinking about the issues faced in this field on the consumer protection, and analysing the policy choices faced there. While there is much merit to the mainstream strategy of leaving this industry unregulated, our paper suggests that a small dose of supervision, focusing on basic hygiene and motivated by consumer protection, may help.



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From Alphaclone via SeekingAlpha: Galleon Group’s 50 Largest Holdings

By D H Smith, on October 20th, 2009

My first employer on Wall Street was the world’s largest pension fund; my second, the fastest growing hedge fund. When I was at the first and interviewing for the second, I had this idea that the best hedge fund were investing on some higher plane, with qualitatively different instruments and strategies put to use by people who were just altogether smarter than those of us at conventional money managers. Once I was in a hedge fund, I realized that these people put their pants on one leg at a time, that they were subject to all the usual range of human abilities and weaknesses, and that their funds may or may not be better though they certainly were more expensive for clients.

Galleon’s top fifty holdings list from earlier in the year is utterly ordinary.

Wyeth went the way of all flesh on Friday; now part of Pfizer.

The founders of the Galleon Group, a hedge fund started in 1997 and which has a technology and healthcare focus, have been charged with insider trading. Galleon is one of the 250 hedge and institutional investment funds that are available on AlphaClone. The fund’s Top 10 Holding Clone, which invests quarterly in the the fund’s ten largest holdings at the time they are disclosed, is up 48.2% so far this year but has not performed very well over time returning a negative 3.9% annualized over five years and a dismal negative 18% annualized since 2000 (all returns as of 10/15/09 close). We thought we’d list the fund’s 50 largest holdings below (as of 6/30/09). Now that the fund will almost certainly wind down, perhaps there are some good short opportunities.

Name Ticker
1 EBAY INC EBAY
2 GOOGLE INC GOOG
3 APPLE INC AAPL
4 OSI PHARMACEUTICALS… OSIP
5 BANK OF AMERICA COR… BAC
6 JP MORGAN CHASE & CO JPM
7 CISCO SYS INC CSCO
8 SPDR S&P 500 SPY
9 DELL INC DELL
10 NVIDIA CORP NVDA
11 E M C CORP MASS EMC
12 WYETH WYE
13 PEPSI BOTTLING GROU… PBG
14 MEMC ELECTR MATLS INC WFR
15 First Solar Inc FSLR
16 VERISIGN INC VRSN
17 YAHOO INC YHOO
18 ELECTRONIC ARTS INC ERTS
19 SPDR Gold GLD
20 INTEL CORP INTC
21 QUALCOMM INC QCOM
22 COGNIZANT TECHNOLOG… CTSH
23 FORD MTR CO DEL F
24 NATIONAL SEMICONDUC… NSM
25 NETEASE COM INC NTES
26 SUNTRUST BKS INC STI
27 TYCO INTERNATIONAL LTD TYC
28 TERADYNE INC TER
29 RESEARCH IN MOTION LTD RIMM
30 ALCON INC ACL
31 HEWLETT PACKARD CO HPQ
32 VISA INC V
33 AMAZON COM INC AMZN
34 BIOGEN IDEC INC BIIB
35 NOVELLUS SYS INC NVLS
36 ANADARKO PETE CORP APC
37 COMMSCOPE INC CTV
38 FTI CONSULTING INC FCN
39 PEPSICO INC PEP
40 ABERCROMBIE & FITCH CO ANF
41 F5 NETWORKS INC FFIV
42 LAM RESEARCH CORP LRCX
43 LEXMARK INTL NEW LXK
44 GAP INC DEL GPS
45 Seagate Tech STX
46 YINGLI GREEN ENERGY… YGE
47 RADIOSHACK CORP RSH
48 KLA-TENCOR CORP KLAC
49 FIDELITY NATIONAL F… FNF
50 ALLERGAN INC AGN


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Senate Investigation: Major Financial Institutions Helped Hedge Funds Avoid Taxes

By G.L.C., on October 23rd, 2008

A year long probe by Senate Permanent Subcommittee on Investigations which relied on internal bank documents and emails has found that some of the nation’s biggest investment banks and brokerage firms including Morgan Stanley, Citigroup, Lehman Brothers, and Merrill Lynch & Co marketed allegedly abusive transactions that helped foreign hedge fund investments avoid withholding taxes imposed on dividends paid by U.S. companies over the past decade. These funds are liable for tax on the dividends they receive from investments in the U.S. at a rate of 30%. The amount of tax avoided could well be in billions of dollars.

The banks actually competed with one another to dream up complex transactions for foreign hedge funds to avoid taxes. The probe also found that some of the internal communications show that the bank officials were concerned that they could run into trouble with the Internal Revenue Service (IRS).

The results of the probe clearly highlight the failure of the IRS and Treasury Department to enforce the law. The banks entered into agreements to give the hedge funds the economic value of dividends, without actually triggering a withholding tax on dividend payments. The foreign hedge funds would sell their stock to an U.S. investment bank just before a dividend was to be paid and simultaneously enter into a swap arrangement with that bank to retain the economics of stock ownership. The U.S. bank paid the foreign hedge fund a dividend equivalent but did not withhold any taxes. The funds technically didn’t own the shares. A few days later, the hedge funds would repurchase the stock from the U.S. bank.

The $32 billion special dividend by Microsoft in 2004 is said to be the trigger that spurred the investment banks and brokerage firms to sell products that would allow their hedge fund clients to avoid paying the associated taxes.

The investigation had some effect. Merrill Lynch & Co stopped doing some of the deals after the committee began its investigation although the investment bank claimed that it acted in good faith when it advised its clients – foreign hedge funds – and it acted appropriately under existing tax law. Citigroup voluntarily approached the IRS and paid $24 million in withholding taxes after an internal audit.

One of the beneficiaries of such transactions – Maverick Capital Management – estimated that such deals helped it avoid $95 million in taxes over an eight-year period.

The result of the probe raises one very important question – where does the loyalty of these investment banks and brokerage firms lie? They are American companies who have reaped all the benefits of being American companies. They have openly helped foreign hedge funds flout U.S. tax laws. Is there something called patriotism or is it profit at any cost?



Leave a comment   Politics and Government   ,