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.

There have been concerns that short sales are behind the big price slides. Short sellers seek to profit from a stock’s decline by selling borrowed shares and replacing them at a lower price. Short sellers have been blamed for the declines in stocks including Fannie Mae and Freddie Mac which were taken over by the Federal government last month.

Concerned about the possible unnecessary or artificial price movements based on unfounded rumors regarding the stability of financial institutions and other issuers exacerbated by short selling, the U.S. Securities and Exchange Commission (SEC) has come out with a new set of rules. The SEC also banned the short selling of nearly 1000 stocks until three days after the $700 billion rescue package is enacted into law.

The new rules require money managers with at least $100 million under management to report short selling if it exceeds a certain percentage of the shares outstanding and is greater than $1 million in value. Short sellers who haven’t added to their positions since the rule went into effect won’t have to report. Mutual funds and exchange-traded funds that short stocks also are subject to the disclosure rules. The disclosures would be made public by the SEC with a two-week delay – due to start in mid-October.

The new rules bring an end to secrecy which short sellers have long held to be one of their dearest tools. Short sellers will have to report which stocks they are short and how their exposure to those stocks changes during the day. The new rules have been welcomed by some who feels that since investors who own 5% of a company’s outstanding shares have to report their stakes, there is no reason for short sellers not to.

The new set of rules has been criticized by many. Forcing such public disclosure would be like asking Coca-Cola to reveal the super-secret formula for its popular fizzy beverage. It could lead to variety of consequences, some of them unintended. Short sellers are already plotting changes in strategy. Short sellers represent a supply of shares when the market is rising and demand for shares when markets are falling. It could affect the liquidity of some stocks if short sellers retreat fearing companies will cut off information flow, investment firms will lock them out of investor conferences and competitors will see who has built what positions. Stocks exposed as targets of well-known shorts could suffer if other investors piggyback on the same companies.

The SEC subsequently modified the disclosure requirement stating that the disclosure will not be made public. This came as a relief to short sellers and other hedge-fund managers worried that public disclosure of their bearish bets might expose them to pressure from the companies they target.

Some analysts argue that short-selling can be used to manipulate share prices and add to pressure on fragile companies. Others say it is a legitimate tool that helps markets function.

The ban originally applied to 799 companies, but the SEC allowed the stock exchanges to add other companies to the list. Before the ban was lifted, about 190 more had been added, including General Electric, General Motors, and CVS Caremark.

In a short sale, investors borrow shares and immediately sell them, hoping to profit by replacing them later at a lower price – a sell-high, buy-low strategy. Short sellers seek to profit from a stock’s decline by selling borrowed shares and replacing them at a lower price. During the ban, borrowing shares has become more expensive, in part because some big pension funds and endowments have stopped lending stock altogether.

Hedge funds were badly affected by the ban and blamed the new rules for pushing them deep into the red. Many trading strategies rely on short-selling, and investors may have sold off some of their long positions in the market, driving prices down, because they were not able to hedge their bets with a corresponding short position. Convertible bonds were also adversely affected because traders typically short a company’s stock when they invest in its preferred shares. The raw number of trades in financial stocks also dropped, as many investors simply sat on the sidelines.

It now appears that the ban probably did not do what it was supposed to do. Since the ban, financial shares have plunged 23%. The market plunge following the ban has started a debate on whether the ban actually worked and whether the short-sellers really played such a big role in the declines. Many feel that the real problem is the weakness of the financial institutions. The lifting of the ban by itself is unlikely to spark another precipitous plunge in the market; instead it could actually bolster stocks. Investors who wanted to exit short positions in recent weeks, which would have meant purchasing shares, did not do so because they feared they would not be able to borrow the stock again to short it later on.

A recent report by Inspector General David Kotz has concluded that the SEC missed numerous warning signs leading up to the shotgun sale of Bear Stearns Cos. Bear Stearns, one of the most aggressive investment banks, agreed to be sold to J.P. Morgan Chase & Co. According to the report, the SEC failed to require the investment bank to rein in its risk taking. It failed to carry out its mission in its oversight of Bear Stearns. Despite the SEC staff having identified in 2006 precisely the types of risks that evolved into the subprime crisis, the SEC did not exert influence over Bear Stearns to use this experience to add a meltdown of the subprime market to its risk scenarios. There are many who blame the present crisis on years of looser regulations that allowed Wall Street firms to take on greater risks without adequate oversight.

The report details how the SEC made no efforts to require Bear Stearns to reduce its debt or raise money, failed to take steps after identifying numerous shortcomings in Bear Stearns’ risk management of mortgages, and also missed opportunities to push Bear management to address the problems. The report criticized the SEC for allowing internal auditors at Bear Stearns, not external auditors who would presumably be more objective, to perform critical work in reviewing the firm’s risk management. The SEC also did not review Bears Stearns’ strategy for informing investors about its funding plans following the failure of two of its hedge funds in July 2007. The SEC took too long to review Bear Stearns’ 2006 annual report and seek more information from the firm, which would have resulted in Bear disclosing more information about its mortgage portfolio to investors.

The SEC maintains that the failure is a result of the SEC not having enough authority to effectively oversee the banks and that the SEC has already expressed its concerns to Congress. The SEC staff completed its review of Bear Stearns’ 2006 annual report after its collapse.

Another report found that the SEC conducted in-depth reviews for only six of the 146 brokerage firms registered with the agency. The failure to carry out the purpose and goals of the Broker-Dealer Risk Assessment program hinders the SEC’s ability to foresee or respond to weaknesses in the financial markets.

As lawmakers take a second look at financial oversight, these reports could be nails in the coffin for the SEC. The power of the SEC could be dispersed to other agencies, such as the Federal Reserve. These reports document the failure of the SEC to either make its oversight program work or seek authority from Congress so that it could work.