Giles Turner speaks to Tarun Ramadorai, reader in finance at Sad Business School, Oxford University, about what is wrong with the AIFM Directive and how alpha eventually runs to zero.
The AIFM Directive has caused cries of unfair within the hedge fund industry. Unlike 1998, when the highly leveraged Long-Term Capital Management did its best to bring down the financial system, the current crisis has had little to do with hedge funds. Despite hedge fund managers relative innocence, many politicians and regulators have been eager to blame the “locusts” (endearingly termed by Franz Muntefering, Germany’s ex-deputy chancellor) for bringing down the system.
But any regulation is relative, and as Tarun Ramadorai, reader in finance at Sad Business School, points out, hedge funds have had an easier time than others. In 2006 the SEC introduced compulsory registration for hedge funds, and then there was a lawsuit against it, which prevented the SEC getting the basic information about hedge funds, and when I mean basic information, I mean, have you been in jail before? One might think the due diligence regarding that information might be pertinent.
For Ramadorai, author of a number of papers on hedge fund risk and performance, the AIFM Directive misses the point: [The directive] came out very quickly after the credit crunch. It seems to me a little bit more time and consultation would not go amiss. [A focus on] position disclosure and transparency, rather than imposing stringent risk limits or changing compensation schemes without further study. That doesnt strike me as the right solution to the problem.
Ramadorais concern is systemic risk. The FSA could very reasonably ask for any fund that is investing in the UK market to give it information about what assets it has invested in, within the UK market. He admits that jurisdiction issues will pose a problem, and that it would be difficult to force any fund that has a toe in the water in the UK to give the FSA access to all its global positions. The way to start is [for the regulator to] ask some information about what hedge funds end investments are within the country or jurisdiction, and I think that is perfectly reasonable, he says.
A recent paper from Ramadorai, co-authored with Andrew J. Patton, associate professor of economics at Duke University, highlighted that hedge fund risk exposures vary significantly month by month, even week by week. Even if regulators received the amount of transparency and data Ramadorai hopes for, do they have the skill set to spot systemic risk? We struggle with that question a lot of the time, he says. There is still no guarantee that the regulators have the necessary expertise to evaluate that information in the appropriate fashion. One solution to this problem is potentially getting people from the industry to come in and spend sabbaticals in the regulator; the problem with that is that it could create a revolving door issue, where you then have problems with potential conflicts of interest.
Ramadorai prefers reducing the gap in remuneration between hedge fund managers and their supposed guardians. Rather than decreasing hedge fund manager pay, regulator pay should be increased in order to attract talent. It makes sense to me that you should have high-quality, well-paid people who are evaluating levels of systemic risk, otherwise you have very sophisticated people on the one hand, and perhaps not as highly incentivized people in the other side. And that is a recipe for disaster, he says.
Unfortunately, this seems unlikely. New regulation within the Dodd-Frank financial reform act in the U.S. could mean seven-figure payouts to whistleblowers. In a typical law of unintended consequences, many bright young things may fail to see the point of working for a regulator if such high sums are paid to whistleblowers. It would be more profitable for many to work in Wall Street just to expose malpractice from the inside, rather than from the offices of the SEC.
Ramadorai, along with fellow academics, has also looked into the issue of risk adjustment for hedge funds. There are investors out there who take hedge funds at face value, he explains. There are other investors who set down benchmarks for hedge funds which are slightly more sophisticated, such as you are saying if you have to beat LIBOR, or a moving target like the S&P 500.
Ramadorai looked at the excess returns hedge funds provided over and above the passive benchmarks. When we were looking at funds of funds, we found that 20% of hedge funds did surmount this obstacle and had alpha, he says. But now this looks optimistic, because you have a one in five chance of getting a good fund. If you did a little bit of digging, then you can run a model to find these funds, which is what the good fund of funds do.
Eventually, the majority of investors spot the top 20% of funds. If you are one of these top 20% of funds, and you get all this capital, obviously you cant deploy it in the same scale that you used to be able to. In some sense, your success is sowing the seeds of your own destruction. If you accept lots of capital, you cant go on delivering returns at the same rate, because your transaction costs become bigger, and the trade becomes more crowded. What this means is that alpha is going towards zero, he concludes.