Hedge funds under increasing regulatory scrutiny

Despite a resurgence in popularity, Janine Mace explains why hedge funds are coming under great scrutiny from regulators worldwide.

While hedge funds may be enjoying a renaissance when it comes to performance, regulators around the globe are increasingly putting them under the microscope.

After a string of collapses, concerns about short selling and allegations of fraud linked to hedge funds, regulators are talking up the need for closer scrutiny of this sector of the market.

Much of the current concern stems from the activities of hedge funds during the global financial crisis (GFC) and their potential to threaten the global financial system.

At the Australian Business Economists Annual Dinner in December, the Reserve Bank of Australia governor, Glenn Stevens, expressed concern about the so-called ‘shadow banking system’ — which in his view includes hedge funds.

“These entities were typically less closely supervised or unregulated, but in some cases their risk-taking behaviour and subsequent travails had systemically significant impacts on the core financial system,” Stevens said.

With regulators now recognising the risks these activities could create, Steven said the “regulatory perimeter is being extended”.

“Some of the relatively less supervised institutions that were problematic prior to the crisis no longer exist. But other institutions whose actions could on occasion be of systemic importance, such as hedge funds, are being subjected to more oversight,” he said.

Regulatory concern has spurred the European Union (EU) to consider imposing tighter restrictions on the activities of hedge funds and private equity groups.

It is currently debating the Alternative Investment Fund Managers Directive, which includes proposals to restrict the access of EU investors to outside funds and new rules on borrowing limits and disclosure of sensitive information.

Although the US and the UK have both vowed to oppose many of the proposed EU controls, regulators in the US are currently taking a closer look at some alleged hedge fund activities.

Bloomberg has recently reported that the US Justice Department is launching an investigation into whether hedge funds have banded together to drive down the value of the euro.

With some investment markets remaining volatile, hedge funds are likely to find themselves receiving more visits from nervous regulators.

In Australia, the Australian Securities and Investments Commission (ASIC) is planning to pay more attention to the hedge fund sector. It is about to commence a surveillance of hedge fund managers to identify any fringe operators whose business models create a fraud risk.

This initiative comes in the wake of the Astarra Asset Management collapse, which led to intervention by ASIC and the Australian Prudential Regulation Authority and resulted in asset freezes and Australian Financial Services licence suspensions.

Feeling relaxed and comfortable

Despite all the regulatory interest, little has changed in the lives of most hedge fund managers.

According to Zenith Investment Partners associate director Ben Davis, the industry is still waiting for regulators to act. “[Since] the GFC there were a lot of reports about changes to hedge funds, but there have been few reforms to date,” he says.

AMP Capital portfolio manager Matthew Hopkins agrees there has been little action, and says this makes it hard to assess the likely effect on the industry.

“It is very early days to draw conclusions about the impact of this debate,” he says.

“There has been a lot of discussion in government circles and it is likely to be beneficial on average if the regulatory regime requires better compliance and government standards. I just hope there are no draconian kneejerk reactions.”

Australian Fund Monitors chief executive Chris Gosselin believes the consequences of any reforms will vary.

“Regulatory initiatives by the EU and the [Securities and Exchange Commission in the US] will affect local managers that want to look to market into those jurisdictions, but it will not have an impact on most local managers,” he says.

“The ASIC surveillance will not affect managers who are doing what they are supposed to. It shouldn’t be a problem unless the manager is doing something wrong.”

Most industry watchers are relaxed about the impact of greater regulatory interest — unless it prevents hedge funds from making money.

“The tighter the controls on shonky operators the better, but if it inhibits the role of good managers it will be a problem,” Gosselin says.

Hopkins agrees the hedge fund industry is generally supportive of reasonable reforms. “Everyone in the industry would welcome sensible and effective regulation,” he says.

The global hedge fund industry association, the Alternative Investment Management Association (AIMA), has already signalled it is unconcerned about proposals for increased oversight.

It supports both registration of hedge fund managers in the US and reporting of systemically relevant information by larger managers to national authorities in the interest of financial stability.

However, it is concerned about the costs additional reporting will impose, according to AIMA chairman Todd Groome, who says: “Managers should not be burdened with expensive and unnecessary reporting requirements. If we ask even smaller managers to provide such information, we run the risk of overwhelming managers and supervisors.”

Getting ready for change

While there has been little concrete action, many hedge fund managers are keen to be ahead of the curve. “There has not been a lot of change to date, but they are focusing on getting their structures right,” Davis says.

One of the biggest legacies of this trend is likely to be increased transparency.

“There is more focus on reporting and risk management, and this may support the bigger managers in the space as they have the internal resources to do this,” Davis says.

Hopkins agrees transparency is growing, particularly when it comes to the proprietary investment techniques used by some funds.

“Increasing openness by managers is being demanded. We are not seeing ‘black box’ type scenarios as being acceptable any more,” he says.

“Managers now need to provide transparency in terms of where the returns are coming from and how they are being generated.”

Despite the push for greater regulatory scrutiny, the biggest force for change in the hedge fund sector may be investor fear. Concern about the lack of control of investment assets in hedge funds has sparked investor interest in managed accounts, with major international managers such as Man Investments leading the charge.

“Investors are seeking to gain greater control of their assets,” Davis says.

According to Hopkins, this trend is gathering pace. “We are seeing increasing interest in managed account structures and greater control over the investments.”

Davis believes for many hedge funds this will become their normal mode of operation.

“We believe many strategies will be moving to managed account structures to reduce the potential for fraud and operational risks. These structures would better control valuation policies, cash policies and the inappropriate use of gating,” he says.

However, such a move is not without its problems.

“Some of the better managers have no incentive to agree to these structures if they are already highly profitable,” Davis says.

“Also, some of the less liquid sectors are more difficult to implement under a managed account structure.”

A bigger problem for hedge funds may be the tighter environment for capital raisings.

“Raising capital is the greatest challenge for hedge funds after performance at the moment,” Gosselin notes.

Hopkins agrees funding is a real problem, despite the launch of several new hedge funds following the GFC.

“Investors are more demanding in terms of the infrastructure they expect to see. You also now need seed investors and a demonstrable track record to succeed with a new fund. It is now much harder to raise the money,” he says.