Commentary: “Scapegoating” the Hedge Fund Industry by Michael T. Jackson

The majority of the blame for the current financial mess should be placed on the U.S. Government, especially the Federal Reserve and the Securities Exchange Commission (SEC) for failure to comprehend or exercise their regulatory responsibilities. Targeting the hedge fund industry is a ploy by the government -- an attempt to leverage common misconceptions and create a scapegoat for the SEC and regulatory failures. Pushing for legislation that imposes additional regulations on the hedge fund industry may make good press for Washington, but the result will have long term damaging effects on our financial system.

"Scapegoating" the Hedge Fund Industry By Michael T. Jackson

April 2, 2009
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The majority of the blame for the current financial mess should be placed on the U.S. Government, especially the Federal Reserve and the Securities Exchange Commission (SEC) for failure to comprehend or exercise their regulatory responsibilities. As is the nature of politicians, however, the culprits have been busily casting about to find others to blame. Clearly, the financial industry also shares some responsibility, specifically the large banks that were packaging and selling junk assets. Washington though, as usual, would like to direct blame at hedge funds. This has been demonstrated by recent events, including the Hedge Fund Transparency Act, the summoning of the most successful hedge fund managers to Washington to testify before Congress, and the current push to reinstate the uptick rule.

The Hedge Fund Transparency Act would require hedge funds to register and disclose more information to regulators. However, more than half of the industry is already registered. According to Hedge Fund Research, about 55% of U.S. hedge fund firms have voluntarily registered with the SEC. These registered funds manage the majority (almost 71%) of U.S.-based hedge fund capital. Globally, firms registered with the SEC manage 60% of the $1.4 trillion in hedge fund assets.[i]

The new administration and members of Congress believe that The Hedge Fund Transparency Act will help solve the financial crisis by bringing tighter scrutiny of the hedge fund industry. There is scant evidence, however, that SEC registration will prevent thieves from stealing. Registration did not help Madoff clients from loosing their money. In fact, SEC registration probably helped Madoff, since prospective clients assumed the SEC was doing its job and performed less due diligence.

Senator Charles Schumer (D-NY) speaks of a lack of regulation as a major contributor to the crisis. I believe that it would be more correct to say that a lack of effective and competent regulation was the major contributor to the crisis. Plenty of regulation already exists. A 2008 study, conducted by the Heritage Foundation, reported that “appropriations for federal regulatory agencies increased 44% from 2001 to 2007, with a corresponding 41% increase in staff positions”. [ii] Additional reactionary regulation, such as reinstatement of the uptick rule, will only serve to make the financial industry less efficient and hurt the economy in the long run.

Why are hedge funds getting targeted? There are many reasons, with the two most obvious being:

• As hedge funds are the least understood sector of asset management, they are easier to blame, and therefore make good scapegoats.
• Regulators need to save face in light of multiple failures to uncover major frauds. By finding a scapegoat, the government can appeal to the U.S. public at large and take advantage of the perception that hedge fund managers exacerbate distressed situations for their own financial gain; totally ignoring the fact that they serve a vital role in capital allocation and market liquidity.
  

As the retired founder and CEO of the San Francisco-based registered investment advisor EGM Capital, I am painfully aware of how regulatory agencies waste resources by focusing on political agendas and overlooking the serious frauds. In my case, after an extensive investigation lasting longer than one year, the SEC found a single hedge fund trade that, although correctly handled according to our hedge fund client agreement, should have been allocated differently under the Investment Advisors Act. The SEC public relations machine trumpeted this as a major victory, in spite of the fact that the trade was reversed, and was totally immaterial (less than 1/3 of 1%) in relationship to the profits delivered to clients that year. In the case of Frank Quattrone, the SEC was responsible for criminal charges being brought which could have landed Quattrone in jail for 20 years. Instead of spending time catching genuine crooks, the SEC and the Justice Department probably spent tens of millions of dollars, along with thousands of man hours, on this case. Luckily, Frank Quattrone had the financial resources, time and energy to fight off the SEC, but clearly at a high emotional and financial cost.

A serious problem facing hedge funds, due to constraints imposed by the SEC, is that hedge funds are not allowed to publicly solicit investors or advertise what they do to the general public. This has led to a one sided view of the industry, resulting in a widespread misunderstanding of hedge funds by Main Street and the media. Lack of knowledge combined with the extraordinary earnings of the top hedge fund managers (well publicized by the press), and finger pointing by Washington, has made the term “hedge funds” the equivalent of a four letter word. With many other financial institutions, large compensation payouts have been based on fictitious profits, whereas most hedge fund managers receive their compensation based on a share of real profits.

Historically, when there has been volatility in financial markets, attention has turned to the role played by hedge funds. However, it is important to note that hedge funds only manage around $1.4 trillion, amounting to less than 3% of bank holdings. [iii] Clearly, since hedge funds are usually forerunners in identifying new trends, and weeding out the failing companies, their market impact tends to be far greater than their share of the market.

Conclusion

Targeting the hedge fund industry is a ploy by the government to save face. It is an attempt to leverage common misconceptions and create a scapegoat for the SEC and regulatory failures. Pushing for legislation that imposes additional regulations on the hedge fund industry may make good press for Washington, but the result will have long term damaging effects on our financial system. The role played by the hedge fund industry in the current financial crisis is relatively minuscule compared to the major role played by Washington, the banks and the mortgage industry.

ABOUT THE AUTHOR:

Michael T. Jackson founded EGM Capital and successfully built a family of hedge funds focused on investing in publicly traded U.S. emerging growth companies. Under his guidance, Jackson grew the firm from a modest beginning in 1986 to approximately $1.2 billion in client assets in 2001. As EGM Capital built one of the best performance records in the hedge fund industry, Jackson’s own professional success was featured in the book Investment Visionaries. Retired since 2002, Mr. Jackson concentrates on philanthropic activities and personal investments.

[i] HFR Media Reference Guide. Hedge Fund Research, Inc. 1/20/2009.
[ii] Examiner.com. Editorial: Regulation is the problem, not the answer. Mar 31, 2008. [http://www.examiner.com/a-1311111~Regulation_is_the_problem__not_the_answer.html]
[iii] Principles and Best Practices for Hedge Fund Investors, Report of the Investors’ Committee to the President’s Working Group on Financial Markets, January 15, 2009.

Source: Michael T. Jackson