CSI for hedge-fund blowups
Finding out exactly what goes wrong at problem hedge funds is key to addressing the risks posed by the growing industry, says MIT professor and insider Andrew Lo.
NEW YORK (CNNMoney.com) -- Growing concern about the effects hedge-fund blowups can have on global financial markets has renewed a push for tighter controls on the $1.6 trillion industry.
In the U.S., regulators are approaching the issue by trying to require hedge funds to register as investment advisers. But a better solution is to target problem hedge funds, says Andrew Lo, a finance professor at the Sloan School of Management at MIT who also runs Cambridge-based investment management firm AlphaSimplex.
For the last few years Lo has been promoting the idea of an independent agency designed to specifically investigate what goes wrong when hedge funds blow up. CNNMoney.com spoke with Lo about this plan, where it's going and why he thinks hedge-fund regulation is inevitable.
CNNMoney.com: There have been calls to regulate hedge funds for years now, but no controls have really managed to stick. Why do you think that is?
Andrew Lo: I think there are a couple of problems with proposed regulations that have come and gone. One is the legality of the rules proposed in the past, which is why they've been challenged and substantially struck down. [An SEC regulation requiring hedge funds to register with the agency was struck down by a federal appeals court last year.]
The larger issue is [the proposals] don't get to the heart of the issue - which is dealing with problem hedge funds and addressing the impact hedge funds have on systemic risk. That's something that really needs to be revisited from a different perspective.
Q: Can the risk posed by hedge funds really be measured?
A: Not very well right now. We don't have the data. We can measure indirectly certain elements of systemic risk, which is what my co-authors and I have tried to do in our research. But we acknowledge that our measures are at best indirect because we don't have the necessary data.
Q. A few years ago, you and your colleagues said the government should create an independent agency, modeled after the National Transportation Safety Board, that would deploy a team of financial forensic experts to examine all major hedge fund collapses. What are the benefits of creating such a Capital Markets Safety Board versus having hedge funds register as investment advisers?
A: The first advantage is that a relatively small amount of resources are required to create this kind of organization versus the amount of resources needed to implement hedge-fund registration and enforce compliance.
Instead of having to monitor all hedge funds, it would produce research and disclosure for problem hedge funds. Over time, that kind of focus would produce an extraordinarily valuable database of potential issues that investors should be aware of and that would allow investors to cause the industry to fall in line. The dollars will flow to where these problems will be less of an issue.
Q: Does this have to be a government agency or could it be self-regulatory?
A: I think it is possible to create a Capital Markets Safety Board that is organized and funded by the industry, but it has to be created to serve an independent oversight function. It can't be an agent of the industry; it can't be window-dressing. It has to serve an independent and informational role in dealing with hedge-fund blowups.
Q: What sort of feedback have you gotten on this idea and where is it going?
A: The industry participants I've spoken to think it's a brilliant idea. It provides oversight that's necessary - but in a cost-effective manner - and it allows the investing public to vote with their dollars once these reports have been made public.
It's the politically most palatable solution but [would] require some kind of critical mass to get [it] implemented. No one has really taken up the challenge of making it happen. That has to come from the government I think.
Q: Transparency seems to be something the hedge-fund industry has always resisted - do you think we'll see a change in this attitude anytime soon?
A: Hedge funds do not provide transparency precisely because that would end up causing a loss in intellectual property in the fund. It is important for there to be protections for this kind of intellectual property and that means a certain lack of transparency.
However, I do believe it's possible to create a situation where an investor gets more information about the risks hedge funds engage in while providing complete protection for the intellectual property of the fund manager, and I think that relies on better risk analytics.
Q: And the Capital Markets Safety Board would also protect hedge funds' intellectual property?
A: Right, we're not asking all funds to disclose information, only funds that have blown up and caused a certain degree of stress. Funds that have lost money for investors - maybe 50 percent or more of their assets. When you're in that position, there's some obligation to explain exactly what happened....
Q: Do you think some sort of regulation is inevitable in the U.S.? If so, what shape is it likely to take?
A: I do think some new forms of regulation are inevitable because the growth of hedge funds has been so rapid. Along with that growth has been inevitable cases of abuse. I think we will see some kind of regulation, and it most likely will be a requirement to register as investment advisers.
I think that process will be onerous. It will be costly to implement. I don't think it will solve the problem of addressing systemic risk in a meaningful way. It may serve other purposes - I don't want to rule out the benefits of offering a potential degree of protection for investors, but I'm not sure if investors are looking for that right now.
Q: It seems like the push for more hedge-fund regulation is becoming more global - at the recent G8 finance ministers meeting, there was a push for tighter controls on hedge funds. Further down the road, do you think we'll see any sort of international regulatory action plan?
A: That would be good idea, but it's not something likely to occur since different countries have different standards and customs for dealing with securities law.
But it would be extremely important for there to be some form of international coordination among regulatory agencies because of the global nature and global reach of hedge-fund activities. Some form of coordination is needed otherwise problems will just be pushed to another corner of the world where regulations are more lax.