New Dawn For Hedge Funds If Ad Ban Lifted

Terry Flanagan

President Barack Obama’s ‘Jobs Act’ is expected to be signed into law next month. The securities-law rollback would lift long-embedded marketing restrictions on private markets, giving hedge funds and private equity managers the ability to advertise to public investors in the mass markets.

Two decades ago, the hedge fund industry was known for its ‘Wild Wild West’ culture as they were largely unregulated and available to just the world’s wealthiest investors. In recent years, hedge funds have diversified their clientele by opening up to more mainstream investors, along with an industry push to increase transparency, due diligence and operational excellence.

“This continues a trend toward convergence of financial services products,” said Patrick Morris, senior managing partner at Hagin Investment Management. “The mutual fund and hedge fund worlds are colliding and they are marketing increasingly to the same clients.”

As transparency increases, the push to widen the hedge fund appeal is “positive” for the investment community at large, according to Evan Rapoport, chief executive of consultancy HedgeCo Networks.

Investment vehicles such as UCITS (Undertakings for Collective Investment in Transferable Securities) funds, which harbor daily liquidity requirements, are moving the alternative investment community toward having “transparency mandates that require funds to report holdings”, according to Rapoport. Still, for some, such vehicles may mirror mutual funds, which will never have the same appeal as hedge funds.

“Ultimately, the appeal of hedge funds is outstanding risk adjusted returns,” said Phil Goldstein, co-founder of fund of funds, Bulldog Investors. “In other words, they have demonstrable edge over mutual funds.”

For Morris at Hagin, a positive spin on the hedge fund industry is long-needed after recent years of scandals, even if such a spin steers hedge funds into mainstream territory.

“The exotic nature of hedge funds, a secret club of super-high net worth investors and institutions that consistently generate above average returns, is simply not the industry today,” he said. “Going into advertising and taking a very public image will increase the scrutiny and continue to demystify the industry.” He noted that hedge funds won’t lose their appeal, but rather will make it easier for investors to compare performance and fees.

“Their appeal will be lost if there is another big set of scandals created by false advertising, overstating performance or failure to disclose risks and fee,” he continued.

Yet, how will large wielders of capital, such as institutions, feel about hedge funds opening their doors to the same investments that have been historically in their wheelhouse? Morris thinks that large end-investors won’t react much to the Jobs Act, except that they will conduct a thorough review of their client confidentiality documents.

“An advertisement that was able to exclaim the virtues of a fund based on the names of its investors might make end-users a bit more shy,” Morris told Markets Media.

While retail investors might be enjoying a better taste of what hedge funds have to offer, sell-side service providers, such as brokers and third party marketing firms, might not be so welcoming towards the Jobs Act, which is designed by Obama to get Americans back to work.

“Hedge funds will become less reliant on third party marketers because they are now able to address a much larger audience and attract capital in ways that they never had access to prior,” Rapoport said.

Other market participants feel that the new mandate to advertising will propel other sell-side player, such as brokers, forward.

“It might take a while to get over the liability concerns but I can certainly see them [brokers] organizing conferences and having hedge fund platforms through which sophisticated investors can access hedge funds,” said Goldstein at Bulldog Investors. “That could be a win-win because a reputable broker will want to be associated only with reputable hedge funds.”

While the new rule may also help spike the rate of hedge fund sponsorships on mainstream outlets, such as CNBC, Morris at Hagin is concerned that additional media hype will push investors into “hot dot” strategies.

“Given how low interest rates are and the product categories that have been most successful raising new money lately, I really worry that the investor will, once again, fall victim to chasing the ‘hot dot’ on the performance matrix without considering the real value of diversification and asset allocation,” he told Markets Media.

“A large inflow into an exotic product creates a major liquidity problem, and any product category that has not suffered a large drawdown or liquidity crisis is set up for a catastrophic outcome. Confidence among retail investors in financial services products is at a historic low.”

Naturally, change ahead for the investment community will solicit a response from regulators, who have yet to comment on the Jobs Act.

Upon Congress’ first approval of the act, there was a proposed clause that addressed the way fund managers must internally qualify investors, according to Rapoport at HedgeCo, who cited that regulation will probably “increase as a result of this type of broad marketing”.

“Currently, an investor simply has to agree that they are accredited and sign off in the funds subscription documents as to how,” he told Markets Media. “Early discussions around this topic centered on requiring either internal or third party verification of the accreditation status of that investor, which would be a big change in the approval process.”

In addition to qualifying investors, reporting performance will also be a challenge for hedge funds in the new open era, noted Morris at Hagin.

“If the numbers are in anyway questionable, it would be very unwise to publish them,” he said. “Most hedge funds don’t have the same structure as a mutual fund, so their numbers are more subject to accounting opinions on valuation. The SEC [Securities and Exchange Commission] will initially have a lot of comments on advertisements and there will be many attempts to get the compliance standards codified through precedents of enforcement action.”

As hedge funds grow in numbers, it remains to be seen which ones will advertise. Perhaps the largest will be slowest to react, according to Morris.

“The largest may not wish to do much advertising at all since their track records are longer, more complicated in terms of valuation and audit and therefore more likely to bring about negative criticism or enforcement action,” he said.

Apart from the difficulty of disclosing information, Goldstein of Bulldog believes that “legitimate” hedge funds are “not going to use hard sell advertising since that will turn off sophisticated investors, but rather use targeted marketing to institutions or high net worth investors”.

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