Alpha-centric investing refers to more than just portable alpha. As we have reported on this blog, it encapsulates new operational infrastructures (UMAs), new fee arrangements (performance fees with benchmark hurdles / fee-per-alpha), new metrics (ranking funds based on alpha instead of absolute returns), new organizational structures (small teams of alpha producers), and new advisory models (fee-based vs. commission-based). A recent investment newsletter highlights another domain that is impacted by this simple idea: regulation.
In his January 26th weekly newsletter Accredited Investor author John Mauldin covers the SEC’s proposed new hedge fund investment eligibility rules (which, as an aside, come attached to new anti-fraud provisions that confirm it is still illegal to break the law).
Currently the minimum total net worth required to invest in private offerings such as hedge funds in the United States is $1 million. (Spent everything but still have a great job? No worries as long as your income is (individually) $200,000 or (with spouse) $300,000). Collectively, these individuals are known as accredited investors.
The SEC is now proposing to raise the net worth threshold to $2.5 million â€“ and require all of it to be liquid (i.e. you can’t count your house or your beloved wine collection). As a result, calculates the SEC, the number of US household’s eligible to invest in hedge funds will drop from 8.5% to 1.3% (about the proportion that was eligible the day the initial rule came into effect in 1982). These households would hereafter be known as accredited natural persons.
The assumption underlying this means test is that the rich are more sophisticated investors than the non-rich (or alternatively that the rich can afford the risk).
Essentially, the SEC wants to protect us from investing in risk factors we don’t understand. According to the new rule:
Not only do private pools often use complicated investment strategies, but there is minimal information available about them in the public domain
Quoting from his 2003 Congressional testimony on the matter, Mauldin makes an impassioned argument against net worth/net income as a proxy for sophistication. He notes that:
…the rich have a considerable advantage in growing assets for retirement, in that they simply have more assets to begin with. They should not also have an advantage in better investment choices.
He advocates a plan being floated by Democrats whereby marketing restrictions would be eased for those hedge funds willing to submit to SEC scrutiny – creating a middle ground between a private investment pool and a mutual fund. (Such a plan would address our concern about the current situation where registration provides no regulatory teeth – only marketing pizazz).
In Mauldin’s plan, hedge funds would have to disclose no more information that they commonly do today (risks, strategies, fees, personnel, management etc.) and could undertake any investment strategy they wished. For the first 7-10 years of a hedge fund’s life, its investors would need to pass what Mauldin refers to as a required level of investment sophistication. After that, they would be on a level playing field with mutual funds.
Mauldin says his proposal would be a boon for the industry since it would open up a massive new market for them. It would also benefit investors, he says, as fees would come down just as the outrageously high fees of commodity funds came down in the ’90s as more funds became available.
An Alpha-centric Solution
Mauldin’s proposal provides a framework into which more targeted tests might be placed. We propose one such test below.
We agree that hedge funds should be transparent with regard to strategies, fees, management, potential conflicts etc. But we think that the SEC’s plan misses a critical additional criteria: the proportion of an investor’s portfolio exposed to non-market risk.
Indeed, the SEC seems to have a hunch they are missing something:
Commenters are also solicited for their views on whether (and why) we should use a standard based solely on the objective net worth and income tests
And Mauldin himself argues that hedge funds should make up a modest, but significant portion of an individual’s portfolio.
No one would suggest that all or even a significant proportion of an investor’s portfolio should be in hedge funds. But a reasonable diversification is appropriate.
We submit that most individual investors are already exposed to de facto hedge funds. After all, mutual funds contain two broad categories of risk and return: market risk (beta) and other risks (alpha). While we commonly assume that the other category is driven by manager skill, we are now learning from the hedge fund industry that what was once thought to be skill might actually be an exotic form of non-market risk. These are the very non-market risks from which the SEC seeks to protect hedge fund investors.
The alpha in a garden variety mutual fund is as complex and unknown as the most opaque of hedge funds. Worse yet, a mutual fund investor is not clear exactly how much of her risk and return is driven by the market and how much is driven by what amounts to an embedded hedge fund. But such a high proportion of most mutual funds’ risk and reward are derived from beta, that the SEC tends not to lose any sleep over the “other” risks. The market, at least, is the devil you know.
In this way, non-market risk factors – be they idiosyncratic manager skill or some exotic beta â€“ play a small but significant role in nearly everyone’s portfolio. Using the same logic, we don’t see why hedge funds can’t also play a small, but significant role in everyone’s portfolio. If the SEC wants to force mutual funds investors to expose themselves primarily to market risk, then why doesn’t it just mandate a proportion of net worth that must be exposed to it. (The proposed rule makes only one reference to limiting the proportion of net worth that can be exposed to hedge funds: 50% of net worth jointly held with a spouse.)
Too hard for people to grasp? We simply don’t buy the argument put forth by many professional advisors that individual investors are too uneducated to get it. John Mauldin is absolutely right when he says:
There is no real reason to believe that smaller investors cannot understand hedge fund strategies, if properly explained. If investors can be assumed to understand the risks involved with individual US stocks, foreign stocks, commodity futures, currencies, options, mutual funds, and real estate, not to mention a host of Reg D limited partnerships, then how can anyone suggest that hedge fund strategies are beyond the ken of investors?
Too hard for the SEC to police? Likely not. After all, the SEC is comfortable monitoring current net worth / net income suitability rules. Setting an annual hedge fund allocation limit for smaller investors of x% is a simple extension.
Mauldin concludes his newsletter with the following fanfare:
I believe it is time to change a system where 95% (and maybe soon to be almost 99%) of Americans are relegated to second-class status based solely on their income and wealth and not on their abilities.
We applaud his leadership â€“ with a nod to a more pragmatic and unique problem of his own: His weekly Accredited Investor newsletter is read by over a million people â€“ many of whom would no longer fit that category if the rule is adopted. To add insult to injury, Mauldin would also have to change the name if his newsletter to Accredited Natural Persons â€“ causing endless confusion in the naturist community.