Hedge fund industry needs to clean up its image


Date: Thursday, January 11, 2007
Author: Phil Davis, Financialnews-us.com

Lack of regulation and transparency have brought the issue to the G8 table.

The hedge fund industry’s inability to manage its own image is coming home to roost. Until now, regulators have failed to impose any meaningful rules on hedge funds, either because there is insufficient understanding of their activities or because – in the case of the US Securities and Exchange Commission – regulation was hastily and ineffectively applied.

But unspecified fears that a hedge fund collapse or a series of failures could lead to a global financial crisis have brought the issue to the G8 table. Hedge fund transparency and risk management will be discussed under the German presidency of the G8 this year, although in the final days of last year Germany accepted that proposals for specific legislation are unlikely to be accepted.

Nevertheless, pressure on the alternative investment industry was further increased by demands from the European Central Bank for a register of centralised information from prime brokers on their exposures to hedge funds.

A European register would fill the vacuum left by the collapse last year – following a court challenge – of the SEC’s requirement that qualifying hedge funds must register with it.

But is the regulators’ goal of providing transparency, and then managing the risks this transparency reveals, achievable in an industry that encompasses so many investment strategies and styles?

Philippe Teilhard, head of alternative investments at Fimat, the brokerage arm of Société Générale, said such efforts are misguided. “Transparency is just a tool. The key is fiduciary duty and integrity. I’m not sure I understand what the G8 agenda is at all,” he said.

Teilhard believes the industry, under intense scrutiny from investors, is taking self-regulation more seriously than is commonly thought. “As in all walks of life, some people take short cuts, but in general there is less leverage, better control and more frequent measurement of risk,” he said.

But Teilhard accepts the industry has done itself no favours by failing to assuage the fears of politicians and regulators. He said: “We have often been inept at dealing with the media. The industry has power and money yet seems to have little influence over the way it is perceived.”

And there are areas in which the industry could easily clean up its image and improve risk management in one fell swoop. Teilhard said: “In the US they should use independent administrators as they do in Europe. The frauds that have occurred due to lack of independent administration don’t help our business.

“People used to denigrate administrators and thought that job was not important. It’s obvious now it is and we are seeing a big restructuring in that part of the industry, creating truly professional firms with proper backing and pricing methodologies.”

Indeed, price transparency is likely to be a hot issue this year, with the UK’s Financial Services Authority and the Alternative Investment Management Association planning to issue best-practice guidelines.

Yet, here, as in many other aspects of proposed hedge fund regulation, there is ambiguity. For instance, do investors expect to receive a real-time snapshot of a hedge fund’s portfolio? The FSA acknowledges the difficulties. In a speech in Germany last month, Callum McCarthy, FSA chairman, said it would be “at best useless and probably significantly counterproductive” to force hedge funds to report large positions.

Many regulators and industry participants accept, at least privately, that achieving transparency and assessing risk across an industry is an exercise in futility. But fund-specific risk management is gathering credibility.

Specialist software providers are mushrooming and the main credit rating agencies have started assigning risk ratings to hedge funds. Moody’s, a credit risk assessment company, recently published its first public rating on an individual hedge fund.

Technology providers report that hedge funds are starting to respond. Olivier Le Marois, chief executive of Riskdata, said: “Hedge fund managers have always viewed risk as their business and something they are there to manage on a case-by-case basis.

"Today, with the increasing sophistication and speed of markets most managers are recognising, this approach is insufficient and the best way to avoid a nasty surprise is to identify, measure and control risk through a systematic process.”

Riskdata claims its risk product would have detected problems at Amaranth Advisors well before any losses came to light. Le Marois says the Riskdata tool showed three clear quantitative warning signals before the problems arose.

However, the take-up of risk tools is far from universal. The chief executive of a large technology provider said: “All hedge funds claim to have a risk system in place, but when we talk to them we find they often have nothing, perhaps just some spreadsheets.”

Even technology providers warn that software should not be used as a crutch. Ron Papanek, director of strategy at Riskmetrics, said: “Software does not replace a manager, it just provides more information.”

Teilhard added: “You can always find a system that justifies your actions. That’s when it ceases to be about risk management. Risk management is not about simulation, it is an attitude.”