Hedge funds are playing a big part in films and on the TV these days but their enduring bad press needs to be vigorously countered, say the AIMA’s Henry Smith and Russell Burt.
Once an industry which appeared secretive and opaque, the alternative investment funds industry now finds itself front and centre in the primetime news, movies and on TV. Recent movies such as “The Big Short” and Showtime’s “Billions” are just two examples of the popular appeal of the industry for the media.
The number of books published on hedge funds could fill a library. While these are very entertaining and, to a limited extent, informative, unfortunately there continue to be politicians and political candidates in the UK, the US and the EU who unfortunately tend to expound populist views that there is something inherently bad about hedge funds.
Populist myths claim they are secretive and only there to enrich the wealthy; they are unregulated, non-compliant and contributors to the global financial crisis; they cause job losses by asset-stripping companies; they are based in secretive offshore tax havens and do not pay their fair share of taxes; and that they perform poorly against major market indices. The mainstream media, by focusing on the excesses on Wall Street or the few instances where a major hedge fund has failed, unfairly hype these views.
These myths need to be dispelled. In recent years this has begun to happen as political candidates for high office in the US from both the Democrat and Republican parties and in Australia with investments in hedge and private equity funds in the Cayman Islands have answered their critics by simply highlighting that there is nothing wrong with these types of investments which are now well established investment products bought by institutional investors and pension funds the world over.
It is a tough ongoing challenge to change general public perceptions, but it is worth persevering as in many cases these views are not simply uninformed and just plain wrong but, more important, may also lead politicians and regulators to develop bad policy and disproportionate regulation to the detriment of those same voters and constituents they seek to protect or represent, and ultimately damage economies.
The Alternative Investment Management Association (AIMA) continues to work hard to educate politicians, regulators and journalists about what really goes on in the industry. AIMA’s excellent research papers pulled together in “The Case for the Hedge Funds: A Compendium of Thought Leadership Reports” and the upcoming “Transparent, Sophisticated, Tax Neutral: The Truth about Offshore Funds” are well worth reading.
Fight the good fight
Here are some of the key messages to help address these PR challenges:
The global financial crisis: blaming hedge funds for the global financial crisis was unwarranted. Official reports prepared for international regulators and various authorities acknowledged that hedge funds did not cause the global financial crisis—it was triggered by failures in the regulated banking industries. Even the largest hedge and private equity funds are neither ‘too big to fail’ and nor do they represent a systemic risk to the markets. Leverage in most typical hedge funds rarely exceeds one to two times assets (as opposed to as much as 40 times assets in the banking industry) and no hedge or private equity fund required a state funded bailout. Hedge funds in fact brought much needed liquidity to the markets after the crisis.
"Hedge funds are an integral part of the asset management industry and contribute to the economy in many positive ways."
The benefits to the global economy: critics claim that hedge funds serve no useful purpose and are merely vehicles for wild speculation, benefiting only the wealthy, often attacking currencies and shorting companies into oblivion or stripping jobs for their own profit.
The reality is different. Hedge funds are an integral part of the asset management industry and contribute to the economy in many positive ways:
Job creation and tax. Hedge funds have created an estimated 300,000 jobs globally, including 240,000 in North America, 50,000 in Europe and 10,000 in Asia-Pacific. They contribute a sizable chunk of GDP in countries where the industries are located. This in turn generates significant taxable revenue for governments. For example, in Europe taxable revenue is thought to be in excess of $8 billion; and that’s before you get to the knock-on benefits to other industries—real estate, restaurants, car dealers, etc—where these jobs are located and the consequential tax revenue generated.
While it might be seen as politically attractive to criticise the industry or seek to raise further tax revenues from the funds or workers in the industry, governments need to be careful that they do not reach a tipping point where their financial centres become uncompetitive and risk losing financial services business, with all the consequential effects for their economies.
Capital allocation. Hedge funds are useful capital allocators and providers of market liquidity. Prior to and since the crisis, the hedge and private equity funds have continued to step up to provide diversified funding sources to businesses to help them grow. They facilitate global capital investment flows into the major and developing economies and finance vital infrastructure projects and assets, such as commercial aircraft, ships, hospitals, roads and power plants in emerging market countries. Again, all of these are examples of how the industry helps economies create jobs and taxable revenues.
Short selling. Rather than being a problem, as some politicians believe them to be, short sellers in fact provide essential liquidity to the markets and can often be an early indicator of which companies or sectors of the economy are about to experience difficulties. Short selling gives investors an ability to hedge the risk of being invested on a long-only basis.
Not just for the wealthy. Much of the negative rhetoric assumes that hedge funds are simply for the wealthy or that they benefit only managers of the funds themselves, and ignore other major stakeholders. Securities laws in many countries may preclude non-accredited retail investors from investing directly in hedge funds, but about 30 percent of the over $2 trillion invested in hedge funds now comes from pension funds, which need to find ways to fund their growing pension deficits by investing in hedge funds.
So everyone, through the pension funds, indirectly benefits from hedge funds’ investments and much-needed portfolio diversification. Any politically driven increased costs, taxes or regulatory and compliance expenses have an indirect adverse consequence for the individual pensioners indirectly invested in those hedge funds.
Performance: market commentators unfairly criticise hedge fund performance by benchmarking performance to the long-only major market indexes. Most hedge funds are not invested in portfolios to match long-only market indexes in that way. Investors can buy index funds if they want to do that. Hedge funds provide alternative investment opportunities and hedged, risk-adjusted and less volatile returns.
In fact, according to a recent AIMA survey, hedge funds finished 2015 up 2.42 percent, beating equities and bonds on an absolute and risk-adjusted basis. Long/short funds may underperform a long-only index in a bull market as they have to pay for the hedges. Over the longer periods hedge funds have been proven to outperform many asset classes on a risk-adjusted basis. Long-only focused index investing carries significant performance risk and volatility.
Regulation and compliance: it is wrong for the media to say that hedge funds lack proper regulation and do not comply with the rules. That is simply not true. The vast majority of hedge fund managers are now regulated. Hedge funds domiciled in the Cayman Islands are also regulated. In addition, service providers around the hedge funds—investment managers, custodians, prime brokers, fund administrators and Cayman Islands independent directors—are often subject to regulation. Collectively, the hedge fund industry has already invested more than $3 billion on compliance and an AIMA/MFA/KPMG survey found that individually hedge funds spend anywhere from 5 percent to upwards of 10 percent of their operating costs on compliance. Governance in the hedge fund space continues to improve and a large majority of hedge funds now have independent directors on their boards.
Transparency: those who allege that hedge funds are secretive or non-transparent and based in offshore tax havens for nefarious purposes, ignore some salient facts. Hedge funds can be limited considerably by securities laws from divulging much information to the media on marketing. The reality is they must make numerous informational reports to their investors and regulators in the US and the EU, for example, by filing regularly Form PF and Annex IV information.
The identity of investors in Cayman is reported to international tax authorities such as the US Internal Revenue Service under the Foreign Account Tax Compliance Act (FATCA) and more widely under the Common Reporting Standard (CRS).
David Cameron, UK prime minister, in September 2013 said “I will make this point: I do not think it is fair any longer to refer to any of the overseas territories or Crown dependencies as tax havens. They have taken action to make sure that they have fair and open tax systems. It is very important that our focus should now shift to those territories and countries that really are tax havens. The Crown dependencies and overseas territories, which matter so much—quite rightly—to the British people and members have taken the necessary action and should get the backing for it.”
Tax neutrality: the Cayman Islands remains the leading tax-neutral fund domicile. This means that Cayman does not impose any “additional” layers of taxation upon the investors in a fund. It is important to understand the importance of the word “additional”. The investors still pay their relevant taxes, but not a duplicative level which would otherwise be imposed.
On a simple level, investors have a choice how to invest. They may purchase stocks, bonds, etc, directly or via a collective investment fund. The preference to use a fund vehicle stems from Modern Portfolio Theory (MPT) and the benefits of diversification along with gaining access to the skills of the portfolio manager to generate alpha. Funds are an extremely cost-efficient way to build a diversified portfolio. Using a tax-neutral fund ensures that taxation is correctly levelled on the investments made and by investors in their own jurisdictions on investment income and capital gains, ie, having a fund established in a tax-neutral jurisdiction ensures that a third layer of tax is not created.
The Cayman Islands government is often commended by the likes of the International Monetary Fund, the Financial Stability Board, the Financial Action Task Force and other governments for the way the Cayman Islands has promoted good governance and adopted international initiatives on anti-money laundering/know your customer (AML/KYC) and implemented good cooperation with international regulators (for example, in relation to the EU Alternative Investment Fund Managers Directive), as well as committing to and implementing tax transparency initiatives such as FATCA and CRS. The Cayman Islands’ AML/KYC laws are rated as good as those of many major OECD members. The 2013 Phase 2 Peer Review Report by the OECD Global Forum on Transparency and Exchange of Information for Tax Purposes gave the Cayman Islands the same rating as that given to the UK and the US.
Institutional investors recognise all this and, after copious due diligence, take comfort that the Cayman Islands investment funds in which they invest are established under internationally recognised legal principles which protect their rights and have been successfully tried and tested through even the most severe of financial crises.
These are a few examples of how the industry might address the current PR concerns and misconceptions. It’s important we continue to educate policymakers so that global regulation and tax policy is both workable and proportionate, avoiding unnecessary costs on institutional investors and the exclusion of pension funds from the world’s best alternative investment funds. Thousands of jobs in the industry and the wellbeing of millions of pensioners depend upon it.
This article represents the views of the authors alone and not Maples and Calder or Marbury Fund Services (Cayman). It is intended to provide only general information for the clients and professional contacts of Maples and Calder. It does not purport to be comprehensive or to render legal advice.
Henry Smith is a partner in the Investment Funds Group of Maples and Calder worldwide, an AIMA global council member and a director of Cayman Finance. He can be contacted at: email@example.com
Russell Burt is a principal of Marbury Fund Services (Cayman) serving as an independent fund director. He is a board member of AIMA Cayman. He can be contacted at: firstname.lastname@example.org
AIMA, Hedge funds, Henry Smith, Russell Burt, Cayman Islands