UK – The Bank of England has warned that long-term savings institutions’ search for yield and their move away from mature-economy equities towards alternative assets might lead to financial instability and abrupt asset price corrections.

The warning, in its half-yearly Financial Stability Review published on Monday, followed IPE’s story last week that the Financial Stability Forum, a global organisation of regulators, supervisors and governments, will look at the systemic risks of hedge fund leveraging in September. The Bank of England’s analysis, therefore, is expected to inform part of the Forum’s review.

The Bank said some of the shift into alternatives was driven by more integrated asset-liability management and/or a greater emphasis on diversification – which were positives. For some of the shift, however, (those partly matching fixed income-like liabilities with low-yielding bonds, for example, pension funds) there has been an accompanying focus on generating excess risk-adjusted returns relative to benchmarks, or alpha.

The Bank’s review said: “In practical terms, this seems to involve asset managers, and defined benefit pension funds in particular, allocating away from mature-economy equities towards a wide range of ‘alternative investments’, including hedge funds, emerging market economy assets, private equity, real estate and commodities.”

The two risks from such a shift were from mis-pricing of risk leading to over-accumulation of alternatives and “abrupt asset price correction” as portfolios adjusted to rising interest rates.

Bank officials are less concerned that recent bad performance in certain hedge fund strategies, such as emerging market and managed futures, which were down –3.31% and –6.46% respectively in April, had caused individual manager failures.

But, “what may be more significant in future is the record sale of capital flows into hedge funds during 2003 and 2004 spread over most of the main strategy types. About $125bn has flowed into about 5,000 live hedge funds since the start of 2003, according to the Bank quoting Tass Research.

This has led to questions about whether returns on capital might be lower in future and if investor expectations were proved to be unrealistic there could be some risk of sizeable withdrawals, the review said. And leverage is important in fixed income and, perhaps, macro funds and these strategies occasionally entail ‘crowded trades’ where investments are concentrated in a few positions.

“For credit-orientated funds, such as ‘distressed’, a combination of leverage, relatively illiquid products and a model-based approach to valuation and trading may, in the event of material asset price shifts, exacerbate stressed conditions.”

The risks are heightened by start-up hedge funds being concentrated in fixed income, currency and commodity markets and leverage taking different forms. In particular, investors, such as funds of hedge funds, “are said increasingly to use leverage, typically to be borrowing from investment banks against collateral in the form of their claims on the underlying hedge funds,” as well as hedge funds and their assets may be leveraged.

In addition, rather than investors using established hedge funds using ‘lock-ins’ to prevent fire sales due to mass withdrawals of money, funds of hedge funds were reported to the Bank to be using “adverse selection” and so turning to weaker or newer hedge fund managers unable or unwilling to impose these conditions. There is, therefore, increased scrutiny on prime brokers’ risk management role, the Bank warned.