GLOBAL – The Financial Stability Forum will review in September systemic risks to the global financial system caused by increasing leverage of hedge funds.

The review has been ordered following regulator and hedge fund manager concern that, although the hedge funds are keeping their gearing relatively low, the underlying investors, especially funds of hedge funds, are also borrowing money in an effort to boost returns. This double gearing is leading to grave concerns among the experts because it is at a vulnerable period as market volatility and the interest rate cycle is turning and fund managers have little certainty about where their alpha, or risk-adjusted returns, will come from.

The Forum, which was formed in February 1999 to promote financial stability through information exchange and its secretariat is housed at the Bank for International Settlements in Basle, completed its first report on hedge funds and their potential to cause systemic risks in the global financial system in early 2000, after the collapse of the very highly-leveraged Long-Term Capital Management hedge fund in late summer 1998 created a near-meltdown in the system. It found hedge funds had, on average, reduced their gearing since LTCM’s fall but said the main defence against a repeat collapse was strong counter-party credit controls.

The second review, at the Forum’s Washington DC meeting on 8 to 9 September, has been ordered to uncover new potential vulnerabilities developing in the hedge fund industry, the unimpeachable source close to the Forum’s decision said. The principle concern is whether counter-party discipline has been eroded, he said, or whether leverage is being introduced through another form, such as by the investors in hedge funds. The main difficulty in deciding upon the extent of the risk to the $800bn industry is the lack of systematic information being collected on the subject but the Forum members have begun work on the subject, he added.

The review is a natural follow-up to the Forum’s first report but was not routine: “It is driven by concerns that have been growing over the last six months, following flows into hedge funds rising at a rapid rate, and anecdotal reports of leverage rising from potential slippage by counter-parties and other entry routes, such as retail or funds of hedge funds”.

He added: “There has been a bit of a flare-up of discussions and episodes of volatility in the last few months have rekindled interest.” He admitted there was concern that hedge funds were more closely correlated to equity markets on the way down than most people assumed. Mercer Investment Consulting said the correlation of the CSFB/Tremont Hedge Fund Index with the FTSE World Index is 0.5 but in severe market falls the correlation is 0.7. One is perfect correlation.

Anecdotal evidence has come from the hedge fund industry experts. Patrick Sheppard, chief operating officer at Mellon Institutional Asset Management, which runs about $7bn in hedge fund assets, said: “The market is at an inflexion point. There are few individuals who are passionate about which style areas will produce large returns. Two years, or even 18 months, ago hedge fund managers could look ahead and know where they could make money - where their alpha was coming from.”

Edhec this week found nine out of 13 hedge fund strategies lost money in May, for the second month running. The MSCI Hedge Invest Index found only two of its 13 strategies made positive returns in May.

Sheppard said: “European event strategies or merger arbitrage by the end of the year after the interest rate environment has steadied should do well. Relative value and momentum strategies have been difficult with the interest rate cycle changing and volatility in markets. Possibly macro strategies have also had a tough time. Convertible bond markets are also ones to watch closely and especially fixed income arbitrage because of the interest rates and volatility.

“There is dangerous leveraging in these hedge funds to make it work. Hedge funds themselves have less leverage than in the late 1990s but the underlying investors are also leveraging. They have to leverage to offer better returns and there is anecdotal evidence of funds of hedge funds in particular leveraging returns to provide juice to their performance, although this is not widespread.”

When asked whether this could lead to a systemic risk to the system, Sheppard said: “A little, from the interest-rate sensitive strategies such as relative value.”

And some experienced hedge fund managers are pulling out of the market and returning money. said Avery Partners, a New York-based merger arb boutique, was returning $270m in assets in a surprise move after its founder, Barry Newberger, decided the strategy was no longer viable. But the Alternative Investment Management Association survey of institutional investors found consultants were recommending their clients invest 50% of their active risk budgets to hedge funds in a sign of apparent confidence.

The US regulator, the Securities & Exchange Commission, however, is expected to start regulating hedge fund advisers later this year over concern about the sector.