Hedge Funds' SEC Reporting Loss Is Actually a Win

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One of the more important issues in investment regulation in 2020 is also one of the least understood. At issue is a proposal by the U.S. Securities and Exchange Commission to raise the reporting threshold for 13F forms from the current $100 million to $3.5 billion. These forms require asset managers and discretionary advisors to disclose their holdings of stocks, puts and calls.

At first glance, this seems like an issue that is of interest only to the 5,000 or so investment managers who would no longer have to report their holdings. The advantage seems to be some reduction in red tape and filing costs, to be weighed against the disadvantage of less comprehensive data on stock holdings. It doesn’t seem to matter much either way and the proposal was uncontroversial over the 10 years it had been percolating up.

But a tsunami of opposition seems to have killed chances for adoption. More than 1,000 public company CEOs, hundreds of investment managers, major stock exchanges, institutional investors and academics voiced strong opposition that was wildly out of proportion to the scope of the proposal. The strength and unity of this opposition is the first clue that something important is at stake.

A second clue is that a survey of the managers who would be exempted by the change found a majority opposed it. Why would firms want to be forced to disclose holdings? The obvious explanation is that having already incurred the significant costs of complying, the firms value the rule as a barrier to competition from smaller firms and innovation. The decentralized finance, or “DeFi,” revolution threatens traditional investment managers, and the 13F rule could be a major stumbling block.

Before delving further into the opposition, let’s go through the reasons for the proposal. The 13F reporting rule grew out of a 1968 concern in Congress that concentration in the investment management industry had left a couple of hundred firms in control of most stocks. There was never any clear problem the information was supposed to solve, just a vague sense that if something was big, the government should know about it. It took 10 years, or until 1978, for 13Fs to be required with a $100 million threshold, an amount that has never been updated.

Meanwhile securities markets had changed in a way that made 13Fs largely irrelevant. Institutional investors were able to get economic exposure to stocks through swaps and other derivatives not captured on 13Fs. Short-selling grew so that knowing a manager’s long holdings only no longer revealed the size or direction of its position. Index funds and more specialized funds meant managers mixed together all sorts of different types of funds from big asset managers, giving little meaning to the result.

On top of that, so much of the information was wrong. A 2016 academic study found massive errors in prices, quantities and other fields. Moreover, because many managers engage in co-advisory and sub-advisory relationships, many holdings were missed or double-counted. The reason for so many errors? The SEC collected the data and pretty much ignored it. There were no systematic checks for accuracy, and no fines for erroneous data.

Raising the threshold to $3.5 billion would exempt 90% of filers, but eliminate only 10% of the stockholdings. Since the errors are almost all from smaller managers, the data quality would improve, so the new numbers would be more useful even if slightly less comprehensive. Some $150 million a year of costs likely passed on to investors would disappear, and more important, eliminating the much higher costs of initial implementation would allow many more small firms to grow beyond $100 million, removing a hurdle for innovation in investment management. And it’s worth pointing out that much of the compliance costs are paid to former SEC staffers working for private sector law and compliance advisory firms.

Why did this obvious reform—adjusting the threshold to go back to capturing the few hundred managers initially contemplated in 1968—suddenly become untouchable? The answer is the increase in investor activism and the rise of decentralized alternatives to traditional asset management. Both of these are enormous positives for investors and, as you would expect, entrenched providers seek to use regulation to hobble competition. But the stated reasons for opposition are paper-thin.

Corporate CEOs claim 13Fs help them identify and communicate with shareholders. But companies can already send communication to all their shareholders. 13Fs don’t tell them who holds their shares; it tells them who advises their shareholders. Companies can use this information to trigger poison pills and other takeover defenses, or to try to co-opt or hobble advisors who may not like the way the company is being run. There are already rules to force disclosure of significant shareholdings in individual issuers.

Institutional investors and academics focused on the importance of the 13F information for transparency, but none mentioned the abysmal quality of the data nor that higher quality data on 90% of holdings is more valuable than garbage data on 100%. None that I read suggested that if the data were so important the SEC should make money managers report accurately.

Finally, all the opposition letters I read spent the bulk of their content on the claim that the SEC does not have authority to make this change. I’m not a lawyer, but I tend to trust the SEC here, with 10 years to think about it and no axe to grind. But if that’s the only problem, the obvious solution is to ask Congress to approve the change, something none of the opponents mentioned.

Investment management is changing rapidly. Investors have already reaped great benefits and potential future benefits are even greater. The SEC could play an important role as a neutral referee keeping all the players honest. But if it is captured by existing regulated entities and the revolving-door interests of staffers, investors will be the losers.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.

©2020 Bloomberg L.P.

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