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Despite Pressures, It's Business as Usual for Hedge Funds: Most Ignore Growing Transparency Demands, Discount SEC Rule


Despite their increasing popularity among powerful institutional investors and pension plans, there's very little proof that in coming years the transparency of hedge funds will increase, or that their exorbitant fees will decline.

In addition, a new study from the Boston-based research firm Cerulli Associates reveals, as many of the nation's 8,000 hedge funds drill deeper into the investing public, the threat they pose to the traditional mutual fund industry may have been exaggerated. The fervor over a new Securities and Exchange Commission rule that will require hedge fund managers to register with the regulator might also be overblown.

"On the issue of transparency, we think a lot of hedge funds will refuse to budge," said Benjamin Poor, a Cerulli analyst and author of the study, "Hedge Funds: The Market for Absolute Returns."

Large plan sponsors and institutions typically wield a great deal of influence over money managers, who relish the opportunity of locking up millions of investment dollars. For mutual funds, disclosure of their positions can be a key selling point. A university endowment, for instance, has many constituents it must answer to, so such information is oftentimes a dealmaker. But for hedge funds, such transparency jeopardizes their business strategy.

For example, one manager reported to Cerulli that while he doesn't mind sharing information directly with some foundations and endowments, his worry is that if they're not sophisticated enough to understand the data, they might seek out someone who does.

"These days, a lot of the wirehouses have a hedge fund, or a hedge fund-of-funds, offering, so if the head of the investment committee can't make sense of it and he takes the information to his broker, there's a good chance that information could circulate a little bit more than is to be desired," Poor said.

But another argument says a hedge fund's list of positions is oftentimes meaningless. For instance, if a hedge fund has a high annual turnover rate, of say 500%, by the time an investor sees the positions, they've probably already changed.

Positions can also be misleading. For example, the traditional long-only manager of a mutual fund might include Japanese automaker Toyota in its top 10 holdings based on its management team or a new product that will give it a distinct market advantage over its domestic competitors. A hedge fund manager, meanwhile, might also have Toyota in its top 10, but only to mitigate risk through a smaller, but more aggressive short position, in a struggling domestic automaker.

"If you don't understand that Toyota is being used in conjunction with shorts on the U.S. automaker, then the information is misleading," Poor said.

Furthermore, some of the off-balance sheet techniques used to generate returns, like leverage and swap agreements, don't even show up on a hedge fund's list of positions.

Fee margins on single-manager hedge funds are also likely to hold firm, Poor said. In fact, many of the better managers are actually raising their management and performance fees. For years, most charged a management fee of 1% and a performance fee of 10%, but the average has risen today closer to 2% and 20%. The best managers, meanwhile, will continue to set fees at whatever the market will bear, which is sometimes upwards of 4% and 40%.

For example, Harvard Management Co., the $26 billion investment manager for Harvard University, paid its six money managers in 2004 a collective $78 million.

"The bottom line is their managers have done exceptionally well," Poor said. "If that continues to happen, high fees will rule the day."

On the hedge fund-of-funds side, fees could fall, as the segment is experiencing intense pressure from consulting firms specializing in hedge funds and registered investment advisors (RIAs) that have carved out a niche for themselves in the space.

"Many fund-of-funds are charging a going rate of 1% and 10%, but there are investment consultants that will do an investment search for 10 to 25 basis points for a larger client and 50 to 75 basis points for a smaller client," Poor said, citing New England Pension Consultants and Cambridge Associates in Boston as swiftly rising hedge fund search specialists.

Cerulli also determined that the brouhaha surrounding the SEC's hedge fund registration rule is probably overblown. Although it would force hedge funds to implement expensive compliance measures, it doesn't scare too many managers. Some do fear that it might be the first inning of an SEC crackdown; but nearly 60% of all hedge funds are already registered, either in an effort to make big institutional clients and advisers more comfortable or because the firm might also manage mutual funds.

"Others are using the two-year lockup provision loophole and not registering, but most told us it's not a big deal," Poor said.