Hedge funds have more than a trillion dollars under management and promise an alpha, or excess return over benchmarks, on the order of 5% — or some US$50 billion. Is this plausible? And, in these days of scandal, are such promises overstated by lack of regulation?
Douglas Cumming, an associate professor at York University’s Schulich School of Business essays an indirect answer in paper that won this year’s award from the Canadian chapter of the Alternative Investment Management Association for best hedge fund research paper.
At the heart of his paper is the notion that hedge funds are best described, not as alpha seekers that benefit from exploiting market inefficiencies, but instead, as compensation schemes managed on behalf of capital providers. Fund manager and capital provider interests are aligned when managers are able to collect performance fees. Cumming applies various measures, including a manipulation-proof one, to hedge fund performance.
That provides a purchase on the relation between regulation and performance. It involves the sociological problem of agency: that investors rely on others to collect returns but those agents’ interests are not the same as those of investors. So there’s a potential slippage between what’s best for the agent, and what’s best for the investor. How hedge fund earn their alpha is not always clear to the investor, nor is it always clear, absent regulation, that investors share in the performance gains.
But a solution, in the form of regulatory oversight, may curtail hedge funds` freedom to deploy their resources efficiently. Among the regulations Cumming cites are minimum fund size, the domicile of such service providers as administrators and auditors as well as restrictions on who can buy. In turn, these limitations may make for inefficient scale, lack of choice in human resource allocation and barriers to entry — evidenced by higher management fees and lower performance fees.
The data Cumming has analyzed suggest that hedge funds that face restrictions on where their service providers may be located show lower returns and minimimum capitalization restrictions have a similar effect. This also holds for distribution rules. The upshot is that these funds have higher fixed management fees, and lower performance fees.
Cumming’s analysis plays out against the following backdrop. In the U.S., hedge funds are largely unregulated. While they cannot advertise, there is no restriction on size or whether service providers are onshore or offshore — in Bermuda, the Bahamas or the Cayman Islands, for example. But other countries do regulate the size and marketing of hedge funds l; they are not, as in the U.S., private placements — and will specify that funds have onshore service providers, from the manager through to the custodian. The question then, is do such regulations hinder alpha?
Apart from the legal variables set out across 24 jurisdictions, Cumming also considers a manipulation-proof performance measure that has more variables than the Sharpe ratio. The Sharpe ratio, which measures the variability of a return achieved over a benchmark such as a risk-free measure like three-month T-bills, is, researchers have found, prone to gaming. An annualized Sharpe ratio, for example, can prove higher than a daily, weekly or monthly one.
Another measure Cumming turns to is multifactor alpha: comparing a fund’s returns not to a single benchmark, but testing them against the small-cap premium, the credit spreads and trending following in bond, currency and commodity markets, among others. A fund that beats the S&P 500, for example, may have exposure to different, passively harvestable, risk premiums.
Some of the more interesting results from the paper are that restrictions on the location of service providers do constrain human capital allocation, resulting in worse performance. While returns are less volatile, risk-adjusted returns are lower.
In addition, while the impact seems neutral on fixed-income costs, performance fees are lower, also connoting an inefficiency. Restrictions on minimum size proved of less statistical significance.
Third-party distribution — wrappers, such as a fund of funds or structured product, that get around prohibitions on direct access to a fund manager for non-accredited investors — also seem to have a negative impact on performance, while increasing fixed fees, which Cumming suggests may be the product of a conflict of interest between the fund manager and the marketer of the fund. It also reduces, to some degree the variability of returns.
Cumming does not offer a normative opinion about the usefulness of regulation, only its apparent effect. While regulation seems to be a drag on performance, it also appears to conduce to lower volatility, and thus, lower risk. But he suggests futher research is in order.
Filed by Scot Blythe, Advisor.ca, scot.blythe@advisor.rogers.com
(01/02/09)