The SEC is expected to trot out as early as July 5 the specific regulations addressing how hedge funds will be able to advertise and overtly market under new rules contained in the new Jumpstart Our Business Startups (JOBS) Act. The risk of substantial losses to unsophisticated investors – from both bad-intentioned scammers and honest, but small and risky hedge funds in need of cash – is likely to be immense.
Officially, industry honchos are in favor of the changes. The Hedge Fund Association, a trade group that looks out for the interests of hedge funds, service providers and investors, recently fired off a press release asserting that “liberalized advertising and solicitations rules ... would help hedge funds raise assets and encourage emerging managers to continue to enter the industry.”
The HFA also asked the SEC for clearer rules to verify that potential investors are in fact accredited.
“We believe this prohibition has unnecessarily limited the methods by which issuers can reach sophisticated investors,” states BlackRock, a major sponsor of hedge funds and private equity funds, in a May missive. “We believe private funds such as hedge funds and private equity funds can be important sources of diversification in an investor’s portfolio and, therefore, should be readily accessible to investors who are eligible to invest.”
The idea behind the provision to let private partnerships that provide much less information than mutual funds to tout their products to millionaires is that it would help small, fledgling investment firms grow and flourish, which, of course is the goal of the JOBS Act — to boost growth of small businesses, startups and entrepreneurs.
And when it comes to hedge funds, it looks like these small funds need a lot of boosting and spurring. For recent industry data suggest that investors are not too keen on small hedge funds.
For the past few years HFR and other scorekeepers have been pointing out that most new money has been flowing into the largest hedge funds — those with more than $5 billion under management. According to BlackRock, in 2011 about 85 percent of new money went into hedge funds with more than $1 billion and 71 percent of the money went to funds with more than $5 billion.
This phenomenon became more exaggerated in the first quarter of this year when $18.3 billion in new capital was invested with firms with greater than $5 billion in AUM, while firms managing less than $5 billion experienced a combined net outflow of nearly $2 billion for the quarter, according to HFR.
That’s outflow, as in “get me out of these little funds.”
“The flight to size continues for hedge fund investors,” says Jed Alpert, Managing Director of Global Marketing at PerTrac, in a press release announcing the results of its own study that found that single-manager hedge funds with greater than $1 billion under management account for just 3.9 percent of reporting funds but control about 60 percent of the total single-manager hedge fund assets. “Investors continue to view larger hedge funds as a better, safer bet.”
Also, more and more institutions moving into hedge funds. And their sheer size and need to see a deep management infrastructure will nudge them to the larger funds.
Never mind that a recent study of more than 20,000 funds by Imperial College of London found that smaller hedge funds outperformed larger funds over the past 16 years.
PerTrac also found that in recent years small hedge funds have regularly outperformed mid-size and large funds, and young funds outperform older ones. Until 2008, small funds have consistently beaten mid-size and large funds, according to the study. But in 2008 — the only negative year for any of the sized-based fund indices — small funds were the worst performers. In 2009, small funds came in second behind mid-size funds in performance. Young funds have outperformed both mid-age and tenured funds in 13 out of the last 15 years.
But there is fresh evidence that the very wealthy — and the group most likely to invest in smaller, fledgling funds — is losing interest in hedge funds. According to the Institute for Private Investors’ Annual Family Performance Tracking Survey, ultra-high-net worth investors have decreased their allocation to hedge funds in the past year. At the same time, 45 percent of respondents increased their allocation to commodities, 31 percent to real estate and 22 percent to private equity.
Why is all this significant to the discussion? Well, for one thing the largest hedge funds — which typically require a $5 million minimum investment — are already flush with assets and in many cases long waiting lists. So, they are not likely to start advertising to institutions. Except, maybe, with image ads — say emblazing their hedge fund logo on the outfield wall of a baseball team they may own.
Rather, when it comes to pushing hedge funds, it looks like the funds that will need to advertise are those that will be trying to reach a group of investors that is becoming increasingly resistant to the asset class. These hedge funds will need to dazzle them with all of the same slick succinct and many times slimy antics used by the same people who bring us the latest round of ads for political candidates and prescription drugs.
Not encouraging.
Sure, the potential targets are supposed to be ‘sophisticated investors’ under the accredited investor rules. But — as I’ve stressed in the past — just because you have been fortunate to amass a net worth of at least $1 million does not make you sophisticated about investment matters. And those so-called sophisticated investors whose net worth squeaks by the legal threshold stand to be vulnerable to scams, for they are the very wealthy wannabes.
More ominous, PerTrac points out in its study that while small funds have generally outperformed mid-size and large funds, their risk profile remains the highest and simulation models suggest this trend could continue, as well.
The HFA does make one good argument for allowing hedge funds to advertise. “The lack of a clear definition of a solicitation has created confusion about what hedge fund managers can disclose in their marketing materials, at conferences or in the media,” HFA president Mitch Ackles points out. Afterall, some managers like Greenlight Capital’s David Einhorn and Pershing Square’s Bill Ackman will speak at conferences and spend a lot of time on CNBC while others won’t even confirm their AUM, hiding behind alleged lawyer advice.
However, when the SEC issues its official regulations on the matter, I hope it requires firms to include all of the potential side effects, as they do with drug ads: past performance is no indication of future performance; past performance data may have been shared with a team that included more senior people; fees are exorbitant and can greatly impact performance; manager gets his performance whether or not he outperforms low fee paying index funds; manager may not necessarily employ the investment strategy he promises in his offering documents.
Afterall, even Ackles himself concedes an unintended but not unexpected consequence of hedge fund advertising will be an increase in fraud. “You will see ads from nefarious characters,” he concedes, stressing this happens in any business or industry. “There is another Bernie Madoff waiting to happen.”
And once again it will be the little big guy — the barely wealthy — who will become a majority of the victims.
