Who is John Galt?

The question that permeates Ayn Rand’s legendary Atlas Shrugged has a peculiar resonance at the moment for financial services in general and for hedge funds in particular. Those unfamiliar with the cult novelist may not be aware of the significance.

The moral justification of capitalism does not lie in the altruist claim that it represents the best way to achieve “the common good.” It is true that capitalism does — if that catch-phrase has any meaning — but this is merely a secondary consequence. The moral justification of capitalism lies in the fact that it is the only system consonant with man’s rational nature, that it protects man’s survival qua man, and that its ruling principle is: justice.
Ayn Rand, “What Is Capitalism?"

Rand’s writing is to capitalism (or at least US readers of her books) as Marx was to Communism, with perhaps a more subtle and less catastrophic effect (or so it may seem at first).

As a child she witnessed first hand the devastating effects of the Russian revolution. She wrote Atlas Shrugged as a polemic against government interference in business. Many interpret her writing to advocate as little government as possible with as little regulation thrown in the way of the innovative and beneficial entrepreneurs.

It should come, therefore, as no surprise to learn that Alan Greenspan, former head of the US Federal Reserve during the build-up to the financial crisis, is a man deeply influenced by Rand’s writing. His invisible hand of the market and light-touch regulation has come in for criticism as a basic flaw in regulation that directly led to a near catastrophic financial meltdown.

What Rand would now make of the rush towards regulation by the bastion of capitalism is anyone’s guess. While the free market economy is not quite in retreat, light-touch regulation and non-interference by governments is certainly a thing of the past.

Given that hedge funds are on the cutting edge of financial service innovation, the increased interest and oversight by governments in the day-to-day operation of funds is unwelcome. Clearly, there has been an over-reaction on the regulation front when it comes to hedge funds.

At least that has been the argument up to now. Certainly, there was an attempt to link hedge to the cause of the financial fiasco. Now, however, after a series of embarrassing and disastrous scandals neatly laid at the door of hedge funds, the cries of innocence are a bit fainter.

Beginning with the Bernie Madoff Ponzi scheme, hedge funds are rapidly losing the moral high ground. Although Madoff was not a hedge fund, his management on behalf of funds of hedge funds (FoHFs) tainted that sector and at one time looked like dealing it a death blow.

The latest spate of insider-dealing arrests in the US of people working for hedge funds coupled with the German revelation of alleged fraud by a European-based hedge fund manager has brought the industry into disrepute.

Just as the EU seriously begins its rewriting of the deeply flawed alternative investment fund manager directive, the misdoings of funds could reinforce entrenched views in the European parliament as well as Brussels that hedge funds, while perhaps not the incarnation of evil that at least one politician has gone on record as saying, are not benign forces for good either.

The question of ethics and moral behaviour is relevant – or at least it should be – to every hedge fund and FoHF manager. The money invested in these funds is given in trust.

Yes, it is clear the people and institutions putting money into funds expect a substantial reward but that in itself is no excuse to throw ethics out of the window and embrace bad business and ethical practice for the sake of making money.

The insider dealing cases in the US and the fraud in Germany is likely to not just be bad press for the industry. It also leaves a bad taste and tarnishes the vast majority of funds that do not lie about net asset values, performance or any aspect of their funds.

As regulators continue to press the industry for more transparency and seek to bring it under far greater scrutiny and oversight, perhaps a good response would be to embrace this opportunity to prove to the world that hedge funds are not only legitimate and sound business propositions but are responsible members of the financial services community.

It is time to shed the secrecy wrapper that has encased so many hedge funds. While this does not mean throwing open all operations to every prying eye, it does mean constructive engagement and co-operation with the regulators at all levels. It should also mean being willing to work with investors to ensure the most appropriate and fullest level of transparency.

On the side of investors, it is important that they make reasonable demands on portfolio managers. It is the responsibility of the investor to undertake proper due diligence. In the past this has, obviously, not been quite as good as it should have been. At the same time investor demands for transparency should lead to greater understanding of the fund’s operations as well as give useful information about its performance and risk profile. Too much information can be as bad as too little. Investors need to have the capacity and skill to understand and analyse information received from funds before they demand the extra information.

How hedge funds can repair their tarnished image in the mainstream media is a good question. This could be an opportunity for organisations like the Alternative Investment Management Association (AIMA) and in the US the Managed Funds Association (MFA) to initiate a public charm offensive.

Amid all of this negative press, it is also interesting to note that hedge funds have quietly and dramatically made a comeback in 2009. The number of launches is rising, as is the amount of money some funds are seeing flowing into the industry.

Innovation continues. The latest fund launches have shown not only the resilience of the sector but its ability to exploit opportunities. Reading the investor climate well, many funds are adjusting fee structures, increasing transparency and offering realistic and fair liquidity terms.

As hedge funds continue to adopt and adapt, the lines between other structures such as private equity will increasingly blur. This brings greater opportunities but also challenges, particularly for those servicing these hybrid funds. The significant changes within the industry will affect all those who support it, including prime services, fund administrators, accountants and the legal profession.

While Ayn Rand might not agree with the increased regulation of the industry, it is almost certain that John Galt would approve a much clearer ethical stance by the sector as well as reaffirmation of its original purpose within the limits of the law.

“I work for nothing but my own profit — which I make by selling a product they need to men who are willing and able to buy it. … we deal as equals by mutual consent to mutual advantage and I am proud of every penny I have earned in this manner.”
Ayn Rand, Atlas Shrugged

It is up to the industry to ensure it can be proud of what it does and at the same time ensure and restore the full confidence of investors. A moral audit might be a good addition to due diligence and operational risk reporting.

ONLINE poll results for October 2009.