By: BILL BLEVINS
Financial Correspondent, Blevins Franks
The Financial Services Authority (FSA), the industry’s independent regulator in the UK, has labelled the hedge fund industry as “complacent” towards risk and condemned its “disappointing” control of insider trading and market abuse.
The FSA report came after it visited a number of hedge fund companies in a bid to tighten up the industry’s operational methods.
“Some hedge fund managers had a high level of awareness and appropriate controls in place, others were less aware, had few controls and demonstrated a complacent attitude to the risks. We are disappointed by some of what we saw”, the FSA reported.
“We will be following up with the firms visited and are launching a programme of visits to a wider cross section of managers over the coming months to formally assess their market abuse systems and controls.”
The FSA plans to monitor the industry’s working practices, not only on insider trading and market abuse, but also on staff training, compliance, distribution of information, keeping records on transactions and recording telephone calls.
Now the Hedge Fund Working Group, established by 14 of the largest hedge fund managers in London, has proposed a voluntary code of practice to combat the pressure for increased regulation.
The financial watchdog is concerned about the increased number of hedge funds and the potential risk they have for the world’s financial systems.
During this summer’s global credit crunch, following the slump in returns, around 55 billion US dollars was withdrawn in July by panicky investors, according to reports from TrimTabs Investment Research and BarclayHedge. It was the worse month for redemptions in seven years.
Hedge funds invested in the sub-prime mortgages were the first to suffer and it is thought that the drop in equity markets towards the end of the month was caused by hedge funds that could not meet the redemption payments.
Hedge funds are supposed to have a stabilising influence on the financial system by their liquidity and diversification but it is thought the mass exodus from hedge funds was at the heart of the 2007 credit crisis.
Hedge funds were still reporting steep losses and falling asset values in October, according to UK lawyers, Withers. “This will no doubt prompt a rush to exit by their stakeholders and investors, forcing fire sales of assets to raise cash to meet redemption requests. This in turn will cause a number of investors to seek to redeem their interests in the funds. The funds can either suspend redemptions or sell assets at depressed prices to meet these redemption requests.”
For some time the Securities and Exchange Commission, the FSA’s equivalent in the US; the Federal Bureau of Investigation; the European Central Bank, as well as the FSA, have all been concerned about the manner in which hedge funds are managed and reported.
The regulators are anxious about the lack of transparency displayed by hedge funds. Hedge fund managers are enigmatic about their strategies which have become increasingly complex and sophisticated and almost impossible for many investors to understand.
Costs involved with hedge funds are high with a potential annual fee of two per cent and a performance fee of 20 per cent. These figures can be doubled if the investment is in a Fund of Funds.
Hedge funds have a reputation for scandals, the most famous of which was the collapse of Long Term Capital Management in 1998, which sparked a banking crisis in the US. The hedge fund lost half its assets in one month, amounting to two billion pounds sterling and later the value of the entire fund dropped drastically before collapsing.
Another scandal involved a trader for Amaranth Advisors in Connecticut, which lost the fund five billion US dollars in one week.
The operating practice of hedge funds include holding “short” positions i.e. selling assets which they do not own at a fixed price today in the hope that the price will fall before they have to deliver the assets. This is the opposite to most other funds that hold “long” positions i.e. shares are bought in the expectation that the price will go up and a profit is made.
Another strategy used by hedge fund managers involves complex investment instruments such as derivatives. A derivative is a contract where its value is derived from the price of another asset.
Hedge fund managers also bet on share price movements, bonds, currencies, commodities and fixed interest markets. Often these funds will be highly geared (borrowed) so small price changes magnify the returns (or losses).
Common complaints made by investors included being deceived about the value of assets; being given inaccurate industry specific data which influenced their decision to invest and slanted the rates of return; misinformation about exposure to the mortgage-backed securities market or to another type of investment which has failed or under-performed.
Despite the criticism, hedge funds have been popular with some investors over the years. Hedge funds can make large profits, they have low correlation with other assets and low volatility.
The UK is the second largest centre for hedge fund managers after the US and London is the leading centre of fund expertise in Europe. According to Hedge Fund Intelligence, the value of assets managed by UK fund managers exceeds 316 billion US dollars.
It is estimated that there are over 300 specialist hedge fund managers and over 79 mainstream asset managers who are managing funds and using hedge fund style strategies.