Hedge funds are not perfectly at the centre of the current market storm – that distinction lies with the banking sector, sub-prime lending and conduits. However the web of linkages between banks and hedge funds, the blurred distinctions between conduits, SIVs, and SIV-lites, the former sponsored and managed by banks, the latter sponsored by banks but managed by hedge funds, and the similarity of issues facing banks and hedge funds, particularly in relation to valuation and risk management, demonstrate how integral hedge funds have now become to the workings of the financial system.
Indeed, it is fair to say that the hedge fund industry has an influence in financial markets which is totally disproportionate to its $1.3 trillion of assets under management.
Whilst the current preoccupation may be with the role of hedge funds in relation to financial stability, there are other equally important issues of concern both to regulators and to other stakeholders. Regulators have a duty of care to supervise the activities of hedge funds not only in relation to financial stability and market integrity but also investor protection, particularly as the industry moves into more retail-friendly structures such as UCITS III.
For the corporate sector, and for some in the media, hedge funds have become, wrongly, synonymous with corporate activism.
And the political world has developed a growing interest in our industry for all of the above reasons plus a concern about the size of the rewards which accrue to the highest earners, and what this means for social justice and the balance of society.
All of these are legitimate concerns and it is incumbent upon the industry to address them. This does not come easily. Ours is an industry which has always placed a high value on privacy, both to respect the confidentiality of our clients and to preserve our own commercial and investment edge. There will be those who argue that public engagement of any kind goes against the grain of the maverick entrepreneurialism which is at the heart of the industry’s success. But such a position is becoming increasingly untenable. With influence comes responsibility.
The HFWG initiative is an important demonstration that hedge fund managers are taking this on board. But it is an initiative not just confined to hedge fund managers. Investors in hedge funds also need to play a partin the process. As Warren Buffett said about corporate governance: “the only real way to get improvement in corporate governance is to have big investors demand it.” If there are improvements to be made to hedge fund standards – and there should always room for improvement – then investors in hedge funds have as big a part to play as the managers themselves.
In the long only world, leading institutions have for a long time played an important role in setting standards and holding managers to account. CalPERS are perhaps the most well known in this respect for the way they have driven the corporate governance debate, but Hermes in the UK has played an equally important part and so have investor bodies like the NAPF.
There are very limited parallels to this in the world of hedge funds. In the United States, Hank Paulson has recently announced that the Presidents Working Group will be setting up two separate, complementary private sector groups to address issues of investor protection and financial stability. One group is for hedge fund managers and the other for hedge fund investors.
In the UK, AIMA have recently encouraged investors to contribute to their work through the establishment of an investor steering committee, and this is a start. But this committee only covers part of the investment community and does not include fund-of-funds, who represent a major share of the hedge fund investor community. It also remains to be seen whether the AIMA Committee will lead to the same kind of engagement as we are seeing with the Presidents Working Group in the US or the Hedge Fund Working Group in the UK.
The alternative asset management industry in the UK is fortunate in its regulatory regime. The principles-based approach of the FSA has given London a competitive advantage vis-a-vis other financial centres and enabled the industry to prosper. But the industry needs to take its responsibilities for self-regulation seriously.
There have been a number of warning signals of late which demonstrate what could happen if the industry does not take up this challenge and how political interest in our industry could lead to bad legislation. Nicholas Sarkozy has attacked “predator” hedge funds and has called for a European tax on what he calls “speculative movements” by financial groups. A range of continental politicians, particularly in Germany, have been in favour of a statutory code of practice. And there are even calls for more regulation in the United States.
The recent G8 meeting steered away from a statutory code of practice. But we should not be complacent. The hedge fund industry needs to be seen to be taking its responsibilities seriously. If not, others will fill the vacuum.
According to Richard Baker, the Louisiana Congressman, if self regulation “does not work, and we had an untoward event, the resulting actions of Congress will be very unhelpful to the market at large.”
Paul Marshall is a co-founder of Marshall Wace Asset Management
The HFWG is chaired by Sir Andrew Large and comprises 14 of the leading hedge fund managers. It is reviewing industry standards and best practice in relation to valuation systems, risk management and disclosure within the hedge fund industry.
The HFWG has published a consultation document that proposes setting up a board of trustees that would assume responsibility for best practice standards and for updating them in the future.
Responses are now invited on the consultation document and the consultation period will run until 14 December 2007. The HFWG intends to issue its final report in January 2008.
Commentary
Issue 31
Responsible Self-Regulation
With influence comes responsibility
PAUL MARSHALL, CO-FOUNDER, MARSHALL WACE ASSET MANAGEMENT
Originally published in the October 2007 issue