| Performance and hedge fund regulation: get the debate straight |
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| 22/11/2004 | |
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Concerns about hedge fund performance are rising as regulators now take aim at an industry that has always been shielded from most rules. Once more, October returns displayed mixed figures for investors eagerly awaiting a much-needed boost. The Hennessee Hedge Fund Index (HHH) produced a positive return of 0,69%, while the MSCI World and S&P 500 (dividend included) climbed respectively 2,47% and 1,53%. The S&P Hedge Fund index is roughly showing the same result at 0,72% and the CSFB-Tremont is up 1,28%. The last illusions investors might have about this asset class should now be quickly fading away: 2004 will not be a memorable vintage for alternative investments. Year-to-date returns are 1,15% for S&P HF Index, 3,34% for the HHH Index and 5,12% for CSFB-Tremont, while MSCI World is up 5,39% and S&P 500 Total Return stands at 3,05%. In any case, global returns should be less than half of the average yearly performance during the 1994-2003 period (11,6 % according to CSFB-Tremont). Despite their poor performance since the beginning of the year, alternative investments remain a fashionable asset class for institutional and wealthy private investors. During the first nine months of this year, hedge funds attracted $47 bn of new money, with more than half ($26 bn) of the total amount poured into funds of hedge funds, according to Hedge Fund Research. Various professionals are now raising the issue of a toughening of the regulation and its potential to negatively affect performance. Nevertheless, it should be noted that the main objective of this new form of regulation is not to restrain hedge fund activities, but rather to limit their impact on the financial system. Over the last decade, hedge funds have become major players on many markets, with commodities, swap, credit derivatives, standing out as the most striking examples of hedge fund influence. Their activities have an impact on the way monetary policies are transmitted to the real economy and pose a global systemic risk through their impact on liquidity, as illustrated by the crisis induced by the collapse of LTCM in 1998. It is then understandable that market, banking regulators and central banks seek to the means to monitor data for now out of their reach - especially those related to debt, off balance sheet outstandings and leverage. Through several official reports published this year (read beside), major financial institutions such as the IMF, the BIS and the BoE have pulled the alarm bell about the risk on financial stability. Two main threats: the growth of assets under management and a strong leverage Much more than the potential negative consequences of regulation, hedge fund performances can be eroded by the growth of the industry, which now tops at $1 trillion. Sure enough, it is not the absolute figure that is worrying: Patrick Artus, head of market research for CDC IXIS Capital Markets, notes that this amount represents only 1 % of total financial assets (equity plus debt), and between 2 and 3% when taking leverage into account. But the fast growth creates a dilution phenomenon leading to the quick disappearance of arbitrage opportunities. In turn, 2004 performance for convertible arbitrage is only 0,20 % year to date. "The first nine months of this year set records inflows. Many participants believe a bubble is forming" warned last week Wilshire Associates, which currently advise Calpers on its plan to double its hedge funds allocation by a further $1bn. "The returns experienced over the last decade may be diluted in future by the sizeable amount of assets entering the sector. Larger hedge funds capital bases could impede their ability to deftly move in and out of securities to generate returns as larger flows chase the same inefficiencies" said Whilshire Associates, also raising concerns about funds of hedge funds and their embedded fees. The vice-president and treasurer of the World Bank, which invests $1,5bn of its $12 bn worth of assets in hedge funds, stroke a similar chord last week. Quoted by Reuters, Graeme Wheeler chastised investors "seeing hedge funds as modern-day alchemists solving their funding problems" At the same time, the New York Federal Reserve Bank has warned prime brokers against slackening their lending rules. It is the second main threat: the debt leverage of hedge funds. In its last quarterly review, the BIS linked the rise of the assets under management in hedge funds and the increase of the loans to non-bank entities (from $2,7tn at the end of 2002 to $3,2tn at the end of march 2004). "According to data from Van Hedge Fund Advisors International, at the end of 2002, more than 50 % of global macro and market neutral arbitrage funds had a high leverage level, equal or superior to 2, but only 28 % of all funds had a leverage superior to 2. From the beginning of 2003, the average leverage of the long short equity and event driven funds has doubled, from 80 % to 160 % today" said Patrick Artus. Portfolio approach All in all, investors must not ignore the risks stemming from hedge funds. Whatever a hedge funds sales executive tells its client, this asset class breeds on volatility and generate it. Byron R. Wien, chief analyst for Morgan Stanley, affirms that it is a mistake to put low volatility at a premium when selecting individual managers and suggest investors to adopt a portfolio approach to hedge fund investing, "using managers with different approaches and adding some and eliminating others each year". "As long as they pick a group of managers with different approaches so they are not closely correlated, they would be better served by choosing managers with superior long term returns, even if they have achieved those returns with relatively high volatility", he explains. The idea is that high volatilities of the individual non-correlated managers will offset one another, producing higher returns with lower volatility for the overall portfolio. In the end, the new compliance rules for hedge funds should be of great help to investors and consultants, who will have access to all the information available when making their alternative allocation. The blooming of a new industry, hedge fund consulting, might soon follow the trail of the explosion of hedge fund managers. This e-mail address is being protected from spam bots, you need JavaScript enabled to view it |
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