Educational Series Vol. 2 - Transparency
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Transparency

By Associate Professor Mick Swartz, Ph.D. (Finance), CAIA in the Finance and Business Economics Department at the University of Southern California. Professor Swartz is on the Board of CalALTs.

February 2013

 

One of the more controversial topics concerning hedge funds deals with the concept of transparency and how much of their investment process they are willing to share with investors and others in the outside world.  Conventional wisdom, fortified by some of the more high-profile hedge fund scandals of the past several years, is that hedge funds are generally secretive and unwilling to share much with anyone and that they choose this secretive course for some nefarious purpose.  In this case, conventional wisdom could not be more off the mark.

 

What critics of hedge fund transparency do not realize is that most hedge funds will make due diligence available to investors at a level that more-than-sufficiently allows them to detect any potential fraud, learn a great deal about a hedge fund’s processes, yet still protect the truly proprietary aspects of a hedge fund managers trading methodology. This last point is incredibly important to investors as a hedge fund’s proprietary trading methodology is typically the driver of returns and only by allowing a hedge fund to protect this seminal aspect of its business does a hedge fund have a chance to continue to deliver the returns that attract investors in the first place.  Indeed, hedge fund “secrecy” with regard to proprietary trading methods protects investors by not allowing others to copy, and thereby likely degrade the future profitability of an historically successful trading strategy.

 

Critics of hedge funds will argue that any “secrecy” at all, even if arguably justified, does a disservice to investors.  This criticism ignores that fact that the general public is not allowed to invest in most hedge funds because a typical investor is not "qualified" in the eyes of the SEC and other regulatory authorities (the CFTC for example, with respect to commodity and futures funds). In addition, to many, secrecy is often a deterrent to investing and therefore there is a fairly robust self-selection process that keeps investors who want 100% transparency out of investments that fail to provide such. Lastly, the transparency criticism of hedge funds fails to recognize that with the auditing and risk management processes available today, an investor or a due diligence expert can readily determine any nefarious activity well before investing and help investors make what are for all intents and purposes, fully informed investment decisions. This does not guarantee investment success of course, however it greatly reduces the chance of an investment in a fraudulent hedge fund.

 

Specifically today, even basic due diligence checks by auditors and other service professionals will not only provide insight into a firm’s professionalism but can quickly determine whether a hedge fund manager is doing what they claim to be doing and whether that can be expected to continue in the future. In addition, due diligence of the hedge fund facilities and operations will reveal whether incentives are appropriate for staff to remain and whether the implementation of the fund is above-board and robust. Also, due diligence may reveal whether a strategy is sustainable for long periods of time and set some appropriate windows for liquidity – that is, when an investor can and should reasonably be expected to withdraw assets they have invested without threatening the manager’s ability to deliver the expected return.  In short, due to the skill of today’s due diligence processes, all of the relevant factors regarding a modern hedge fund can be so readily discerned that continuing complaints of manger “secrecy” seem largely unjustified, particularly given the recent influx of pension and other institutional assets into hedge funds.  Indeed, there are few investors as rigorous in their due diligence as pension funds and if they choose to invest in a hedge fund, it is hard to imagine a scenario in which they have not been provided more-than-sufficient transparency by that hedge fund prior to investment.

 

Ultimately, the transparency question goes back to the fact that today, many citizens are highly distrustful of financial institutions and paint all of them, whether they be an overleveraged bank bailed out with taxpayer money or a garden-variety hedge fund, with the same assumption of bad behavior.  Justified or not, this generalization will continue and perhaps, be exacerbated by some hedge funds’ continuing insistence on complete secrecy.  The remedy for this will derive from two developments:  1) investors better appreciating that in order to deliver the kinds of index-beating returns that are expected of them, hedge funds must be allowed to protect some information from disclosure; and 2) hedge funds taking an increasingly balanced approach to due diligence and allowing investors to get the detailed information needed to be comfortable not only that a hedge fund is not fraud, but that it has a robust, sustainable business and trading approach that has a good chance of continuing to succeed in the future.  At CHFA, we firmly believe that both of these developments can be achieved by education and outreach such as this ongoing Educational Series and by continuing to promote both investor and manager participation in sound, standardized due diligence processes.

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