A New Code of Conduct For Hedge Funds

But will it be enough?

Originally published in the February 2008 issue

The Hedge Fund Working Group [HFWG] has recently released the findings of its consultation with the hedge fund industry, encapsulated in a set of voluntary standards. Much of its emphasis is on the conflicts of interest between managers and investors, and the improvement of governance within funds themselves. Compliance with the hedge fund standards will be voluntary, working on the basis of a ‘comply or explain’ scenario.

Sir Andrew Large, announcing the results of the consultation on 22 January, said that it was now time for “investors to help take this forward. This is a voluntary, market-led initiative based on disclosure. It is the investors who can provide the market discipline to ensure these standards are widely adopted.”

The HFWG’s composition is also interesting, made up as it is of 14 leading hedge fund managers, mostly based in London (the acknowledged capital of European hedge fund management with over $400 billion currently being managed by UK-based hedgefund operations). It was established last year as a response to ongoing fears being voiced by politicians (rather than regulators) about the threat posed by hedge funds to global financial stability. From an industry perspective, it is a shrewd move, as it stands as a practical answer to criticisms levelled at the sector by European politicians, amongst them German Chancellor Angela Merkel, and Peer Steinbrück, her finance minister.

What’s in it for investors?

One of the big selling points being aired by the HFWG was that its work would be of greatest help to investors, providing them with a set of principles and best practices which will help them to understand how hedge funds should be managing risks. These standards focus on the key areas of governance, disclosure, valuation, risk management, and activism. Each of these areas was ‘mapped back’ to the original set of principles articulated by the FSA.

Brad Ziff, a member of the HFWG and Director of the Hedge Funds Advisory practice at Oliver Wyman, a management consultancy, reckons that hedge fund firms will only have to make “minor adaptations” to meet the new standards. “Many hedge funds already have a number of these practices in place in some manner and will only need to sharpen them or be more careful in the manner in which they apply what they already do,” he says. “Others will need to make certain investments in resources, technology, additional models or approaches to risk, to meet the best practices.”

Ziff says it is perfectly likely that some firms will find that the new practices will not suit them, and will explain why they are not complying. He argues the standards are “market friendly and flexible,” and that it is up to individual firms, and their clients, whether or not they are adhered to.

Much of the onus in this new regime lies with investors. Ultimately, they will be the ones who will have to go out and encourage managers to adopt the practices. “The practices are only valuable to investors if there is support for the initiative,” says Ziff.

Tom Brown, Head of the Hedge Fund Services practice at KPMG in London, thinks that the response to the report from investors has been positive thus far. The only point of weakness he sees is the self-certificating nature of the regime, which “is only as good as the honesty of the people participating.” If the code is seen to be breached on one or more occasions, it will inevitably be devalued in the eyes of investors. Independent verification, for instance via GIPS and SAS 70 standards, still provides a more credible way for hedge funds to promote their credibility to investors.


The new standards also tackle the issue of valuations. The HFWG is calling for an independent process for the valuation of all complex financial instruments, and for higher levels of competence amongst the staff being tasked with these valuations. It is easier said than done, however.

According to Jérôme de Lavenère Lussan, Director of Laven Partners, “Agreements between managers and administrators are usually worded in such a way that nobody is held ultimately responsible for inaccuracies. If an asset is hard to value, it is currently permissible for the administrator to rely on information from the fund manager or the prime broker, which can lead to conflicts not fully addressed by the ‘new’ standards.”

Laven Partners is suggesting that the standardisation of agreements between fund managers, administrators and prime brokers would help to tackle the issue.

Dermot Butler, Chairman of Custom House, the Dublin-based hedge fund administrator, believes that administrators that were already following the practices laid out by AIMA, and had a satisfactory SAS 70 Type 2, will already be largely adhering to the HFWG principles.

“A hedge fund administrator needs to be ready to provide information to investors or counterparties as requested by the fund’s governing body, for instance the board,” he says. “None of the potential information requests [in the code of conduct] look too daunting. Indeed, most hedge fund administrators would be used to these requirements,” he said.

Butler does not see a challenge on the valuations front either, so long as the firm is following AIMA’s recommendations on hedge fund valuation, as issued last year. On risk management, he thinks administrators will need to keep an eye on the investment risk reports that may be generated in future, and see if any of these are to be provided by the administrator rather than the fund manager. “In my view it is not the hedge fund administrator’s responsibility to provide risk reports on the investments, and indeed that could represent a substantial uncompensated risk to the administrator,” he says.

Will it be enough?

Hector Sants, the new CEO of the FSA, is known to be in favour of some form of code of conduct that the hedge funds industry can sign up to, rather than a regime that the regulator would be tasked with enforcing. In a statement to The Hedge Fund Journal, the FSA said: “We welcome this initiative, and consider that its recommendations are a constructive addition to the material which hedge funds can draw upon.”

At London fund management consultancy Kinetic, partner Andrew Shrimpton thinks this is a new high water mark for the industry. “There is mounting evidence each week that hedge funds are not a threat to financial stability, and this will help to dissipate that,” he says. “It is a best practice standard that has been introduced here, one that goes beyond the minimum standards enforced by the FSA.”

The launch of the Hedge Fund Standards Board in the wake of the report is another shrewd move, as it ensures that current enthusiasm of the code of conduct does not go ‘off the boil’ in years to come, and its existence remains a suitable counterpoise to any further political criticism coming the hedge fund industry’s way in the months ahead. The hope that there can be some degree of convergence with the President’s Working Group Study on Hedge Funds in the US holds out the prospect of one day having some kind of set of globally recognised standards, although commentators like KPMG’s Brown suspect any US response will take into consideration the more litigious environment that prevails there.

We now await with interest the appointment of the permanent trustees of the HFSB, with Christopher Fawcett, AIMA’s Chairman, already named. If other individuals of similar calibre join him, it should provide the Board with plenty of credibility and much-needed political muscle going forwards.