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Is Hedge Fund Secrecy a Sign of Skill — Or a Red Flag?

As the SEC considers exempting many firms from disclosing their equity holdings, an academic study delves into a unique hedge fund dataset.

In the years leading up to the 2008 financial crisis, a large asset manager kept a database on current, past, and prospective hedge fund managers — grading them on, among other characteristics, their transparency (or lack thereof).

Over a decade later, the hedge fund industry may be about to get a whole lot less transparent — and researchers argue that this data should raise alarms about secretive managers.

These researchers are Sergiy Gorovyy, Patrick Kelly, and Olga Kuzmina, the authors of a new paper, “Does Secrecy Signal Skill? Characteristics and Performance of Secretive Hedge Funds.” Using a proprietary database originating from what the authors describe as “one of the largest” fund of funds in the U.S., they analyze 192 hedge funds during the period between April 2006 and March 2009, looking at how the most secretive managers compared to those that were more transparent.

“What the paper can shed a light on is, is there reason to be concerned if a hedge fund is being secretive,” said Kelly, a senior lecturer at Australia’s University of Melbourne.

As Kelly and his co-authors write, “secrecy is the hallmark of the hedge fund industry.” Exempt from many disclosure requirements under the Investment Company Act of 1940, hedge funds generally have a reputation for being secretive, whether it’s a quant firm guarding an advanced trading algorithm or a traditional stock-picker waiting until the last minute to give up portfolio positions via 13F filings. Employees are often required to sign stringent non-compete agreements, ostensibly to protect trade secrets. And even basic information like fund returns is not commonly reported publicly.

The conventional wisdom is that this lack of transparency is a trade-off for better performance. As one hedge fund consultant observed, “the managers that are less transparent tend to be managers that have done very well and performed very well, and they can kind of dictate not only the terms of their fund but the level of disclosure they’re willing to give.”

This secrecy, as the study’s authors note, “may allow [hedge funds] to pursue proprietary investment strategies with less concern that others might mimic and free ride on their strategies.”

Past academic research cited by the authors seems to bear this out: A June 2017 study in the Journal of Financial Economics determined that performance drops after a hedge fund begins filing 13Fs. And earlier research has indicated that seeking confidential treatment for 13F holdings is linked to “positive and significant abnormal returns.”

These studies, however, referred to information that was withheld from the general public. By using the fund of funds' database, Kelly argued, “we’re asking what does it mean when a hedge fund is secretive from their own investors.” 

Based on their findings, secrecy — with respect to investors — doesn’t necessarily indicate a successful proprietary strategy or private information.

The more secretive funds, they found, did not outperform the more transparent funds. Instead, the researchers found that secretive hedge funds actually underperformed peers during the financial crisis — suggesting, according to the authors, that the secrecy veiled higher risk-taking.

“As best as we can tell, it doesn’t seem to signal skill,” Kelly said. “If anything, it suggests that funds might be taking on more risk.”

Admittedly, the sample is limited, focusing on a slice of the larger hedge fund industry over a relatively short time period culminating in the 2008 financial crisis — a seismic event for the asset management industry that brought changes in regulation and investor behavior.

Still, the research, though based on a decade-old data set, is timely, as the U.S. Securities and Exchange Commission considers a rule change that would significantly reduce the number of hedge funds required to disclose their largest U.S. equity positions via quarterly 13F filings. The SEC has proposed raising the threshold for firms required to submit these forms from $100 million in assets under management to more than $3.5 billion — exempting roughly 90 percent of current filers, according to the Wall Street Journal.

[II Deep Dive: The SEC Is Proposing a Big Change. These Firms Are Not Happy About It.]

“Personally, I have mixed feelings,” Joseph Larucci, partner at consulting firm Aksia, said of the proposed change. “On the one hand I think it will make the market more inefficient, as players will no longer be able to trade around 13F information, potentially reducing crowding around holdings, which should improve returns for managers who do original work.”

From a due diligence perspective, however, Larucci said that some investors “will lose a tool in the due diligence toolkit.”

If the proposal is passed, Larucci believes that managers will likely become more selective in which positions they disclose, even to investors. And the industry as a whole is likely to become much less transparent, as others have noted.

“Secrecy can also be used to hide evidence that managers are deviating from promised fund styles, or possibly even engaging in bad behavior,” Kelly argued. “If it were a signal of skill, that would be important for investors to know. If it is not, I would argue that it is also important for investors to know.”