Hedge funds have long lingered in a gray area of regulatory oversight. Because only so-called “sophisticated” investors are allowed to invest in these often high-risk, high-reward offerings, regulators have traditionally followed more of a caveat emptor approach to oversight. In fact, until 2010, it wasn’t even clear which agency had regulatory power over hedge funds, notes Colleen Honigsberg, who was recently awarded a PhD at the Columbia School of Business.
Enter the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. It significantly changed the regulatory landscape for such funds, making clear that large hedge funds would be under the supervision of the Securities and Exchange Commission (SEC). Since then, however, the SEC and financial industry leaders have been butting heads over not just how to regulate hedge funds but also whether oversight is even necessary.
Honigsberg’s recent paper, “The Surprising Benefits of Mandatory Hedge Fund Disclosure,” which was supported by a grant from the Chazen Institute for Global Business, sheds new light on the subject. “My findings provide preliminary evidence that mandatory regulation has reduced financial misreporting at hedge funds — and that the decrease is driven by disclosure requirements,” she says.
Honigsberg’s research took advantage of an unusual series of changes in securities laws between 2004 and 2010 that allowed her to measure the impact of regulation on a group of hedge funds. In 2004, a new SEC rule required a number of previously unregulated hedge funds to register with the Commission, thus subjecting these funds to the disclosure and enforcement rules associated with registration. This SEC rule, however, was later struck down by the courts, allowing the funds to remain unregulated until Congress stepped in with Dodd-Frank and reinstituted a similar registration requirement.
The repeated changes in regulation, and resulting gap between periods of disclosure requirements, allowed Honigsberg to identify a direct link between the lack of regulatory controls and an increase in financial misreporting within this subset of hedge funds. (For more on how she measured misreporting, see below.) By comparing misreporting before and after regulation for the funds affected by the changes in the law with incidences of misreporting at funds that were not affected by that change in the law (the control group), Honigsberg was able to isolate the impact of regulations on financial reporting.
By the Numbers
Mining data from thousands of hedge funds, Honigsberg used three different analyses to determine the level of misreporting at each hedge fund:
- For the first measure of misreporting, Honigsberg looked at the number of times monthly returns were reported as just below zero compared to the number of times they were just above zero. “Monthly returns tend to follow a smooth distribution over time,” she says. “But fund managers have strong incentives to avoid reporting losses so they find ways to turn tiny losses into tiny gains.”
- For example, if a portfolio includes hard-to-value assets such as derivatives, fund managers have some discretion in how to determine a derivative’s current value. A small change in an assumption, such as whether a future dividend will be 3 percent or 4 percent, can lead to changes in the value the hedge fund records for the derivative. “You can use those changes to make a small change to the value of the asset,” she says. “As long as assumptions are reasonable and consistent across different models, auditors will be hard-pressed to push back—and may not even notice.”
- The second measure, “cookie jar accounting,” involves fund managers accumulating reserves during good times and then adding them back into the portfolio during bad times to inflate reported results.
- Finally, her third measure tests for conformance with Benford’s Law. Benford’s Law examines whether monthly returns follow a predictable distribution based on a logarithmic curve. It predicts that the first digit in monthly returns reported by hedge funds should be a one 30.1 percent of the time, a two 17.6 percent of the time, and so on. Honigsberg found that 32 percent of the funds in her sample that were identified by the SEC as fraudulent deviated from Benford’s law. In comparison, only 18 percent of the general hedge fund population strayed from the predictable pattern.
Across all three analyses she found that misreporting of financial returns rose significantly during periods without disclosure requirements. “My research shows that simply by hiring a compliance officer and making internal reforms to try to conform to disclosure requirements improved reporting,” she says.
Honigsberg is quick to make a distinction between “misreporting” and out-and-out financial fraud. Fraud implies intent, and her analysis wasn’t designed to make that assessment. Still, the research provides compelling evidence that regulatory oversight and financial disclosure requirements play an important role in protecting investors. They also support the argument that hedge funds should be regulated, she adds.