Reserve Bank of Australia's Stevens Flags Australian Hedge Fund Risk

Pointedly for the fledgling Australian hedge fund industry, incoming Governor of the Reserve Bank of Australia, Glen Stevens has issued a strong warning that hedge funds pose a risk to financial stability which is difficult for regulators to deal with. Mr Stevens was speaking at an event organised by the Hong Kong Monetary Authority and the Hong Kong Association of Banks on 15 September 2006.

According to the ABC, Mr Stevens said that the increased use of debt and the growing complexity of investments could disrupt markets when harder times came, as they surely would. He said it would be under abnormal conditions, when liquidity in markets was under pressure, that difficulties could arise. This post reviews Mr Steven's speech and seeks to identify areas that participants in the hedge fund industry in Australia should be aware of.

In particular, Mr Stevens referred to hedge funds as being "lightly regulated and often highly leveraged." While this might be the case globally, it is less true in Australia where investment managers are licensed under ASIC supervision and disclosure for retail funds at least is required by ASIC to be included in Product Disclosure Statements (PDSs). Admitedly an absence of industry wide data makes it hard to assess, but anecdotely hedge fund products in Australia are generally not highly leveraged.

Hedge funds' record of rapid growth and high reported returns has attracted a lot of attention by investors, Mr Stevens said. Ten years ago hedge funds were regarded as an exotic asset class, but now they are increasingly seen as part of the main stream for pension funds, university endowments and the like. Financial institutions are also increasingly in the habit of establishing in-house vehicles to tap the appetite for hedge-fund-type investments on the part of investors. Mr Stevens is right that awareness of hedge funds has increased dramatically in Australia in recent years, and while holdings of such funds have increased, they still represent a small weight in institutional and retail portfolios. In another post on this blog on 17 August 2006 titled Australian Superannuation Funds Use of Hedge Funds, a survey by the University of NSW and the Australian chapter of AIMA showed that current allocation to hedge funds by Australian superannuation funds of under 3% is expected to rise to over 4% over the next 2-5 years. Similar data for retail has not been compiled, but is likely to be similar.

According to Mr Stevens, the very term 'hedge fund' seems to be used rather more loosley than it used to be: he says we are really talking about any investment vehicle which is willing and able to take advantage of the vast array of financial products, 24-hour trading and ample liquidity to expose the funds of sophsticated investors to virtually any conceivable type of risk. The range of risks and lack of correlation with traditional equity and bond asset classes of course is one of the real attractions of hedge funds.

In Australia, hedge funds are not necessarily lightly regulated; they are treated by the regulator in much the same way as other managed investment vehicles. Around half of Australian hedge funds are retail managed funds that are carried in a PDS and registered with ASIC. Many of the wholesale and overseas investor funds/mandates have strategies that mirror the Australian retail offerings and Australian-based managers operate with an Australian Financial Services Licence.

Mr Stevens observed that by exploiting (and thereby eliminating) pricing anomalies and by being less encumbered by prudential controls than most other financial institutions, hedge funds promote efficiency in the allocation of capital by searching out returns more effectively than others. On the assumption, moreover, that those who put money into hedge funds know what risks they are taking - which might, increasingly, be a big assumption - people might take the view that what investors do with their money is their own business. Rather than being less encumbered by prudential controls imposed by the law, hedge funds are less encumbered by the mandate they have been given by investors and their advisers. The well-intentioned limits that have grown up around more traditionally managed monies have come at cost in terms of flexibility and ultimately return. The shift to hedge funds is a practical acknowledgement that straight-jacketing an investment manager will curb investment returns, and may even increase risk if the limits include limits on the use of hedging.

Critics, on the other hand says Stevens, claim that hedge funds can overwhelm and distort small markets; a tendency for herd behaviour, and application of leverage, amplifies the problem. When hedge funds decide simulataneously to get into or out of a position, they can disrupt market functioning. The entities in question are essentially those financial investment vehicles which are outside the normal pridential regulatory net. The situation that Mr Stevens describes threatens market integrity and is something that the RBA should be very sensitive to and monitor closely. However, it would be useful to know just how many entities are outside the "prudential net" as Mr Stevens put it. Is this a risk presented more by overseas funds that might be larger, better coordinated and more lightly regulated? The failed attempt by the SEC to require hedge fund registration may have been a setback in this respect. Ideally, a system that required registration in each major jurisdiction that was recognised in other jurisdictions with comparable regulation would be most effective.

In Australia, the rapid growth of AIMA's membership suggests a willingness of managers to understand the particular requirements of the Australian jurisdiction as AIMA has a strong regulatory and compliance element, including membership by leading legal and accounting firms in the hedge funds industry.

Mr Stevens highlighted two issues that regulators need to address:

• Ensuring there is sufficient disclosure to allow investors to make informed judgements about the risks and returns. In Australia, the regulatory authorities draw no distinction between hedge funds and other investment managers; the regulatory regime is determined by what the entity does, rather than what it is called. This ensures a level playing field.

• Ensuring that the activities of investment managers which are not subject to prudential supervision do not threaten the financial viability of firms, such as banks, that are. This approach emphasises to the counterparties of hedge funds and other highly leveraged institutions (such as prime brokers, banks and investment houses) the importance of strong risk management, collateral, knowing their customer and so on. The aim here is to preserve the prudential strength of the core part of the sysstem in the interests of economic financial stability, while allowing the part beyond the prudential net to play its role in taking on risk.

In Australia, given the role of ASIC in supervising the managed funds industry, including hedge funds, it is the second point that is most relevant. Mr Stevens notes that it is difficult, because of the complexity of the strategies adopted for counterparties to really understand the risks they are exposed to. Prime brokers take this risk management very seriously, not least of all because in extreme situations their own capital is potentially at risk. The credit departments of prime brokers play an active role in assessing investment strategies at the outset and ongoing and setting limits that seek to manage this risk. In most cases prime brokers also act as custodian of the assets of the fund, which gives them timely access to portfolio data and the ability to enforce the limits they set on each manager's fund.

Mr Stevens is sceptical of the argument that hedge funds necessarily add to liquidity. Under conditions of pressure, Mr Stevens argues that leveraged investors are more likely to need to use the liquidity of the market than to be able to contribute to it. On such occasions - which is when liquidity is needed most - these funds surely are liquidity takers, not providers he says. This argument, however, doesn't acknowledge one of the real benefits that hedge funds bring to markets - the use of short selling - which provides a natural offset to leveraged investments. This allows both buyers and sellers to express their view no matter what their current holding in a security.

Mr Stevens also suggests that hedge funds might command undue market power because of the brokerage they generate for investment banks. It is brave to suggest that listed markets can be manipulated in this way without risk of loss. In any case, such opportunities would be limited to particular hedge fund strategies and asssumes that for a particular transaction, market forces can somehow be subverted by these financial institutions in favour of hedge funds. This is a risk, but frankly in a properly functioning market unlikely to occur.

In summary, much of the risks that have been put forward by Mr Stevens could be asssessed by simply taking a closer look at the participants in Australia and the strategies they are adopting. In view of the fact that Mr Stevens is the incoming Governor of the RBA his comments deserve to be addressed. As half of the hedge funds in Australia are retail managed funds, their strategies are outlined in PDSs which are registered with ASIC. Public information could be supplemented by surveys that determine how many strategies involve leverage and what amount of everage is used.