Journalism in the Public Interest

Ad Wars: The SEC Is Turning Hedge Funds Into the New Ginsu Knife

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Fresh from having declined to constrain money market funds, the Securities and Exchange Commission has moved to loosen marketing constraints on hedge funds.

Two weeks ago, the agency threw up its hands and said it would not be able to defend millions of investors from money market funds that do things like invest in dodgy European bank bonds yet proclaim themselves to be perfectly safe.

Instead, the S.E.C. — mandated by Congress through its misnamed and harmful JOBS Act — proposed rules last week to lift advertising restrictions for hedge funds and other kinds of private investment offerings. The rules haven’t been finalized, but we can look forward to an ad featuring a wizened couple in matching tubs overlooking a sunset, holding hands and talking about how they just put money with the next George Soros.

The old rules for hedge funds make little sense. Surely, hedge funds should be able to pitch investors with data about their returns and methods. But there’s a problem: The S.E.C. does not have any new resources and has not implemented any policies to police these pitches.

Letting slip the dogs of advertising comes as some professional investors and academics doubt that the industry can continue to produce outsize investment returns — if, in fact, it ever did. As they get bigger, hedge funds struggle to score good results. As investments have become increasingly correlated and interrelated, it gets harder to execute safer and unique strategies.

In a perfect world, hedge fund advertising would improve the world of investing. Hedge funds, after all, are wildly misunderstood. A good hedge fund seeks steady returns in good markets and bad. Many of the best-managed funds aren’t actually trying to beat the market in its best years. And many of the good funds seek uncorrelated results, so that the returns don’t move in lock step with the stock market.

And, honestly, few things could be worse than mutual funds, which in aggregate underperform the stock market and charge too much to do it.

The problem is that the way this loosening looks on paper and the way it will play out in the real world are a tad different.

If Groucho Marx were alive today, he’d say that he would never want to invest in a hedge fund that would have him as a limited partner. One doesn’t see Le Bernardin and Château Lafite filling the airwaves during N.F.L. games. The ban on law firms advertising was lifted in the 1970s. Today, Jacoby & Meyers advertises on television; Sullivan & Cromwell does not. Drug ads have wrought a parade of patients demanding new (high-margin) medicines from their doctors that often offer few benefits over the old (off-patent) ones.

Even professionals have a problem in evaluating hedge fund performance, because distinguishing skill from luck and excessive risk-taking is extremely difficult. For instance, funds often don’t even let their own employees know how much leverage they are taking.

Take the case of John Paulson, who is famous for having shorted the housing bubble, making billions. The result is that many, surely including Mr. Paulson, were convinced of his brilliance.

Before his world-renowned score, he was a grinder, eking out decent returns with a relatively small fund. Afterward, his fund grew exponentially to tens of billions under management.

Then his returns nose-dived. His main fund plunged 36 percent last year and has dropped another 13 percent this year, according to The Wall Street Journal.

Last week, after Citigroup’s private bank pulled out of his fund, Mr. Paulson convened a conference call with Bank of America investment advisers and their clients to explain what was going so horribly wrong with his funds.

It turns out that Mr. Paulson was like the Old Man in the Hemingway novel: He happened to be the guy, through some skill and some luck, to land the biggest fish in the world. How much of each did he have? No one can know.

Another lesson from Mr. Paulson’s experience is that even if a fund manager is smart, people who put their money into them are dumb. Citigroup and Bank of America look as if they were typical. Average investors chase performance, putting in money after the great years. Then they panic, pulling their money out at the bottom.

Look for this to be replicated frequently when hedge funds start advertising. Simon Lack, in an important recent book "The Hedge Fund Mirage" (Wiley), argues that hedge funds have been great for hedge fund managers and not so great for their investors. The managers get huge fees. Investors would have been better off investing in Treasury securities, he says.

The hedge fund trade group says that Mr. Lack has it all wrong. Their logic, however, hasn’t been persuasive. Felix Salmon, a blogger for Reuters, wrote that the hedge fund group’s complaints have "convinced me of the deep truth of Lack’s book in a way that the book itself never could."

At least hedge funds specialize in separating people from their money through excessive fees. Other types of offerings prefer to do so through less savory means. The opening of hedge fund advertising has garnered much of the attention, because of the tantalizing idea that we will all soon be able to invest with the best minds on the planet. But the S.E.C. is also lifting rules on other kinds of securities offerings from small companies. Many of these will require less disclosure and will be particularly ripe for fraud.

So the best-case scenario from the agency’s move is a bunch of Paulsons, while the worst-case is a bunch of Madoffs. It doesn’t seem like a great bargain.

The S.E.C. declares in a fact sheet that it will keep the rules about who can invest. Yet the victims of Bernard L. Madoff, who orchestrated the largest Ponzi scheme in history, were accredited investors. The agency does not plan to mandate any new process to ensure that investors are accredited, or whether their investments are appropriate for them.

This all harks back to a precrisis specialty: get rid of supposedly outdated regulation, but create no new limits or powers to keep things from blowing up.

I feel like the SEC learned plenty:  Deregulate, and you have a cushy job waiting for you when you move on.

I mean, we staff the SEC with former bankers and when they leave, they go back to the big banks.  Many go to banks in trouble to advise the legal team against the SEC.  So, isn’t it a little naive to wonder why they’re benefitting the financial companies at the expense of investors?

And it’s the entire financial sector, not just investment banks and hedge funds.  Banks, brokers, exchanges, funds, and the lot of them currently operate by profiting from your losses (charging you fees or outright unloading their bad assets on you) and reducing your gains (by using knowledge of your trades to jack up prices).  The house always wins, as they say.

The SEC has feet of clay in defending the investing public.

Harry Markopolos, who blew the whistle on Bernard Madoff, found a stone wall at the SEC for years.  As his book “Nobody Would Listen” details, the SEC has no incentive yet to defend the public vigorously.

Time to make by SEC a truly investor consumer protection agency.  Who in Congress is interested?

Our beloved national hero, President Reagan, deregulated our institutions from the unnecessary governmental burdens of all kinds. So, SEC has not done anything foriegn to the observers of our national finance systems. It will continue until next bust.

The headline of this article is totally misleading:

As the article notes, Congress ORDERED the SEC to pass these rules. So blaming the SEC (as the author and commenters do) is ludicrous.

If Congress passed a law allowing Exxon to drill for oil in Yosemite, Jesse Eisinger would blame the National Park Service.

Accredited investors who would think that any return, hedge fund or other would be consistent should lose the accreditation.  To think too that it would be reasonable to jump in with Paulson because of the “hit” he scored especially to the tune of tens of billions is equally nuts.  Stay with small hedgies, look for those who invest in things you understand (thanks Warren) and be ready to change managers quickly. 

As for the SEC, they haven’t been able to find their backsides with both hands for many years.  And don’t let them tell you it is their budget (or their ambitions for future employment in the securities industry).  The problem is really simple… gross incompetence coupled nicely with bureaucratic bungling led by bungler in chief, Shapiro..

Kai Falkenberg

Sep. 5, 2012, 2:45 p.m.

Let’s not forget that the Dodd Frank Act included a provision that exempted from FOIA disclosure nearly all docs provided to the SEC by hedge funds. (See Congress later narrowed the exemption but the funds have still managed to shield key docs from FOIA disclosure.  So while the new rules on advertising will allow them to trumpet their purported returns, the public (and media)‘s ability to confirm those claims and perform due diligence is limited.

I’m no fan of the SEC, but this was approved by Congress in the JOBed
Act.  Wait til you see what is allowed for new issues of small companies.  Caveat Emptor

I have three pieces of advice about hedge fund advertising:

1) Don’t invest in anything you do not understand. 

2) Don’t expect anyone to protect your investment, especially the government or any such organization.

3) If you still want to invest, reread 1) and 2) until you change your mind.

Since the advertising will not tell you how they do their thing, why would you hand over your money to these people?

If the crisis of 2008 did not awaken people who want to invest in the stock market to its flagrant abuses nothing will and fools who wish to be fooled will find a way no matter what.

Thank you for this - but like most Americans, I want more :).

I would like to see an exercise where actual, substantial banking and stock market regulation in the PUBLIC interest - some improved, some additional, and some removed where necessary - is gamed out, noting impacts to the economy, but as free as possible of partisan exclamations. I imagine it would result in substantial loses to wall street, a lower stock market, and quite possibly the break up of big banks.

But in the long term I would hope to see a stronger economy, a more transparent stock market, and an end to exotic financial instruments.

If anyone knows of such an existing exercise, I’d appreciate knowing about it.

Response to Kai Falkenberg: You are wrong; hedge funds undergo annual audits by third-party auditors and you can obtain the audit results, thereby verifying the performance claims.

Kai Falkenberg

Sep. 8, 2012, 4:18 p.m.

Dez, those “audits” would not bring me much comfort. See

clarence swinney

Sep. 11, 2012, 8:38 a.m.

America’s moral compass is no more. Psychopath Republicans no longer fake their disdain for the poor and middle class taxpayers. Over the past decade they have launched a war against these people unprecedented in American history. Secondly, Republicans absolutely hate the President of the United States and use the vilest racial rhetoric in an attempt to remove this man from Office, all at the demise of economic stability for tens of millions of American families. Republicans hate black people, immigrants, Muslims, labor unions, women and gays, but they ‘say’ they are not racist, they say they are not ‘bigots’. Thirdly, they say they are for ‘small government’ but massively expand Federal and State government to take control of women’s bodies, bust unions, remove democratically elected officials..etc

Robert Bowers

Sep. 11, 2012, 4:56 p.m.

NYTimes Op-Ed Columnist Paul Krugman wrote on
September 9, 2012 about the the JOBS act:

“... the bill went nowhere, of course, blocked by Republicans in Congress. And now, having prevented Mr. Obama from implementing any of his policies, those same Republicans are pointing to disappointing job numbers and declaring that the president’s policies have failed.

Think of it as a two-part strategy. First, obstruct any and all efforts to strengthen the economy, then exploit the economy’s weakness for political gain. If this strategy sounds cynical, that’s because it is. Yet it’s the G.O.P.’s best chance for victory in November. “

Jesse Eisinger is saying here that it has now passed or somehow been revived and will soon be ordered by congress to be enforced by the SEC.

Which is it?  How can congress order the application of a law that hasn’t been passed into law? 

Pardon me, please, if I am off base or misreading things.  I’m a Canadian and I find American political disputes puzzling and, sadly, no longer at all entertaining.  I keep trying to understand how it is, and for what reason, an entire nation would shoot itself in the foot with such righteous glee.  Is there a big prize hiding somewhere that everyone is after, something better than money, power and sex?  Probably not.  Those are the big ones…right?

I know that the opinions of outsiders aren’t appreciated.  I’ll sit down.  Americans always know what they are doing so I’ll just stick with one question.  The one above. Or two.  They’re both pretty good, eh?



Sep. 13, 2012, 3:21 p.m.

US NET WEALTH-$59,000 Billion
5% CONTROL –74%
Stocks & Mutual Funds—1% own 50%—90% own 10%
Financial Securities—1% own 60%—90% own 2%
Trusts—1% own 38%—90% own 20%
Business Equity—1% own 65%—90% own 5%
Non-Home Real Estate—1% own 28%—90% own 23%
Derivatives—5 US Banks hold $250,000 Billion of $600,000 B world wide
Is this a crazy financial system or what?  Rich Gamblers Heaven.
Problem each winner has a loser.

Jesse Eisinger

About The Trade

In this column, co-published with New York Times' DealBook, I monitor the financial markets to hold companies, executives and government officials accountable for their actions. Tips? Praise? Contact me at .(JavaScript must be enabled to view this email address)