Shaping tomorrow's hedge funds
The writer Mark Twain memorably pronounced that reports of his death were greatly exaggerated. Today he could be suggesting a similar sentiment about hedge funds.
Overall trends suggest hedge funds are here to stay. Consider that the average hedge fund had its 17th consecutive positive year in 2004, showing a 7.7 percent net gain for the year, according to Van Hedge Fund Advisors International. While the annual performance levels declined from 2003 figures, the returns were still admirable given the stock markets’ pre-presidential election doldrums, rising oil prices and interest rates. Certainly, the ability of hedge funds to produce gains in a variety of market conditions has been proven.
The growing enthusiasm for hedge funds as an investment alternative reflects fundamental changes in markets, economics and attitudes rather than some form of irrational exuberance. As a result, questions have unsurprisingly arisen regarding the transparency of the market, risk management, regulation and whether or not there is appropriate liquidity in the financial system to cope with the occasional setback.
The Price of Popularity
Evidence of the growing popularity of hedge funds and the attention paid to their structures and strategies can been seen as hedge funds have popped up on regulators’ radar screens everywhere. Fresh in their memories, perhaps, is the 1998 collapse of Long-Term Capital Management (although one must remember that LTCM represents only a single – albeit dramatic – failure in this almost 60-year-old virtually unregulated industry). But if hedge funds posed the threat to financial markets that some observers suggest, why would so many large and conservative institutions in Europe, the U.S and Asia have so much experience with them? Why would others, just as large and conservative, be considering investing in them for the first time?
The hedge fund industry is sufficiently mature, transparent, and experienced in managing risk to continue on a non-regulated basis. But should the regulatory winds prevail, increased regulation aimed directly at protecting individual investors will significantly change the hedge fund landscape. If developments are taken to their logical conclusion, hedge funds will ultimately find themselves on a regulatory par with collective and mutual funds where the regulations are designed to protect the retail investor, even though their participation in the sector is, at least for the time being, negligible.
A regulated hedge fund industry would ignore the sophistication of the high-net-worth individuals and institutions that have been the traditional source of hedge fund capital since the first fund was established back in 1949. Former U.S. President Bill Clinton may be endorsing hedge funds for the retail investor, however the product’s natural investor base will likely remain predominantly institutional – at least in the near-term.
Highwaymen or Heroes
The London School of Economics weighed in on the subject last year in a paper entitled ‘Highwaymen or Heroes: Should Hedge Funds be Regulated?’ In it, authors Jon Danielsson and Jean-Pierre Zigrand set out to study the need for regulating hedge funds, using existing regulatory approaches and their own models as a frame of reference.
The pair acknowledged that studies have shown hedge funds can provide the benefits of diversification, competition and price discovery to the financial system. Their own models emphasised the value that hedge funds, as unregulated institutions, can play in alleviating liquidity problems.
Suppose, they argued, that all financial institutions were regulated, and the economy suffered a significant shock leading to a liquidity crisis. In this scenario, regulated institutions may be prevented from engaging in essential trading activity for fiduciary reasons, perversely exasperating the crisis. Alternatively, if hedge funds remained restriction-free, they would be able to continue trading which could ultimately help contain the crisis.
Despite these potential benefits, Danielsson and Zigrand concluded that there are compelling reasons why at least some form of hedge fund regulation is necessary. Collapse of another big hedge fund, they argue, could trigger “a systemic crisis episode”. Although one could debate this theory, they do suggest the possibility that a host of inefficient and overbearing regulations would be likely to follow. Putting all other considerations aside, should so much time, energy and other resources be spent on 2 to 3 percent of the world’s total assets?
A New World Order
The first step in what could be the new world order of hedge fund regulation here in the U.S., is a move by the U.S. Securities and Exchange Commission to require registration of hedge fund advisors who manage funds with more than 15 investors or $25 million in assets. The SEC also requires hedge funds to appoint a chief compliance officer. Clearly, these actions will increase managers’ costs and bureaucracy.
Will such regulations also reduce absolute returns? Possibly. Risk is managed when risk is analysed, and the financial system today has more knowledge and skill with risk analysis and management than at any time in history. Additional reporting costs could most certainly place a drag on the return and ultimately the viability of some funds.
Should this and more transpire, some investment firms offering hedge funds will simply accept this new state of affairs and continue to run their operations status-quo in cooperation with the new regulations. Others will choose to outsource more investment operations activities to third-party administrators, thereby avoiding the costs and mitigating the risks associated with these new requirements. Finally, some will opt to exit the market altogether, attributing it to the loss of secrecy forced upon them. This type of shake-up could ultimately lead to manager consolidation, where all but the largest and most successful independent boutique firms get elbowed out of the hedge fund scenario.
Hedge funds thrive on volatility and competition. If regulations become restrictive and deter new entrants, those already established in the industry with a plausible track record and faithful following will more than likely continue to practise. But with limited new players entering the market, the industry is vulnerable to staleness and stagnation. Regulation won’t kill the hedge fund industry, but it could unquestionably restrict its growth.
A Move to the Mainstream
While governments and regulators contemplate their next move on this proven investment class, recent reports indicate that hedge funds are continuing to move out of the realm of the alternative and into the mainstream.
A State Street study conducted at the Global Absolute Return Congress in October 2004 found that a majority of institutional investors intend to add hedge fund holdings to their portfolios over the next three years in an effort to find better risk-adjusted returns and broader diversification.
Study participants included representatives of corporate, public and government pension funds around the world, as well as endowments and foundations with combined investable assets of more than $1.2 trillion.
One-third of the institutional investors responding to the study said they had at least 10 percent of their portfolio assets invested in hedge funds. Half the group said that within three years 10 percent or more of their assets would be invested in hedge funds. The 16 percent of respondents who were not invested in the asset class all said they planned to have some allocation to hedge funds within one year. The largest increase will come from public and government pension funds.
What is also interesting is that those who are more experienced in investing in this asset class seem to prefer buying directly into hedge funds, while the newer participants in the category seem to prefer funds of hedge funds. Funds of hedge funds offer built-in diversification and are well-suited for investors still working their way up the hedge fund learning curve.
No matter what the preference of investors, our results indicate that the hedge fund industry is clearly a viable one. What began as a niche category catering mainly to high-net worth individuals and U.S. endowments and foundations is becoming a permanent fixture within institutional portfolios.
Elsewhere around the world, Japan is a region showing acute interest in hedge funds. According to Greenwich Associates, Japanese institutional investors using hedge funds more than doubled to 40 percent in 2004 from 18 percent a year earlier. Among European institutions, the proportion using hedge funds jumped to 32 percent in 2004 from 23 percent a year earlier. For U.S. institutions, 23 percent used hedge funds in 2003 and preliminary data from Greenwich's 2004 research indicates that usage reached 28 percent.
As institutional investors become increasingly familiar with hedge funds, it is important that service providers have the right solutions in place to meet the demands inherent to the industry’s proliferation. Add the prospect of regulation to the equation and the needs of these investors will become more even more complex.
Given that the demand for hedge funds will continue to climb, and that in fact the public’s appetite for alternative investments appears to be on the rise, regulators must weigh the benefits of added restrictions against the overall health of the industry, taking into account both the effectiveness and the costs of the outcome.
Greater transparency is often cited as one way of approximating the effects of regulation without damaging the product, but many investment strategies are complex, not easily understood, and very short-term. The supposed benefits that would arise from increased disclosure would often be not only transitory but could even be meaningless. If the investments concerned have been unwound by the time investors have been informed of their existence, chances are likely that the proceeds could already be redeployed elsewhere.
It’s still unclear what the hedge fund regulatory environment will look like in the next five years, let alone the next five months. However, if an avalanche of regulatory developments does materialise, it will represent a cultural shift that will catch some hedge fund providers unprepared. When controversy or scepticism surfaces around an investment product, regulators often respond by grabbing hold of the transparency stick and pushing for more investor disclosure and reporting. In that kind of environment, turning to a third-party administrator would be a way for asset managers to keep pace with the changing regulatory requirements and risk environments worldwide.
Should they chose a third-party provider, managers should chose an administrator with a history of providing transparency and valuation, familiarity with the retail sector and a close working relationship with global regulatory bodies.
The new world order of hedge fund servicing is certainly in the works – with or without more regulation. Administrators must be ready to meet the strategic and operational challenges that this realignment will present.
Gary Enos is executive vice president and head of alternative investment services for State Street Corporation