An Essential Precondition: Debating the Issue of Transparency within the Context of Hedge Funds Adoption

Presentation to the Middle East Alternative Investments Summit, Dubai

Richard Collins, 18 February 2008

Introduction

I am delighted to be here this afternoon to participate in this Middle East Alternative Investments Summit where I have been asked to cover the topic of ‘An Essential Precondition: Debating the Issue of Transparency within the Context of Hedge Funds Adoption’.   And when thinking about what to cover here, it seems to me that I am being asked to provide a debate with only myself – which makes it easier!   Normally I have a lot of empathy with President Reagan’s view of economists – he once said ‘Give me a one handed economist – because they’re always saying ‘On the one hand, and on the other hand’.   So please forgive me if you feel afterwards that there has been a lot of ‘on the one hand, and on the other hand’!

The main issue I have had to deal with in preparing this talk is what new can be said. In the research conducted, there are umpteen different studies by esteemed practitioners, regulators, president’s working groups, academics and others, all covering the issue of disclosure and transparency of the industry.  But I will try and add a little to the debate rather than simply regurgitating what everyone else has said – and I should emphasise at this point the usual disclaimer that the views expressed are necessarily my own and do not necessarily represent those of the Qatar Financial Centre Regulatory Authority.

I know that the ‘Context of Hedge Funds Adoption’ really means disclosure to investors in the funds. But my first postulation is that I do not see how one can really isolate that from the wider issue of hedge fund transparency and disclosure to the wider world – ie to anyone who has an interest in what is happening in the industry. The logic goes – if it’s suitable for disclosure to an investor about what’s happening within one of these entities, why not for a regulator, why not [in a suitable way] for the marketplace? So my analysis will go slightly wider than simply investors.

I thought it might be helpful to structure the talk into the following:

• The Macro picture – ie some helpful backdrop;
• Who has said what – ie some summary of the umpteen studies referred to above;
• Areas of Broad Consensus – ie where opinions seem reasonably convergent;
• Areas of Divergence – ie where they are not so;
• Specific Areas of issue – ie some particular topics of interest;
• Hedge funds and the sub-prime debacle – roles and responsibilities.

We have heard from Paul McNamara about the outlook for the industry.  And let’s put the industry in context.   The last decade has seen a rapid growth in both the number of hedge funds and the scale of their assets under management, currently understood to have risen by well over 400% since 1999, to stand in the region of $2 trillion.  They are also responsible for an increasing share of trading volume, with some estimates putting this at 50% of the market total.  This growth, in combination with hedge funds’ perception as secretive, amorphous, highly-leveraged structures, the recent market difficulties has caused attention to turn to the issue of transparency and disclosure.  Put simply, there is a general feeling out there that we need to know more.  Yet, exactly what more we need to know, and how much of it, is the subject of much debate.

The hedge fund industry remains one in evolution, particularly with regard to the growing investment by institutions.  In its 2007 study, State Street noted that around two-thirds of institutional investors are allocating more than 5% of their portfolios to hedge funds, while only 4% have no hedge fund allocation at all.  The corresponding studies for 2005 and 2006 showed less than half of responding institutions were allocating more than 5% to hedge funds, with 16% having no allocation.[1]  With that increase, has come a gradual realisation within the industry itself that, to continue to attract and maintain such investment, it must change significantly, including being more transparent.

Transparency is, however, not a magic bullet, a one-stop cure-all for the issues facing the hedge fund industry, real or imagined.  But before we can analyse the pros and cons of greater transparency, we need to consider some sort of analysis of the benefits and risks of the industry – and, of course, many of the dangers attributed to hedge funds are not exclusive to that industry.  Indeed, as the industry matures, the differences between hedge funds and traditional investments are becoming less marked.  In Europe, new rules introduced under UCITS III are blurring boundaries between alternative and traditional vehicles by allowing the use of exchange-traded instruments and over-the-counter derivatives, although these remain subject to rather tighter parameters and restrictions.  The more traditional financial service providers, including banks, pension funds and mutual funds have moved into some of the instruments, such as derivatives, more commonly perceived to be the tools of hedge funds, so the debate needs to be put in the context of issues facing the financial services industry as a whole.  Indeed, it might be said that a number of the investment banks’ trading areas are no more than giant hedge funds. And it is interesting that one of the criticisms that has been levelled at Societé Generale is that its lack of transparency and disclosure in unwinding the positions of Jerome Kerviel contributed in no small measure to the market turmoil towards the end of January 2008.

Defining what a hedge fund is

Given that there is no legal or regulatory definition of a hedge fund, it may be better to define the entity by its characteristics – ie by what an entity does rather than what it is called.

In broad terms, a hedge fund may be regarded as a private investment pool, loosely regulated, funded in the main by experienced, high net worth and institutional investors and creditors, that invests in a variety of assets, often utilising considerable leverage, are professionally managed and, generally, not directly available to the retail public.  As Sir Callum McCarthy, Chairman of the UK Financial Services Authority, has pointed out, however, hedge funds should not be regarded as an asset class in and of themselves.

Although hedge funds can certainly be regarded as heterogeneous with regard to strategy, size and management style; typically, however, they exhibit some or all of the following characteristics:

• They tend to be both long and short in the market, although not necessarily market neutral, or fully ‘hedged’;
• They utilise leverage, or gearing, in their trading strategies;
• They have a performance-based fee over and above a fixed fee structure (the traditional 2 and 20 scenario), thus compensated on both scale and performance;
• Their managers are usually co-investors;
• They are broadly invested across a wide spectrum of instruments, including derivatives;
• They have an objective of absolute return;
• They can have ‘lock-in’ periods for investment;
• They are unrestricted in the trading strategies and instruments they utilise; and
• They demonstrate a high degree of opacity.

This can be contrasted with ‘traditional’ funds, which are typically invested long-only, not leveraged, restricted from utilising derivatives and more narrowly invested, often benchmarked against an index on a relative return basis, and have lower fees.  A further important distinction is that traditional funds are usually heavily regulated, with more onerous requirements in relation to transparency and disclosure.

Given the dramatic growth in hedge fund assets under management, it follows that the industry must be seen as providing benefits that are not available from the traditional investment industry and which overcome investor concerns about high fees and lower reporting transparency.

The Benefits of Hedge Funds:

At a market level, the benefits are traditionally seen as being that hedge funds offer:

• A valuable arbitrage role in reducing or even eliminating mispricing in financial markets;
• The addition of breadth and depth to capital markets;
• An important source of liquidity, both in periods of calm and stress; and
• An important source of risk transfer and diversification by taking risks that would otherwise have remained on the balance sheets of other financial institutions.[2]

Hedge funds are active traders and contribute to increased market efficiency and liquidity through their frequent trading and ability to exploit arbitrage opportunities.  In a study, the Federal Reserve Bank of New York has said that this activity is thought to be generally stabilising and provides considerable benefits in terms of greater market liquidity, lower volatility and more stable relationships in the relative prices of financial assets.[3]

At an investor level, the benefits of hedge funds are generally considered to include:

The potential to reduce overall portfolio risk through an additional asset class;

• The potential to provide returns in both bull and bear markets;
• The potential for superior risk-adjusted performance, through precise areas of expertise, greater freedom and flexibility and a broader range of financial instruments;
• A focus on absolute as opposed to relative performance – they are only concerned with generating positive returns, rather than benchmarking performance;
• Greater incentives for the managers since hedge fund managers’ interests are generally aligned more with those of the investor than in traditional vehicles, often with the manager’s own capital invested;
• A degree of sophistication, recognised by banks, pension funds and insurance companies as a way to reduce portfolio volatility and potentially enhance returns;
• A huge variety of investment styles – many uncorrelated with each other – provides the investor with a wide choice of strategies to meet investment objectives;
• Providing an ideal long-term solution, eliminating the need to time entry and exit from the markets; and
• Diversification not otherwise available through traditional vehicles.[4]

Hedge funds are perceived as deliverers of superior ‘Alpha’, that measure of profit attributable to managerial strategy over and above simple market correlation.

The Risks of Hedge Funds:

The commensurate risks, however, are the:

• Capacity for leverage – they can be vulnerable to pressure to liquidate assets quickly if they sustain significant losses;
• Complexity of instruments utilised which makes it difficult to assess risk;
• Potential overimportance in the markets;
• Opacity – they are not subject to public disclosure or regulatory reporting and operate largely outside the framework of other requirements.

As far as the first of these is concerned, however, the fact that they are able to liquidate quickly can put them at an advantage.  An oft quoted example is that the better hedge funds’ willingness to take decisive action has been compared with the inertia of one big investment bank’s management, who it is alleged knew in August 2007 that its proprietary trading desk was taking large positions, but missed an opportunity in October to take advantage of the market rally.  One insider estimates that swifter action would have capped losses at around $1 billion, rather than the $9.4 billion written off in December[5].

The risks can also be said to break down into three categories: managerial, operational and systemic.  The first two tend to be the focus of investors, the last the issue that most concerns regulators.

Systemic risk

It is generally accepted that banks have considerably enhanced their counterparty credit risk management processes since the LTCM crisis of 1998.  However, hedge funds create systemic risk to the extent that they can disrupt the ability of financial intermediaries or financial markets to provide credit efficiently.  The US President’s Working Group on Financial Markets identified the potential for liquidation of a highly leveraged institution to lead to volatility and sharp asset price declines that heighten uncertainty.[6]  But in the context of systemic risk, we should also remember that hedge funds are generally invested across a wider range of assets than banks and traditional funds and are more directed towards arbitrage.[7]

Systemic risk is not always clearly defined, but is broadly seen as the risk that an event represents such a crisis that it impacts not just on the financial system, but also on the real economy.  This could happen, as we have seen recently, through repercussions from an event resulting in a reduction in productive investment by the curtailment of credit provision.  However, it should be emphasised that the optimal level of systemic risk is not zero.  While a regulator might sleep easier through the imposition of stringent limits on leverage or investment in illiquid markets, this would unduly hinder the proper workings of the financial sector, with obvious wider implications for the economy.  That being the case, the concern should, rather, focus on the existence of inefficient systemic risk.

Hedge funds could well link to the real economy through banks’ direct exposures to them. If a bank has a large exposure to a hedge fund that defaults or operates in markets where prices are falling rapidly, the bank’s greater exposure to risk may reduce its ability or willingness to extend credit to worthy borrowers.

Hedge Funds and Liquidity Risk

We have affirmed that hedge funds are viewed as being liquidity providers within capital markets, thus contributing to market efficiency.  But recent experience and history suggests that hedge funds are also moving increasingly into less liquid markets, such as structured credit and distressed debt.  In combination with leverage, these rather more illiquid assets, together with short-term financing, expose the hedge fund to possibly significant liquidity risk.[8]  It is perhaps this that has driven some hedge funds to incorporate longer lock-up periods on withdrawals and increased use of notice periods for redemptions.  At the same time, the prime brokers are seeking added transparency in respect of hedge funds’ positions.

It is useful, also, to distinguish between ‘market liquidity’, the facility to trade without affecting prices, and ‘funding liquidity’, which is the ability to obtain funding in circumstances of credit curtailment or other event.  While distinct, these two phenomena interact in crucial ways.  In times of abundant funding liquidity, traders can finance positions, trade in higher volumes to smooth prices and inject liquidity.  Conversely, weak market liquidity tends to increase volatility, leading to variation margin and collateral calls that reduce funding liquidity.  Market liquidity shocks impact on the trader’s ability to fund positions, driving prices lower by selling assets to meet margin calls.  If hedge funds, usually smoothers of market imbalance are themselves weakened by losses brought on by unusually large market shocks, it raises questions about who would be available to step in to stabilise the situation.

In this sense, collateralisation may prove inadequate.  Clearly, the current concern is the banks’ exposure is to hedge funds.  Banks’ direct exposure to hedge funds has been growing in tandem with the hedge fund industry itself, although this is heavily collateralised, with each bank having a clear self-interest in managing risk exposures.

Nevertheless, it is generally accepted that it is the very characteristics of hedge funds, in particular their opacity and incentive structures, together with leverage, that fuel the potential for a substantial market disruption.  With the increasingly complex and heterogeneous nature of investments, the unwinding of positions may prove more difficult and inefficient.  Also, the large commercial banks and broker-dealers provide substantial funding to the hedge fund industry through the absorption of counterparty credit exposure, credit lines, financing and direct investment – so a shock to a bank brought on by a hedge fund could have wider impact should that bank, and/or others, curtail the provision of liquidity to other funds or the wider market.

Who Has Said What?

I mentioned earlier that there had been umpteen pontifications by great worthy bodies on the whole issue of transparency.   Here are some of them listed.

• UK Alternative Investment Management Association – guidance on valuation of positions
• UK Hedge Fund Working Group – Hedge Fund Standards, January 2008
• US Managed Funds Association – Approaches towards Alternative Investments.
• US President’s Working Group – Agreement Among PWG and US Agency Principals on Principles and Guidelines Regarding Private Pools of Capital
• New York Federal Reserve
• UK Financial Services Authority
• OECD – The Role of Private Pools of Capital in Corporate Governance, May 2007
• IOSCO – Principles for the Valuation of Hedge Fund Portfolios, Final Report 2007
• CFA Institute Centre for Market Integrity has produced the Asset Manager Code of Professional Conduct
• Banque de France – Financial Stability Review: Special Issue on Hedge Funds, April 2007
• European Parliament Policy Department – Economic and Scientific Policy studies on Hedge Funds Transparency and Conflicts of Interest (December 2007) and Hedge Funds and Financial Stability (November 2007)

All of the above studies, encompassing industry participants, governments, central banks, regulators, academics and trade bodies, approach the issue from the perspective of raising standards through adherence to voluntary codes of conduct.  The common theory is that adherence to standards will encourage all participants to ‘raise their game’ by virtue of the fact that investors will naturally gravitate towards those funds and managers applying these standards.  Standards have been applied to such important and topical issues as disclosure, professional conduct and valuation.

Most recently, in January 2008, the UK Hedge Funds Working Group, a practitioner-led body of 14 UK hedge fund managers, has issued its final report on hedge fund standards.  These standards have been established as a voluntary code and based on a ‘comply or explain’ premise, with the emphasis on disclosure.  In this way, signatories to the Hedge Fund Standards Board code will either demonstrably comply with its requirements, or explain why it chooses not to do so, thus providing the investor with disclosure of information on which to base his investment decision.

The European Parliament policy study on Hedge Funds Transparency and Conflicts of Interest, while broadly welcoming the Hedge Fund Working Group Standards, suggests that, in certain areas, for example in relation to independence of valuations, the Standards do not go quite far enough.

The CFA Institute seems unique in arguing for full position transparency on top of disclosure of strategy and risk measures.

Now, I come from a long career in financial regulation, the vast majority of it spent on the private sector side of the regulatory fence.  So I am afraid that I am slightly cynical about suggestions from the industry – there is usually an element of ‘they would say that, wouldn’t they?’  In particular, I would have to say that if industry are setting out standards for disclosure, it is only because this will benefit the industry first and the investor second.

Areas of Broad Consensus

But let’s look at the areas of broad consensus in the various reports above.  Regulators, academic studies and industry experts are all in general agreement as to the benefits of hedge funds to the wider market as providers of liquidity, takers of risk and price stabilisers.  There is also a general consensus that hedge funds’ opacity to investors and the market will need to change, with a move towards greater transparency and disclosure.

There is a sentiment within regulators that qualified investors in hedge funds have a right to open themselves up to the potential rewards of hedge funds, and expose themselves to the commensurate risk of loss.  While it is agreed that it is indeed opaque to both investors and the market, there is a recognition that the hedge fund industry is only open to direct retail investment to a very limited extent, if at all, so the usual caveats in relation to investor protection and compensation do not apply.  By the same token, market players have a duty to exercise their own effective due diligence and risk monitoring.

It is also a common theme that investors themselves have a role to play in driving the impetus for greater transparency and disclosure.  As institutions play a greater role in hedge fund investment, they, together with funds of hedge funds, are able to demand greater disclosure of information.  This institutional involvement is bringing greater focus on issues such as asset valuation, risk monitoring and internal controls.  In selecting and adopting a hedge fund manager, it is incumbent on the investor to carry out thorough due diligence, to gain an understanding of risk controls, investment strategy, management and governance.  Important areas to cover include:

• Ownership of the fund management company to ensure the fund’s terms – such as redemption policies and lock-ups – tally with expectations and that compensation is aligned with performance;
• Adherence to strategy, through analysis of current and historical track records;
• Background check on both the fund and its principals;
• Trading procedures;
• A review of documentation such as the offering memorandum and disclosure documents; and
• A review of internal procedures to ascertain what the manager does himself and what tasks are outsourced to third party service providers.[9]

As another driver towards transparency, it is important to remember that many pension funds are themselves bound to disclose details of their investment portfolios, which must necessarily involve a review of the entire investment portfolio, including alternative investment strategies.

It is also recognised that one of the important elements to be developed in relation to hedge funds is that of international regulatory cooperation.

And from the funds’ perspective, some who are seeking to develop business with institutional clients see improvements in professional standards, including transparency, as providing a useful means of boosting investment by creating an asset class with demonstrable integrity, which will only encourage more investors to diversify into hedge funds.

Areas of Divergence

Opinions tend to differ not in substance, but in emphasis, with the most common areas of debate being:

• Hedge fund correlation and contagion risk
• The degree of regulatory oversight
• Too much transparency may not be a good thing for investors
• Retailisation
• Side Letters
• Perception and its consequences
• Conflicts of interest – performance fees and valuation
• Shareholder activism
• Moral hazard
• Agency issues
• Knock-on effects

First, hedge fund correlation and contagion risk

Given the very wide variety of trading and investment strategies and vehicles employed within the hedge fund sector, there is some disagreement with regard to how close is the correlation between hedge funds and, thus, whether a shock to one would necessarily have implications for others.  However, the recent near-collapse of two Bear Stearns hedge funds in 2007 demonstrates the potential for contagion risk between funds and this is an area where further study is needed.

The degree of regulatory oversight

As noted above, the general industry consensus is that a voluntary, industry-led code of practice, coupled with effectively implemented measures of market discipline, is the best way forward for the industry in addressing the concerns of investors.  However, this consensus houses a spectrum of opinion and, at one extreme, is the call for outright regulation of the hedge fund industry, through such measures as restrictions on capital, activities or use of leverage.  So far, this point of view has not received too much attention, the general feeling being that such measures could bring with them substantial costs that would, in practice, outweigh and diminish the benefits of hedge funds in terms of market liquidity and price discovery.  Moreover, prior regulatory responses to a perceived laxity in credit risk management have involved an increase in the oversight of lenders, so to impose such supervision on hedge funds, the borrowers, would reflect a significant switch in policy.  In addition, such a policy of outright regulation runs the risk of driving the hedge fund industry entirely into jurisdictions with lax regulatory regimes.  A Securities and Exchange Commission initiative to bring more regulation to hedge funds was rejected by the Supreme Court in 2004 and the SEC is now proposing raising the bar for investor eligibility instead.

Too much transparency may not be a good thing for investors

An argument, propounded by certain industry practitioners [what a surprise!], is the idea that investors think they want transparency in terms of strategy and position reporting but, in fact, it will be detrimental to them in the long run.  Disclosure of such information, it is argued, will adversely affect the fund manager’s ability to put into practice the very techniques he has developed, as he will be faced by others either trying to emulate that strategy, or trading against him.  Furthermore, the emulation of these strategies by less adept managers is likely to end badly, with possible damage, both financial and reputational, to the industry as a whole.  In addition, short positions are inherently different from long and greater disclosure could lead to destabilising trading by competing investors.[10]  Personally, I never noticed this being a problem in the investment banking world of new products and strategies!

‘Retailisation’

One of the comforts that regulators take from the hedge fund industry is that, broadly, they are not open to direct investment by the retail public.  However, a recent European Parliament study[11] argues that the various national regulations in Europe are fragmented and has highlighted the anomaly that, during the bear market in 2001 – 2003, retail investors lost substantial proportions of their assets in ‘traditional’, highly regulated products, while better diversified and more secure investments are not open to them.  By the same token, while a wealthy individual can buy into any hedge fund, well-qualified, and regulated, investment managers acting on behalf of retail clients are restricted in terms of the products they can sell.

There has also been a rapid growth in investment products that closely resemble hedge funds, such as structured products and closed-end funds that are already marketed to retail customers.  Moreover, retail investors are already indirectly, and to a degree, invested in hedge funds through pension or life funds, predominantly through multi-manager funds or funds of funds.  This can lead to a number of layers of costs which ultimately are not transparent and are not to the benefit of the retail investor.

Notwithstanding the above, however, I submit that opening hedge funds up to direct investment by retail clients at this stage in their evolution would be most unwise.   Put simply, it is bad enough expecting retail customers to understand much of what they invest in at present, to allow them entry into a new market with greater opacity is, frankly, dangerous. We should not forget that in many of the various market crashes of the past – from the South Sea Bubble in 1720 to the Wall Street crash of 1929, and the dot com bubble of 2000, there was much in terms of a contributory factor from panicking retail investors.

Side letters

Side letters represent bilateral arrangements between a hedge fund and certain investors, often conferring favourable terms in respect of redemption, lock-in periods, fees, enhanced disclosures, or subscription rights.  Such undisclosed side letters are now being regarded as unfair to other investors in the fund, but it may not be feasible or desirable to do away with them altogether; for example, funds of hedge funds could utilise such arrangements to maximise returns for their own investors.  That being the case, there is a general move towards disclosure of at least the existence of such side letters to all investors, along with material terms contained therein.  There is some divergence of emphasis on materiality between regulators and codes of practice, but, for example, if a fund manager could be compelled to sell more liquid holdings to meet a client’s redemption terms in a side letter, this would be something that could materially affect other investors in the fund and should arguably be disclosed.

Perception and its consequences

The hedge fund industry is perceived as being opaque and secretive.  This, in combination with its use of leverage, as well as often highly complex, perhaps illiquid over-the-counter instruments has contributed to the nervousness with which the industry is often viewed.   Now, many may say: does this matter?  I postulate that it does – the very perception that there are a large number of market players doing things ‘in the dark’ which have an impact in the markets, could of itself contribute to uncertainty in the markets.   It’s a bit like the ‘Heisenberg Uncertainty Principle’ in physics – ie the very act of observance changes what is being observed. [For the non-physicists amongst us, the most common form of the principle is if one opens a door onto a darkened room containing a plant – the light that you let in to observe the plant contributes to a growth of the plant and therefore what you observe is not what the status was before the door was opened].

So if we expand this thought, what we have is that hedge funds are a contributory factor to market uncertainty – which is not necessarily a good thing.

Conflicts of interest – performance fees and valuation

Often, and it would appear increasingly, hedge funds can invest in illiquid, obscure or untraded and complex instruments which are consequently difficult to value, particularly in the structured credit markets.  A conflict of interest is inherent due to the presence of incentive fees, which encourage a manager to place the highest possible value on assets at the time of fee calculation, normally at calendar year-end.  An academic study has found that hedge fund returns are significantly higher in December than in other months.[12]  By the same token, managers may be tempted to postpone bad returns until after the fee calculation period.  Such practices represent a clear case of market abuse, if not outright fraud, and a number of the organisations listed above, including the Hedge Funds Working Group, have proposed valuation best practice guidelines for adoption by the industry.

Shareholder activism

This issue arises through the separation of economic and voting rights through hedge funds’ utilisation of derivative instruments and stock borrowing, which might be used to reduce the transparency of their interests in a company and voting activism.  Opportunities can arise through lax corporate governance for activism to take place, notwithstanding the operation of the EU Transparency Directive, which sets disclosure at 3%, with 1% increments thereafter.  For example, a hedge fund could borrow stock to vote, while at the same time taking a short position in the derivatives market to the same or even greater amount.  Such empty voting has the potential to harm the economic interests of the shareholders in general and has clear implications in terms of market abuse.  This could be combated by the aggregation of all derivative positions, both long and short, for reporting purposes along with other forms of interest in the company.[13]  The Hedge Fund Working Group proposed standards suggest that funds should not vote in situations where they are not economically exposed.

Moral hazard

There is an argument that greater regulation may lead to a situation where moral hazard persists.  The argument is that, with more transparency being imposed by regulators, the incentive of investors to carry out their own thorough due diligence is weakened by over-reliance on these regulatory standards.  On the other hand, while there is no indication that there is any likelihood that governments would ever bail out a hedge fund, the perception that the largest financial intermediaries are ‘too big to fail’ may engender a laxity in monitoring credit risk and limiting exposures in currently profitable areas.  However, it seems to me that this is an argument which is perennially postulated by industry when there is any increased transparency suggested – I for one am not persuaded by it!

Agency issues

It is the general consensus among regulators that market discipline, through the application of counterparty credit risk management, rather than direct regulation, is the best way to mitigate risks posed by hedge funds.  Most recently, this has been reiterated by the US President’s Working Group on Financial Markets (2007).  However, there may prove to be circumstances where counterparty credit risk management is insufficient and these are likely to be exacerbated by a lack of information. or in situations of heightened competition, Both of these , of course, apply to hedge funds.

Agency issues may arise through different incentives of participants, where the agent may act in his own self-interest and a lack of information coming from the hedge fund may accelerate these by making it harder to define the correct counterparty risk ratings to apply to credit terms and trading limits.  In this scenario, insiders’ incentives may lead to excessive risk-taking.

The total return basis of hedge fund compensation creates a strong motive to take on risk and, with limited transparency, it is easier to conceal those risks from both counterparties and investors.  Risks that are most easily concealed are those with a small probability of severe adverse consequences but which, in exchange, offer high levels of compensation at other times.  Credit derivatives represent just such an investment.[14]  We are familiar with controls such as margin, collateralization and trading limits but the key question remains how effectively these are implemented and enforced.

‘Knock-on’ effects

Banks’ credit exposure to hedge funds may have a number of wider implications, the most obvious being a hedge fund collapse weakening banks and degrading their ability to provide liquidity to the financial system of credit to borrowers.  Alternatively, where there is close correlation or common exposure to market risk between a bank’s proprietary desk and the hedge fund, defensive trading by the fund after a shock could impair that proprietary position; this would magnify the impact beyond the bank’s credit exposure to the fund, or hedge funds in general.  Clearly, the size of such exposures would dictate whether these conditions might reflect a systemic crisis.

The Subprime Debacle and its Consequences

I now want to turn to a brief analysis of the sub prime debacle and the consequences that have flowed therefrom. And there is no better person to look to for his marvellous quote about what we know and what we don’t than Donald Rumsfeld, who came up with the gem:

“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.”

And in the hedge fund world, I’d like to postulate that there’s a lot that we know we don’t know, but there’s probably also an awful lot of things that we don’t know we don’t know!

Examples of collapses

Headline-making collapses of hedge funds have, thus far, not been too numerous, although hedge funds as a class see an annual closure rate greater than that for ‘traditional’ funds.  Amaranth remains fresh in the memory, as does the near-collapse of two Bear Stearns funds in the summer of 2007, referred to above.  2008 has already seen the closure of Sailfish Capital Partners, which managed $2 billion in the summer of 2007, with the indications being that this will not be the only such closure this year.  Atticus Group Fund lost over 13% in January, Maverick Capital 9%, as reported by SYZ & Company.[15]  MFA President John Gaine, however, speaking in November 2007, believes, “…while I believe…it may be premature to draw lessons from these events now, I equally believe that concern about proper valuation practices (not just to deliver returns, but also to measure risks) are at the heart of unease about hedge fund and other strategies where there is no ready market for the instruments being held or traded.”[16]

It is this unease that I believe could see issues or events being magnified into crises by market apprehension based on inadequate knowledge and understanding of hedge funds’ strategies, risk management and ultimate asset value.  It is this information gap which also leaves us unable to answer with any certainty whether the financial markets are over the worst of the crisis.  Again, this is a sort of Heisenberg Uncertainty Principle in operation – if we were all able to observe what was happening then we would be observing something different!

Let’s also think about whether the hedge funds have contributed to the credit crunch.

 There is a disparity of opinion on exactly how large a part the hedge fund industry has played in the subprime crisis of last year and the ongoing credit crunch.  The linkage between banks and hedge funds was amply demonstrated by the recent examples of BNP Paribas, Goldman Sachs and Bear Stearns, all three of whom were adversely affected by their own hedge funds.  BNP was forced to suspend withdrawals from its funds invested in illiquid, hard-to-value credit securities, causing a spike in the inter-bank rates and a resulting loss of confidence in that market. In August last year, Goldman Sachs was compelled to provide funding to one of its leading global equity fund which had lost 30% of its value in one week.

On the other hand, in a speech on 20th November 2007, no less a personage than Hector Sants, Chief Executive of the UK Financial Services Authority, stated that, “FSA’s view…is that hedge funds were not the catalyst or the drivers of the summer’s events and their subsequent behaviour was broadly in line with the assumptions which underpin our regulatory approach.”

It may well be the case that hedge funds were not the prime catalyst. But I think we would all agree that it remains unclear whether the market has now fully absorbed all the toxic waste that has flowed from the debacle, hedge funds included..  With the subprime crisis now appearing to shift towards the prime market, the worst may not yet be over.  Arguably, the last several years of low volatility and liquidity have engendered an element of investor complacency and far more leverage, perhaps not necessarily within the hedge funds themselves, but within the fund of funds industry.[17]  The fund of hedge funds industry has generally been seen as a ‘safer’ and more diversified way for investors to access hedge funds.  However, there is now some debate over their exposure to the credit crunch and the implication arising from that – and it has been postulated that it is possible that  funds of hedge funds have suffered from an expanding ‘duration gap’: what they owned was longer-dated than what they owed.[18]

While some hedge funds made considerable profits last year by shorting the ABX subprime index, the collapse of Sailfish Capital Partners in February 2008 demonstrates that not all of the ramifications of last year’s market turmoil have necessarily worked their way through the system.  A leading industry expert has said: “This year will be the year with the highest number of hedge fund failures given the huge number of new and untested hedge funds.  Last year there were some easy trades: short financials, short subprime, long non-US and emerging Markets.  This year there’s no clear trend and no safe place to hide.”[19]So far, 2008 has produced some uncomfortable indications, with the average stock-picking hedge fund posting a 4.1% drop in January.

And we come back to the question – even if hedge funds were not the catalysts or driver for the sub-prime debacle, has their presence and opacity in the marketplace helped or hindered the situation?  In other words, if there was more transparency in their operations, would the sub-prime debacle have been identified sooner? Would everyone have dealt with it sooner? Is this desirable?

Well, I think it is generally accepted that the fundamental cause of the subprime debacle and the ensuing credit crunch was the irresponsible lending by instititutions on a grand scale to people who really couldn’t afford it.  Packaged products of these toxic loans were sold by the lenders to whoever may have been willing to purchase – of which hedge funds may have been ready buyers.  And the longer that the hedge funds were able to conduct these transactions without any external party being aware of this and perhaps asking what on earth was being bought here and on what basis, the longer the ticking bomb of the subprime crisis was able to be kept just ticking. It is possible to postulate that had the hedge funds been questioned earlier over their exposure to these products then the issues could have been identified earlier.  I recognise that one might say the same thing about the supervision of banks themselves, and there has already been some callings to account in respect of some regulators’ actions. I suspect there will be more to come.

But this brings me to another, wider issue in the debate. Here we are, in the 21^st Century, with all the latest information technology at our disposal, and all commentators are still saying that we don’t know the full extent of the subprime debacle.  Frankly, I would ask – is it right that, in the advanced financial markets of the 21^st Century, we simply do not know?

And this is what I think is likely to be the greater overall issue which will contribute to hedge funds becoming more transparent than probably they really want to.  I think it more than likely that, whilst the dust from the subprime issue settles, people will say – why did it take so long to work out what was going on? And one very substantive part of the answer is – because there was insufficient information available to the authorities when they needed it and in the format they needed it. People will then say – there are large elements of the financial marketplace who currently conduct business in an opaque manner – these include these entities called hedge funds. And they will conclude that, notwithstanding whether or not the hedge funds were any catalyst or contributor towards the crisis last summer and the consequences thereof, we need to have systems in place so that we know what is happening more quickly and action can be more quickly taken when something not good is happening.  And the only way that this can be achieved is by having more transparency and disclosure about what everybody is doing, not just the hedge funds, but also other parts of the marketplace.

And so the alternative investment industry, I think, will in all likelihood be swept up in more such rigorous disclosure of everybody’s actions.

Thank you for listening.

References:

[1] 2007 State Street Research Study – ‘Vision Volume 2 – Issue 1: Hedge Funds, a State Street Report’

[2] Address by Timothy F Geithner, President and CEO, Federal Reserve Bank of New York, 17th November 2004

[3] Khambu, John, Schuermann, Til and Stiroh, Kevin J., “Hedge Funds, Financial Intermediation and Systemic Risk” FRBNY Economic Policy Review, December 2007

[4] © The Hughes Trustco Group Limited, 2007

[5] Financial Times, January 29, 2008: ‘Hedge funds demonstrate resilience in thorny times’.

[6] Quoted in Khambu, John, Schuermann, Til and Stiroh, Kevin J., “Hedge Funds, Financial Intermediation and Systemic Risk” FRBNY Economic Policy Review, December 2007

[7] “Hedge Funds and Financial Stability” Study by the European Parliament Policy Department, Economic and Scientific Policy, November 2007

[8] See Khambu, John, Schuermann, Til and Stiroh, Kevin J., “Hedge Funds, Financial Intermediation and Systemic Risk” FRBNY Economic Policy Review, December 2007

[9] 2007 State Street Research Study – ‘Vision Volume 2 – Issue 1: Hedge Funds, a State Street Report’

[10] Brunnermeier and Pedersen, “Predatory Trading”(2004), quoted in Naik, Narayan, ‘Hedge Funds: Transparency and Conflict of Interest’, European Parliament Policy Department, Economic and Scientific Policy Study, December 2007

[11] Naik, Narayan, ‘Hedge Funds: Transparency and Conflict of Interest’, European Parliament Policy Department, Economic and Scientific Policy Study, December 2007

[12] Agarval, Daniel, and Naik, Narayan (2007) “Why is Santa so kind to hedge funds?  The December return puzzle!”

[13] Naik, Narayan, ‘Hedge Funds: Transparency and Conflict of Interest’, European Parliament Policy Department, Economic and Scientific Policy Study, December 2007

[14] Rajan (2005), ‘The Greenspan Era: Lessons for the Future.’ quoted in Khambu, John, Schuermann, Til and Stiroh, Kevin J., “Hedge Funds, Financial Intermediation and Systemic Risk” FRBNY Economic Policy Review, December 2007

[15] The New York Times, February 12, 2008: “Bad bets and accounting flaws bring staggering losses.”

[16] Ibid.

[17] Doug Kass, TheStreet.com, 3/5/2007, “Subprime’s Next Victims: Hedge Funds.”

[18] Dave Shastri, The Hedge Fund Journal, Issue 33, December 2007 / January 2008: “Painting a clearer picture.”

[19] Bradley H Alford, Alpha Capital Management, quoted in The New York Times, February 12, 2008: “Bad bets and accounting flaws bring staggering losses.”