October 2018 ended with the hedge fund industry suffering its worst monthly decline since September 2011, according to the HFRI Fund Weighted Composite Index. Some commentators are predicting that 2018 will end with the hedge fund industry experiencing its worst annual performance since the failure of Lehman in 2008. This news comes on the heels of a disastrous decade for hedge fund performance. In the years following the financial crisis of 2007-2009, the S&P 500 consistently outperformed the hedge fund industry. Even Warren Buffet famously predicted that a basket of hedge funds would underperform the S&P 500 over a 10-year period from 2007-2017. He in fact won that bet as his basket of hedge funds earned 2.2 percent over that period while the S&P 500 earned 7.1 percent.

Such dismal performance should, however, be of minimal concern, because hedge funds are private investment vehicles that are restricted to the likes of high net-worth individuals and institutional investors that can presumably fend for themselves. Such investors are thus largely excluded from the investor protection guarantees under federal securities laws, and their losses should have a limited impact on the public.

However, pension plans, endowments, foundations, and others that act as fiduciaries (“Fiduciary Investors”) comprise the bulk of investors in hedge funds. Some experts have estimated that over half of the $3 trillion of assets in hedge funds come from pension plans and other retirement investments, while others have estimated that 66 percent of foundations and 83 percent of endowments are invested in hedge funds. Retail investor beneficiaries of Fiduciary Investors should theoretically be entitled to the panoply of investor protection guarantees under federal securities laws. Yet, they are denied these protections by loopholes in statutes that define Fiduciary Investors as being capable of protecting themselves. Pension plan beneficiaries, and other classes of retail investors, must therefore rely on Fiduciary Investor representatives to make optimal investment decisions on their behalf.

Investing in hedge funds is not necessarily irrational from an economic standpoint. In exchange for restricting pools to elite investors, hedge funds can access an entire universe of financial instruments and strategies that are inaccessible to its registered mutual fund counterparts. These innovative strategies can greatly assist pension plan trustees to diversify their portfolios. Hedge funds also tend to perform better during volatile and declining markets.

But given the pervasive evidence of subpar returns and excessive fees, many Fiduciary Investors seem to have made economically irrational decisions in continuously increasing their investments with hedge funds.  And the opacity of the hedge fund industry makes it difficult to challenge these decisions. Irrespective of whether hedge funds can earn superior returns under various market conditions, they are typically more expensive than mutual fund counterparts. Fiduciary Investors have further demonstrated substantial difficulties in understanding the complexities of hedge fund strategies and fees. Many have paid exorbitant amounts in “hidden” expenses related to unanticipated accruals of performance fees, costs associated with monitoring hedge fund investments, or portfolio company fees.  PEW Charitable Trust recently published a study that concluded that the 73 largest state-sponsored pension plans in the United States are paying approximately $4 billion in annual hidden fees.

By and large, economically irrational hedge fund allocations are enabled by the opacity of the industry. Hedge funds are not subject to the same disclosure obligations as registered investment funds since they are private entities. Pension plan trustees can effectively conceal the pervasive problems of underfunded plans by investing in an opaque industry that guarantees superior returns at some obscure time in the future, even if those returns never materialize.  Investing in hedge funds is also a politically safe approach because the investments are not easily scrutinized by beneficiaries or the public at large. Having the freedom to invest in opaque markets effectively makes it easier for Fiduciary Investors to shirk their fiduciary duties.

These misallocations are potentially costing retail investors billions of dollars in retirement benefits. They further result in a troubling wealth-transfer mechanism from the bottom 90 percent of income earners to the top .01 percent. Employees across the country have effectively transferred a sizable portion of their wealth to the highest income earners, without receiving above-market returns. Hedge fund advisers have among the highest incomes. During certain periods, the top 25 hedge fund advisers earned more than all kindergarten teachers combined within the United States, while similarly exceeding the combined income for all of the CEOs within the S&P 500.

My recent article defines this problem as the hedge fund conundrum. It uses an historical institutionalist lens to examine how lawmakers may have enabled the retail investor harms discussed herein. A theoretical lens of this nature provides a novel approach for delineating processes and patterns behind the development of the law over prolonged periods. Identifying these patterns provides additional guidance in developing effective strategies to advocate for preferred institutional changes.

Subsets of historical institutionalism such as conversion and drift provide useful models for examining how lawmakers eroded  concepts of “publicness” under federal securities laws. Public offerings originally encompassed those open to retail investors and therefore subject to extensive regulatory oversight.  According to Professor Kathleen Thelen at MIT, conversion generally occurs when political actors redirect laws and policies to meet new purposes that stray from their original intent.  In a similar vein, lawmakers altered the public/private dichotomy under federal securities laws  by adopting regulations that specifically defined Fiduciary Investors as belonging to the elite class of investors that could protect themselves despite the fact that retail investors often comprise the bulk of their underlying beneficiaries. With respect to drift, Professor Jacob S. Hacker at Yale University generally describes this concept as the failure of lawmakers to update laws and policies to respond to changes that naturally occur in an evolving economy.  In exploring how drift further contributed to these harms, lawmakers then failed to revise such Fiduciary Investor carve-outs  to accommodate evolving notions of publicness brought about by the exponential growth  of the hedge fund industry.

My article concludes with preliminary thoughts on a two-pronged solution. The first prong suggests creating a regulated market for “hedge fund-like” strategies by loosening the trading restrictions that currently apply to registered mutual funds. This would increase the extent to which innovative opportunities for diversification and wealth maximization by Fiduciary Investors could  be accessed in a transparent market subject to extensive regulation and oversight by the SEC. Scholars have also noted that increasing competition in this manner is often the best safeguard against excessive fees. The second prong calls on Congress to exclude Fiduciary Investor access to private funds altogether if the first prong proves ineffective. Overall, researchers and regulators should explore evolving notions of publicness under federal securities laws given the speed with which innovation alters the effects of these laws in a dynamic and growing economy.

ENDNOTES

1. Hedge Fund Research. Inc., HFRI Falls in October as Equities Suffer Steep Losses, https://www.hedgefundresearch.com/news/hfri-falls-in-october-as-equities-suffer-steep-losses (Nov. 7, 2018).

2. Akin Oyedele, Warren Buffett has won his $1 million bet against the hedge fund industry, Insider (Jan. 2, 2018), https://www.businessinsider.com/warren-buffett-wins-million-dollar-bet-against-hedge-funds-2018-1.

3. Barry Ritholtz, Hedge-Fund Mediocrity Is the Best Magic Trick, Bloomberg (Feb. 15, 2018) https://www.bloomberg.com/view/articles/2018-02-15/hedge-funds-underperform-yet-keep-attracting-pension-fund-money.

4. Preqin, Largest Hedge Fund Investors Hold Outsize Influence (March 28, 2018) http://docs.preqin.com/press/HF-Investors-Mar-18.pdf.

5. Brink Lindsey & Steven M. Teles, The Captured Economy: How the Powerful Enrich Themselves, Slow Down Growth, and Increase Inequality 25 (Oxford University Press 2017).

6. Philip Bump, The 25 top hedge fund managers earn more than all kindergarten teachers combined, Post (May 10, 2016) https://www.washingtonpost.com/news/the-fix/wp/2015/05/12/the-top-25-hedge-fund-managers-earn-more-than-all-kindergarten-teachers-combined/?noredirect=on&utm_term=.5393c997cb47.

7. The Pew Charitable Trusts, State Public Pension Funds Increase Use of Complex Investments 2 (April 12, 2017), available at http://www.pewtrusts.org/en/research-and-analysis/reports/2017/04/state-public-pension-funds-increase-use-of-complex-investments#2-important-terms.

8. Kathleen Thelen, How Institutionalism Evolves: Insights from Comparative Historical Analysis in Comparative Historical Analysis in the Social Sciences (James Mahoney & James Rueschemeyer eds., 2003).

9. Jacob Hacker, Privatizing Risk without Privatizing the Welfare State: The Hidden Politics of Social Policy Retrenchment in the United States 98 American Political Science Rev. 243-260, 246 (May 2004).

10. Jonathan Rothwell, Make elites compete: Why the 1% earn so much and what to do about it, Brookings Institution (March 25, 2016), https://www.brookings.edu/research/make-elites-compete-why-the-1-earn-so-much-and-what-to-do-about-it.

This post comes to us from Professor Cary Martin Shelby at DePaul University College of Law. It is based on here recent article, “How Did We Get Here? Dissecting the Hedge Fund Conundrum Through an Institutional Theory Lens,” available here.