Peter O'Dwyer reports on how, at last, some regulators and politicians are beginning to recognise the positive role of hedge funds on the global economy.
Many articles on hedge funds start off with a "what is a hedge fund?" introduction. The US print media usually caveat any hedge fund article with a starting description of hedge funds as "lightly regulated investment vehicles prone to scandal". This ignores the fact that, outside the US, hedge funds are generally heavily regulated. Even within the US, where regulation has lagged behind, the number of hedge fund collapses as a percentage of the total market is very small.
Personally, I prefer those definitions of hedge funds delivered by the nonspecialists. The German Socialist Vice- Chancellor and Minister for Labour and Social Affairs, Franz Müntefering, famously referred to hedge funds in 2005 as being "...like swarms of locusts that fall on companies, stripping them bare before moving on...". One suspects that there was some confusion here with asset-stripping private equity types from the Hollywood movies of the 1980s, but, hey, why let the facts stand in the way of a good sound-bite?
Britain's popular social commentator and motoring journalist, Jeremy Clarkson, recently stated "I have no idea what a hedge fund is, but after a day trip to Mustique, I think I need to plant one" (Sunday Times, 23 April, 2006). This was perhaps getting closer to the truth.
The Oxford English Dictionary defines a hedge as:
A fence or boundary formed by closely growing bushes, or shrubs
A contract entered into or asset held as a protection against possible financial loss
A word or phrase used to allow for additional possibilities to avoid overprecise commitment.
Now, whereas , most hedge fund managers would obviously point to the second definition as describing their products (which are largely constructed so as to reduce volatility and produce absolute returns, irrespective of whether the market is rising, or falling), the third version has a certain charm about it, as many critics of hedge fund managers would certainly complain about their managers' failure to "avoid over-precise commitment".
In 2006, KPMG, together with Prof. Amin Rajan of CREATE, an independent think-tank, produced a seminal study of hedge funds, describing them as a "catalyst reshaping global investment". In fairness, however, it is the pithy soundbites that one recalls from their excellent, but otherwise lengthy and academic, report. My favourite, in describing the variability in quality of hedge fund managers, is their comment after interviewing many institutional investors that "When you have seen one successful hedge fund manager, you've seen one".
This follows their assertion that the world of hedge fund managers divides into the:
15 per cent who are 'stars'
55 per cent who are 'wannabes', and
30 per cent who are 'has beens'.
The key to success for all managers is to have a rising pool of talent that can devise new strategies, and more importantly commercialise them at an ever increasing pace, before they become commoditised and the alpha disappears.
The key for investors is to be able to find the 'stars' and avoid the 'wannabes' and 'has beens', but whoever said that bit was easy?
How are they doing now?
Despite the frequently predicted demise of hedge funds and their managers and the many political attacks, 'hedgies' appear to be generally doing OK, thank you, as we move towards the end of 2007. The volume of assets invested in international hedge funds is creeping towards US$2,000 billion, having only surpassed US$1,000 billion in the past two years.
The recent credit crunch has inevitably focused attention on hedge funds and their role in the sub-prime turmoil. However, despite the best endeavours of the hedge fund nay-sayers, they have not been able to blame their usual whipping boy for this particular problem. Indeed, hedge funds have been in the market, buying up credit and providing some badly needed liquidity in a constipated market.
Much to the chagrin of the European 'Rent-a-Left', Charlie McCreevy, the EU Commissioner for Internal Markets and Services, has recognised as much in a speech to the European Parliament on 5 September. It is worth quoting in its entirety what the Commissioner had to say about hedge funds and the credit problems:
"Many hedge funds have been particularly active in the structured credit markets. Many of those hedge funds - and their wealthy private or institutional investors - may have incurred losses, some heavy, in recent months. That is the way markets go.
Sophisticated players in hedge funds know this. Financial markets function on risk. I do not criticise those who make fortunes when times are good. I am not going to shed any tears now if there are losses. However, the crucial thing is that hedge fund failures do not appear to have spilled over to the wider financial system. Investment fund rules (UCITS) have held up. Our prudential framework and bank risk controls have - as we expected - prevented hedge fund failures from triggering wider systemic disruption.
As much as some people want to demonise hedge funds, they are not the cause of the difficulties in the market.
Let us not forget where the present crisis has its roots. Poor quality lending, compounded by securitisation of these loans in off balance sheet vehicles that few understood the risks associated with. These are issues that prudential authorities and supervisors will need to focus on in the time ahead."
Can it be that regulators and politicians are finally beginning to recognise the good influence that hedge funds have on the global economy?
The US View
Recent statements by Federal Reserve Chairman, Ben Bernanke, would appear to support this contention. Mr. Bernanke's comments that US financial watchdogs should in future look to a more principle-based, risk-focused approach, rather than the traditional US rules-based supervision, seem to follow a trend that has been taking shape internationally over the past few months. Speaking at a Federal Reserve Conference in Atlanta in May, he mentioned in particular the approach in the UK, which he said was gaining "considerable influence on this side of the Atlantic". He also made reference in his paper to a decision by the US President's Working Group in February 2007 not to call for tighter federal supervision of hedge funds, but rather to look towards a combination of market discipline and more vigilance by regulators.
Mr. Bernanke's statements on hedge fund regulation were also reflected in comments from Japanese Vice Finance Minister, Hideto Fujii, who said that there was no difference between the Group of Eight (G8) member countries concerning the monitoring of hedge funds.
He stated that, "I think there is no difference between the G8 member countries with regard to their basic opinions on this" (Reuters, 14 May, 2007), referring to the emerging consensus that the risks to the global economy have more to do with the entities that do business with hedge funds, rather than with the hedge funds themselves.
This new-found sophistication by the international regulatory and political community would appear to reflect the fact that, having had an opportunity to stand back from some of the more inflammatory "locust"-type attacks on hedge funds, politicians and their regulatory colleagues are at last beginning to differentiate between the obvious liquidity and market advantages of hedge funds, versus the risk that, from time to time, lenders to or creditors of hedge funds may become over-exposed.
The EU View
The EU also finally seems somewhat reluctantly to be jumping onto this bandwagon. In a recent statement from Ecofin, the council of 27 European finance ministers, strong support emerged for what were previously considered the heretical views of Charlie McCreevy.
In an official statement on the issue in May 2007, the finance ministers stated that the present system of supervision was adequate and that hedge funds, on the whole, contributed to the efficiency of the financial system. Peter Steinbrück, the German finance minister and then Ecofin president, said that he was hopeful that a code of conduct could be signed with industry by the end of 2007. Therefore, there would now appear to be a widespread consensus on the new voluntary approach, and it remains to be seen whether, going forward, this will be put in place by the hedge fund industry itself (the approach favoured by Mr. McCreevy), or by some new Brusselsbased bureaucracy (the approach not surprisingly favoured by Germany and France).
However, it would appear from the statements from the US, Japan, and Europe, that a welcome consensus is beginning to emerge.
President's Working Group
In his comments concerning the "President's Working Group", Mr. Bernanke was referring to the President's Working Group on Financial Markets (PWG), which was originally established after the Long-Term Capital Management (LT CM) collapse of 1998. The PWG is chaired by the Treasury Secretary, and is composed of the Chairmen of the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. Its mandate is to further the goals of enhancing the integrity, efficiency, orderliness, and competitiveness of financial markets, and to maintain investor confidence.
In its first report, which followed LT CM, the PWG recommended that no changes be made to the exemptions for hedge funds under the Investment Companies Act and the Investment Advisors Act, which govern the mutual fund industry in the United States. The PWG took the view that the registration of hedge funds and their advisers did not appear a useful method of monitoring hedge fund activity.
Following the successful court challenge in 2006 by New York hedge fund manager, Philip Goldstein, to new hedge fund regulations introduced by the SEC, the PWG was reconvened to look again at hedge funds and what they term "private pools of capital".
In February 2007, the PWG reported by issuing a set of new principles and guidelines, which, following on from their 1999 statements, are designed to guide US financial regulators as they address public policy issues associated with the rapid growth of private pools of capital, including hedge funds. The first significant statement of the PWG which is worthy of note was that,
"The current regulatory structure, which is based on these principles is working well. As we noted in 1999, "in our market-based economy, market discipline of risk-taking is the rule and government regulation is the exception."
Therefore, the PWG would seem to be strongly of the view that the market is the best disciplinarian of hedge funds. Treasury Secretary, Henry Paulson, elaborated on this view by stating,
"Those who would believe that the role of regulators is to guard against any losses, or somehow prevent losses, or to prevent a hedge fund from having problems, they have a different philosophy about regulation than I do" (New York Sun, 23 February, 2007).
In summary, recent international regulatory and political developments seem to show that governments are slowly beginning to understand the hedge fund industry more, and are beginning to appreciate the valuable role that it performs in providing liquidity and stability in the global financial economy.
In recent days, there has been much talk of a US$75 billion stabilisation fund called the Master Liquidity Enhancement Conduit, being put together by Citigroup, Bank of America, and JP Morgan to buy up troubled mortgage-linked securities, and restore some price stability to that market. Where governments and central bankers fear to tread, who is there to tidy up the securitisation mess?
Super-locusts to the rescue!
Peter J. O’Dwyer is a business and financial consultant with a number of interests. He primarily specialises in providing bespoke advice to cross-frontier businesses, in particular to those involved in international investment funds, holding company structures and structured finance and to Governments and regulatory authorities. He is Managing Director and proprietor of Hainault Capital Limited, based in Ireland. He is a non-executive director of several private and public companies, including investment companies, mutual funds, energy, property and hedge funds domiciled in Ireland and the Cayman Islands for amongst others; HBOS, Barclays Capital, Citigroup and BNP Paribas. He is a former director of a Shari’a hedge fund and has lectured widely on the subject of Shari’a investment funds.