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Penny Herscher

Penny Herscher

Posted January 23, 2009 | 08:31 PM (EST)

Hedge Fund Ethics and How They'll Lead to More Regulation


Hedge funds took a battering 2008 - and as they have been battered by the storm two questions of "right" and "wrong" have been coming up that show that there are ethical codes at work here, but no agreement on what the "right" answer is.

Some background: There are about 10,000 hedge funds open now, down 4% over the year, but still managing $1.6 trillion dollars. About two thirds lost money in 2008 and of those that did are down an average of 29%. This matters because hedge funds are typically paid both on : 20% of the gains - and on : 2% of the assets under management. High fees (see Henry Blodget's explanation of the fees here) for which investors expect to get a consistent above market return (until hedge funds systemically move the market, which they clearly do now...). And, more importantly, the hedge fund managers must recoup their losses before they can start collecting fees on the profits again. This could take years - which would mean the managers were only collecting 2% - mouse nuts for many of these guys.

And here's where the "ethical" questions come up:

If your fund is down and you know it is going to take years to recoup the losses and get paid at 20% of profits again do you:

a) stay with the fund until you have recouped the losses and made your investors whole - working for "psychic income" as Kenneth Griffin of Citadel fame told the New York Times or
b) leave - retire, switch to a new fund, start a few fund - basically start again? If you had many years of excellent performance before this one terrible year you may well be able to raise another fund.

In the first case there's a moral high ground to climbing back out and keeping your commitments to your investors, but maybe the second case makes sense if you can't climb back out from that fund. Maybe you can't keep your key players or your strategy no longer works and your investors are better off with you closing the fund and returning their money.

The second question is whether to allow investors to take money out of the hedge fund. Again hedge funds are not acting consistently. One of your investors wants to pull his money out - do you

a) allow him to knowing that doing so could hurt the remaining investors that are staying in because you'll be forced to selling into a falling market? Much of the volatility in November and December was redemption selling as hedge funds were force to liquidate equities and debt so investors could withdraw funds. Or do you
b) tell investors they can't take their money out and you are going to hold it until it is a more stable time to sell?

Again this is a current raging debate in the hedge fund world that takes on the ethical language of right and wrong. I know I'd want to be able to get my money out if I'd lost faith in a fund!

Managing money in this market is incredibly difficult - some would say it's a crap shoot - and hedge fund performance matters because not only rich people invest in them -- institutions invest in them. Some portion of many regular American's retirement income is invested into hedge funds through their company or state pension funds. Given the current lack of regulation and transparency, how the hedge funds can move the market, and these grey questions that are unresolved even within the hedge fund community, it's a given that the new administration is going to put in more regulation.