Like US President, European Parliament also getting biased advice on hedge funds

28 April 2008

Since The President’s Working Group (PWG) released it’s “Best Practices for Hedge Funds” Report (see related posting), many commentators have cried foul that the recommendations lack teeth - the result, they say, of the fact that the committees were comprised of hedge fund managers themselves.  But while the PWG recommendations may have been biased, the European Parliament is getting an equally biased view of hedge funds.  But the bias there is firmly against hedge funds.  In mid-March, the EP’s Committee on Economic and Monetary Affairs published this 24 page report titled “Working Document on Hedge Funds and Private Equity”.

While the conclusions were largely the same as the PWG (transparency guidelines etc.), the document takes a far more skeptical view of the industry (which, of course is no surprise given that the PWG committees were private sector committees).  Here are some examples:

On leverage: “There has been mixed evidence of the average leverage of a hedge fund….For example, Peloton…was 4-5 times leveraged, owing money to 14 banks, which was described as normal for an average hedge fund…Although Peloton actually made a profit out of the sub-prime crisis, the spill-over of the crisis affected the fund simply due its additional investments into the credit markets with their leverage simply too high to manage if any of the bets went wrong. This shows that regardless of the trigger, consequences of any financial markets crisis will affect vehicles and institutions with higher leverage more than well capitalised conservatively run financial institutions.”

(Ed: A hedge fund that actually made money probably isn’t the best example to use when trying to prove leverage is bad.)

On fees: “Fees are usually composed of a percentage of assets under management (management fee) plus a percentage of funds’ annual profits (performance or incentive fee). The former amounts on average to 2 percent of the net asset value of the fund on the day of payment…”

(Ed: 2% management is actually above ”average” and usually management fees are accrued monthly, not once a year based on the initial contributed capital.)

On industry concentration: “The latest ranking of largest hedge funds firms also indicates how deeply all players are getting into the hedge-fund business, especially already highly concentrated sector of investment banks like JP Morgan and Goldman Sachs (first and second with 33 and 32.5 billion USD in hedge fund assets respectively). There is not one single big investment bank that does not have its own hedge fund.”

(Ed: No surprise - hedge funds emerged out of investment banks’ proprietary trading desks.  With the amount of regulation faced by major investment banks, this suggests the average hedge fund is more regulated today than in the past.)

On transparency: “…hedge funds operate in the shadows, with their business model based on exclusive information and investment strategies deriving from proprietary models known only to the manager…”

(Ed: Every business aims for an “exclusive” and “proprietary” business model - long-only managers, Warren Buffett, Microsoft, McDonald’s…Why does this sound so nefarious all of a sudden?)

On systemic risk: “Although there is no direct evidence that hedge funds are posing systemic risk, they do increase the volatility of financial markets in two ways: by herding and by exposure of other financial institutions to hedge funds…Recently, the ECB tried to assess the crowding of their trades but concluded that there is not sufficient information on investment portfolios to come to any conclusive evidence and that more transparency as to the portfolios is needed.”

(Ed: Guilty until proven innocent.)

On systemic risk (attempt to tar hedge funds #2): “[The] World Economic Forum stated in its 2008 Global Risk report that, rather than hedge funds, it was the structured products and off-balance-sheet vehicles of banks and investment banks, which created the current turmoil. The question is, however, not only whether hedge funds have triggered the crisis, but also whether they have managed to play their role (as always argued by the proponents) and went against the market, thus acting as a stabilising factor and provider of liquidity.” 

(Ed: Okay.  If hedge funds aren’t the problem, then at least they are guilty of not saving the rest of us?)

After making a relatively weak case against hedge funds, the report concludes by asking the question: “What is the rationale in having lightly or unregulated private pools of capital such as private equity funds and hedge funds operating in the market alongside tightly regulated institutions such as pension funds, insurance companies, banks and others?” 

This would be a fair question if it weren’t for the fact that the report includes pages and pages of examples showing how a) banks are becoming dominant in the hedge fund industry, b) pensions and insurance companies can herd with the best of them and c) funds of a similar size to hedge funds that are managed within large financial institutions (like, say, SocGen) have less investor transparency than funds where the manager often makes personal presentations to institutional clients.

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