I recently spoke with Bruce Yandle for an upcoming episode of EconTalk. (It should air the middle of next month) One of the most fascinating stories he told was one that he attributed to George Stigler. It went something like this.
Suppose you want to figure out why a particular regulation passes and the way that it’s written. Imagine the Legislature putting that regulation up for auction. Suppose people could bid on the terms of the regulation and the outcome went to the highest bidder.
Pretty crass, isn’t it? But what a useful way to organize your thinking about the political process. There isn’t a literal auction. But what the example does is focus your mind on two questions:
Who has the incentive to show up and be heard?
Who is going to make the most noise?
I was thinking about this Stigler story in the context of the issue I described in this earlier post. When we see the SEC increasing regulations on hedge funds, they always say the reason is to protect investors from taking on too much risk or it’s to improve the stability of the financial sector. But as Bruce points out in another story, the bootlegger and Baptist story, regulators and politicians always want to claim the moral high ground. There’s usually a self-interested group involved as well. So think about that auctioning off of regulations
that Stigler mentions. We know who the Baptists are–the handwringers worrying about protecting the investors from themselves. The regulators always talk about that motive. But who are the bootleggers–the people with a financial stake in the regulation?
Some readers pointed out that hedge funds appear to have high returns and that makes it politically attractive for politicians to handicap them as a response to populist envy. I don’t think that’s what’s going on here and the Stigler story helps explain why. Those angry "men in the street" aren’t in the story. They don’t show up at the auction. They’re not angry enough. The issue of the rich’s ability to enjoy the returns from hedge funds isn’t in the public consciousness to get anyone angry enough to complain about it. And politicians can’t make any political capital from reining the hedge funds in. The average voter isn’t aware of what’s going on and won’t take enough notice. No, the people who show up at the auction of Legislative Activity are the ones with a big, big stake—the hedge funds themselves and their competitors. And evidently, the hedge funds are getting outbid by those competitors. Who are they?
As a number of readers pointed out, the biggest competitors are probably the mutual funds. TDL writes, discussing the proposed regulation that will require hedge fund investors to have net worth of $2.5 million rather than the current level of $1 million:
The most to benefit from an increase in the investment cap in "hedge
funds" would be mutual funds. Mutual funds have been losing out to
"hedge funds" at the higher end of the investor spectrum for some time.
There are more people with $1,000,000 (excluding homes) in assets than
the $2,500,000 asset cap proposed, those individuals with $1,000,000 in
assets would have to find a place to put their capital. The next best
thing to a "hedge fund" is a mutual fund (although broker teams, that
act as money managers, would benefit they would have to be much more
responsive to their clients than mutual fund managers would.)
Also to take into consideration is the fact that mutual funds are
much more politically connected than are the "hedgies". I will also
give an example of where mutual funds benefit from the current
regulatory regime (at the expense of investors and competitors); mutual
funds do not have to advertise their management and sales expenses when
they advertise their returns, contrast this with "hedge funds" who
explicitly are prohibited from even publicly advertising their returns.
Who has had a better rate of return over the past twenty years, mutual
funds or "hedge funds"? Cui bono?
Also extremely interesting are these two comments sent to me from friends who run hedge funds. The first runs a large one:
Your readers have the right answer. Mutual funds are behind the
regulations since hedge funds have been stealing customers and perhaps
more importantly stealing their best employees. Hence, without paying
their best employees more they are left with mediocre employees and
generate lower returns. It is a vicious circle for them. Lower
returns causes them to lose more customers to the hedge funds. More
regulation of hedge funds increases the minimum size to start one.
E.g. I would not be able to start my own fund today in the way that I
did given that I would need $250,000/year just to comply with the
And from one who runs a small one:
My 2 cents are that this is driven perhaps more by large bank’s
in-house investment management divisions. They typically take 1% of
total assets, and often just allocate-and-leave, meaning that a, say,
$5M estate yields JP Morgan $50k per year, with about 10 hours of work
up-front to allocate, and essentially none thereafter… True the
mutuals would also benefit from limiting hedge funds, and most large
mutuals are bank-owned, but I don’t think qualified investors make up
very much of their asset base, in contrast to the wealth management
More than who’s driving the regulation, I think an interesting
phenomenon is the failure of larger funds to organize against
regulation. I’d think they would be the most threatened by somebody
like me, and they are probably pretty eager to protect their fees,
typically at least 1-2% of assets plus 10-20% of gains (!)
If I understand that last part correctly, some of the regulation then is the existing large hedge funds keeping out the smaller ones. And of course, they will justify it by saying that it’s important that the industry not have its reputation ruined by small badly run renegade hedge funds. Ah, bootleggers and Baptists.