Wednesday, September 20, 2006

Keep your hands off my secrets

I'm embarrassed to say that, despite working in the industry, I never really thought about this issue before. In short, are a hedge fund's holdings a trade secret, and - if so - is their periodic required disclosure actually justified?

First of all, some background on what we are talking about here for people not familiar with the business. Firms that hold more than $100m in stocks have to disclose their positions in a quarterly filing. This filing is only a snap shot (like a partial balance sheet), and there is a lot that it will not tell you about the fund. You'll never know about any trading within a quarter, only the net effect at the end. It doesn't disclose short positions, nor any information about options (either long or short). Finally, there is no information about the amount of leverage used (or cash held in reserve).

So, how strong is the case? Well, all the details of a firm's investment activity taken together are certainly a trade secret, and potentially incredibly valuable. These details are the transcript and blueprint of the "product" produced by money managers, namely a series of time-sensitive buy and sell decisions involving a number of different securities (and potentially asset classes). Investors (especially in hedge funds) pay enormous sums to acquire this product; to be forced to disclose all would be to de facto steal from the managers, and also have the investors in the fund subsidize those in the public who would use the disclosures to their own benefit.

So, if disclosing all the investment program details would be so bad, what about the partial disclosure required in a 13F? They are partially bad, and the amount of useful information disclosed varies greatly depending upon the type of fund involved. The most affected are long-term, long-only shops - a careful following of their 13Fs would allow you to almost completely mimic their investment program for free (albeit with a significant lag).

It would seem that, absent some compelling public interest, disclosure should not be required. What, then, is the interest?

Remember that certain other types of disclosure would not be affected if 13Fs were done away with. For example, buying more than 5% of a company's stock would still trigger a reporting requirement. Also, investors in a fund itself could demand certain disclosures, and - if they were not satisfied - refuse to invest and take their money elsewhere. And access to investor lists for things like proxy fights would likewise be unaffected.

In the end, it seems the current disclosures do little other than to feed a need for voyeurism (of which I have been guilty) among professional investors and to satisfy the inertial wants of the regulatory bureaucracy at the SEC. Neither of these reasons strike me as compelling, certainly not enough to appropriate part of the investment program that others are paying so dearly for.

I agree with Goldstein. Am I missing something?


Phillip Goldstein said...

Not only are you not missing anything but hard evidence of the harm to investors from forced disclosure is right before your eyes.

Do you think Amaranth’s investors were harmed by its being required to file a form 13F as it desperately tried to liquidate large equity holdings needed to stay solvent? Do you think this is evidence that undercuts the SEC’s argument that a 45-day lag pretty much eliminates any competitive harm that might result from public disclosure of a manager’s positions? Do you think Amaranth might have gotten higher prices for its equity holdings if they were not publicly disclosed? This is what Nick Maounis said on Friday, Sept. 22:

"Market conditions deteriorated rapidly during the week of September 11. Material losses began early in the week, and we accelerated our efforts to reduce our exposures. On Thursday, September 14, the Funds experienced roughly $560 million in trading losses on their natural gas positions. We continued to attempt to reduce our natural gas exposures, while also selling other positions to raise cash in order to meet margin calls. As news of our losses began to sweep through the markets, our already limited access to market liquidity quickly dissipated."

Gadfly said...

Philip makes an excellent point about connecting this issue to Amaranth (especially since I posted twice on them already!), and I should have done it myself.

For readers not in the markets, one thing you need to know is that nothing brings out the “vulture” side of people like the smell of blood. Knowing Amaranth was in trouble and in need of raising cash, other enterprising traders/fund managers undoubtedly checked Amaranth’s 13F to see what stocks they were likely to try to dump. Those traders would then try to get in ahead of Amaranth (say, by shorting the stock), depressing the price further and leading to less proceeds going to Amaranth. In the case of a thinly-traded stock, potential buyers might be unwilling to buy it without a discount to market, knowing how much more of it Amaranth still needs to get rid of.