Raising the bar for hedge funds
By Stanley Goldstein and Frank Plantan
Even the best economists have trouble explaining the recent unraveling of
global financial markets. Headlines suggest a lack of focus in Washington and
on Wall Street. This has contributed to a crisis of confidence in not only our
policymakers but also the system itself.
Rationality among professional traders has given way to fear verging on panic.
The spillover effects are impacting even firms whose balance sheets were
considered sound. Because hedge funds operate in the US for the most part
outside the regulatory environment overseen by the Securities and Exchange
Commission (SEC), the Department of the Treasury, and the
Federal Reserve, many construe hedge funds to be above the law, serving the
sole interests of fund managers and their wealthy clients.
Until the past year, enviable returns reinforced the logic of the industry's
freedom of operation. It was this freedom, and the belief that unfettered
market forces would play the role of ultimate regulator, that shaped changes in
behavior. Industry advocates claimed that this operating environment proved the
worth of self-regulation, noting that managers who committed fraud were
prosecuted, that transparency in fund transactions was advanced as a result,
and that funds that engaged in illegal practices were disciplined by the
marketplace itself through losses and exits.
But this paints too rosy a picture. Withdrawals and liquidation of investments
now test the resilience of the industry, challenging its working assumptions.
Some investors, unconvinced that losses have been due to fallout from larger
market forces, have turned litigious in their search for evidence and
explanations of investment losses. They have faulted fund managers and charged
them with unsuitable investment decisions, insufficient or improper disclosure,
misrepresentation, negligence, misconduct, and other behaviors relating to
omission of information.
Hedge funds, though not among the worst culprits in the financial crisis, have
drawn disproportionate attention because of their size, fees, and secrecy.
There is much discussion today about taking a fresh look at the regulatory
environment in which hedge funds operate - with five of the more prominent fund
managers recently testifying before Congress.
Nor has it helped the industry that a number of high-profile fraud cases cast a
spotlight on the industry. The two leading financial market regulators, the SEC
in the United States and the United Kingdom's Financial Services Authority,
face increasing pressure from the public and have begun to contemplate new
regulations.
What changes can restore public confidence in the industry while enhancing
market forces, even if there is not a return to historic performance levels?
Elevating the role of ethics, making it a fundamental corollary to the normal
functioning of the market and the basis of transparency and accountability will
produce these results. An accepted code of conduct and best practices -
hallmarks of all professions - will shape the hiring and training of personnel,
define management responsibilities, enhance investor relations, and help
moderate government regulation.
Moreover, the institutionalization of ethical practices by hedge fund managers
in their organizations will lead to higher profitability. Surveys of chief
executives in other business sectors and growing empirical evidence indicate
that ethical behavior leads to higher profit levels. The same should hold for
hedge funds. This is not simply a matter of weeding out the bad apples in the
industry, but of establishing standards and norms that will socialize new
professionals to expectations concerning ethical standards.
Behavior modification is difficult but possible. Systemic changes in society
usually occur incrementally. Think of walking into a business meeting in 1962
and finding 12 smokers among the (mostly) men in the room. It is unlikely one
could imagine such a meeting today. Changes in smoking behavior and the role of
women in business came first from the public, particularly civil society groups
that lobbied for changes in laws and also changed public perception about the
acceptability of certain behaviors. Changes in perceptions and preferences
eventually impacted corporate culture.
What do smoking habits have to do with hedge funds? Peer pressure and standard
business usage can nudge the managers of hedge funds to set standards of
conduct and ethical behavior out of enlightened self-interest.
Many charities today are adopting whistleblower policies and creating audit
committees within their boards of directors. There was no mandate behind this
promulgation. Rather it was the questions that grantors had begun to ask that
led to their creation. After repeated queries regarding whistleblower and
corporate governance policies, charities caught on to the fact that it is
better to attend to these issues as a means to attract funding.
The ultimate goal of such behavior is to reap the value of a good reputation.
The voluntary adoption of these policies has a direct impact on a charity's
ability to instill confidence in funders. Most charities would prefer to avoid
such expenditure of time and resources, but consumer and client demands make it
a necessity.
One of the best examples of the power of ethics to guide behavior comes from
the New York State Society of CPAs (certified public accountants). Serving on
one of the society's committees is a highly desirable privilege for an
accountant. The accounting firms that make up its leadership know which firms
behave ethically and which ones cut corners or cross the line either legally or
ethically. Such individuals are effectively excluded from committee membership,
which consequently limits both their professional and their revenue growth.
Within the accounting community and individual firms, this paradigm produces a
profound amount of peer pressure to dissuade and ostracize miscreants. This
implicit code of conduct emerged in the industry without legislative action.
The army has an old saying: "Anyone can fool the company commander but no one
can fool the guys in the platoon." Soldiers know in a matter of weeks who they
would be willing to share a foxhole with and who to avoid. Likewise,
self-regulation with high standards will lead to an elevated set of
expectations on the part of investors. If some hedge funds do not meet these
standards, they will find investors taking their money to funds where they
implicitly have more confidence. In this way, industry usage will push the
management of these financial organizations to do what the buyer expects and
demands.
Investor expectations can elevate ethical behavior. Hedge funds have the
opportunity to push for higher standards out of enlightened self-interest. By
being proactive they can help set the framework for the debates to come
regarding new regulations. This approach also complements the President's
Working Group on Financial Markets for establishing a best practices standard
for the hedge fund industry.
Hedge fund managers already share characteristics with professionals in
medicine, law, accounting, and higher education. Each has a highly specialized
knowledge base; there are certain barriers to entry into the profession; they
represent a societal elite. What is missing is an associational body that
oversees the conduct of its members and insists on conformity to professional
norms. University faculty, lawyers, and doctors all risk sanction, censure, and
even expulsion from the profession when they violate these norms. Self-policing
has been shown to be effective, especially as a complement to regulatory
agencies involved in external monitoring.
The way forward is difficult. Unlike public corporations, nongovernmental
organizations, international organizations, and universities, hedge funds are
not structured in a way that facilitates addressing ethical issues. Most hedge
funds are small, closely held organizations with a small staff. The presence of
an ombudsman reporting on malfeasance would be at best awkward and likely
difficult. Escalating regulatory risk and the new demands for reporting and
transparency compel the hedge fund industry to take the lead in order to
maintain the independence and freedom of movement it values.
Doing so will create powerful bonds with stakeholders through an investment in
corporate citizenship. A growing base of empirical evidence reports that good
corporate citizenship also inspires people to disseminate good opinions about a
company. Such word of mouth can be especially powerful in the relatively small
world of the hedge fund industry and can be far more powerful than advertising
in developing and maintaining loyalty and investments in a world where
reputation and confidence means more than superficial branding.
For hedge funds to move in the direction we propose is a challenge but not
impossible. There is a clear value proposition to putting ethics at the core of
the industry and its transactions. Doing so can reduce costs of compliance,
improve human resources, stabilize the market, enhance the confidence of
investors, and reduce industry volatility related to scandal and fraud.
Government regulation would not signal the death knell of the hedge fund
industry, yet it would dampen the flow of capital if it becomes too intrusive.
Self-regulation would relieve the pressure on governments to take drastic
action. Adam Smith, in his Wealth of Nations, explained how man engages
in actions for his own self-interest but in the process enriches the community
around him. Hedge funds deserve the opportunity to grow into that
self-governance mode.
Stanley Goldstein is president, New York Hedge Fund Roundtable, and Frank
Plantan is co-director of the International Relations Program at the
University of Pennsylvania.
(Published with permission of the
Global Policy Innovations program at the Carnegie Council for Ethics in
International Affairs.
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