The chairman of fund complex MFS Investment Management is calling for the formation of a task force to overhaul performance reporting for hedge funds. In a keynote address today to the National Investment Company Service Association’s (NICSA) annual meeting in Miami, Robert Pozen told the assembled mutual fund executives that hedge funds—once a product reserved for rich and institutional investors but now being sold to less-sophisticated retail clients—pose a “systemic risk” to retail investors, largely because hedge funds have loose performance-reporting standards and little oversight.
Pozen, perhaps best known for his progressive proposal to fix Social Security, said, “What really galls me about hedge funds is that everyone thinks the performance is that good.” The misconception, he says, is fueled by several factors, including a voluntary reporting process. “The good ones report, the bad ones don’t,” he said. Another reason is that industry performance metrics are skewed due to “survivor bias,” i.e., they don’t account for the hedge funds that have blown up and exited the business. Then there’s the selectivity of start dates, he says, where certain hedge funds exclude a period of poor performance from its track record in an attempt to manipulate its returns.
The Greenwich-Van Index, a proxy for total hedge fund returns, posted an estimated 8.3 percent gain in 2005, well ahead of the traditional market indices. In comparison, on a year-to-date basis, the S&P 500 returned 4.9 percent, the Nasdaq increased 1.4 percent, the Dow Jones Europe Stoxx Index gained 4.7 percent and the Morgan Stanley Capital International World Equity Index returned 7.6 percent.
While acknowledging that regulators have made strides by requiring hedge fund advisors to register under the Investment Advisers Act of 1940, Pozen said that further action is required. He is urging regulators to launch a task force to put together a uniform reporting standard for hedge funds. “It would make it clearer which hedge funds are good and which are bad,” Pozen said. “I seriously doubt there are 8,000 geniuses out there.” There are now an estimated 8,000 hedge funds, roughly equal to the number of mutual funds. (Which begs the question: Does Pozen and the mutual fund industry fear hedge funds for siphoning off assets they could otherwise be managing?)
Pozen also argues that hedge fund managers do not align their interests with their shareholders by setting performance-based fees without any downside risk for the fund managers. Managers have the right to a share of the profits, in most cases more than 20 percent, but they don’t share in any losses. (Of course, many have “high-water marks,” meaning the manager can’t be paid a performance fee until he surpasses the high point of value of the fund.)
More than 900 hedge fund advisors who registered with the SEC met their enrollment expectations earlier this month, despite a heated court battle to remain unfettered by SEC oversight. Hedge funds now manage about $1 trillion in assets, according to the Managed Funds Association, the Washington, D.C.-based trade association for alternative investments. Hedge funds now account for 60 percent to 70 percent of the trading volume on the New York Stock Exchange. Hedge funds often employ complex trading strategies like short selling and arbitrage and use esoteric instruments like options, futures and commodities.
The NASD is currently conducting a sweeping investigation of hedge fund sales practices to determine whether some firms sold investors hedge fund shares ill-suited to their investment needs.