Hedge fund regulation
Published: January 22 2008 09:43 | Last updated: January 22 2008 13:59
Amid the global financial ructions, Tuesday’s publication of a set of voluntary standards for UK hedge funds felt like a solution to an old problem. Since work started on the project last June, mortgage lenders and structured finance desks have emerged as the mischief-makers, not managers taking straightforward punts on the movement of securities.
That is not to say the 140-page document – codifying existing best practices on disclosure, valuations, risk, governance and shareholder conduct – is a waste of time. On valuations, for example, it recommends third-party assessments. This tackles the conflict of interest inherent in most asset management models: while the manager is paid on the basis of assets going up in value, the investor just wants them fairly valued. The low cost of using the code’s kitemark should also encourage adoption, and not just in the UK, which is home to around 70 per cent of non-US hedge fund assets.
The code’s raison d’être is to provide extra comfort to investors but it is questionable whether they need it. Institutions seem happy to take their chances on the information provided. Global asset growth in the hedge fund industry was more than 50 per cent last year, according to Hedge Fund Research; overall assets under management should nudge $2 trillion this year. Moreover, the funds will remain in a regulatory lacuna. The standard-setters are at pains to emphasise that a new body funded by levies, the Hedge Fund Standards Board (HFSB), will oversee the standards, not compliance with them. While the Financial Services Authority will continue to regulate fund managers, the actual funds remain subject to very low-level supervision.
There is no way of telling whether the standards, on their own, would have been enough to head off the threat of tougher oversight. But with markets in the state they’re in, there is more than enough skulduggery elsewhere to keep regulators occupied.
http://www.ft.com/cms/s/1/78e6e28e-c8ce-11dc-b14b-0000779fd2ac.html
Financed by the industry, the Hedge Fund Standards Board will promote best practices and act as a “custodian” of voluntary guidelines.
www.businessweek.com/globalbiz/content/jan2008/gb20080123_145472.htm - 45k - Cached - Similar pages - Note this |
hedge funds standards board (HFSB) You might have already heard of the Hedge Fund Standards Board (HFSB). They are an organization built from the pocket …
richard-wilson.blogspot.com/2008/01/hedge-fund-standards-board-hfsb.html - 75k - Cached - Similar pages - Note this |
Firstly, the Hedge Fund Working Group has mysteriously evolved into a self appointed “Hedge Fund Standards Board.” Secondly, every single “standard”—already …
nakedshorts.typepad.com/nakedshorts/2008/01/new-standards-q.html -
Jan 23, 2008 … A Hedge Fund Standards Board is being set up to act as custodian of the standards. The board’s trustees will be responsible for updating the …
www.hedgeweek.com/articles/detail.jsp?content_id=241013 - 41k - Cached - Similar pages - Note this |
Jan 22, 2008 … The “comply or explain” expectation on hedge fund managers, the planned establishment of a Hedge Fund Standards Board to maintain the …
www.bis.org/press/p080122.htm
The UK-based Hedge Fund Working Group released its final ‘Hedge Fund Standards’ report, 140-odd pages of sound-sounding stuff that the good guys are already at least trying to do, and the bad-to-mediocre will studiously ignore. With markets focused on on their own calisthenics, the feedback loop on Tuesday’s announcement was more muted than it might have been a few months ago.
The Financial Times’ Lex acknowledged that a lot of the issues long blamed on hedge funds really, paraphrasing Bill Gross’s famous “non-bank banks” comment, belong on the doorstep of “non-hedge fund hedge funds.”
Amid the global financial turmoil, Tuesday’s publication of a set of voluntary standards for UK hedge funds felt like a solution to yesterday’s problem. Since work started last June, mortgage lenders and structured finance desks have emerged as the real mischief-makers, not money managers taking honest punts on the movement of securities. [Emphasis added.]
But Castle Hall’s Chris Addy, on his Risk Without Reward blog, was was profoundly disappointed:
We see two problems with the final report. Firstly, the Hedge Fund Working Group has mysteriously evolved into a self appointed “Hedge Fund Standards Board.” Secondly, every single “standard”—already woolly—has been amended so that a hedge fund manager is only required to “do what it reasonably can.” In all, this magic phrase appears some 40 times in the text of the standards. [Emphasis added.]
Somebody, and from a quick scan of the formal comments on the draft released last October it’s not immediately obvious who (although the report credits five prominent law firms with large hedge fund practices with helping bring the document together, so that would probably be a good place to start with the search warrants) got to this one with the castration shears.
Meanwhile, serendipity rules. The report was published on the same day that Bayou scammer James G. Marquez was sentenced, and something called Protean Investment Risks began offering insurance to protect hedge-fund portfolios “from any misrepresentation of assets, theft or other type of fraud by hedge-fund employees or directors.”
Linkage after the jump.
Doing what you reasonably can
by Chris Addy
Risk Without Reward Jan. 22 2008
Hedge fund regulation [$$]
The Financial Times Jan. 22 2008
Insurance for Hedge Fund Investors
DealBook (The New York Times) Jan. 23 2007
Hedge Fund Working Group Standards Board
Hedge Fund Working Group Standards Board
Hedge Fund Standards: Final Report
Hedge Fund Working Group Standards Board
Consultation Responses
http://nakedshorts.typepad.com/nakedshorts/2008/01/new-standards-q.html
The Hedge Fund Working Group, a group of hedge fund managers based in the UK, today published its final report, “Hedge Fund Standards.” It is, of course, encouraging to see any effort to define operational, accounting and business “best practices”: as due diligence practitioners, our work shows us each day the degree to which operational controls vary enormously across today’s hedge fund industry. We are, however, profoundly disappointed with the HFWG’s final document.
We had previously commented on the issuance of the HFWG’s draft report back in October 2007. We were also interested to read a subsequent article in the Financial Times, which made the point that the “weakness lies in the woolliness.” According to the FT at the time:
“It is hard to quibble with the main focus areas of the draft, such as fuller disclosure of where funds have invested their money, what strategies they follow and what their illiquid holdings are actually worth. The weakness lies in its woolliness. The draft standards stipulate the setting of “risk limits”, for example, without any attempt to calibrate them. This does not address the problem, which is that many funds’ limits are meaningless, set wide enough that they cannot be breached. Ditto the requirement that governing bodies appoint “reputable” auditors. The non-word “adequate” is used more than 40 times, while “sufficient” crops up almost as frequently.”
The final version, however, puts the first version to shame.
We see two problems with the final report. Firstly, the Hedge Fund Working Group has mysteriously evolved into a self appointed “Hedge Fund Standards Board”. Secondly, every single “standard” - already woolly - has been amended so that a hedge fund manager is only required to “do what it reasonably can”. In all, this magic phrase appears some 40 times in the text of the standards.
Let’s turn first to the idea of the HFWG becoming the “Hedge Fund Standards Board”. As accountants, Castle Hall Alternatives lives in a world where bodies such as the Financial Accounting Standards Board, International Accounting Standards Board and their peers worldwide promulgate accounting standards. At first glance, the name “Hedge Fund Standards Board” evokes the same sense of authority and independence.
However, the HSFB is not independent: its initial members are the 14 hedge fund managers who formed the hedge fund working group. There is, critically, absolutely no representation from investors.
We are very disappointed at the lack of balance in this initiative. It is simply impossible to introduce credible and enduring guidance as to industry best practice without specific involvement from investors. Indeed, in our view, investors should be the group that leads any best practice initiative: it is likely that investors may prefer distinctly tighter operational controls than hedge fund managers may prefer to deliver.
Let’s turn to the standards themselves. We’ll take a couple of examples - the very first standard on disclosure, and, secondly, the critical section on valuation.
The October 2007 HFWG draft report said that the best practice standard for disclosure was:
“Managers should carefully consider the appropriate level of disclosure and explanation of its investment policy/strategy and associated risks in the fund’s offering documents and marketing materials. When doing so they should take into account the nature (that is, the identity and sophistication) of potential
investors.”
This was already a bit - wait for it - woolly (exactly what is an “appropriate level of disclosure”, and is it a good idea to leave it to the manager to decide what is “appropriate”?) However, as the final “Standard”, the text becomes:
“A hedge fund manager should do what it reasonably can to enable and encourage the fund governing body to include an appropriate level of disclosure (taking into account the identity and sophistication of potential investors) and explanation in the fund’s offering documents of the fund’s investment policy/strategy and associated risks.”
Turning to valuation, the October 2007 draft said that:
“A hedge fund manager should seek to ensure that conflicts of interest over asset valuation are avoided by arranging for the fund to appoint an independent third party valuation agent and/or (where agreed with the fund governing body) by operating a segregated independent in-house valuation function.
The fund’s administrator will often be responsible for calculating the fund’s net asset value and, based on such calculation, the fees and expenses payable to the manager. Where the fund’s administrator is unable to perform this function or where the manager is involved in the valuation process because of its role in assisting the administrator, the manager should ensure that the relevant employees operate independently of the portfolio management team and are not remunerated according to the value of, or increase in the value of, the fund’s portfolio.”
In our view, best practice is always to appoint an effective, independent administrator (although we agree with many commentators that effective is just as important a criteria as independent). The HFWG hence provided an unwelcome either / or in this critical area, although the overall emphasis on independence and segregation of duties was a very positive step in the right direction.
2008’s final standard becomes:
“A hedge fund manager should do what it reasonably can to enable and encourage the fund governing body to put in place valuation arrangements aimed at addressing and mitigating conflicts of interest in relation to asset valuation.
HFSB believes that the most satisfactory way to achieve this is for a hedge fund manager to do what it reasonably can to enable the fund governing body to appoint an independent and competent third party valuation service provider.
HFSB acknowledges, however, that in some cases it will not be possible in practice to achieve both independence and the required level of competence by appointing a third party valuation service provider, in which case the involvement of the hedge fund manager in the asset valuation process will, to a greater or lesser extent, be unavoidable.
Where a hedge fund manager determines the value of any of the fund’s assets (whether by performing valuations in-house or providing final prices to a valuation service provider), it should operate a valuation function which is segregated from the portfolio management function and should explain its approach to investors. If a smaller or start-up manager considers it impractical to do so, it should disclose this in its marketing documents and do what it reasonably can to enable and encourage the fund governing body to disclose this in the fund’s offering documents.”
This “standard” now has multiple layers of exceptions - how can investors determine when involvement by the hedge fund manager in pricing to a “greater or lesser extent” is best practice, or when it is unacceptable? When does it become “impractical” to have third party oversight over valuation?
As we think about these issues, it is helpful to make a distinction between “best practices” and what we might call “threshold practices”. Threshold practices are the minimum that investors will accept, recognising that, in an imperfect world, it is unrealistic to expect every hedge fund to tick every “best practice” box. That does not mean, however, that such practices are ideal. True “best practices” must provide investors with the maximum level of protection from loss due to either honest error or, on occasion, dishonesty. We often make the point that if no-one ever made an honest mistake and if everyone was always honest, no business organisation of any type would need any operational controls at all. People do make mistakes, however - and every now and again someone breaks the rules - meaning that the goal should always be to create the most robust control environment possible.
Clearly, some very skilled and thoughtful managers have contributed to the HFWG standards and the document will generate welcome further attention to the best practice debate. We stand by our view, however, that to be meaningful, any best practice framework must be more specific, prescriptive and, above all, must incorporate the needs and preferences of hedge fund investors, not just the manager community.
TrackBack URL for this entry:
http://www.typepad.com/t/trackback/2427902/25381036
Listed below are links to weblogs that reference Hedge Fund Working Group - “doing what you reasonably can”:
……………………….
The Hedge Fund Standards Board acts as custodian of the best practice standards published by the Hedge Fund Working Group on Tuesday, 22 January.
Please click here to download the HFWG Final Report.
To access the foreward, executive summary and the best practice standards only, please click here.
http://hfsb.org/?section=10563
http://hfsb.org/?section=10563
![[Vikram Pandit]](http://s.wsj.net/public/resources/images/HC-GF900_Pandit_20051014070931.gif)
1.
January 13th,
2009
1:30 pm
Be careful of those hedge funds who actually made money in 2008. In other words, those who have been “successful” on short selling. It’s time to say something on that topic.
First, the fact that they made money in 2008 means that hedge is not even a part of their game plan. What is it? You name it.
Second, short selling itself means they are heavy on leverage. Anyone dare to use more leverage in such a year as 2008 is more perilous than Bernard Madoff.
Last but not least, let no one say any more that these guys are Americans.
— Posted by think again
2.
January 13th,
2009
2:57 pm
This fallout will certainly continue
I am just curious why all the greed blinded the hedge fund managers who couldn’t use various dynamic or static hedging to protect 100% of capital regardless of where the funds went
Yuri Rutman
http://section181.blogspot.com/
http://www.noci.com
— Posted by Yuri Rutman
3.
January 13th,
2009
7:18 pm
UBS, Citigroup and Merrill Lynch lost nearly $150 billion and were recused by their government or another institution. There are still more losses to be counted.
Hedge funds didn’t create the systemic meltdown of the financial system like the banks like Bear, Lehman, Merrill, Citi and UBS. Hedge funds only created losses for those investors foolish enough to pay out 2/20 for a false sense invincibility. At the end of the day, the large fees charged and the surviorship bias of information on purported returns created a large hoax that many of these ordinary money managers had supernatural powers. it was bound to happen as the market got bigger, cheap money disappeared and the upward market momentum stopped.
— Posted by hammer