If you hate hedge funds, you hate yourself

Tue Mar 4, 2014

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A conversation with attorney and author Timothy Spangler.


Timothy Spangler is an attorney, academic and commentator who divides his time between New York and Los Angeles. His recently released book, " One Step Ahead: Private Equity and Hedge Funds After the Global Financial Crisis," is an attempt to bring alternative asset managers out of the darkness for readers who think hedge funds and private equity firms are inherently mysterious or mischievous.

In person, Spangler is funny and wry, and when our in-person conversation the other week was cut short due to weather-related travel issues, we continued it over email:

Josh Friedlander: You chalk up a good deal of vitriol against hedge funds to mainstream ignorance of their substantial role as managers of public money (hence the headline of this piece), and the willingness of cynical politicians to exploit that information gap. Do you think that ignorance will diminish as hedge funds become more public? Balyasny recently ran an advertisement in Pensions & Investments, and Galtere is using a video to market itself!

Timothy Spangler: I hope so. To the extent that hedge fund managers take advantage of the new JOBS act rule, we could see more information about these funds circulating to the general public. This would be a good thing. Although over the years they have been branded "secretive" and "shadowy," it has been because of the prohibition on general solicitation and general advertisements contained in Regulation D that hedge funds have so severely limited their interaction with the media.

JF: Yes, although the law doesn't just let anyone market. They have to select the exemption under rule 506(c) of Regulation D of the 1940 Act, which carries the burden of vetting the accreditation  of one's investors. Some will embrace this and others won't. On a larger level, is Fidelity not hated just because they advertise or is there more to it? Will advertising or having a bigger public face really change perceptions of hedge funds?

TS: I think there are two angles here. First, advertising as a means to expand the assets in these funds and bring new investors into them. Second, advertising as a way to mold or drive public opinion, regardless of whether the individual ever actually invests. The biggest stereotype surrounding hedge funds over the past 30 years was that they were "shadowy" and "secretive." What was never very well understood outside the corridors of law firms and the internal compliance function at these funds was that because hedge funds are open-ended and constantly marketing their shares, they were always restricted in what they could say publicly in order not to run afoul of strict SEC rules on pumping up securities sales with well-calculated press releases, media interviews and other selective disclosures. So the standard advice given was to simply say nothing to the press. The JOBS Act potentially changes this, by allowing hedge fund managers to speak openly and widely about their funds and in the process educate people about what they do. What are the expectations here? I don't think that the goal is to convince a sizeable majority of Americans that hedge funds are the saviors of modern capitalism, but instead just that hedge funds are a natural outgrowth of a century of evolution in the financial markets, that they are not alien or suspicious or inherently untrustworthy and that for many investors who seek high returns; they are an acceptable component of a diversified portfolio.

JF: My guess is that the hedge funds can only do so much to help their own image. The real turbo charge could come from household names in finance, especially the large mutual fund complexes, which are seeing early indications of public interest in liquid alternatives and figure they can do a great job marketing those products. As a result, I wonder if there will even be a "hedge fund industry" in 10 years. It appears that asset management is on its way to a firmer split between talent and distribution, though some managers will always want to own the entire process. Mais où sont les hedge funds d'antan?

TS: I think it is probably too early to consign hedge funds to the snows of yesteryear. Underlying the "hedge fund industry" as we may want to define it for purposes of easy conversation is an underlying dynamic about "access to talent." This is what has always driven the industry forward since its earliest days. Talented money managers do not need large platforms and big balance sheets and a diversified financial services conglomerate. Although they can at times be certain advantages, they are not necessary in order for a talented man or women to ply their trade successfully. I think the form and deliverables of "hedge funds" will continue to evolve over time in response to market forces and investor demands, but the underlying dynamic of "access to talent" and the preference of many talented individuals to establish their own independent and entrepreneurial firms will continue.

JF: But there's only so much money that institutions can deploy in small scrappy hedge funds (the romanticized "two guys and a Bloomberg"). Does this mean we'll have a huge number of institutional players and an even more ghettoized group of small managers actually focused on high returns rather than conservative and stable returns?

TS: When we are discussing hedge funds, it's hard to generalize too much about structure and size of firms. There have always been, and will continue to be, wide variations in headcount, assets and other measures. That said, to the extent that hedge funds remain a talent-driven business, as new talent arrives on the scene, there will be new start-ups going into the market and as performance persists, a handful of firms will institutionalize. Ultimately all hedge funds are in search of high returns. You could argue that as soon as they begin to prioritize "conservative and stable" returns, they have become mere asset aggregators and return to the domain of traditional money managers rather hedge funds.

JF: Well, there definitely seems to be a power law advantage at work in terms of assets. The big don't just get proportionately bigger. Given the capacity constraints that wouldn't permit institutional investors to allocate capital much lower down the food chain, the biggest firms get the vast majority of the money. You say that all hedge funds are in search of high returns, but we've often seen the opposite. These days it's sometimes difficult to know whether startups are even after sizable gains or are instead in search of a risk-adjusted profile that will let them ultimately raise institutional assets. There will always be some funds willing to accept volatility in exchange for a chance to significantly compound assets, but as the distribution networks allow a broader asset base from day one, I do wonder how many firms will be tempted to just pick and beat a benchmark.

TS: We should remember (for better or worse) that hedge funds are just another species of the genus "investment management," so all the perils and pitfalls of the industry generally - such as a tendency to prefer asset aggregation to performance - can conceivably plague hedge funds just as much as traditional products. In the end investors still put their faith in the performance fee structure to motivate the manager to pursue high returns. In theory, management fee should not be, in itself, so much of a profit center as to distract the manager from the single-minded pursuit of performance. In reality, though, that is not always the case.

JF: Well, there's no performance fee in some of the 40-Act structures that look poised to allow a fundraising boom. In a closed-end vehicle, at least, good performance is the only way to increase assets, which is the only way to increase fee revenue, so interests are aligned, though less potently than in a straight performance-fee structure. Do you think this type of retail distribution is likely to result in muted returns relative to a performance fee incentive?

TS: There is a lot of excitement surrounding liquid alternatives and the ability to move alternative investment strategies into the hands of retail investors. I think it will take time to see which managers are able to successfully deliver performance to these investors. High net worth investors used to be the bedrock of hedge funds before institutional interest began to grow over the past decade. In that regard, retail investors should be a natural demographic for hedge fund managers to appeal to. The question is inevitable about which managers go into the retail space and what is their motivation. Are they giving the retail investors access to the best strategies or simply to those strategies that were unable to find other investors?

JF: If I can revisit our earlier discussion of awareness and blame, you've argued that a large amount of the industry's profits stem from successfully investing on behalf of institutional investors representing teachers and other public servants. I joked that your book has too tame a title and could instead be "If you hate hedge funds, you hate yourself." Why do you think hedge funds are sometimes an attractive scapegoat?

TS: I attribute it in part to the high level of financial illiteracy that we tolerate in society, particularly as it applies how markets actually work. Because too many people are not familiar with how stock markets operate, how prices move in response to trading and other forces, it is difficult for them to understand what hedge funds actual "do." Together with a few headlines about insider trading, it's very easy just to presume that anyone who makes money off investing over a prolonged period must be receiving illegal assistance of some sort. If the markets really are "casino capitalism," then the only way you can consistently beat the house in Las Vegas or Atlantic City is by cheating. So hedge funds must be cheating as well! It's not a very elaborate argument, but when paired with ignorance and fear, it's a powerful one for many would-be critics.

JF: There's this implication in some of the rhetoric that no one can earn high annual returns without cheating. But does mainstream perception matter? No one wants to be vilified, but people will always agree with Balzac that "The secret of a great success for which you are at a loss to account is a crime that has never been found out, because it was properly executed." People see a fortune made off complicated (though not inexplicable) maneuvering and they assume the worst. But hedge funds operate for the most part in places where the people around them understand what they do. Why the angst at being pilloried by Obama or other public figures for political gain, especially when the policies of this government have been a huge boon to hedge fund portfolios?

TS: I guess the question is whether we are actually "at a loss to account" for the reason why some investors do better than other. I believe it goes back to whether we believe there is such a thing as investment talent, or whether it is unlike other forms of human endeavor, like sports or music or cooking, and talent cannot be said to exist there. If that is the case, then we are actually undermining the entire continent of active investing, and not just the peninsula of hedge fund trading. I don't think most observers are willing to go that far. But Wall Street generally and hedge funds in particular have much more work to do to explain to the investing and saving public exactly what it is that they do to make the world a better place. With so many public pension plans investing so heavily in recent years in hedge funds, it's a little disconcerting that on Monday the trustees for vast numbers of government employees can write a large check to a hedge fund and then on a Wednesday a senior figure in Washington decides to rail on hedge funds in order to score points on a cable news channel. But no one yet has been willing to stand up and point out the inherent conflict in such grandstanding.

JF: With this book, do you aspire to take up that cause?

TS: One Step Ahead has as one of its central theses the goal of bringing widespread attention to the important linkages between public pension plans and the alternative asset classes. The 2012 Presidential campaign demonstrated how little people knew about this symbiotic relationship.

JF: Yes, but are we going to see you on TV taking cracks at politicians or revealing these conflicts? Will the MFA be shining a Spangler Spotlight into the dark night to call up an unmasking man?

TS: Hopefully!

ISSN: 2151-1845 / CDC10004H