Hedge Fund Transparency?

Mike's alerting me to a huge expansion of the federal bail-out into hedge funds - yes, hedge funds - made me think (for some reason) of Sebastian Mallaby. Although he wrote this a couple of weeks ago, I think it deserves a bit of attention:

Madoff illustrates a problem with investment outfits that claim to have some special sauce that is too valuable to discuss. People who entrusted their money to Madoff thought he had a clever options trading strategy; they were wrong. Worse, people who entrusted their money to respected banks and investment advisers had no idea that their savings were being passed out the back door to Madoff. On Monday, I happened to be visiting one of the most famous traders in Manhattan. He had invested with a hedge fund that had in turn invested with Madoff, hot-potato style.

The good news is that Madoff's fraud was so brazen that any future imitators may be spotted. A newly chastened wealth management industry will be warier of people who hire bucket-shop auditors; the "fund of funds" industry, which gets paid to do due diligence on hedge funds, will feel appropriate pressure to redouble its efforts. Even though hedge fund managers may legitimately refuse to disclose their trading strategies, there are some things they can be open about. Do they trade through a respected external broker? (Madoff apparently didn't.) If their returns clock in at 1 percent per month with eerie consistency, can they explain why? (Madoff could not have.)

I can think of three reasons why hedge fund managers might refuse to disclose their trading strategies:

1. They're "secret sauce" isn't anything special - it would be easily replicated by their competitors;
2. They're engaged in trading strategies that skirt the boundaries of the law, and people would be appalled that their actions are legal (or might conclude, even under present law, that they're not); or
3. Like Madoff, they're criminals and disclosure would reveal their crimes.

Now sure, some hedge fund managers may truly have developed secret trading methods and sophisticated models of predicting markets, that would lose their power if their competitors had even a hint of how they worked. But why am I thinking that the principal reason for the secrecy lies behind door #2, and that the net result is that the industry demands a freedom from regulation and oversight that protects those who, like Madoff, lurk behind door #3?

Although Mallaby is not skeptical of hedge funds - quite the opposite - he is concerned about door #3: As a result of the way the system is structure, he tells us, "the bad news is that less-brazen fraudsters may be impossible to detect" and "this Achilles' heel could eventually kill hedge funds". Nonetheless, "Responding to this scandal with more regulation would be like thrusting more pills on a patient who refuses medication." (Why do I suspect that Mallaby has no problem drowning hedge funds in taxpayer money, even to the likely benefit of hedge fund managers who are continuing to perpetrate their hard-to-detect frauds?) Wouldn't Madoff's fraud have been discovered even with a modestly thorough audit? "No.... Regulation bad...."

This is curious:

Perhaps half of all funds use strategies about which there is no great secret, so disclosure is possible...

If that's truly the case, how do we justify the astronomical compensation taken by hedge fund managers? How can anyone defend taxing their income at the capital gains rate, instead of as... income?

Moving to more current news:

Last month, five hedge-fund managers who each made more than $1 billion a year were called before Congress to discuss the industry's role in the crisis and the case for regulation. Four of the five said they thought that hedge funds could pose a systemic risk to the economy. "Any institution that has a pool of capital at its availability and uses reckless leverage indeed poses a potential systemic risk to the marketplace," said Philip A. Falcone, manager of Harbinger Capital Partners.

When pressed, the hedge-fund gurus agreed that they could probably live with some form of disclosure to a federal banking regulator, as long as the data are not shared with the public.

How... special.