Gary Gensler's 2-and-20 Push Won't Help Hedge Fund Investors

(Bloomberg Opinion) -- Securities and Exchange Commission Chair Gary Gensler gave a speech this week to the Institutional Limited Partners Association, a lobby group of hedge fund investors, and it seemed out of step with both the history of investment fund regulation and the needs of hedge fund investors today. It started with the standard paean to New Deal financial regulation that omits the most important point vis-a-vis hedge funds, which is that private funds were created to avoid the problems that legislation caused.

SEC and Internal Revenue Service rules pretty much forced funds to buy only highly liquid stocks and bonds without concentrated positions, leverage, shorting or derivatives. Positions had to be disclosed publicly. It proved impossible for managers to beat index funds under those constraints, but the legislation allowed managers to charge 8.75% of assets as a load when a fund was purchased or money was moved to a new fund, which advisers could do every three years without attracting oversight attention. Annual management fees often topped 2%. Virtually no investors read the SEC-mandated proxies, mainly because they were written to protect managers against investor lawsuits, not to help investors. The mutual funds that helped investors — index and money market funds — were initially blocked and then discouraged by the SEC.

This is not to say the SEC only harmed investors. Major actions like abolishing fixed commissions, fair disclosure regulation and the performance and fee disclosures that eventually led most investors to choose either index funds or low-fee active funds with long-term records of outperformance were essential improvements for investors. In recent years the SEC has increased public access to hedge fund strategies both by liberalizing rules for investing in private funds and allowing “liquid alts” — traditional hedge fund strategies in the form of public mutual or exchange-traded funds. But the public mutual funds created by New Deal legislation charged investors far more in fees than they delivered in excess performance, and it was mainly private companies like Vanguard and Morningstar that fixed the problems, not regulators.

The most destructive rule was the virtual prohibition on performance fees for public mutual funds. That meant the only way for a manager to increase revenue was to raise more assets. Performance was a nice-to-have since it made raising new assets easier, but the main compensation went to people who could raise money, rather than people who could deliver market-beating performance. The result was gigantic fund management companies with sophisticated sales strategies and huge advertising budgets whose funds consistently did worse than random stock picking.

Wealthy investors and institutions had the option of private funds that were free from the investment and fee restrictions of public funds (but still subject to SEC anti-fraud and market regulation). Most hedge funds pursued the opposite business strategy of public mutual funds, with compensation directed toward people who can beat the market. Performance mattered, not asset growth. In fact, many funds with limited-capacity strategies closed to outside investors so that managers and employees could keep 100% of the total performance rather than only 20% of the excess performance.

Gensler explicitly did not address the question of whether private funds outperform the market after fees. But the debate is only about whether a randomly selected hedge fund will outperform the S&P 500 Index. The answer depends mainly on what period of time you consider. There’s no question that many hedge funds can be combined with traditional long-only investments to provide better risk-return ratios and long-term growth; nor that institutional investors with large allocations to private funds have better long-term performance than institutional investors who avoid private funds.

The SEC Chair’s suggestions that hedge fund fees should go down would likely result in fewer of the best funds being available to investors, and top funds being replaced by “me too” funds that can be run more cheaply by people willing to work for flat salaries rather than 20% of whatever they can beat the market by, and with core business strategies oriented toward selling the funds to more investors rather than improving performance. Gensler wants investors to have the same kind of performance comparison information for private funds as they do for public funds. But the SEC maintains a list of public funds, and they must disclose their assets under management, positions and daily values. This makes it easy to calculate performance statistics for any fund, and to compare to category averages. To bring the same level of public transparency to private funds would mean forcing them to disclose periodic information in public — not just to investors — and to avoid less-liquid positions.

Another Gensler target is conflicts of interest. Many fund managers run multiple funds, and the personal interest of the manager can be to put the best positions in the funds with the highest performance fees or the largest proportion of manager ownership. Many other conflicts can arise. Conflicts of interest are not bad in themselves. No responsible person can avoid all conflicts. The point is to manage them properly. There are five main tools for this: personal trust, the law, contractual provision, oversight and incentives. The SEC, and regulators in general, tend to emphasize the law and oversight. Gensler wants to strengthen the legal fiduciary duties of managers and to improve oversight, both of which are reasonable on their own. But he wants to weaken abilities to negotiate specific contractual provisions and the incentive provided by performance fees. Bureaucratization of conflict also tends to undermine personal trust.

The overall thrust of the speech seems to be that private funds should be more like public funds. There’s no acknowledgement of the mistakes made with public funds that created private funds in the first place, nor of the tremendous value at least some private funds offer to investors. Of course, part of Gensler’s job is to address any real problems in private funds, but of equal importance is preserving the benefits of these funds, expanding access to them and exporting their good features to public funds. Hedge funds have plenty of strident enemies who know little about them, they don’t need Gensler — who knows a lot about them — to join the mob.

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.

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