Shortcut Navigation:

End Special Treatment for Hedge Fund Billionaires

February 24, 2016

One of the primary lessons of the 2008 financial crisis was that systemic crises begin in opaque, highly leveraged “shadow” areas of financial markets. While the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 made significant progress in addressing regulatory failures prior to the crisis, it did not do enough to address the problem of hedge funds.

It is time to recognize the very real risks that hedge funds pose. It is time to put an end to the regulatory forbearance and special tax breaks enjoyed by the hedge fund industry. And it is time for pension investors to re-evaluate their investments to protect the retirement savings of working people throughout the country.

Hedge Funds and Systemic Risk

The risks posed by hedge funds are as varied as the investment strategies they pursue. Long Term Capital Management, whose 1998 near-failure forced the Federal Reserve Bank of New York to orchestrate a restructuring, is a prime example of the risks that can occur when a highly leveraged hedge fund falls on hard times.

Hedge Funds and Short Termism

Strategies employed by activist hedge funds can put pressure on companies to engage in financial engineering or cost-cutting measures that cause stock prices to go up in the short term but undermine the long-term viability of target companies.

Hedge Funds and the Puerto Rican Crisis

Today, vulture hedge funds are central players in the crisis in Puerto Rico, which has $72 billion in debt and not enough to make the required payments. As a U.S. territory, it cannot restructure its debts in bankruptcy. Puerto Rico, in recession for the past decade, has been forced to cut public services, close schools and lay off workers. Its pension fund is expected to run out of money by 2020.

Puerto Rico must restructure its debt as part of any strategy to return to economic growth. But hedge funds, which hold as much as half of the public debt, are opposing legislation that would allow Puerto Rico to file for bankruptcy. The hedge funds, instead, are pushing for further austerity measures—an immoral position considering nearly half of Puerto Ricans already live in poverty.

Federal Regulators Must Strengthen Safety, Soundness and Investor Protection Regulations

The Dodd-Frank Act gave federal regulators new authority to designate nonbank financial institutions as systematically risky. The Financial Stability Oversight Council has begun to scrutinize institutions outside the banking sector and must take a close look at hedge funds as a prime candidate for enhanced regulation.

Too-big-to-fail banks have substantial exposure to hedge funds through prime brokerage relationships. The Volcker Rule, which was part of the Dodd-Frank Act, put substantial limitations on these relationships in order to protect banks from future problems in the hedge fund industry. Regulators should look closely at prime brokerage as a potential source of systemic risk and make sure banks are adequately protecting themselves.

Finally, the Securities and Exchange Commission must act as the primary line of defense to protect investors from abuse by hedge funds. When it uncovers that private fund managers have charged investors improper fees, it is incumbent upon the agency to take strong enforcement action and, together with the Department of Justice, enforce our nation’s criminal securities laws against those who violate them.

The SEC also must require hedge funds to provide better disclosures to investors about fees, investment strategies, use of leverage, holdings and the value of their assets. Disclosures to federal regulators also must be improved so they have the information necessary to prevent systemic threats that may arise from hedge fund trading activities.

Pension Funds Must Re-evaluate Their Hedge Fund Investments

Strong action by the SEC requiring better hedge fund disclosures can help pension fiduciaries make sound decisions when considering investments. Unfortunately, we do not have the luxury of waiting for SEC action. Workers’ retirement savings are being put at risk by high-cost, high-risk hedge funds.

Leading U.S. pension plans have decided to reduce or eliminate their hedge fund investments and embraced better, more affordable ways to achieve diversification.

We encourage all pension funds to closely consider their asset allocations. This should include a comprehensive review of hedge fund performance, net of fees and a comparison to low-fee alternatives. In addition, pension funds should require hedge fund managers and consultants to provide comprehensive fee disclosures and make that information publicly available.

Too often, pension funds have paid hundreds of basis points in fees to hedge funds, only to find they receive the same investment outcomes they could have gotten by investing in the broad public markets for a fraction of the cost. Under no circumstances should pension funds pay alpha prices for beta performance.

It is Time to Put an End to Tax Breaks for Hedge Funds

We must put an end to the unfair tax breaks that benefit some of the richest members of our society. The most high-profile of these is the carried interest tax loophole, which allows wealthy fund managers to convert their income into long-term capital gains and pay half the tax rate of regular working people. This is unconscionable. It is time, once and for all, to close the carried interest tax loophole.

Hedge funds also take advantage of tax havens and tax breaks for offshore reinsurance companies, and press corporate targets to use tax arbitrage to create the artificial appearance of earnings growth. These unfair tax breaks benefit rich hedge fund managers at the expense of the rest of us.

It is time to put an end to the fiction that selling investments only to wealthy investors somehow insulates our financial system from the risks hedge funds pose. Policy makers and regulators must do their part to make sure that hedge funds are regulated and taxed appropriately. Finally, pension plans must re-evaluate their hedge fund investments and account for all of the risks, returns and costs.

Join Us Online