FYI | Aug 21 2007
By Greg Peel
For an organisation representing 60 Australian hedge funds – or at least the 60 local members of the Alternative Investment Management Association – to publish an updated set of disclosure guidelines with the intention of ensuring potential investors are fully versed in the sort of risks they might be facing when investing in hedge funds, is laudable. To release it on August 16 is unfortunate.
The Australian Financial Review reports there is currently some US$1.75 trillion under management in an estimated 9800 hedge funds around the world. Losses in the industry as a result of the credit crisis in 2007 are expected to be “unprecedented”. Under normal circumstances, about 8% of hedge funds fail each year. That figure is expected to double in 2008, and within five years experts predict one third of all funds will be gone.
That’s a big call. For one thing, the label “hedge fund” is fairly loose and secondly, an awful lot can happen in five years. But suffice to say, hedge funds are about to become as popular with investors as interest rate rises are to mortgagees. They will still continue very much to exist but the playing field has been very much redefined.
AIMA estimates that investment in Australian hedge funds totals (or totalled) over $63 billion. This month’s release constitutes the second set of voluntary industry guidelines. The first was released in 2002, but following the financial reform act of 2003 AIMA decided to model its guidelines more closely on the Corporations Act. The 2003 reforms came about when Merrill Lynch became the scapegoat in the US for advice being given to investors in stocks without disclosure of underwriting activities. Investors may have now noticed that daily broker reports contain more disclosure of interests of the firm and individual staff than they do actual information.
“The Guidelines, which have been developed by members of the AIMA Australia Regulatory Committee over the past year, create a clear communication format to enable potential investors to easily compare and assess the hedge fund offerings available to them. Their release reinforces AIMA’s goal of setting sound practices for hedge fund industry stakeholders and demonstrates the Australian hedge fund industry’s global leadership in the area of good disclosure and promotion of hedge fund products,” so the press release goes.
Once again, this move can only be applauded. But to read some of the guidelines included in a document that has clearly been months if not years in the drafting is almost to weep.
“Hedge Funds in Australia are required to conform to the same regulatory obligations as other managed funds, however, the nature of hedge fund structures and trading strategies suggests additional disclosure is required compared with more traditional managed funds. AIMA Australia believes that the hedge fund industry will benefit from adopting good disclosure and promotion practices in the marketing of hedge fund products. To this end it has prepared guidelines on disclosure, which are set out in this document.”
And here are some excerpts:
“The intention to leverage the investors’ capital, whether through financial gearing, or amplified market exposure through derivatives, should be disclosed. The disclosure should indicate the conditions under which the leverage is expected, typical leverage to be applied and the maximum degree of leverage proposed. Where financial leverage is proposed, the generic source of that leverage (eg banks, prime brokers or derivatives) and whether the manager has committed credit facilities available, should also be disclosed.
“The risks associated with leverage and how they will be managed should be clearly described.
“Hedge fund liquidity can differ in several respects from the experience of investors in traditional managed funds. For example, investment securities purchased may form part of larger transactions. These securities may require more time to be converted to liquid assets than individual securities. Some funds may hold non-listed securities.
“Generally the risks statement should include a general statement that the hedge fund is subject to investment risk including possible delays in repayment and loss of income and principal amount invested and the fund manager does not guarantee the performance of the fund or the repayment of capital or income invested in the fund.
“Other risks that may need to be disclosed include:
…The risk that returns may be adversely affected by market conditions including market volatility, interest rates, economic variables, political events, war, natural events and changes in law which may occur globally or at a country, industry or asset class specific level;
…liquidity risks, including the risk of illiquidity of securities or underlying investments;
…risks associated with the use of derivatives;
…risks associated with the use of leverage.
“The valuation section should describe in detail the valuation policies for valuing the investments of the hedge fund (and if applicable, the underlying investments), and identify who performs the calculations.”
The above guidelines could have specifically been written with regards to collateralised debt obligations (CDOs), if the guidelines chose to use an example. For it is a combination of leverage, liquidity, volatility, derivative and valuation uncertainty that has defined what is known as the “subprime” crisis, but what is really a crisis of over-extension into new-fangled and little understood products by hedge funds and their willing investors that has its roots in excess global liquidity. A few low-income US mortgagees helped, but they were really just the catalyst for the house of cards to be knocked over.
So if hedge funds do have a future – and mark my words they surely do – then they will be keenly advised to take heed of the new AIMA guidelines, even voluntary as they are. So too should investors be ready with all the right questions.
But it will be all academic for a while, at least until all the bodies of the fallen have been removed from the battlefield. And that’s going to take some time.
