In disturbed conditions hedge funds add to market volatility and the ‘herd’ phenomenon can accentuate market movements and destabilise market dynamics. How do you plead?”

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Behind the mask
Hannah Smith ls


Michael Fallon, a member of the Treasury Select Committee, asked five influential players in the hedge fund world: “In disturbed conditions hedge funds add to market volatility and the ‘herd’ phenomenon can accentuate market movements and destabilise market dynamics. How do you plead?”

These industry representatives were grilled by the committee last month as part of an ongoing inquiry into the causes of the banking crisis.

The hedge fund sector as a whole has been demonised as the crisis has deepened. Hedge funds are a secretive and media-shy segment of the market, partly because legislation prohibits them from speaking freely to the press. As a result these complex investment vehicles are seen as strange and exotic, and are largely misunderstood.

Blame has been laid at hedge fund managers’ doors as the authorities have tried to understand the drivers of the credit crunch, the force of which has taken everyone by surprise. Critics of hedge funds say they hastened the collapse of the big banks by betting that their share prices would fall; caused upheaval in the markets by simultaneously selling off their assets; and tried to create market dislocations to take advantage of the resulting buying opportunities.

But hedge fund managers say they too have been the victims of Britain’s financial collapse and not the cause.

Hedge funds stand accused of profiteering by making short bets on banking stocks, driving them down, and thereby causing instability in the financial system.

Quizzing the managers, Nick Ainger, a Treasury Select Committee member, asked how the vast profits hedge funds made through shorting banks that subsequently failed might have affected the public’s confidence in the financial system.

Paul Marshall, the co-founder of Marshall Wace, a prominent hedge fund group, says the key responsibility of a hedge fund manager is to his investors, so managers try to keep their vehicle’s performance stable through volatile markets.

“Certainly, in the case of Marshall Wace that is how we use hedging,” he says. “Typically there will be shorts and longs in the same sector. If we look at the aggregate position last year, the industry lost – we are not proud of it – 18%. The industry is not sitting there making vast fortunes at the expense of the British public.

“Somebody said to me yesterday that to blame hedge funds was like blaming passengers for a bus crash. The hedge funds are themselves suffering from the financial environment. Occasionally, some of them make profits and that is taken out of context and is, I think, misleading.”

Hedge fund bosses blame the banks for overstretching their balance sheets and buying toxic assets, and claim it was only a matter of time before this would drag their share price down. Marshall says the aggregate leverage in the hedge fund industry fell from 1.7 times to 1.4 times in 2008, compared with an average level of 40 or 50 times for the banking sector.

Douglas Shaw, the head of BlackRock’s proprietary alpha strategies team, says: “Some hedge funds have made profits from the decline in bank share prices. They had a legitimate purpose to serve in trying to meet the objectives set by their clients, but I do not think it is right to say they made money out of the misfortune of others.

“They felt that share prices in banks were too high; they had an expectation that those share prices would fall, but the fact that prices did indeed fall does not mean they made the share price fall.”

Graham Shore, the managing director of Shore Capital, is similarly incredulous that hedge funds caused the collapse of the banking sector.

“It may be that by going short and using leverage, hedge funds made the markets react more quickly than they might otherwise have done, but there is no credibility in the idea that hedge funds caused the banks to collapse,” says Shore. “The banks were over-exposed and they were holding the wrong sorts of assets. Their share prices would have come down anyway.”

Other voices of dissent say hedge funds acted as a warning system that something was afoot in the markets. Christopher Miller is chief executive of Allenbridge Hedgeinfo, a hedge fund research and ratings service. He says: “Some hedge funds actually alerted the world to the subprime problem by betting against it and stopping it from building up further.”

When HBOS’s shares fell by more than 70% in a few days, the Financial Services Authority (FSA) suspected foul play by short sellers and put a temporary ban on shorting banking stocks. But an investigation found no evidence that rumours about the bank’s financial stability had been started by short sellers to drive down the share price.

Research by IMS Consulting in December 2008 reveals widespread criticism of the perceived “knee-jerk” reaction by the regulator to plummeting banking stocks. Those surveyed said the FSA should have consulted the industry before introducing the ban.

Among the 100 respondents within the hedge fund industry, IMS says there was no support for a short selling regime that singled out financial stocks. Most (95%) said restrictions should only be applied to instances of naked short selling, or during a rights issue. Naked short selling can be used to illegally manipulate stock prices by selling securities that may not exist. Managers sell them on without owning them.

Some industry commentators claim the FSA’s emergency measures made the situation worse by restricting liquidity in the market. Miller says: “The temporary ban on shorting was a good thing in that it showed shorting had absolutely no effect. Liquidity was reduced after the ban was introduced. The truth is that hedge fund activity decreases volatility through providing greater liquidity to the market. No-one could argue that arbitrage strategies, which involve shorting, do not make markets more efficient.”

An arbitrageur arguably behaves something like a vulture circling a herd of drought-stricken antelope, waiting for the weakest to fall so it can devour the remains. A grisly image, but it illustrates how, in the view of hedge fund managers, they encourage the survival of the fittest. They prey on distressed assets, removing inefficiencies in the market and ensuring only the strongest companies survive. Hedge funds say this function in particular proves they are good for the economy.

Miller describes the relationship between hedge funds and the market as “mutualistic symbiosis”, in which increased liquidity and efficiency comes from trading volume and
arbitrage strategies, which benefits both parties.

However, talking abstractly about how hedge funds benefit markets gives little comfort to investors whose personal losses have quashed their confidence in the financial system. One such group includes the victims of Bernard Madoff’s pyramid scheme, which fleeced thousands of investors out of about $50 billion (£34 billion).

Institutions such as Bramdean, a British alternative assets boutique, as well as Fortis, RBS and Santander, and individuals including Sandy Koufax, a legendary baseball player and Frank Lautenberg, an American senator, all lost significant sums to Madoff.

It is important to note that Madoff was not technically running a hedge fund. He was actively trading securities using a hedge fund-style strategy. His clients could only invest through feeder funds which kept them at arm’s length and prevented them carrying out due diligence on Bernard L Madoff Investment Securities (BMIS) itself.

A paper released last week by EDHEC Risk and Asset Management Research Centre points out “red flags” within Madoff’s business that potential investors should have noticed.

The report, written by François-Serge Lhabitant and Greg Gregoriou, both academics, identifies several warning signs. These include the obscure auditors that Madoff was using, unusual fee structures, lack of disclosure and too few staff on the payroll. They say: “The list of due diligence red flags was so long and unsettling that it should have deterred potential investors.”

In fact, as early as 2000, Harry Markopolos, a financial analyst, had noticed underhand activities at BMIS. He suspected Madoff had perpetuated a fraud on the scale of about $7 billion.

The Securities and Exchange Commission (SEC) finally investigated both the firm and one of its feeder funds in 2005 but found nothing more than a few technical violations that were subse­quently corrected, according to EDHEC. The case was closed.

On the face of it, the SEC seems to have a lot to answer for following such a gross oversight. The losses from Madoff’s giant Ponzi scheme were not confined to American investors, and neither was the resulting loss of confidence in the financial system.

Lhabitant and Gregoriou say a traditional hedge fund would not be able to conduct itself the way Madoff conducted his quasi-hedge fund strategy. A hedge fund manager would not be allowed to be the custodian and administrator of their own assets due to the obvious conflict of interest and the ease with which those assets could be manipulated.

What Madoff perpetuated has been described as the largest fraud in history. But it is important to remember that it was a fraud, and not evidence that the entire hedge fund sector is on the brink of systemic failure. So are people really right to be wary of hedge funds or is this just fear overtaking greed? Should hedge funds face stricter regulation?

Unsurprisingly, opinion is divided. Gavin Anderson, a British financial public relations agency, polled 30 hedge fund managers from Britain, America and Continental Europe soon after the Madoff scandal broke. More than half (58%) said their sector should face more stringent regulation, while 71% were “resigned to governments extending regulation of their industry”. The survey also revealed negative and even fearful attitudes to the British hedge fund industry. More than 60% of respondents thought more financial scandals would emerge in 2009, and some 70% said a Madoff-style fraud could occur in London.

Could Madoffgate happen here? Miller says no. “It is highly unlikely that a fraud like Madoff’s would happen in the UK, but of course you can never say never. One of the main issues was auditing. The SEC generally accepts the information given to it by companies. It allowed Madoff to get away with it.”

Shore shares this view. Although he concedes there will always be a possibility something similar could happen here, he says there is a world of difference between regulation of hedge funds in America and Britain. “Hedge funds in the US have never been regulated,” he says. “In the UK, managers are regulated even if the underlying hedge fund is operating from an offshore base where there is a light level of regulation.”

He adds that regulation in Britain is tougher than the popular perception, “It is a misconception that hedge funds are unregulated. There is a very light touch in the US, but in the UK there is regulation whether you are an onshore or an offshore vehicle. I would always want to invest with a manager who is on the FSA register. The UK’s regulatory environment gives it a great competitive advantage.”

If the FSA did attempt to take on a greater role in policing the hedge fund sector, it might struggle. Olivia West, a fund of hedge fund manager at Shore Capital, suggests the FSA would not be fit for purpose as its remit is to protect retail investors, for whom hedge funds were not initially intended. She says institutions should be responsible for conducting their own due diligence before investing in these vehicles, and doubts whether the FSA could prevent an incident on the scale of the Madoff fraud.

Paul Marshall’s comment to the Treasury Select Committee that hedge funds have been as much a victim of the credit crisis as long-only funds, seems to bear out when you consider performance data from the sector.

Recent research from SEI, an operations outsourcing company serving hedge fund clients, says 2008 was the worst year on record for hedge funds, with most strategies posting double-digit losses. As the credit crisis deepened, hedge funds globally saw $70 billion of redemptions between June and November last year, according to the Centre for Hedge Fund Research.

West agrees performance was dire across the board in 2008. “Over the calendar year to December 31, 2008 the Credit Suisse Tremont Blue Chip index was down 26%, which is horrendous performance for a total return product. For comparison, global equities measured by the MSCI World index fell 42% and the Credit Suisse High Yield index fell 26% over the same period,” she says.

“You don’t want hedge funds to be too correlated with each other, but unfortunately they were all correlated in 2008. The key element was deleveraging which led people to seek liquidity wherever they could find it. They had to sell off their best, most liquid assets to raise cash.” The problems arose when hedge fund managers all did this at once, she adds.

SEI surveyed 95 hedge fund investors across Britain, America and Continental Europe in August 2008 and re-interviewed 32 of these in November to see how attitudes had changed. Its findings suggest that generally investors are taking a long-term view and maintaining their commitment to hedge funds, although they are concerned by dreadful performance figures.

Between the first and second surveys, the number pointing to performance as their biggest worry rose from 67% to 84%. Lack of liquidity, funds failing to accomplish their stated goal, and headline risk were other areas of concern.

One point to note is that some respondents to the survey remain committed to the sector because they have no choice – their capital is subject to lock-in provisions and cannot be withdrawn. Another is that the survey was conducted before news of the Madoff fraud broke so the reaction to this was not taken into account.

Three out of four investors questioned in November said they had taken “no action” in response to the credit crisis. One in 10 planned to cut their exposure to hedge funds by at least 10%, citing concerns over transparency as the reason.

It seems reasonable to assume that due diligence standards will be tightened and investors will scrutinise hedge fund managers’ risk management processes. SEI’s report concludes: “The hedge funds succeeding in years to come will be those that stand up to intensified due diligence by exhibiting institutional quality, providing more transparency and delivering consistent, non-correlated returns over time.”

Miller is convinced that a big shake-up in the sector is on the horizon. “Hedge funds will survive, but the strategies that relied on high leverage will no longer exist.

“Managed futures strategies, for example, will continue to do well because they do not need buoyant ­markets, they just need markets that are returning to their normal trends,” he says.

For those hedge funds that survive the worst of the downturn, it is unlikely they will be able to access a high degree of leverage for some time. West explains: “Average leverage from the beginning of 2008 up to now is astonishing in terms of how much it has come down. There is no longer the same availability of credit.”

She says there is a close correlation between levels of volatility and leverage in the market. When volatility began to spike last year, hedge funds needed more leverage to be able to achieve returns. Shore explains that this phenomenon is similar to a ship sailing on rough waters – it needs more sails higher up the mast to move in such turbulent conditions.

As well as widespread deleveraging, another potential trend this year could be hedge funds moving towards a
Ucits III structure to meet investors’ demands for transparency.

According to West: “A lot of institutional hedge funds are already duplicating their structures as Ucits III. But a lot are taking the Ucits III structure that lets you get short exposure without taking short positions, by using derivatives or ETFs instead, for example.

“I think we will see this pattern continue – Ucits III hedge funds have lower fees, daily dealing and increased transparency, which overcomes investors’ worries about lack of liquidity and ease of trading,” she says.

GAM is one group that has already made this move, packaging its GAM Star Absolute EuroSystematic hedge fund as a Ucits III vehicle. Rob Cornish, an investment manager on the fund, says running a hedge fund in this way has advantages, as long as there is a sensible risk management protocol.

Ucits allows firms to bring long/short funds onshore within a tax efficient structure, and gives diversification benefits to investors who can allocate up to 10% of their portfolios to alternative assets, Cornish says.

Strict compliance rules are also beneficial to clients, he adds. “For example, the Ucits III counterparty risk requirements, with respect to how much of the fund’s assets can be deposited with a single institution, are much tighter than people would expect in the offshore world.”

In a post-Madoff climate of fear, tighter rules and less opacity in the hedge fund arena could be a strong selling point for these products. But Cornish warns Ucits III is not a substitute for due diligence.

“Even if the majority of asset management houses did adopt Ucits III, regulation in itself does not provide a perfect solution. There is much more that must be done,” he says.
Few hedge funds have adopted the Ucits structure up to now, but Cornish says this is because it is still early
days – the IMA’s Absolute Return sector, where such funds would sit, is less than a year old.

“Over the past 12 months market conditions have meant that hedge funds have been preoccupied with issues such as performance and liquidity,” he says.

“I think it is more likely that you will see a continuation of the trend that we have experienced to date. That is, for traditional long-only fund management businesses to launch long/short Ucits III products rather than experienced hedge fund managers.”

However, looking further forward, Cornish expects the overall convergence between retail and institutional investment products to continue.

The depth and scale of the financial crisis has shocked the world, and it is not surprising that the authorities and the public have looked to every corner of the financial services industry in the search for answers.

While the hedge fund chiefs pleaded “not guilty” to Fallon’s charge, last week the heads of the “big five” British banks apologised for their role in the crisis. Many parties have contributed to the disastrous events of the past 18 months. The problem facing the authorities is how to learn from these mistakes and attempt to repair the damage.