The Case For Hedge Funds

AIMA's post-crisis thought leadership

Originally published in the July/August 2014 issue

Ever since the onset of the financial crisis, AIMA has worked tirelessly to demonstrate the case for hedge funds to policymakers, regulators, investors and the media. We have now pulled these various arguments and pieces of research together into a major compendium of our work, which we have called “The Case for Hedge Funds: AIMA’s Post-Crisis Thought Leadership”.

This article contains extracts from many of AIMA’s white papers and articles on a range of topics including the industry’s social utility, the impact of institutionalization, shadow banking, short selling and the industry’s reputation. AIMA is also well known for its comprehensive range of tools and guidance for members like our due diligence questionnaires and our suite of sound practice guides, which are available for members on the website and not covered in this compilation of thought leadership.

The work of demonstrating the value of the industry, of course, continues. We have more research in the pipeline which will enable us to continue to demonstrate the value of the hedge fund industry to the broader economy. AIMA will continue to make the case for hedge funds.

Jack Inglis
Chief Executive Officer, AIMA

The response to the crisis
“Whilst AIMA is extremely supportive of the ongoing efforts to resolve the global financial crisis, there is still a misconception that hedge funds played a significant role in the credit crisis and there is a very real threat that through this misunderstanding ill thought-out or politically driven regulation may be imposed. Many of the concerns expressed loosely about a ‘hedge fund problem’ relate to wider financial market issues; for too long hedge funds have been wrongly targeted as universal scapegoats for a wider market malaise. If all hedge funds disappeared tomorrow, these issues would still remain.

“Hedge funds did not cause the present market turmoil – they have an essential role in providing liquidity to the markets and will be important in assisting in any eventual recovery. With a significant part of assets under management coming from institutional investors, the hedge fund industry plays a key role in preserving savings and pensions across Europe and also generates tens of thousands of jobs across the continent. It is part of the solution, not part of the problem.

“AIMA’s role, as the global hedge fund industry’s voice, is to ensure that the voice of the hedge fund industry is heard by regulators and policymakers, to bring to their attention the benefits of the hedge fund industry and dispel the misconceptions surrounding it and, in doing so, add value to the current regulatory debate.

“The global crisis requires a global solution. AIMA is working closely with key authorities at a national, European and international level to reach global consensus on the issues concerning the hedge fund industry. Having set out its views to various authorities – such as the UK Financial Services Authority, the European Commission and the International Organization of Securities Commissions (IOSCO) – on what an enhanced, appropriate and proportionate regulatory framework could look like, AIMA has now publicly announced its new policy platform.”

– ‘A time for clear thinking’, by Andrew Baker, AIMA; HEDGE magazine, April 2009

Financial stability
“Throughout the G20, policymakers and practitioners are striving to construct a global system of oversight and supervision capable of identifying the build-up of excesses and stresses in the financial system, and address them in a timely and effective manner. The goal is to mitigate systemic risk and market meltdowns, and the related negative effects on the real economy.

“A fundamental premise underpinning the policy discussions is a desire to improve transparency; both at the market and counterparty level, and with and among supervisors. The global hedge fund industry, through AIMA, in February 2009 announced its support for a variety of policy initiatives focused on improving transparency. These included mandatory manager registration and the periodic reporting by larger managers of systemically relevant information to supervisors and other macro-prudential authorities. These principles are now universally recognized as the correct way forward.

“AIMA has been working with national and supranational authorities to develop a supervisory framework. Most appreciate the difficulties inherent in devising a reporting system for systemically relevant information. The data gathered needs to be relevant to the risks we seek to mitigate, and it must be understood that neither the public nor the private sector can draw on infinite resources.

“The primary goal is to improve the supervisory understanding of market dynamics, not to interfere in markets or to seek a ‘zero-failure’ regime. Policymakers should recognize that they will not be able to prevent all failures; nor is that a desirable goal.

“Hedge funds are not systemically ‘important’ institutions, based on the risk they pose to the financial system. But as mature market participants, they can and should contribute to financial stability analysis by providing authorities with systemically ‘relevant’ information. It should be noted that many of the largest hedge fund managers have been voluntarily sharing information with national and international authorities for many years.”

– ‘Hedge funds should contribute to stability’, by Todd Groome, AIMA; Financial Times, 31 January 2010

Hedge fund myths
“There is a famous scene in Don Quixote by Miguel de Cervantes when our hero attacks windmills that he imagines to be giants. The idiom ‘tilting at windmills’ is derived from this scene, and is used to illustrate the folly of attacking imaginary enemies. The phrase was used by Treasury minister Lord Myners to criticise Europe’s proposed Alternative Investment Fund Managers Directive. He said the regulation ‘tilted at mythical windmills and at times panders to prejudice’. Our industry is often portrayed as capable of single-handedly bringing entire countries and economies to their knees. The industry has been accused of causing the global financial collapse, of being dangerously over-leveraged, of ruining countless banks, and now of provoking a new sovereign debt crisis. The truth, of course, is far more prosaic and even dull.

“There are individual banks with bigger balance sheets than the entire global hedge fund industry. The industry is often said to be highly leveraged, yet leverage levels in the hedge fund industry are usually in the order of one or two times assets. Some sources have suggested the hedge fund industry accounts for half of all trading on stock exchanges, yet no figures have ever been produced to validate this. Other policymakers have suggested that hedge fund activity in the sovereign CDS market exacerbated the Greek debt crisis, causing Greece to pay significantly more on its debt. But again, the available data does not back this up. Similarly, short selling of financial stocks was argued to be ruinous for those banks affected. But an examination of the figures shows that not only did short sellers account for low (single-figure) percentages of total capitalization of banking stocks, but the subsequent bans failed to prevent the continuing fall in value of those bank shares.

“The critics of the world’s hedge fund industry should find some real monsters to slay. Rather than making the industry a scapegoat for all the ills of the modern world, they should devote their efforts to producing lasting solutions for the genuine and critical problems we all face.”

– ‘Don’t blame hedge funds for world’s woes’, by Florence Lombard, AIMA; Financial Times, 2 May 2010

The investor transformation
“The perception has long been that those who invest in hedge funds are high-net-worth individuals – the very wealthy. That was largely true when hedge funds first began many years ago, but it is no longer the case. Today, investors in hedge funds are more likely to be institutions such as university endowments, charitable foundations, public and private sector pension funds and sovereign wealth funds.

“This investor transformation has been a gradual process that reached a material milestone last year when, according to research by AIMA, institutions for the first time accounted for an absolute majority of hedge fund assets under management. Research has also shown that during much of the past 10 years, institutional investors represented the majority of net new investment capital in the industry. Such institutional interest is also evident among smaller hedge fund managers and many institutional investors are early-stage investors with smaller funds, even start-ups, believing they offer the opportunity for attractive returns.

“Of capital from institutions, AIMA’s research suggests that about one-third comes from pensions. Pension managers describe their interest in hedge funds as higher quality returns as well as additional risk management expertise and trading or market nimbleness – attributes which are particularly valued in recent volatile markets. From a macro perspective, advanced economies across the world are facing demographic pressures, and the funding positions of many pensions are challenged. Hedge funds are viewed as offering better risk-adjusted returns than other asset classes.

“The institutionalization of the hedge fund industry has been a developing theme for the past 10-plus years, and is likely to continue. As participants in a maturing industry, hedge fund managers of all sizes and from all regions are equipped today to attract and professionally service the growing institutional investor base. The infrastructure evident among asset managers and firms today will also assist them to meet new regulatory demands, and to offer a growing variety of products to the expanding institutional and individual investor base.”

– ‘The institutionalization of the hedge fund industry’, by Todd Groome, AIMA; Institutional Investor, 22 July 2010

The industry’s social utility
“We have heard a lot about speculation recently. Whether it has been cocoa in particular or commodities in general, or the pound, the euro, or sovereign debt, policymakers and self-appointed experts have queued up to attack ‘speculators’ whose speculation is allegedly ruining markets, bringing down currencies and economies – and even threatening to make chocolate more expensive.

“Some of the language used has been pretty choice. Some leaders talked of Europe being ‘under attack’ from speculators. Jean-Claude Juncker, the Prime Minister of Luxembourg and head of the Eurozone Finance Ministers’ group, commenting on a possible collapse of the currency zone, told Handelsblatt: ‘We have the instruments of torture in the basement, and we’ll use them when it’s necessary.’

“There is a way to neutralise ignorant and prejudiced attacks [about the hedge fund industry], and it is education. Making people understand that our industry is not part of the problem, but part of the solution. Showing them that we genuinely contribute to the economies in which we operate and to the global economy as a whole. Not only in terms of delivering returns to investors and price-discovery and liquidity to markets, although that is important, but in real tangible terms that people really understand.

“Jobs are one important example of that, but perhaps even more important is the social dimension the industry now has as the guardian of many people’s pensions and savings and the facilitator of their business loans and mortgages. In many instances it is hedge fund activity that enables pension funds, insurers and banks to offer the services that they do because they are niche operators capable of assessing and pricing risks that others are unwilling or unable to undertake.

“Ultimately the best antidote to attacks on ‘speculation’ is to demonstrate the social utility of financial services in general and our industry in particular. If our industry is perceived by policymakers as rich people making money for rich people using borrowed money then they will not hesitate to impose punitive regulation. If they understand that we are a vibrant, creative and indivisible part of the asset management sector delivering real and important benefits to society, they might think twice.”

– Speculation and social utility’, by Andrew Baker, AIMA; HFMWeek, August 2010

Value to investors
“The hedge fund industry has had no shortage of critics. It has been described as ‘locusts’, ‘parasites’ and other unsavoury terms. The main charge is that the industry contributes nothing to society or to the broader economy. The charge is mistaken and shows a misunderstanding about how the industry operates and who its investors are.

“A significant majority of its assets come from institutional investors like pension funds, insurance companies, charities and university endowments. There are very good reasons why institutional investors have chosen to invest ever-greater allocations into hedge funds. Because hedge fund managers use a variety of investment tools, they are better able to ‘hedge’ (remove unwanted risks) and thus deliver better risk-adjusted returns. If you look at risk-adjusted returns over the last decade, hedge funds have consistently outperformed unhedged mainstream investments like equities and bonds. And they have done so with lower volatility. Steady returns with low risk and low volatility are, of course, valuable to institutional investors like pension funds.

“The figures suggest that institutional investment now makes up about two-thirds of all assets being managed by the hedge fund industry. These institutional investors do extensive due diligence on the hedge fund managers they appoint. If they think it’s worth investing in hedge funds, it is worth listening to them. Investment by pension funds in hedge funds could mean a more secure or even a bigger pension for you when you retire and lower pension contributions while you are still working. Investment by university endowments and charities in hedge funds could mean more resources for them to devote to their important work, and less risk of market-related losses.”

– ‘Hedge fund critics misunderstand the industry’, by Andrew Baker, AIMA; Bloomberg, 29 September 2010

Short selling
“Of course short selling has its critics, often within those companies that are shorted. With Lehman, HBOS, Northern Rock, Anglo Irish, Kaupthing and others during the crisis, it was the same story — short sellers were blamed for their troubles. However, the picture that has emerged of those companies that failed is not of innocent victims of ruthless short sellers, but of badly run and often over-leveraged institutions. They fell not because they were shorted, but because they had been mismanaged.

“Short selling is really just a way of expressing a view that a particular stock is over-valued, and it appears now that the doubts many short sellers had about the companies they shorted were more than justified. And it is important there is a powerful incentive for investors to find out what is wrong with individual companies. For example, it was shorters who were the first to work out that something was up with Enron. Short sellers devote considerable time, effort and resources to establishing the reality behind corporate rhetoric.

“An enlightened supervisory regime, therefore, would observe their market signals and use them as a sort of early warning system. Rather than being a source of trouble, the practice actually offers regulators a useful way of anticipating trouble.”

– ‘Why short selling is good for capital markets’, by Andrew Baker, AIMA; Financial Times, 20 February 2011

“There are plenty of other examples where hedge funds were the “canary in the coalmine” that first noticed the approaching danger. It will not have escaped anyone’s attention that it was a hedge fund that first took a sceptical view about the over-valuation of the US housing market, well before the crisis. A decade before that it was hedge funds who first began to wonder if stocks were over-valued. More recently, hedge funds have expressed doubts about the ability of various sovereign and public entities to manage their fiscal positions, and have bought protection in the credit default swap market before those countries actually ran into financing difficulties and credibility problems in the bond markets.”

– ‘Good value in short selling’, by Andrew Baker, AIMA; Financial News, 1 November 2010

Shadow banking
“We have been hearing a lot recently about the ‘shadow banking’ sector. Senior bankers and lawmakers seem to have found a new bogeyman. The International Monetary Fund has called for enhanced oversight of “shadow banking activities”, while the G20 has instructed the Financial Stability Board to develop regulatory recommendations by the autumn.

“The broader point made by critics of “shadow banking” — that hedge fund managers are part of a vast, unregulated sector that threatens the stability of global financial markets – is wrong. Hedge funds do not inhabit the regulatory equivalent of the shadows. All the major jurisdictions where they operate – whether in North America, Europe or Asia-Pacific – regulate the industry rigorously, and generally have done so for years. What is more, this already significant level of regulation is being increased, not lessened, by legislation introduced since the financial crisis.

“It is of course no accident that the re-emergence of the ‘shadow banking’ term has coincided with the efforts of the US Financial Stability Oversight Council, among others, to identify systemically important financial institutions that will be the subject of additional supervision. But there is no evidence to suggest that a single hedge fund is sufficiently large, leveraged, complex or interconnected that its failure or financial stress would cause such severe disruption.

“Do not just take AIMA’s word for it. The UK Financial Services Authority conducts twice-yearly surveys of the 50 largest UK-based hedge fund managers, including some of the behemoths of the global industry, and has yet to find an individual hedge fund that poses a systemic risk.

“Of course it is possible that individual hedge funds could act together to create systemic impacts. But the hedge fund industry’s heterogeneous and proudly contrarian nature makes such unified action highly unlikely. The truth is that systemic risk continues to reside in ‘too big to fail’ institutions. Hedge funds, for their part, are not unregulated, shadowy or even bank-like. They are, as independent academics have noted, rigorously regulated, transparent to their supervisors, not systemic, and ‘small enough to fail’.”

– ‘Hedge funds are not “shadow banks”’, by Andrew Baker, AIMA; Financial Times, 15 May 2011

The industry’s reputation
“Three years on since the last crisis, it’s worth considering what has changed since 2008, and what progress the industry has made in terms of how it is perceived not only by the general public, but by investors, regulators, policymakers and the press. It’s easy to forget just how bad some of those headlines were three years ago: ‘Hedge fund horsemen of the apocalypse’, ‘Beasts who can tear firms apart’ and ‘Greedy pig billionaires’ were all real headlines. We are not seeing the same kind of hostility today. Where hedge funds were specifically blamed for the crisis three years ago, politicians now, insofar as they attribute blame, tend to point the finger at ‘speculators’ and their ‘speculation’.

“It may appear a subtle distinction but it is an important one. It means our industry is no longer in the crosshairs. Analysts and commentators have moved on too. Whereas three years ago it was common for our industry to be blamed for the crisis, now there is broad agreement that this is a debt crisis caused by political failures. In fact, some previously critical commentators have changed their tune. BBC business editor Robert Peston, not noted as a friend of the industry, now says hedge funds are ‘a model for how the banking system should be reformed’.

“What the industry can do is to seek to demonstrate its value to the general public. Because institutional investment now makes up a majority of the industry’s AUM it means the industry is now acting as the guardian of many ordinary people’s pension money and other investments. That is an important message for the industry to convey.”

– ‘Our industry is no longer in the crosshairs’, by Christen Thomson, AIMA; HFMWeek, 7 December 2011

Investor satisfaction
“The latest hedge fund performance figures show the average fund was down nearly 5% in 2011, and have prompted some to say: ‘The hedge fund model is broken’. It is worth noting that global shares, according to the MSCI All-Country World Index, were down 9.4% in 2011, but nobody is arguing that the joint-stock company model is broken. And no-one would argue that the mutual fund model was broken, either, after one bad year.

“It is worth putting 2011 in context as one of three down years in the last 20 for the global hedge fund industry. During 1999-2010, the major hedge fund indices averaged overall returns (after fees) of more than 8% per annum.

“Investors continue to express confidence in the industry. Barclays Capital has just put out a report saying that investors may add about $80 billion of net new capital to hedge funds globally in 2012, the most since 2007. More than half the investors surveyed by BarCap plan to increase their hedge fund investments in the coming year, more than seven times the number that plan to reduce their allocations.

“This may be because many strong managers with excellent performance-to-risk track records have continued to succeed in a harsh investment environment. And even those with poor results this year can often point to many years of success before this one. It is also because hedge funds can provide an important source of diversification for many investors. Pension funds have traditionally invested a large part of their portfolios in stocks and bonds, but there are now question marks hanging over the risk/return characteristics of both as a result of the sovereign debt crisis and concerns over the outlook for corporate profitability and growth.

“Indeed, many investors actually see hedge funds as a port in the storm. At least in theory, in a volatile and uncertain world, an investment manager who is active and who can hedge, which is to say, one who can offer protection on the downside, ought to be well placed to navigate the stormy weather we’re seeing right now.”

– ‘In defence of hedge funds: Institutional investors are giving a vote of confidence’, by Andrew Baker, AIMA; City AM, 20 January 2012

Long-term gains
“Hedge funds, their role within financial markets, and the returns they generate have been under considerable debate since the global financial crisis of 2008. Some policymakers have been quick to blame hedge funds for market failures, while some critics have questioned their performance.

“A newly published study from the Centre for Hedge Fund Research at Imperial College London, however, uses compelling empirical data backed by detailed analysis to contribute some much-needed objectivity to the debate about the merits of hedge funds. The research — commissioned by KPMG, the international audit, tax and advisory firm, and AIMA — provides powerful proof of hedge funds’ ability to generate stronger returns than equities, bonds and commodities, and to do so with lower volatility and risk than equities and commodities.

“The publication of this study comes during a momentous period for the industry. There has probably never been a time when there has been more interest in — and scrutiny of — the activities of hedge funds, whether by investors, policymakers, regulators or the media. Much of this is welcome and is in the long-term interest of the industry. Performance, fees and transparency have always been pivotal issues, but they have assumed even greater importance since the crisis. By focusing on a time period of some 17 years, the researchers have been able to present an informed and balanced view. Despite a desire in some quarters to focus on ever-shorter periods of performance, the real picture, as the study shows, is that hedge funds have been a very solid investment for a long time.”

– ‘Hedge funds prove their worth over the long term’, by Andrew Baker, AIMA; Institutional Investor, June 2012

Building a more robust financial system
“In terms of investor protection, we offer our support to policies and regulations designed to maintain and enhance sound legislative and regulatory structures which protect and enforce investors’ property, shareholder and creditor rights in a fair, equitable and proportionate manner. There is ample evidence showing that economies which provide robust regimes for the protection of property and contractual rights develop deep and liquid capital markets which are the source of economic growth.

“In terms of regulatory consistency, AIMA believes that all financial markets participants should be regulated in an appropriate and proportionate manner. Consistent and effective regulation of the financial sector, and the hedge fund industry in particular, should reflect the value of the industry to market liquidity and efficiency, the interests of its investors and the economy at large.

“In terms of understanding and mitigating systemic risk, we believe that it is desirable to have diverse participants in the financial markets with different capacities to take on particular risks. Micro-prudential regulation which does not recognise the different risk-bearing capacities of various financial actors could increase homogeneity of participants in the market. Rules which produce the same responses to economic shocks will aggravate those shocks.

“Regarding the problem of ‘too-big-to-fail’, we recognise that each type of financial services-related entity poses its own types of financial and, potentially, systemic risks. We believe that those risks should be adequately addressed in order to ensure that financial institutions are capable of failing without endangering public finances and the economy.

“In terms of market integrity, we call for clear and internationally harmonized definitions of market abuse. But we stress that the most effective way to combat market abuse is to target the actual abusive behaviours, not to restrict legitimate activities or the use of certain technologies wrongly seen as proxies for market abuse.

“In conclusion, AIMA believes that capital markets are crucial in the financing of the economy and the hedge fund industry plays an ever-increasing role in the entire chain of investing and financial intermediation, contributing to market depth, sophistication, transparency and thus its ability to support growth. It is important for the industry that the financial markets on which it operates are well functioning. We therefore wish to participate actively in the elaboration of policies in the areas of asset management and financial markets regulation with the aim of improving investor protection, market transparency and financial stability overall.”

– ‘AIMA’s Policy Principles reflect the importance of capital markets’, by Andrew Baker, AIMA; HFMWeek, 9 October 2013

The institutionalization of the industry
“The global hedge fund industry has made substantial investments in operational infrastructure and regulatory compliance since the financial crisis. This investment, already counted in the billions of dollars, will continue to rise as the industry becomes ever more institutionalized and is required to meet the new challenges posed by regulatory reform.

“AIMA has sought to examine this process in depth. In 2012, we produced a report with KPMG called ‘The Evolution of an Industry’ that looked at the increase in the global industry’s operational sophistication and transparency to investors. We followed this up in 2013 with arguably the most comprehensive survey of compliance investments made by hedge fund managers globally. That report – produced with KPMG and the Managed Funds Association (MFA) – included the views of 200 hedge fund managers representing more than $910 billion in assets under management.

“What we hoped to discover was how greater regulatory scrutiny was impacting managers and uncover some of the solutions that managers had implemented in response. We also wanted to compare the cost of compliance across different regions.

“The report, called ‘The Cost of Compliance’, found overwhelmingly that the sector was taking its compliance obligations seriously, with significant investments already having been made by many of those operating in the sector. Not only were managers putting significant time, effort and capital into meeting regulatory requirements, the majority had also elected to absorb these costs themselves, rather than passing them on to their funds and their investors.

“Ultimately, the addition of new resources and sharpening of focus on regulatory compliance and risk management suggest that managers are committed to meeting regulatory requirements as well as the increased demands of institutional investors. But it is important that regulation does not raise barriers to entry to the industry, since next-generation managers are an important source of new ideas and talent. Getting the balance right will be key.”

– ‘Investing in regulatory compliance’, by Andrew Baker, AIMA; Preqin’s Hedge Fund Report January 2014

‘Value to the real economy’
“The financial crisis of 2008 threw into sharp relief the weaknesses of the banking sector, prompting massive state bail-outs and decisive supervisory action by G20 nations. But this has left policymakers in the EU with a dilemma. How do they ensure that building a more stable, resilient financial system does not come at theexpense of economic growth? New rules have required banks to scale back the amount of money that they lend, which in turn means that European firms – particularly the region’s legion of small and medium-sized enterprises (SMEs) – are less able to access the capital that they need to be able to invest in and grow their business.

“This has led to increasing interest on the part of EU policymakers in the role that market finance – sometimes referred to as part of the ‘shadow banking’ system – could play in terms of filling the lending gap and allowing firms to access the capital that they need for growth. In its simplest form, market finance is based on a model whereby businesses are able to raise capital from investors by issuing shares and bonds – by accessing capital markets.

“Europe is an interesting region to consider, because it is characterized by differences between countries in terms of the balance between market finance and bank-based lending. We at AIMA, the global hedge fund industry body, were keen to explore these differences, to see whether this could provide broader insights into global financial structure and its future evolution. Specifically, what do differences in the balance between bank lending and capital markets mean for economic growth? Do capital markets offer a source of finance that has positive spill-over effects on the economy?

“AIMA asked two leading German academics in this field – Christoph Kaserer, Professor of Finance, Chair of Financial Management and Capital Markets, TUM School of Management, Munich; and Marc Steffen Rapp, Professor of Finance, Accounting & Finance Group, School of Business and Economics, Philipps-Universität Marburg – to explore these questions. Their work has resulted in the publication of a new study, titled ‘Capital markets and economic growth − Long-term trends and policy challenges’, which was launched in Brussels on 20th March. The study’s key finding is that the balance between market finance and bank lending does matter and that overreliance on banks comes at a cost in terms of reduced economic growth.”

– ‘Capital markets and the EU’s growth strategy’, by Adam Jacobs, AIMA; EU Reporter, 25 March 2014

Leverage and systemic risk
“Anyone skimming over the FCA’s latest Hedge Fund Survey could be forgiven for thinking that the UK’s hedge fund firms had suddenly loaded up on risk. After all, one of the survey’s main findings was that “collectively hedge funds have raised their leverage to 64 times fund assets” which is a figure far higher than normally associated with hedge fund leverage.

“A closer look at the data solves this paradox. The increase in leverage had been caused not by a dramatic increase in borrowing but rather by the FCA looking at a different measure of leverage which includes gross notional exposures. Gross exposure, which includes the notional amounts of all derivatives positions, will soon need to be reported under AIFMD, and it is also contemplated as a measure of hedge fund leverage by the recent FSB-IOSCO paper on systematically important financial institutions in the asset management sector.

“The fact that AIFMD and FSB-IOSCO look at gross notional exposures highlights a growing divergence and inconsistency in the way that risk data is gathered and interpreted in the financial system. Leverage numbers for banks, asset managers, broker dealers and hedge funds are being calculated differently. What is good about the FCA survey is that it provides the elements to be able to piece together a more adequate picture of risk incurred by hedge funds and compare it to the rest of the financial sector.

“So while the hedge fund sector has grown in recent years, the industry as a whole remains diverse, with even the largest managers being smaller than medium-sized banks. They have considerable liquidity in their portfolios and are employing much lower levels of leverage than other parts of the financial sector. The FCA data supports the thesis that, today, no individual hedge fund or manager is systemically important to the extent that its failure would endanger financial stability in Europe or globally.”

– ‘Hedge funds do not pose a systemic risk’, by Jack Inglis, AIMA; Financial News, 7 April 2014

“It is a debate possibly as old as the hedge fund industry itself. Investors, commentators and the media have long mulled over how to understand hedge fund performance and compare it to other investments. But since the financial crisis, and the QE-fuelled boom in public equities markets that followed it, these debates have intensified.

“It is all too common today for comparisons between aggregated hedge fund indices and equities indices like the S&P 500 to be made. For example, a set of monthly hedge fund index figures is often compared to the S&P 500 in that period with the latter used as a proxy for the ‘market’, with the difference between the two interpreted as hedge funds either under or overperforming “the market”.

“This of course is not the way most institutional hedge fund investors or funds of hedge funds measure the performance of their allocations. They may have a particular return figure in mind for the hedge fund part of their portfolio – the ‘risk-free’ rate plus X, say – or be seeking to lower volatility or provide downside protection.

“They are not generally looking at their hedge fund allocations and thinking, ‘we must beat the S&P 500’. Just as there are many different types of hedge funds, so there are many different things that investors are seeking from their hedge fund allocations.

“Indeed, it is striking that recent surveys have highlighted high levels of investor satisfaction in hedge funds at a time when many commentators have claimed that the industry is being outperformed by the ‘market’. The reason for this is that investors are not allocating to hedge funds to beat the S&P 500, but to allow them to meet their asset-liability management objectives in terms of risk-adjusted returns, diversification, lower correlations, lower volatility and downside protection.”

– ‘Understanding hedge fund performance better’, by Jack Inglis, AIMA; InvestHedge, 9 June 2014