Is a New Disaster Hiding in Refco's Hedge?
Is a New Disaster Hiding in Refco's Hedge?
Hedge funds are out of control - will they strangle the world's finances, asks Heather Connon
October 16, 2005
The Observer
UK Guardian
The headline in the Guardian said it all: 'World's hedge funds face crisis as Refco suspends trading'. Underlying the stories was the worry that the troubles at a US futures broker few of us had ever heard of could herald the economic meltdown which the doom-mongers have been predicting ever since hedge funds became the masters of the universe.
Such fears are understandable. First, the hedge fund industry has been growing rapidly. According to the latest asset survey by Eurohedge, the bible for hedge funds in Europe, funds under management in Europe alone have trebled since 2003 and now stand at $279 billion (£159bn) while, worldwide, there is now more than $1,000bn invested in more than 8,000 hedge funds. Some are very big: 50 funds in Europe and almost 200 in the US have assets of more than $1bn.
While some take an even more long-term approach than traditional fund managers, holding assets for years, many other are very active traders, buying and selling shares, bonds, futures and other instruments rapidly. That makes them a key part of the financial market: CSFB has estimated that global investment banks made more than $25bn, an eighth of their total revenues, through dealings with hedge funds. And, while such funds account for only about 5 per cent of total assets under management worldwide, they are estimated to account for between a half and a third of all daily trading on the London and New York stock exchanges.
Yet we know virtually nothing about them. It is even hard to get details on who the large hedge fund managers are: Eurohedge eventually supplied a list of the top 10 managers and most of us would recognise only two of the names on it, Gartmore and Man Group. The official reason for the secretiveness is that anything else would look like marketing to prospective investors, which is prohibited under current regulations.
But the lack of publicity undoubtedly suits the industry: as Christopher Fawcett, co-founder of Fauchier Partners, a hedge fund adviser, and chairman of industry body the Alternative Investment Management Association, points out, most successful hedge fund managers are already closed to new money and have no need to advertise themselves to investors - or to have details of their, usually extremely generous, salaries splashed in the headlines.
They do not have to give anything away: most hedge funds are based in tax havens such as Bermuda or the Cayman Islands where regulation is, at best, light. The managers themselves are usually based here, so are subject to authorisation by the Financial Services Authority, but the funds themselves escape the net.
Probably the best-known hedge fund is one that no longer exists: Long Term Capital Management, whose collapse following the Russian debt crisis seven years ago, precipitated a global financial crisis. The growth of the industry - particularly the growth of its dealings with other parts of the financial services industry - mean that regulators cannot risk a recurrence of the LTCM collapse. Across the globe, they are stepping up their surveillance in the hope of spotting problems before they happen.
While there have been fears that Refco could be the catalyst for another collapse, others are more sanguine. Fauchier points out that it is relatively small and that the big guns on Wall Street are already there helping to sort it out. In Britain the FSA thinks the risks of a repeat of LTCM are limited because of 'enhanced risk management by hedge fund counterparties [the banks and brokers they deal with] and the seeming absence of hedge funds with the level and exposures taken on by LTCM'.
But it admits there is a risk that: 'The failure or significant distress of a large and highly exposed hedge fund - or, with more probability, a cluster of medium-sized hedge funds with significant and concentrated exposures - could cause serious market disruption.'
It is in the process of consulting on the need for increased regulation but, even before that process has finished, it has stepped up its activities in the area. A new unit to supervise 25 'high impact firms' - hedge funds whose activities have a big effect on international markets - will be up and running by the end of this month, headed by Andrew Shrimpton, who was the FSA's head of asset management. It is also stepping up its surveillance of both hedge funds and the banks and brokers through which they trade, as well as beefing up liaison with other regulators. IOSCO, the international organisation for securities commissions, is looking at hedge funds' own internal systems and procedures to ensure they are satisfactory for protecting their investors.
It is this area that has been found wanting in the latest crop of hedge fund disasters: Refco's chief executive is accused of hiding $430 million he owed to the company; Bayou Capital and Wood River Partners, which both stopped trading in recent months, have been accused of hiding losses and faking returns to investors.
But there are already signs that is changing: Ian Morley, chief executive of Dawnay Day, Olympia - which manages funds of hedge funds - says transparency is increasing, more funds are adhering to international accounting standards and many larger hedge funds are now employing a risk control officer, separate to the compliance officer, so that they fully understand the nature of the risks within the firm. Such improvements, he said, are being demanded by the institutions which are their main investors.
The need for better administration, and the beefed-up regulation, is likely to change the shape of the industry. Charles Beazley, head of Gartmore's hedge fund business, thinks funds need to be at least $75m in size to break even, given the regulatory and administrative costs, yet 72 per cent of hedge funds have less than that under management. Indeed, a survey by accountants KPMG found that a fifth of all hedge funds close each year due to business, not investment, failure.
And, while the industry boasts that it can make better returns than conventional fund managers, the statistics do not necessarily bear that out. A survey by accountants KPMG found that only 15 per cent of fund managers are clear stars capable of generating the returns clients expect; a further 55 per cent are what KPMG describes as 'wannabes', who have yet to prove that they can perform and the rest are 'has-beens', whose performance is not good enough for them to survive.
'When you have seen one successful hedge fund manager, you've seen one. They are a rare breed and typically only retain their stardom for three years,' says KPMG.
Keeping track of this disparate bunch of managers is a real challenge for regulators - but the challenge will not necessarily diminish as hedge funds grow in size. The bigger the hedge fund, the more likely it to employ a range of strategies - and that could make them riskier, rather than safer.
Colin McLean, chief executive of Edinburgh-based fund manager SVM, which has some investment in hedge funds, says the argument that the risks in the industry are not correlated, and therefore more manageable, is becoming less accurate.
While there may be no obvious connection between, say, the Japanese yen, Russian bonds and US exchange rates, if they are held by the same people, and everyone wants to withdraw them at once - say because of a panic in the market or a liquidity crisis in one firm - the effects could be severe.
The authorities prevented a global disaster in 1998 by rescuing LTCM and making liquidity available in the system. The Pollyannas say that such a lifeboat will not be needed again: few hedge funds these days have the level of borrowings which LTCM did - debt was around 50 times its net assets - and regulators are much more on top of the problem.
The doom-mongers say that even the most astute of regulators cannot hope to stay on top of the problem - and that, when disaster happens, the size of the lifeboat needed will be beyond the capacity of the financial system.
We can only hope that the vessel will never have to be tested.
A short history of the hedge fund
* They were invented in 1949 by financier AW Jones, who wanted to make his investors money, but also make sure they didn't lose any.
* Most investment funds are 'long only': managers put money in stocks they think are good, and hope they go up. Jones's idea was to 'short' some shares as well - to identify those he thought were overvalued and bet on them going down.
* As an investment strategy, its value was demonstrated during the bear market of 2001-2002, when 'long only' funds lost 45 per cent but hedge funds stayed profitable.
* Bankers are scrambling to start hedge funds because they can charge high fees: typically 1 or 2 per cent of the assets managed, plus 20 per cent of profits.
* These days a host of 'derivative' products exist, enabling fund managers to make increasingly complex bets.
http://observer.guardian.co.uk/business/story/0,6903,1592954,00.html
Hedge funds are out of control - will they strangle the world's finances, asks Heather Connon
October 16, 2005
The Observer
UK Guardian
The headline in the Guardian said it all: 'World's hedge funds face crisis as Refco suspends trading'. Underlying the stories was the worry that the troubles at a US futures broker few of us had ever heard of could herald the economic meltdown which the doom-mongers have been predicting ever since hedge funds became the masters of the universe.
Such fears are understandable. First, the hedge fund industry has been growing rapidly. According to the latest asset survey by Eurohedge, the bible for hedge funds in Europe, funds under management in Europe alone have trebled since 2003 and now stand at $279 billion (£159bn) while, worldwide, there is now more than $1,000bn invested in more than 8,000 hedge funds. Some are very big: 50 funds in Europe and almost 200 in the US have assets of more than $1bn.
While some take an even more long-term approach than traditional fund managers, holding assets for years, many other are very active traders, buying and selling shares, bonds, futures and other instruments rapidly. That makes them a key part of the financial market: CSFB has estimated that global investment banks made more than $25bn, an eighth of their total revenues, through dealings with hedge funds. And, while such funds account for only about 5 per cent of total assets under management worldwide, they are estimated to account for between a half and a third of all daily trading on the London and New York stock exchanges.
Yet we know virtually nothing about them. It is even hard to get details on who the large hedge fund managers are: Eurohedge eventually supplied a list of the top 10 managers and most of us would recognise only two of the names on it, Gartmore and Man Group. The official reason for the secretiveness is that anything else would look like marketing to prospective investors, which is prohibited under current regulations.
But the lack of publicity undoubtedly suits the industry: as Christopher Fawcett, co-founder of Fauchier Partners, a hedge fund adviser, and chairman of industry body the Alternative Investment Management Association, points out, most successful hedge fund managers are already closed to new money and have no need to advertise themselves to investors - or to have details of their, usually extremely generous, salaries splashed in the headlines.
They do not have to give anything away: most hedge funds are based in tax havens such as Bermuda or the Cayman Islands where regulation is, at best, light. The managers themselves are usually based here, so are subject to authorisation by the Financial Services Authority, but the funds themselves escape the net.
Probably the best-known hedge fund is one that no longer exists: Long Term Capital Management, whose collapse following the Russian debt crisis seven years ago, precipitated a global financial crisis. The growth of the industry - particularly the growth of its dealings with other parts of the financial services industry - mean that regulators cannot risk a recurrence of the LTCM collapse. Across the globe, they are stepping up their surveillance in the hope of spotting problems before they happen.
While there have been fears that Refco could be the catalyst for another collapse, others are more sanguine. Fauchier points out that it is relatively small and that the big guns on Wall Street are already there helping to sort it out. In Britain the FSA thinks the risks of a repeat of LTCM are limited because of 'enhanced risk management by hedge fund counterparties [the banks and brokers they deal with] and the seeming absence of hedge funds with the level and exposures taken on by LTCM'.
But it admits there is a risk that: 'The failure or significant distress of a large and highly exposed hedge fund - or, with more probability, a cluster of medium-sized hedge funds with significant and concentrated exposures - could cause serious market disruption.'
It is in the process of consulting on the need for increased regulation but, even before that process has finished, it has stepped up its activities in the area. A new unit to supervise 25 'high impact firms' - hedge funds whose activities have a big effect on international markets - will be up and running by the end of this month, headed by Andrew Shrimpton, who was the FSA's head of asset management. It is also stepping up its surveillance of both hedge funds and the banks and brokers through which they trade, as well as beefing up liaison with other regulators. IOSCO, the international organisation for securities commissions, is looking at hedge funds' own internal systems and procedures to ensure they are satisfactory for protecting their investors.
It is this area that has been found wanting in the latest crop of hedge fund disasters: Refco's chief executive is accused of hiding $430 million he owed to the company; Bayou Capital and Wood River Partners, which both stopped trading in recent months, have been accused of hiding losses and faking returns to investors.
But there are already signs that is changing: Ian Morley, chief executive of Dawnay Day, Olympia - which manages funds of hedge funds - says transparency is increasing, more funds are adhering to international accounting standards and many larger hedge funds are now employing a risk control officer, separate to the compliance officer, so that they fully understand the nature of the risks within the firm. Such improvements, he said, are being demanded by the institutions which are their main investors.
The need for better administration, and the beefed-up regulation, is likely to change the shape of the industry. Charles Beazley, head of Gartmore's hedge fund business, thinks funds need to be at least $75m in size to break even, given the regulatory and administrative costs, yet 72 per cent of hedge funds have less than that under management. Indeed, a survey by accountants KPMG found that a fifth of all hedge funds close each year due to business, not investment, failure.
And, while the industry boasts that it can make better returns than conventional fund managers, the statistics do not necessarily bear that out. A survey by accountants KPMG found that only 15 per cent of fund managers are clear stars capable of generating the returns clients expect; a further 55 per cent are what KPMG describes as 'wannabes', who have yet to prove that they can perform and the rest are 'has-beens', whose performance is not good enough for them to survive.
'When you have seen one successful hedge fund manager, you've seen one. They are a rare breed and typically only retain their stardom for three years,' says KPMG.
Keeping track of this disparate bunch of managers is a real challenge for regulators - but the challenge will not necessarily diminish as hedge funds grow in size. The bigger the hedge fund, the more likely it to employ a range of strategies - and that could make them riskier, rather than safer.
Colin McLean, chief executive of Edinburgh-based fund manager SVM, which has some investment in hedge funds, says the argument that the risks in the industry are not correlated, and therefore more manageable, is becoming less accurate.
While there may be no obvious connection between, say, the Japanese yen, Russian bonds and US exchange rates, if they are held by the same people, and everyone wants to withdraw them at once - say because of a panic in the market or a liquidity crisis in one firm - the effects could be severe.
The authorities prevented a global disaster in 1998 by rescuing LTCM and making liquidity available in the system. The Pollyannas say that such a lifeboat will not be needed again: few hedge funds these days have the level of borrowings which LTCM did - debt was around 50 times its net assets - and regulators are much more on top of the problem.
The doom-mongers say that even the most astute of regulators cannot hope to stay on top of the problem - and that, when disaster happens, the size of the lifeboat needed will be beyond the capacity of the financial system.
We can only hope that the vessel will never have to be tested.
A short history of the hedge fund
* They were invented in 1949 by financier AW Jones, who wanted to make his investors money, but also make sure they didn't lose any.
* Most investment funds are 'long only': managers put money in stocks they think are good, and hope they go up. Jones's idea was to 'short' some shares as well - to identify those he thought were overvalued and bet on them going down.
* As an investment strategy, its value was demonstrated during the bear market of 2001-2002, when 'long only' funds lost 45 per cent but hedge funds stayed profitable.
* Bankers are scrambling to start hedge funds because they can charge high fees: typically 1 or 2 per cent of the assets managed, plus 20 per cent of profits.
* These days a host of 'derivative' products exist, enabling fund managers to make increasingly complex bets.
http://observer.guardian.co.uk/business/story/0,6903,1592954,00.html
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