Hedge funds and Private Equity - PES

no correlation with market indexes, it goes without saying that they are suitable for portfolio diversification
with few risks when they anticipate the narrowing of spreads. However as LTCM
revealed, high returns on those strategies imply a large leverage and both legs of the investment
are losing if spreads widen in disorderly market conditions. Even seemingly careful strategies
might put HFs in jeopardy if they indulge in high leverage.
But arbitrage strategies have always made a modest proportion of HF investments and this
proportion is shrinking for both structural and cyclical reasons. Directional bets are dominant
and deliver mediocre results in adverse macroeconomic conditions. Nonetheless hedge funds
developed massively after 2000 while rates of interests slipped downwards and equity markets
plummeted. Institutional investors were looking for a dual strategy:
A benchmarked passive portfolio to cover their costs
An active management portfolio in the hope of boosting their overall return. To try to achieve
their goal they invested both in funds of funds and in individual hedge funds. Controlling their
active portfolios raises new problems of performance measurement (taking account of the
probability of extreme losses) and risk assessment.
It is quite plain that the opacity of hedge funds deprives institutional investors of any meaningful
quantitative risk control.
The more hedge funds rely on fathomless investment strategies that increase markedly in weight
according to table 2 (specifically multi strategies and event-driven), the more their institutional
clients have to rely on the good faith of fund managers. The only control institutional investors
can engineer is upstream. They should develop networks of acquaintances to facilitate reference
checking in order to get a thorough understanding of the would-be fund manager’s investment
operations. It is awfully costly and time-consuming. Often pension fund trustees have neither the
organisational resources nor the ability to run the investigation in-house. They must resort to
counsellors biased towards getting more business for hedge funds.
It should be commonsense that a reasonable policy of market transparency would improve the
principal agent relationship inherent in delegated management.
Hedge funds are going to manage more and more public money and a significant “retailisation”
is under way. The call for some regulation will gain momentum. In the EU, as far as UCITS III
allows mutual funds to indulge in hedge fund-type strategies, the need for a common regulation
regime addressing hedge funds and their managers becomes pressing. Three motives for regulation
are financial stability, investor protection and market integrity (against frauds, market abuse
and money laundering).
Financial regulation is most effective when it targets the conflicts of interest between market
participants, risks, and stress points within the financial services supply chain. The supply chain
for the hedge fund market is particularly complex when compared to the ‘traditional’ asset
management industry because of the use of various counterparties (often unknown to the
investor) and due to anomalies such as fund managers and actual funds being regulated in onshore
and off-shore jurisdictions.
The supply chain approach to regulation allows policymakers to identify the areas in the market
which are most likely to give rise to detriment, recognise the different levels of sophistication of
various market participants, and deploy targeted, proportionate regulatory interventions.
Part III – Lessons to be drawn for future regulation
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