Through a glass, darkly - socially responsible investment and hedge funds

These are the days that try the hearts of hedge funds. Just when it seemed the regulatory onslaught was easing, another threat to the industry has manifested itself.

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While the Securities and Exchange Commission (SEC) investigation into Goldman Sachs may be politically motivated, aimed at enhancing the SEC’s position as a tough regulator with further clampdowns on errant banks and built on rather shaky foundations, the fallout for hedge funds could be profound.

Paulson & Co is as close to a hedge fund icon as is possible. Its funds are the Holy Grail for many investors. To be dragged into the spotlight and seen to be doing such borderline shady deals is a blow not only to Paulson but to the hedge fund industry as a whole.

Regardless of the fact the trade has been dissected and written about for some time, the inference of the SEC investigation, even though it has so far cleared Paulson of any wrongdoing, is that there is something just not right about such deals.

No matter which way the deal is examined, hedge funds do not come out of this well. Despite the Goldman Sachs view, “nothing unusual or remarkable”,  general consensus seems to be different.

Goldman painfully displayed in its grilling by the US Senate its incomprehension of the reasons why Main Street rather than Wall Street is so appalled by the deal. This attitude further exposed the shortcomings of the system epitomised by Goldman.

The investment bank may well have become a whipping boy for politicians eager to find someone to blame for everything wrong with the financial system, but the tone of questioning and Goldman’s response masks a much more worrying growing divide.

It is not just US senators and the average man on the street who are appalled at what has been going on in the financial world. When investors in funds like Paulson & Co start to question whether they want to be associated with a hedge fund involved in such deals, it is time for the industry to take a long hard look at what it does and how it does it. Just making money may not be enough to keep – or attract – investors in future.

The image of the greedy hedge fund manager, intent only on making money and with no care or concern for society, the greater economy or anyone else, is not the one the industry wants to project.

Just when funds had seemed to gain some sympathy from the general press and shed their aura of secrecy and dark dealing, the Goldman case is likely to lead to a renewed frenzy of accusations, remonstrations and general finger wagging bemoaning the lack of moral fibre and ethics among hedge funds.

Whether the Paulson deal was legal or not is immaterial. It has been shown to be not just a clever way to make money but one cynically designed to maximise profit with minimal regard to the consequences for anyone else.

Investors should start to look twice at such deals and question whether they want to be associated with and investing in funds that execute dubious trades. Their own reputations may be tarnished by association.

While many scoff at the idea of ethical investing, hedge funds may find that investors are not quite so cavalier about where they place money in future.

The proliferation of ethical indexes, socially responsible investment and the  growing vocal lobby groups for moral-based investing adds weight to the argment in favour of hedge funds taking this seriously. Such voices may not be so easy to dismiss in future.

At the recent Bank of America’s (BoA) annual shareholders’ meeting in Charlotte, North Carolina, 39% of the vote was in support of a resolution sponsored by faith-based institutional investors belonging to the 300-member Interfaith Centre on Corporate Responsibility (ICCR), an increase of 9% over a similar proxy resolution at Citigroup on April 20 this year.

The ICCR member-sponsored resolution gave BoA shareholders as well as Citi’s a way to express their concerns about the lack of transparency in the derivatives market. Shareholder votes on the derivatives disclosure resolution are expected at the Goldman Sachs (May 7) and JP Morgan Chase (May 18) meetings.

The resolution targets four of the five US financial institutions, accounting for a reported 96% of all derivatives trading in the US. It also marks the first time the banks will face a shareholder vote on explaining their policy on how collateral is secured for the derivatives they use and what their policy is about using their customers’ funds for other speculative activities.

The question then suggested is how long before such resolutions or concerns are aimed at hedge funds and funds of hedge funds (FoHFs) investing directly or indirectly into such derivatives.

Investors are beginning and will continue to question whether they want returns at any cost. Madoff has already exposed the soft underbelly of investor greed. The Goldman Sachs deal has exposed an ugly face of financial dealing, one as greedy and uncaring as any caricature of a hedge fund manager portrayed in the media.

So, how can hedge funds and FoHFs address this issue? First, hedge funds need to think twice about any trades that could be interpreted as unethical. Borderline legality should be a red flag for a fund. FoHFs should begin to look more closely at underlying portfolios to see if the funds they are investing into have the potential to attract negative publicity.

As regulators, particularly the SEC and in the UK the Financial Services Authority, begin to look more closely at what and how hedge funds trade, the repercussions of not being above reproach could be catastrophic. Imposing more regulation is much more likely than a relaxation of rules.

No matter what the outcome of the SEC case against Goldman Sachs – not to mention the potential of other cases to contaminate the industry – the spotlight shone on the industry has yet again revealed flaws and reinforced the perception of ruthlessness and unethical behaviour. Real or imagined is immaterial. The industry needs to deal with this.

One way could be the drawing up of an ethical code of conduct by a respected body such as the Alternative Investment Management Association, possibly together with other major industry lobby groups such as the US Managed Funds Association. Best practice guidelines may also help stave off unwelcome further regulation while at the same time giving investors a clear indication that fund managers are keen to address ethical concerns head on rather than ignore them.