Hedge Fund Transparency Concern
A distinct characteristic of the Hedge Fund industry is limited transparency. Hedge Fund managers have long been secretive, even a bit paranoid, about disclosure, because they are afraid of leaking their unique strategies even with signed confidentiality agreements with investors. Co-investment and incentives fees are the solutions to aligning interests and securing trust with investors, rather than answering all questions of investors. Co-investment means that the manager and many of the partners or employees of the management company also invest a significant portion of their personal wealth in the fund. An incentive fee is a source of compensation to hedge fund managers, wherein they share in the upside return when the fund generates positive results. The function of the incentive structure is to encourage the hedge fund manager to generate the highest possible return for investors in order to maximize their own benefit at the same time. (3)
Without transparency, it is challenging to monitor whether a manager has been complying with regulatory standards and his/her promises to investors in regular conditions. Due to multiple hedge fund scandals in the era, transparency has become a major concern of investors even though co-investment and incentive fees still have their bonding effect. Rising concerns of such kind threaten existing assets under management (AUM) and impede new investment. The issue must be handled properly because AUM is the foundation of a funds success as the 2% of AUM is generally charged by hedge funds as a base management fee. This fee is the primary source of a fund’s income, and therefore critical to funding its operating expenses and development. Hedge funds may also encounter redemptions (AUM outflow) occasionally, which makes its attraction to new investments (AUM inflow) important for maintaining a net inflow. (3)
But achieving or approaching transparency is, by nature, contradictory to a hedge fund’s success in most cases. Hedge funds are different from regular funds for they are utilizing a much wider range of investment tools and combinations of such tools as they are pursuing the highest possible return. The strategies of hedge funds are usually unique and costly. An industry culture of secretiveness is essential to the protection of a fund’s core competitiveness. Nevertheless, more investors than ever are rejecting the old notion that hedge funds must be allowed to stay behind the curtain. Therefore, the hedge fund industry as a whole has become more proactive in balancing the need to keep investors informed and protecting confidentiality. Competitive pressure has fueled voluntary disclosure of an increasing amount of information. Many institutional investors, the major asset contributors of the industry, require managers to agree with meeting minimum transparency standards before investing in the funds. (1)
But is this a reasonable request? It seems plausible at first glance, for all investors would certainly prefer to learn the details about where their money goes and how their money is invested. As increasing numbers of hedge funds reveal their positioning, more investors reject the traditional notion that hedge funds are supposed to operate in a black box. Many argue that transparency will allow investors to hedge the risk of certain investment decisions made by the hedge fund manager. For example, an investor can simply enter an opposite position or purchase a derivative contract when he learns that his manager has a tremendous amount of position in a particular security. (1)
There are advantages from a fund manager’s perspective as well. The progress of increasing transparency can be more helpful than expected when it serves as a means for developing relations between the manager and the investors. Communication and trust will be fostered when a manager properly educates his investor with sincerity and convincing strategies. A prosperous long-term relationship is surely built on these two components. (1)
From the fund manager’s viewpoint, the disadvantage is that their positions might become known to other traders, putting them at a significant competitive disadvantage. This can tremendously affect managers who have entered into sizable, illiquid position. In addition, most hedge funds strive to discover undervalued stocks not covered by mainstream analysts. They hope to find a diamond, and build a large position in the stock. This practice requires absolute confidentiality that can be seriously impaired by transparency. Hedge fund managers also worry that their proprietary trading models will be replicated by competitors if full transparency is in action. Managers definitely will try to protect their core competitiveness at all cost in this far-from-over negotiation. (1)
There are actually fewer disagreements regarding the need for transparency among investors, hedge fund managers, and governmental offices. Global regulatory forces have shown concern and taken action. Directives in both the U.S. and E.U. have enacted regulations to promote transparency and oversee the potential for systemic risks caused by the industry. It remains a debate as to what degree a hedge fund should reveal its details. Other than that, the cost incurred by disclosure should also be considered. Different analytical capacity and cost considerations of hedge funds have led to a variety of delivery methods for the long-craved transparency. (1)(2)
One solution proposed is through the use of “Separate Accounts”. Different from an investor in the common partnership, an investor in a separate account will have complete transparency in every detail, for the portfolio is directly owned by the investor. It is easy to monitor and managee, as the investor has full control of all actions taken within the account. The benefit of using separate accounts must be considered with the costs it incurs. These costs include the fee for extra accounting, auditing, trading, etc. These fees will be associated with the particular investor who owns the complete separate account, while fees are proportionally borne by all investors. (1)
How to properly respond to the transparency concern while remaining competitive will be a primary issue for hedge fund managers to address. As the hedge fund industry is growing rapidly, the need for more regulation and transparency is essential for its continuous expansion and a firm future. Hedge funds industry is having its growing pains, but it also means that it is having its considerable attraction and potential.
Hedges, James R. “Hedge Fund Transparency.” · The Hedge Fund Journal, https://thehedgefundjournal.com/hedge-fund-transparency/.
“The Coming Evolution of Hedge Fund Transparency.” EVestment, Peter Laurelli, 10 Oct. 2016, https://www.evestment.com/coming-evolution-hedge-fund-transparency/.
Mirabile, Kevin. Hedge Fund Investing: a Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance. Wiley, 2016.