Friday, October 21, 2011

SEC Clamping Down on Large Hedge Funds?

Jesse Hamilton of Bloomberg Businessweek reports, SEC to Weigh Hedge Fund Rule on Systemic Risk Data Analysis:
Hedge funds and private-equity funds will be asked to deliver “extraordinary amounts” of new data to the U.S. Securities and Exchange Commission under a rule set for a vote next week, said SEC Chairman Mary Schapiro.

Under the version of the rule proposed by the SEC on Jan. 26, firms managing more than $1 billion would have to file quarterly information on fund assets, leverage, investment positions, valuation and trading practices on a new Form PF. That added oversight would also come with routine inspections.

“We have high hopes for the Form PF data,” Schapiro said today at a Managed Funds Association meeting in New York. The form was a requirement in last year’s Dodd-Frank Act, and Schapiro said the information will help her agency and the Financial Stability Oversight Council “understand where the risks are in the financial system.”

The January proposal described how the regulators will use the new data to assess whether a firm threatens to destabilize the financial system, as in the 1998 collapse of Long Term Capital Management LP. The SEC is set to vote on the final version of the Form PF rule Oct. 26.

Separately, Dodd-Frank requires the SEC to set up registration rules for private fund advisers. The registration, adopted in June, requires the reporting of “census-like data” on employees, investors and assets they manage. Unlike the registration data, the Form PF information wouldn’t be public.

Short-Selling

Also today, Schapiro said the SEC wouldn’t consider short- selling bans such as those being weighed in Europe. So-called naked short selling, in which traders bet on an investment’s decline but don’t borrow shares as in regular shorting, was temporarily limited by the SEC in the 2008 credit crisis.

“I can’t envision the SEC doing another short-selling ban,” she said.

Schapiro also cautioned hedge funds to make sure they have “robust compliance policies” in light of recent insider- trading cases involving funds’ dealings with expert networks, such as in the conviction and July sentencing of former SAC Capital Advisors LP portfolio manager Donald Longueuil to a 30- month prison sentence.

“We’re right in the middle of so many cases and investigations,” Schapiro said, adding that funds should be “extraordinarily careful.”

She said there is a “pretty bright line” between legitimate research and insider information and crossing it “absolutely undermines confidence in the integrity of our marketplace.”

In another article, Katya Wachtel of Reuters reports that Schapiro doubts SEC will ban short-selling:

The Securities and Exchange Commission is unlikely to join the European Union in imposing another ban on short-selling, SEC Chairman Mary Schapiro said on Thursday.

"Never say never, but it is hard for me to imagine the SEC ever doing a ban on short-selling again," Schapiro said at a hedge fund industry conference. During the financial crisis in 2008, the SEC limited traders' abilities to bet that certain stocks would fall.

Earlier this week, the European Union said it would regulate short-selling of stocks and bonds more strictly and ban "naked" credit default swaps on government bonds to help ensure more stability in financial markets. In a naked swap, the holder has no risk of financial loss if the underlying security falls.

Schapiro was the keynote speaker at a conference sponsored by the Managed Fund Association, one of the most prominent lobbying groups in the nearly $2 trillion hedge fund industry.

The SEC chief also discussed insider trading in the hedge fund industry, and the controversial use of so-called expert networks by traders and portfolio managers. Expert networks match industry experts with fund managers to help them understand companies better.

The SEC and other government agencies have investigated abuses in the use of expert networks -- including the sharing of non-public information -- and several arrests and convictions have resulted in the past year.

"There is nothing wrong with doing tremendous due diligence and research to understand a stock," Schapiro said. "But there is a line, and I think it is a pretty bright line."

She said the SEC is currently involved in several cases.

"Insider trading is absolutely not a victimless crime," she said.

Schapiro said the SEC would vote next week on a proposal for SEC-registered investment advisers to work with funds and report information -- including assets under management, use of leverage and trading positions -- to the commission periodically.

While the data would be kept confidential, hedge fund managers are nervous that the information would reveal their highly classified and often profitable trading strategies.

In February. the Managed Fund Association sent a letter to regulators saying that "it is highly unlikely that any hedge fund is systemically significant at this time." Therefore, the industry should not be the target of increased scrutiny and reporting obligations, it said.

The SEC already started investigating one powerful hedge fund, Steve Cohen's SAC Capital, to examine whether the fund used insider information to profit from Johnson & Johnson's takeover of Cougar Biotechnology Inc in 2009. The civil inquiry is also looking at whether an "expert network" business that is part of an investment bank leaked nonpublic information to traders.

I won't comment on the specific case except to say this: in the financial services industry, hedge funds have first dibs on any information that gives them an advantage over other investors. Why? Because they generate the most fees for investment banks and thus are at the top of the client food chain when it comes to sharing material information. This is why I urge all pension funds to reevaluate their relationships with hedge funds. Most of these funds are charging 2 & 20 in management and performance fees, selling beta as alpha, and they're not sharing important information with their clients. And I'm not talking about "insider trading" information, just normal information like which sectors and stocks they're overweighting and why. Too many pension funds are way too timid when dealing with hedge funds.

As far as the SEC is concerned, I think these new proposals are a bunch of smoke & mirrors. I've already covered Wall Street's "expert networks" and think they're full of it. Insider trading goes on all the time, and it's not just hedge funds engaging in this illegal activity. Sure, they threw the book at Raj Rajaratnam, but that won't deter other idiots from engaging in insider trading. All they'll do is sharpen their skills to go undetected, which is very easy to do.

But what about this ambitious project to inspect the quarterly filings of firms managing over $1 billion? While that seems intelligent, the reality is that it's fraught with potential pitfalls. Even I have been hoodwinked looking into quarterly filings of elite funds. For example, look at the top holders of Trina Solar (TSL) as of June 30th, and you will see Maverick Capital, one of the elite hedge funds I track (click on image to enlarge):

Had you bought shares of Trina Solar (TSL) blindly six weeks after the end of the quarter, when top holders were disclosed, you would have gotten your ass handed to you. Elite hedge funds and other elite funds know people look into their quarterly filings and often use that to their advantage, either shorting the stock or going long a stock. The point is analyzing data from large hedge funds is not as easy as it seems and unless the SEC has extremely competent people doing this, and pays them competitive wages, they won't be able to decipher all the data.

[Disclosure: I trade solars and am currently long Trina Solar and believe investors should take a hard look at all solar shares after the Q3 solar slaughter. Chinese solars and Chinese shares have been clobbered with the Euro crisis and rumors of an impending Chinese economic slowdown. Moreover, US solar firms have filed anti-dumping complaints against Chinese solar firms, but China slammed these complaints.]

And L/S Equity funds are easy; wait till you see the volume of data coming from global macro funds engaging in all sorts of complex trades using OTC derivatives. The SEC and other global regulators should seriously consider forcing all hedge funds to use managed account platforms that are supervised by central agencies (central banks?) and staffed with extremely competent people that know what they're doing. Only then will they be able to aggregate all the data of complex trades and see patterns of systemic risk. And even that isn't a given but this proposal should be given some serious thought. The cost will be low (pooling assets to lower cost) and all hedge funds should be part of it, not just those managing over $1 billion.

As far as the ban on short-selling, I agree, it will have the opposite effect, but I am still perplexed as to why the SEC allows naked short-selling to take place. If a fund doesn't own the shares or bonds, they shouldn't be allowed to speculate. Some of the wild gyrations I've seen in the stock and bond market are directly related to naked short-selling and high frequency trading. The SEC has a history of covering up Wall Street crimes and I'm afraid that they are just blowing smoke in our face with all these new proposals. On that note, I leave you with a couple of excellent Morningstar interviews with Vanguard founder, Jack Bogle, who says that speculation is dwarfing investing. Listen to what he says and think about how it will impact pension funds and other long-term investors (click on refresh if videos do not load).

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