The perfect storm – hedge funds in a time of uncertainty

By Marcus Killick, Chairman and Commissioner of the Gibraltar Financial Services Commission (01/07/2007)

In LATE OCTOBER 1991, three weather conditions combined. The first, an innocuous low-pressure system, merged with an icy cold high-pressure system drifting down from Canada. The resulting storm in the North Atlantic in turn met a late-season hurricane, Grace, blowing from the south. The effect was for that storm, in weather terms, to explode.

As a result winds blasted over the ocean at more than 100 mph. Ocean waves peaked at 100 feet – the height of 10-storey buildings. Waves 30 feet high battered the New England coast, destroying 200 homes. Nine people died, including the six-man crew of a swordfi sh boat from Gloucester, Massachusetts. all) as rational. History teaches us that this is only mostly correct. In a crisis irrational behaviour inevitably occurs. Investors are neither ignorant nor do they have perfect knowledge. Their behaviour is therefore as affected by others (‘herd trading’) as it is by market information.

Called at the time the ‘Hallowe’en Nor’easter’, this has become better known in the public mind as ‘the perfect story’.

Freak combinations of events, which themselves are manageable but together are virtually uncontrollable, are not restricted to nature. The combination of debt default by Russia, falling global stock markets and rapidly increasing debt spreads which brought the mighty Long Term Capital Management (LTCM), and nearly the financial system as a whole, to its knees, was the financial equivalent of a perfect storm.

However, the ability of investors to profit from a falling as well as rising market is highly attractive, as are the abilities to leverage and control exposure to loss by the use of derivatives. Therefore, since the decline of LTCM the hedge fund industry has grown exponentially into a US$1500 billion industry (or more, no one actually knows). Between 2005 and 2006 nearly half of the USA Securities and Exchange Commission’s (SEC) newly registered investment advisers were hedge fund advisers.

Small international financial centres from Cayman to Jersey are the home of a significant number of the world’s hedge funds. This is mainly fi scally, partly regulatory, driven. More than possibly any other product, hedge funds have begun to synonymise how the offshore world has developed into being providers of sophisticated high quality financial products. This is the future of the remaining successful centres and far from the seedy (and mainly unjustified) old image of homes for tax dodgers and money launderers.

Furthermore, the top offshore centres now have the independent support to further develop this. The independent reviews conducted by the IMF, have shown the major offshore centres, far from being a weak link in the global regulatory chain, match up to and sometimes beat their onshore counterparts.

Yet hedge funds, despite their popularity, are considered by some to bring with them significant risks which require a regulatory response. It is this that has caused one of the fiercest arguments in the finance industry lately.

Currently the debate now raging is over a range of simple issues. Yet, however simple the issues, the debate is passionate. The first is the definition of “what actually is a hedge fund?” In its paper of March 2006, publishing the results of its latest survey of hedge funds, the International Organisation of Securities Commissions (IOSCO) and none of the responding member regulators has adopted a formal, legal definition of the term ‘hedge fund’. IOSCO had in 2003 come out with some general characteristics of such funds, but there still exists no globally agreed definition of the term.

The second disagreement concerns the requirement to register funds in order to allow regulators to have a better understanding of the industry.

The SEC has estimated there are 8,800 hedge funds operating in the US but, because they are usually incorporated offshore, it was impossible to be certain. The SEC therefore introduced a rule requiring funds with more than 15 clients, or US$30m, to register with them. In June 2006, a US federal court overturned this rule (at the time of writing the SEC had yet to decide whether to appeal).

The second issue is who should be permitted to invest in hedge funds? Whilst they have been historically restricted to market participants, corporations and wealthy or experienced individuals, there is now a move, backed by some regulators such as the UK FSA, for retail investors to become involved. Yet the SEC has raised the minimum wealth of investors, barring hedge fund investment by any person or couple whose assets are worth less than US$1.5m (the limit was previously US$1m). This was because it believed the definition of ‘accredited investors’ (those who could invest in hedge funds) was ‘wholly inadequate’ to protect unsophisticated retail investors.

The issue of the retailisation of hedge funds has been raised by the March 2006 IOSCO report. IOSCO had found that few jurisdictions report any significant retailisation of hedge funds at this point in time, but some regulators anticipate that this is changing or may change in the future.

However, the third and most critical issue is the one for which no general solution has yet been proffered, that of systemic risk. The risk is that hedge funds might significantly accentuate a market downturn, both in speed and severity. Indeed they might be a significant systemic risk in themselves. This is because many funds invest aggressively using leverage and derivatives which increases the opportunity to profit but also carries the potential of higher losses.

This fear is based on the size of the industry, its investment strategies and its use of sophisticated predictive models. The comparative youth of the hedge fund industry means that many of these models have been untested in truly adverse market conditions. However, skilful stress testing in theoretical situations may be markets, like the weather always have the possibility of the freak combination of occurrences –the chance of the perfect storm.

In fact the reliance on modelling as a predictive tool is fraught with danger. Models often fail because they treat humans(and hedge fund managers are human after

Yet some still stand in danger of confusing correlation with causation. For years the number of storks in Finland correlated closely with the number of babies born there. There was however no causation.

Yet some believe that because certain indices currently move in relation to each other they are somehow tied with an invisible economic umbilical cord. Similarly, supposedly diverse strategies may unexpectedly correlate. LTCM used models based on the belief that volatility could be accurately predicted and that their exposure to the market could thereby be restricted. They calculated that they were unlikely to lose more than US$35 million in a single day. On Friday, the 21 August 1998, they lost $553 million.

The truth is that if market panic occurs it is general not selective. As a result market crashes result in the fall of virtually all areas, both sound and weak. As further investments are dumped to offload positions there is no guarantee that buyers will be there to step in in time. In previous crashes those holding fundamentally strong stocks could retain them until the market returned to sanity and corrected itself. Yet the ability of hedge funds, highly leveraged, with squeezed liquidity and facing margin calls to ride the storm, is far less clear. If a stock falls too quickly the opportunity to hedge may be lost; even fully hedged portfolios are not risk free.

Furthermore, as more hedge funds are created, the drive towards higher risk, lower liquidity strategies (eg emerging markets) and to stand out from the herd will grow. If investors pay high charges they will expect higher returns. Safe mediocrity is not an option.

There is, however, no commonality of view on the systemic risk posed by hedge funds. For example in July Sir John Gieve, the Deputy Governor of the Bank of England, said that hedge funds “have played a positive role in recent episodes of turbulence by absorbing some of the losses”. However, he added: “Their capacity and willingness to provide liquidity in the event of a large shock to the market remains uncertain.”

Others, like Professor Andrew Morris, go further and argue there is no “regulatory gap” in respect of hedge funds.

 Maybe a market downturn will not cause a systemic problem. Regretfully this is not the only negative issue affecting hedge funds. Between 2000 and 2005 mUS regulators alone unearthed 51 cases involving hedge fund advisers who have defrauded investors to the tune of US$1bn. Again, offshore has to be especially careful and must seek to avoid such issues as far as possible because of those who will claim such incidents just show offshore as inherently evil’ and so seek to validate their bias and erroneous views. Fortunately, to date many hedge fund frauds such as Bayou Management, could have been detected far earlier if it had been within a supervisory regime.

Similarly, hedge funds are capable of being used as vehicles of market abuse. This could be insider trading, facilitating negative market rumour to drive down a stock in which the fund has a short position, or a range of other devices, all of which affect market confidence. In March the UK FSA announced that there had been signs of insider trading before 29 per cent of UK mergers and acquisition announcements. Given the size and nature of the hedge fund industry it would be surprising if some of those signs had not come from them. For the good of those who behave, the risks of misbehaviour must outweigh its benefits.

Systemic risk, stock fraud and market abuse were not created by hedge funds. They have existed from the time stock markets emerged (does the “South Sea Bubble” ring any bells?). We all, regulators, industry and consumers alike consider we have learnt from the past, that our risk analyses provide sufficient early warning. Yet hedge funds have created a new paradigm because of their size and aggressive investment approach in an interconnected world where markets can change in seconds. Therefore the arrogant belief that we have controlled the risks that resulted in past crashes poses a major issue, particularly to those offshore centres that are the home to many of the hedge funds.

These centres are caught between the proverbial rock and a hard place. If theyincrease their regulatory supervision to alevel higher than onshore, they will drivefunds away. Yet if they simply match onshore requirements and a problem occursthey will come in for disproportionate criticism as the ‘home’ of the failed fund. As the home, it will be argued that they should have done more. Such accusations might not be fair, but any reader of the numerous historic attempts by onshore to deflect blame offshore will know they will be made and they will have an impact.

Offshore centres cannot, therefore, stand apart from this debate; we must engage with each other and collectively. We must ensure we are aware of the size, number and nature of the hedge fund industry in our locations. This can be done in a cost-effective way and one that does not breach the legitimate confidentiality of the trading strategies of the individual funds. Additionally, valuation methodology and charging structures should be transparent, links that may createconflicts of interest disclosed, proper audits carried out. Regulations should require that only appropriate (ie fit and proper) persons are engaged in the market. As the types of investor who may use hedge funds increase so must the risk warnings be clearer. We expect this of other types of investments – why not hedge funds?

Regulators must, however, ensure as far as is possible (for example for systemic risk reasons) that we don’t constrict the management of the fund by restricting, for example, how much leverage or how much risk is permitted. Our role here should be mainly to ensure that the corporate governance of the fund is such that the fund follows its own rules.

Appropriate regulation, far from restricting the growth of a sector, has been shown to encourage it. Under regulation and the resultant lack of trust by the investor is as deadly as overregulation.

Elements of the industry itself mustalso take self regulation seriously. As firms scramble to win business from hedge funds they must not overlook proper due diligence. Advisors, brokers and the funds themselves must have adequate processes against and be vigilant in looking out for market abuse.

By engaging in the international debate now the leading offshore centres can help frame a suitable supervisory regime for the hedge fund industry. If we fail to do so we may be left with a regime that is unsuitable for our needs.

In the hedge fund industry we have a huge new force in the global financial economy. It has the power to drive the markets forward but it also has the powerto plummet us into recession. It is globally portable, so weakening the power of national regulators to supervise them. As a result we have an over mighty subject.

What concerns me as a regulator is that part of the industry believes in its own immortality and that its predictive models will anticipate and counter any risk the markets may throw at it.

The truth is there is no such thing as aperfect market – but there is such a thing as a perfect storm.