Long-term Matters: Hedge fund concerns
Hedge funds have, without doubt, delivered ‘loadsamoney', especially for their staff and their richest and smartest customers over the past few decades. And there is also no doubt that short-selling can send a useful signal to the market about hidden risks.
But their wider impact is far less positive. On average, hedge performance has been a lot worse than is recognised. And short-selling - especially when combined in practice with ‘activism' (very different from ‘stewardship') - is rarely about improving the long-term health of the company or sector. Academics have made the case for a negative role of hedge funds in sub-prime and the argument is probably stronger at company-specific level.
The fate of firms like Cadbury could have been decided by activists short the acquirer, long the target and who, therefore, vote for value-destroying transactions to gain on both ends. Our colleague Frank Partnoy called this "empty voting", a term popularised by Henry Hu and Bernie Black.
Recently, the hedge fund sector has gone into what may be the start of a tailspin. This is the result of political and economic chaos but also due indirectly to hedge funds themselves. The political gridlock in many parts of the world is the predictable consequence of narrow-minded and short-term self-interest. Many books and articles explain how the ‘alpha' mind-set has infected the minds of elite decision makers across the world.
Of course, hedge funds aren't unique - all investors have similar tendencies, albeit not so aggressively encouraged. Many pension funds, sovereign wealth funds and endowments think they have benefited from hedge fund ‘alpha' because they only do a micro-level analysis and ignore how they have suffered from volatility and other externalities that are harder to measure but which have a big impact on their longer-term interests.
Thankfully, some hedge fund managers understand the importance of fundamental change. George Soros is one. And some prominent managers support action to make financial markets more climate-change savvy. But it would take many more before this sector's great wealth was matched by real social contribution.
No amount of PR-led philanthro-capitalist hype can compensate for this inherent social irresponsibility. And integration of ESG factors into hedge fund strategies - belated but welcome - does not make them suitable for responsible investors. Those who advocate ‘self-regulation' should be ignored - these processes have little impact because this is how they were designed to be.
I agree with Roger Martin, the Dean of Rotman Business School in Toronto, who advocates adverse tax treatment, and for pension funds to be prevented from investing with any manager that charges both a fee for assets under management and carried interest (eg, 2-and-20-type fees) That would result in a big washout but leave good managers able to deliver huge benefits (in any real-world comparison) that are much better aligned with the long-term interests of beneficiaries. And if hedgies think they can do better as traders in banks, good luck to them.
Of course, if enough large clients got together and gave the industry a clear ultimatum, then perhaps it might happen. But, sadly, there doesn't seem to be the collaborative leadership in the asset-owner community for such action. So, unless regulators act, individual beneficiaries will continue to be abused by financial decision makers who fear career risk from doing the right thing when everyone else is doing the opposite.
Pressure will be needed for regulators to take decisions in the public interest, given that most regulators and their political masters suffer from cognitive and other forms of capture. Hedge funds today are major contributors in elections at the national level and in key cities like New York and London. It will take a wide-ranging coalition of public interest groups to balance out their influence.
Raj Thamotheram is an independent strategic adviser, co-founder of PreventableSurprises.com and president of the Network for Sustainable Financial Markets