Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Hedge Fund Frauds

In August 2005, investors in the Bayou Group of hedge funds in the United States discovered that the $400 million of assets that Bayou purported to have did not really exist. For several years, the accounts of the fund had been completely falsified. Since then there have been many proposals for tighter regulation of hedge funds.

Many of these proposals which try to make hedge funds look more like mutual funds do not make sense. Academic research going back several decades has consistently shown that
buying an index funds (or perhaps even better, an Exchange Traded Fund or ETF) out performs
actively managed mutual funds. Research has also generally shown that by and
large those who beat the market in any single year are not likely to do
so year after year on a consistent basis. In short (apart from ETFs)
mutual funds provide a completely useless asset class – they do not
expand the investment opportunity set for investors.

Basically, the regulatory
restrictions on leverage, derivatives and short selling mean that all
mutual funds are just more expensive versions of an ETF.
Like branded gasoline, mutual funds are a branded commodity where one uses
expensive marketing efforts to demonstrate that one’s product is
somehow different from (and superior to) the competition.

Academic research on hedge funds is more recent and perhaps therefore
less conclusive. But the limited evidence that is there suggests that
hedge funds do expand the investment opportunity set. They provide
absolute returns that are weakly correlated with the market. Risk
compensation per unit of beta is therefore excellent, and risk
compensation per unit of standard deviation is respectable. This makes
them a useful addition to the portfolio of many investors.

If we defined investor protection in objective finance theory terms
therefore we should make mutual funds more like hedge funds rather than the other way around.

So what is the right regulatory response to Bayou? Jenny Anderson has an interesting proposal on this subject (“A Modest Proposal to Prevent Hedge Fund Fraud”, New York Times, October 7, 2005) which requires only a simple modification to the SEC’s registration requirememt for hedge funds that comes to effect in February 2006.

“The [SEC] should ask for two other pieces of information: the name of the accountant responsible for auditing the fund and the name of the broker-dealer through which the hedge fund trades – including whether that broker-dealer is affiliated with the hedge fund.

These issues were critical red flags in the fraud at Bayou. Its auditor, Richmond-Fairfield Associates, was a fake accounting firm created to produce false audits of Bayou. Bayou Securities was the broker-dealer through which trades were made to create real commissions for Bayou’s principals, who used them as compensation on top of 20 percent incentive fee they made on their fraudulent returns.”

This is perhaps the most sensible response to Bayou.

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