The Risks Within the Hedge Fund Industry
Diccon Smeeton
ABN AMRO
Introduction
A quick scan of the financial press reveals many influential pundits still consider the hedge fund industry to be a cabal of rapacious, Gordon Gecko types, or “locusts” hell-bent on financial Armageddon!
Incontrovertibly, the hedge fund industry has witnessed explosive growth since the early 1990s. It no longer bears any resemblance whatsoever to the cottage industry of a decade ago, however, and is a respected alternative asset class essential to an institutionalized investment portfolio, with risks better understood and managed by all participants. Growth has been fuelled largely by significant fund development in Europe and in Asia, albeit from low bases, although the longest established, most institutionalized and largest funds remain North American. The total amount of capital invested in these alternative investments now significantly exceeds US$1tn, and the capital inflow shows no signs of abating. As the industry has grown, and ancillary services around it have mushroomed, the range of strategies and investment styles has also expanded and with them the associated risks. Significantly, the pressures on banks to engage with hedge funds has also increased and, consequently, bank exposure to the sector has increased, although we believe this remains overstated and more diffuse.
Nevertheless, the risks of doing business with this unregulated, leveraged client group remain significant but perhaps are overstated—and are certainly often misunderstood. The nature of the business undertaken by hedge funds means that they often invest in significant concentration, or in illiquid securities. The lack of transparency can cause problems when managing risk and is perhaps the biggest hurdle in any assessment of the risk of any particular hedge fund.
Leverage does contribute to the risks of the industry but managers now demonstrate greater caution in utilizing leverage than they did pre-1998 and rarely utilize the levels offered by banks and brokers, contrary to spectators who appear to believe in the widespread misconception that leverage is directly proportional to investment success. The lack of controls around leverage, the “herd mentality” of many hedge fund managers and the resultant herd-like behavior of their funds may cause problems for the financial markets as a whole. Additionally, as hedge funds potentially combine high levels of leverage with their increased involvement in increasingly complex OTC products, the industry could be susceptible to a systemic reduction in liquidity. Potentially aggravating this are capacity constraints that are evident in thinly traded markets or securities. This could potentially be exacerbated by the anecdotal pressures that are beginning to become apparent among certain service providers, particularly administrators. The industry has changed phenomenally, however, since the collapse of LTCM in 1998 and huge advances have been made in risk management, technology, and market practice that considerably reduce the possibility of such a mammoth recurrence.
Due Diligence
As the industry has grown, many strategies of hedge funds have become less opaque and more complex to the risk professionals whose job it is to monitor their activities, and the tools available to manage the risks have improved. The “traditional” reliance on unsophisticated, nuclear-option additional termination events in master documentation, in which a fund manager is faced with catastrophe, and front-office pressure on the risk “cost centers” to maintain a profitable account can be very forceful, has been replaced with an array of risk management options that includes frank, regular, and open relationships with hedge fund managers, risk measurement models sensitized to liquidity and concentration restraints, collateral management systems that can actually call for initial margin as well as the daily mark, plus greater education of and increasing risk tolerance by senior credit risk management in banks for hedge fund risks. Risk professionals in many of the leading banks and financial institutions now have the appropriate tools necessary to assess the risks incurred and have gained greater access to hedge fund management companies.
In general, hedge fund managers have a symbiotic relationship with banks, a crucial factor not always appreciated fully by the deep-pocketed bureaucratic behemoths, nor readily acknowledged by the canny “hedgies” that have skillfully played brokers off against each other for years. The liquidity and the credit limits provided by banks are vital to funds in order to enable them to achieve their investment objectives and ensure their survival during liquidity crunches by keeping funding in place. By appreciating the significance of banks to their investment objectives, hedge fund managers have begun to improve the level of disclosure that they provide to their counterparties. The more enlightened have also begun to appreciate the benefits of treating the risk departments of banks as “partners,” and the “best practices” hedge fund managers now go to great lengths to ensure that counterparty credit officers have a solid understanding of all aspects of their business activities. A good relationship with a key credit officer, who has been kept well informed of business activities, has proved beneficial to many fund managers in times of difficulty.
There are two major owners of risk in hedge funds (other than the risks borne by the principals and employees): investors and counterparties. The risks incurred through investment are manifold and are largely overcome through significant levels of both initial and ongoing due diligence to ensure solid understanding that higher returns necessitate a higher risk-taking appetite and an appreciation of investment portfolio diversification. The largest risk to investors tends to be either poor performance or fraud. Hedge fund managers, particularly in “start-up” phase, are keen to attract and retain investor assets. As a result, they tend to be forthcoming with requests for information when approached by potential investors. Risks, therefore, other than performance or fraud, are relatively easily understood and mitigated. Trading relationships tend to be more complicated, as fund managers are sometimes reluctant to provide “proprietary” information to other market participants, despite almost universal adherence to Chinese Walls policies in place at all banks. The primary foundation of good risk management when dealing with hedge funds in any capacity is extensive initial and ongoing due diligence. This would normally involve site visits to the offices of the management company in order to satisfy oneself that the operations are sufficiently robust to handle the proposed activities of the hedge funds under management. The due diligence process would normally involve meetings with the CEO/CIO of the fund in order to fully understand the strategy and the means that will be employed to achieve the fund’s investment objectives. In addition, a thorough due diligence process would require a meeting with the fund manager’s COO and chief risk officer in order to fully understand the operational infrastructure, as well as the risk-control measures in place to protect the fund and its activities.
Regulation
The lack of regulation of the majority of hedge funds is often cited as a key contributor to the risks run by the sector, yet as the market-timing scandals among mutual fund managers, Enron and WorldCom, even the collapse of Barings, demonstrate that regulation offers minimal protection against a determined fraudster. Many hedge fund managers, however, are regulated by the local financial regulator (e.g., the FSA in the UK and the CFTC or the SEC in the United States). It is a fact that the absence of regulation does not noticeably contribute to the risks run, but it does mean that hedge funds tend to operate below any kind of regulatory radar. In addition, the presence of a regulator (which, despite best efforts, is almost always under-resourced) could give both investors and service providers a false sense of comfort or imply a degree of sanction that reduces the fundamental “caveat emptor” caution relating to any investment decision and fundamental due diligence that investors and counterparties are now continually upgrading and refining.
The fact that hedge funds tend to be incorporated in offshore financial jurisdictions means that the burden of regulation is unlikely to extend to the funds themselves, thus preserving the tax benefits of investors and maintaining an active industry of brass-plate manufacturers in some corner of the West Indies. The involvement of a local regulator, however, governing the activities of a fund manager should, and does, provide some comfort to both investors and counterparties. These regulators tend to provide a measure of protection against fraudulent activities, particularly the FSA in the UK, which conducts a thorough investigation of principals before providing registration. Once a fund is established and trading, it is doubtful that a regulator will uncover fraud or illegal activity before investors incur a loss.
Investment companies registered with the US Securities and Exchange Commission (SEC) are subject to a high level of scrutiny with regard to their activities concerning (amongst other things) the short-selling of securities and the use of leverage. Consequently, many hedge fund managers have historically opted to operate as .unregistered investment companies. As of February 2006, the SEC implemented a rule change that required almost all US hedge fund managers, as well as those hedge fund managers located in jurisdictions other than the other things) the short-selling of securities and the use of leverage. Consequently, many hedge fund managers have historically opted to operate as “unregistered investment companies.” As of February 2006, the SEC implemented a rule change that required almost all US hedge fund managers, as well as those hedge fund managers located in jurisdictions other than the United States, but with US investors, to register with the SEC as investment advisors, under the Investment Advisors Act. This requirement applies to firms managing in excess of US$25m and which are open to new investors. This rule is currently under review, having been subject to successful challenges in US courts. In June 2006, the US Court of Appeals for the District of Columbia overturned the rule and ordered the SEC to review it. Nevertheless, it is a matter of time before hedge fund regulation mark II is revealed. An interesting aside: many fund managers opted to return money to investors or to close their funds and thus avoided the need to register with regulators. Making themselves so exclusive has served to increase their appeal and investors appear to pay eye-popping management fees for the privilege of having these titans manage their money.
Most UK-based hedge fund managers are registered with the Financial Services Authority (FSA) and, as a result, regulatory developments have not had a significant impact on their activities. Given the requirement of UK-based fund managers to register with the SEC if they have US investors, some European managers have forcibly redeemed their US investors. In June 2005, the FSA published discussion papers on hedge funds, focusing on systemic risk and consumer protection. In 2005, the FSA also created an internal team to monitor the activities of the 25 hedge funds doing business in the UK that are perceived to represent the highest levels of risk to the financial industry. It is widely agreed that the FSA’s use of guidelines, adherence to recommended best practices and encouragement of dialogue as opposed to a prescriptive set of rules is a model worth expanding.
Recent pronouncements by the European Central Bank (that the threat of the potential risks to the financial markets as a result of hedge fund activities are comparable to an epidemic of bird flu—not surprising given the rhetoric adopted by some local politicians to describe hedge funds) and by the Bank of England (which, in what can perhaps be described as a more measured and less knee-jerk reaction, has engaged with market participants in an attempt to highlight specific risks posed by hedge fund activity) illustrates that the issue of hedge fund regulation remains a live topic and that the various issues are not always adequately highlighted and any discussion is still clouded with a lack of solid understanding around the industry. It is likely that hedge funds will continue to be further embraced by regulation as the industry grows (particularly if hedge funds are increasingly offered to retail investors). As the industry has become more sophisticated and risk management techniques have increased so substantially, however, the risks to investors could be overstated. Regulation would be unlikely to prevent the occurrence of a significant market event and the victims of such an event would probably include hedge funds as well as banks and other financial institutions.
What Would Be the Impact on the Industry of a Failure of a Hedge Fund?
Surprise, surprise—the sun would still rise tomorrow, the resilience of the industry would again be demonstrated and certain hedge funds could even make outsize profits. It is a truism that the “Wall Street community” proved themselves to be the lender of last resort to the hedge fund sector, after agreeing to the Federal Reserve-orchestrated bail-out of LTCM. It is likely that the industry participants would once again resolve a similar crisis.
Perversely, it may be a blessed, “normalizing,” relief should a counterparty suffer a loss from dealing with a hedge fund. Almost unique among any sector to which it extends financial services, banks are terrified of incurring a hedge fund loss yet expect it as a normal cost of doing business in the retail, commercial, and corporate sectors. This continuing fixation with “zero loss” has its roots in the hoary sound bite among senior risk management that all hedge funds are “correlated,” meaning any single loss is magnified into a financial tsunami. We observe, however, how the hedge fund industry and its service providers have continued to thrive since the 1998 LTCM debacle, the bursting of the tech and dotcom bubbles, and the Ford/GM downgrade in 2005.
Hedge funds fail for any number of reasons and attrition is a regular occurrence. By far the most common failure, however, is associated with poor performance. In the event that a fund performs badly, it is difficult for the fund managers to attract sufficient investor assets. In turn, this makes it difficult for the manager to retain or attract staff due to the lack of fee income (either in the form of performance, but also in the form of management fees). The lack of fee income also makes it difficult for the fund manager to invest in state-of-the-art risk management systems. When this happens, hedge funds tend to die quietly and disappear which shows maturity among participants, rather than the unrecognizable stereotype of a desperate gambler taking a last chance outsize risk.
Since the Federal Reserve-sponsored rescue of Long Term Capital Management in 1998, banks have become a great deal more sophisticated in their risk management process. In addition to the general level of due diligence conducted prior to permitting trading limits, banks demand collateral to support the counterparty risk, as well as tighter levels of documentation to govern the trading relationship between the fund and its trading counterparties. The development of cross-margining and cross-netting systems enables banks to benefit from a balanced book of business from a hedge fund, in exchange for favorable margin treatment for the hedge fund. These measures have served to protect individual banks from risk of loss in the event of a counterparty default. In addition, the widespread use of risk management techniques has also reduced the risk of systemic loss across the wider banking industry.
A recent phenomenon has been liquidations of hedge funds as a result of the weight of capital flowing into the industry or the crowding of certain strategies. As the market has become more crowded, hedge fund managers have found that their ability to generate superior return has become threatened by the sheer number of counterparties chasing the same deals. This has had two effects: first, managers may be forced to invest in higher-risk transactions in order to meet investors’ return expectations; and second, funds are failing, having been unable to justify their stubbornly consistent management and performance fees in the face of lackluster investment returns.
Ongoing Risk Management
Hedge funds represent a significant, and increasing, client base for many banks. The activities of hedge funds now touch on many different business activities undertaken by investment banks and provide liquidity in many markets. As their importance to banks increases, the risks that banks face when doing business with funds also grow. Internal pressure to remain competitive, as well as to minimize capital utilization, and thus bolster profitability has caused the risk departments of banks to look for inventive risk solutions to protect the banks from the risk of loss.
A thorough and ongoing due diligence process is the best means of protection against risk of loss, as it bolsters collateral management and trade capture systems. The ability to conduct stress testing on the bank’s portfolio of trades, both with individual hedge funds and with the sector as a whole, is an area banks continue to enhance. Banks with a prime brokerage operation are in a stronger position when it comes to risk management than those without. This is due to the levels of transparency that a prime broker is able to exercise, which enables the prime broker to control and manage their own risks in a more holistic way.
There is no substitute for “knowing the customer.” It is important that risk departments are able to establish their own relationship with the principals or risk managers at the hedge fund management companies, instead of relying on the relationship that is in place between the fund and the business areas of the bank. Risk departments should insist on receiving financial disclosure from funds on, at least, a monthly basis. This disclosure should, at a minimum, include information relating to the NAV of the fund, NAV per share as well as performance information. Quality is, of course, better than quantity. Most fund managers are content to provide the same information to counterparty banks as they are prepared to provide to their investors. This should not be viewed in isolation and should be compared to other funds following the same strategies, in order to establish some kind of peer comparison and perhaps be scrutinized in some detail after counterparty and portfolio stress-testing exercises have been conducted.
As the flow of institutional capital into hedge funds increases alongside the rising incidence of fraud cases that have caused losses for investors, there has been heightened focus on operational due diligence. Operational risk is particularly relevant with hedge funds, due to the wide disparity between the resourcing of each management company, which can vary between small private offices to deeply resourced, institutional money management companies. The increase of availability of outsourcing providers has gone a long way to improving the operational risks run by hedge funds, as there are now a variety of robust middle-office functions available on an outsourced basis.
Perhaps the area most vulnerable to operational risk, and therefore one that should be subject to particular scrutiny by market participants, is that of portfolio valuations. This is an area that can be susceptible to manager manipulation. There is a risk that unscrupulous managers will use asset valuations artificially to boost fund performance, or to smooth over mark-to-market losses of the fund portfolio. A legitimate source of valuation risk arises if an investment strategy is to invest in thinly traded or illiquid securities. If this is the case, the fund has little choice but to accept the risk that valuations might be hard to come by, or might reflect very wide bid/offer spreads. Some unscrupulous managers, however, might exploit illiquidity in order to falsify performance records. This can be avoided by ensuring that there is a robust, independent valuation process in place (i.e., that the back office or third-party valuation agent calculates month-end valuations, independent of front-office involvement. This helps to prevent the risk that investment managers might be able to “mark” their own book). Investors and credit counterparties should demand transparency over the valuation process, as well as evidence that the prices are achieved consistently. The most practical solution to this issue is to ensure that the fund manager has appointed a third-party fund administrator to provide valuations. Best practice would suggest that the administrator calculates the NAVs using data derived exclusively from independent sources and with no reference to the fund manager. We must be realistic, however, that third-party administrators are straining under unprecedented demand, high staff turnover and “exotic” trades that inevitably compromise the integrity of the valuation process. In many cases, any prices are hard to obtain for esoteric investments.
How Is the Banking Industry Coming to Terms with This Growing Investment Class?
Hedge funds represent a significant proportion of investment banks’ revenues. This is due to their demand for a wide range of products, ranging from cash instruments to structured finance transactions. Increasingly, banks are having to be creative in their product offerings in order to meet the demands of this sophisticated client base and industrialize the process of managing their hedge fund risks. As another example of the symbiotic relationship, banks increasingly see hedge funds as an investor base ready, at a price, to assume some of their own risk.
A major impact of the development of the global hedge fund sector has been that banks have had to evolve in order to retain trading personnel. This has meant that banks have had to revise the remuneration offered to proprietary traders in order to match the pay packages offered by hedge funds.
The risk management (encompassing both credit and market risk) departments of banks have been obliged to become more sophisticated and responsive in the ways that risk is managed and measured. Increasingly, banks use sophisticated stress-testing techniques in order to measure and monitor portfolio concentrations and correlation risks. The use of VaR and cross-product margining further reduces the banks’ exposures to portfolio risks, as well as providing a true measure of counterparty exposure. The days of idiotic panic-stricken fire drills where staff sacrificed weekends to prepare impressively comprehensive (but incomprehensible) spreadsheets are surely numbered.
Stress testing is becoming a more widely used tool by both hedge funds and banks. The significance of severe market events is measured using a variety of scenarios. These scenarios tend to be based on both hypothetical scenarios and real events. While it can be argued that hedge fund managers are paid to manage money in a variety of risk scenarios, stress testing is an increasingly useful means of measuring the likely impact of specific risk events on funds. The results of stress tests are used as a risk management tool on both sides, and their importance must increase.
Operational risk is a significant source of risk for hedge fund managers, who are increasingly demanding higher levels of operational competence from counterparties as well as service providers (such as administrators, prime brokers, custodians, and valuation agents). Hedge funds are susceptible to operational risk at every level and as they invest in more illiquid or complicated products. Therefore, the abilities of prime brokers and administrators to obtain accurate market pricing is becoming more important. In addition, hedge funds themselves are looking to diversify their risk by entering into multiple prime broker agreements, as well as entering into trading limits with a diversified selection of banking counterparties.
What Might Happen Going Forward?
It is inevitable that “alternative investments” will continue to grow in importance. Increasingly, “real money” or long-only fund managers are utilizing investment techniques (insofar as regulations permit) that have traditionally been seen as being reserved for hedge fund managers only. In addition, many of the traditional asset managers are establishing hedge funds for a number of reasons: to retain investment management talent, to retain investors seeking superior investment returns, to generate hedge fund fee income, and to diversify their investors’ risk profiles, as well as to allow these investors to benefit from investment returns in falling markets.
It is also likely, however, that we will see an increase in the number of closure rates as fund assets increase. This is for a number of reasons, but most significantly because there is likely to be too much cash chasing too few opportunities. This underperformance will result in dissatisfied investors, and lead to redemptions, a natural “Darwinian” occurrence. Additionally, hedge funds are investing in assets that represent high risk of loss. An example is that these funds invest in distressed securities and, as interest rates rise and defaults increase, those funds that have bought the highest-risk, lowest-grade securities start to experience significant losses. The risks of loss are particularly high, given that most major hedge funds invest in fixed-income securities, even if this is not their main investment strategy. Should a significant credit event cause a loss of confidence in the corporate bond market, funds are likely to find that many of their investments become increasingly illiquid.
Another significant risk facing the industry is complacency from banks themselves, evidenced by the continued penny pinching on trade capture, collateral management and risk management systems. As hedge funds become more important to banks, it is likely that risk departments will face increasing pressure to relax standards and lower the barriers to entry with regard to credit quality and collateral measures. A wholesale reduction in standards will make banks more susceptible to systemic risk, irrespective of the quality of a bank’s individual hedge fund portfolio.
It is most likely that hedge fund growth will slow due to pressure from banks themselves. The banking sector appears to be facing two distinct trends: first, an increased drive for profitability; and second, continued consolidation. Banks are increasingly looking to improve their return on equity and, as their shareholders demand reduced volatility of earnings, consequently they limit their exposure to any particular sector. This rule also applies to exposure to trading counterparties. Some estimates claim that global assets under management in the entire hedge fund sector will total US$6tn within the next decade. Growth of this magnitude will put pressure on bank credit lines, particularly if further industry consolidation results in fewer market participants. Given the various risk mitigators required by banks when trading with hedge funds, the volumes of business can be high but the “actual” risk (measured to a specific confidence level) comparatively low. Nonetheless, the risk appetite is likely to be finite. As pressure on credit limits grows, it would seem inevitable that banks will provide credit to those funds that either represent a comparatively low level of risk or that generate significant revenue for banks. As a result, it is likely that the growth of the hedge fund industry will be constrained by the banks’ ability to provide credit.
The risks of dealing with hedge funds remain the same as they always have. Both banks and investors, however, are benefiting from both improved standards of disclosure and the latest advances in risk management techniques.