The JOBS Act and Those Evil Hedge Funds

We aired our problems with hedge funds as alternative investments time and again in this space, but we still do find them better than the basic buy and hold strategy for stocks. As a result, we often find ourselves defending hedge funds as managed futures frequently gets lumped in with the strategies under this umbrella. As we read all the freak-outs over the lifting of the advertising ban found in the JOBS Act, this is one of those cases.

As an example of the backlash to the lift, the Huffington Post reports:

To better understand this sudden change in market for hedge fund advertising, let’s look at the changes in the advertisement of prescription drugs: Manufacturers used to only able to advertise to dispensing physicians, but are now allowed to directly market to consumers. This meant that patients who once relied on professional advice now could “diagnose themselves” and start asking for a prescription drug by name. “I can’t sleep,” patients now say. “I need Ambien.”

Similarly now, consumers can call their financial advisers, bypass professional financial advice and demand to be invested in a particular hedge fund, the advertisement of which has caught their eye. What is the best strategy for consumers? For the answer to this, I went to Steve and Charles, each with decades of experience in the investment management industry; Charles having run two of the largest custodians and Steve as the current No. 1 ranked Independent Advisor in the nation according to Barron’s.

Steve says, “As an industry, we have made it harder for consumers to protect themselves–not easier–through all of the disclosures required. At some point, it’s overwhelming and people make decisions based on the summary that’s presented to them by their advisor or broker.”

Charles added, “Consumers have been disadvantaged by all of this disclosure, not protected. Since disclosure clearly isn’t enough, the only way for investors to know that they are getting the right products is if their advisor is a true fiduciary, that is, is legally bound to always put their clients’ interests ahead of their own.” Mix “small print” and “mass market” and it’s a recipe for potential disaster for investors.

When hedge funds, many of which have been prohibited from even having a website, are finally allowed to advertise to the public, how might high net-worth investors perceive their efforts? At first, these individuals may be skeptical of these attempts to “lure” them. However, a few good years of returns will bring the average investor begging for access as we’ve seen in tech stocks, for example. Conversely, there is a real opportunity in the hedge fund industry to create compelling messages to drive interest in specific funds or strategies. Social media platforms and a demographic shift toward a younger wealth makes this opportunity perfectly timed for some funds to on-board many new investors. Firms that can effectively communicate what might be complicated strategies in a concise and balanced manner should succeed.

We feel like we’re in a unique position to comment here. See, as long as a managed futures program doesn’t register under a 4.7 exemption with the CFTC, and complies with NFA promotional guidelines, they’re already allowed to do much of what the JOBS Act is opening up to hedge funds (examples being this blog, our database, and our manager spotlights).

First off, there seems to be this major concern about hedge funds targeting non-accredited investors – that the ability to widely market will usher in your social security-reliant grandmother. Realistically, this is unlikely. It’s a waste of advertising dollars to try to saturate that wider market, especially when advertising to accredited investors is expensive and time consuming as it is. Trust us on that one. Beyond that, there can be major legal repercussions for failure to verify the status of an investor, and those of you who know legal counsel for hedge funds know that they are tremendously risk averse.

We can agree on two points, though. Yes, there is such a thing as “too much disclosure”, and yes, there are going to be funds that exploit this and the lifting of the advertising ban, but such is also the case for mutual funds and the like. The regulators will do their best, but they will never be able to catch all the shifty fund marketers in time. There can be ten pages of disclaimers on your marketing material, but whether or not the end investor – regardless of their wealth – understands the content of those pages is anyone’s guess. This is what necessitates a third party, like an RIA. Hedge fund due diligence is hard – harder than most investors realize.

On the flip side of this, the advertising could be good for the very reasons the article laments. We’ve known one too many advisers who have gotten nearly complacent in their allocation strategies for clients. We certainly know some that are dedicated to ongoing research and strategy evolution, but for the lazy in the group, client-fueled demand may help to push them to self-educate.

A girl can dream, right?

We’re also hopeful that the change results in better education for investors in general. Generally speaking, especially in the wake of 2008 and recent hedge fund scandals, attempting to convince an investor to allocate to something they don’t understand can be like spitting into the wind. Should the hedge fund industry really double down on investor education, it would be, in our opinion, a win-win. Investors are better able to make informed decisions, and because they now better understand how it all works, from the fund perspective, it’s hopefully stickier money.

The pharmaceutical consumer advertising push metaphor, we will say, is pretty shoddy. Hedge fund allocations are unlikely to cause investors to give birth to firemonsters, even if poor performance may have brought them close to stroke. And allocating is not as simple as scribbling a prescription on a pad; saying you want a hedge fund is not the same as having the hundreds of thousands of dollars in available capital to invest.

In other words, while we acknowledge the potential for some negative consequences from the ban lift, we feel some of the reactions have been largely overblown. Besides, you probably have little to worry about. If hedge fund managers are like many of the CTAs we know, advertising won’t necessarily be their focus or forte.