Hedge Funds: Risks and Regulation [Reprint 2014 ed.] 9783110907346, 9783899491494

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Hedge Funds Risks and Regulation

Institute for Law and Finance Series

Edited by

Theodor Baums Andreas Cahn

De Gruyter Recht · Berlin

Hedge Funds Risks and Regulation

E d i t e d by

Theodor Baums Andreas Cahn

w G_ DE

RECHT

De Gruyter Recht · Berlin

Proceedings of a Conference held in Frankfurt am Main on May 22, 2003 Co-Sponsored by the Institute for Law and Finance, Johann Wolfgang GoetheUniversität, and Deutsches Aktieninstitut e.V.

@ Printed on acid-free paper which falls within the guidelines of the ANSI to ensure permanence and durability. ISBN 3-89949-149-1 Bibliographic information published by Die Deutsche Bibliothek Die Deutsche Bibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data is available in the Internet < http://dnb.ddb.de > . © Copyright 2004 by De Gruyter Rechtswissenschaften Verlags-GmbH, D-10785 Berlin All rights reserved, including those of translation into foreign languages. No part of this book may be reproduced in any form or by any means, electronic or mechanical, including photocopy, recording, or any information storage and retrieval system, without permission in writing from the publisher. Cover Design: Christopher Schneider, Berlin Data Conversion: jiirgen Ullrich typosatz, Nördlingen Printing and Binding: AZ Druck und Datentechnik GmbH, Kempten Printed in Germany

Preface The number of hedge funds and the assets they have under management has increased in recent years. This increase became significantly more pronounced after the market downturn in 2001. Hedge funds can help investors to benefit from volatile and even sinking stock markets. However, despite the prominent use of the word "hedge" in their name, such funds rarely offer a safe hedge against risk, given that they depend heavily on skill-based investment techniques and often invest in highly speculative financial instruments. Nevertheless, such funds received no specific treatment in the legislation of such major markets as Germany and the United States for years. Against the backdrop of international regulatory concern for hedge funds, the Institute for Law and Finance (ELF), in cooperation with Deutsches Aktieninstitut e. V. (DAI), brought together leading scholars, lawyers and bankers in Frankfurt in May of 2003, to assess the risks, opportunities and regulatory challenges that hedge funds present. At the time of the conference, German lawmakers were still discussing the need and possible content of a new law. The fruit of their discussions was the German Investment Modernization Act (Investmentmodernisierungsgesetz), which entered into force on January 1,2004, and increased the attractiveness of offering hedge fund products on the German market. This inaugural volume of the Institutefor Law and finance Series contains the proceedings of our May 2003 conference, and serves the ILF's mission to act as a centre for policy studies in capital markets, financial and corporate law. It is the ILF's desire to contribute to the quality of capital markets, banking and company legislation in Europe by facilitating the discussion and dissemination of the economic and legal policies on which such legislation is formulated. We therefore hope that our conferences, Working Papers and this Institute for Law and Finance Series will stimulate discussion and add to the quality and diversity of policy discussions in international law and finance. The editors of this volume would like to thank our partner in the hedge funds conference, DATs managing director, Prof. Rüdiger von Rosen, for his valuable support, as well as the many staff members of both the DAI and the ILF whose tireless attention to detail made the conference possible. Frankfurt am Main, March 2004 Theodor Baums

Andreas Cohn

Table of Contents Part One: From an Economic Perspective On Myths, Bubbles and New Paradigms in the Hedge Fund Industry Alexander M. Inekhen The Regulation of Hedge Funds: Financial Stability and Investor Protection Franklin R. Edwards

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Ρart Two: The Regulation of Hedge Funds 1. U N I T E D STATES

Waking Up to Hedge Funds: Is U. S. Regulation Really Taking a New Direction? Marcia L. MacHarg

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2 . U N I T E D KINGDOM

Should Hedge Fund Products be Marketed to Retail Investors? A Balancing Act for Regulators Ashley Kovas

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3 . GERMANY

Hedge Funds Regulation in Germany Edgar Wallach

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Part Three: Practical Aspects Legal Aspects of German Hedge Fund Structures Kai-Uwe Steck

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Vili

The Contributors Alexander M. Ineichen Mr. Ineichen is Managing Director and Global Head of AIS Research at UBS. He started his financial career in origination of risk management products at Swiss Bank Corporation in 1988 and has been in equity derivatives research since 1991. In his current role he oversees research on Alternative Investment Strategies (AIS) and a research product on capital flows. Mr. Ineichen authored the much consulted research publications, "In Search of Alpha—Investing in Hedge Funds" (2000) and "The Search for Alpha Continues—Do Fund of Hedge Funds Add Value?" (2001), as well as the book, Absolute Returns—Risk and Opportunities ofHedge Fund Investing (2002). He holds a federal diploma in economics and business administration from the School of Economics and Business Administration (SEBA) in Switzerland and the designations of Chartered Financial Analyst (CFA) and Chartered Alternative Investment Analyst (CAIA).

Franklin R. Edwards Professor Edwards is Arthur F. Burns Professor of Free and Competitive Enterprise; Director, Center for the Study of Futures Markets of the Columbia Business School, Columbia University, New York. Professor Edwards is a specialist in financial markets and institutions, financial regulation and derivatives markets. He teaches courses on futures markets and contemporary issues in financial markets, and has written dozens of books and articles on topics in banking, financial markets and derivatives, including a textbook, Futures and Options, and his recent New Finance: Regulations and Financial Stability.

Marcia L. MacHarg Ms. MacHarg is a partner of the U. S. law firm of Debevoise & Plimpton LLP, where she represents buyers and sellers in mergers and acquisitions, principally in the investment management and financial services industries, and advises U. S. and international clients in organizing funds for public or private sale in the United States, and in offshore jurisdictions, including Germany. She is the editor of International Survey of Investment Adviser Regulation, a comprehensive review of the regulation of investment advisers in 28 countries and the European Union, and is a contributing author to The Investment Company Regulation Deskbook. She gratefully ack-

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nowledges the assistance of her colleagues, Lothar Kneifel and Monica Arora, in the preparation of her contribution to this book. Ashley Kovas Mr. Kovas is a Manager in the Business Standards Department of the Financial Services Authority where he leads a team responsible for various asset management policy issues including the co-ordination of the FSA's work on hedge funds. He has previously been employed by various asset management firms in a variety of regulatory compliance roles. He has also consulted for KPMG. The Financial Services Authority is an independent non-governmental body, given statutory powers by the U.K. Financial Services and Markets Act 2000. Kai-Uwe Steck Dr. Steck is an attorney in the German Asset Management practice group of Shearman & Sterling LLP. He specializes in banking law and the regulation of investment funds. His current practice focuses on providing regulatory advice to banks, financial intermediaries and investment companies. Dr. Steck has published numerous articles in German and US law journals, and has spoken on his areas of expertise at a number of conferences. Edgar Wallach Dr. Wallach is a partner of the German law firm of Hengeler Mueller, where he focuses on securitised and non-securitised investment products of various types, including alternative investments, and represents clients in connection with German, European and internationally structured funds projects. Dr. Wallach is currently designing a number of funds structures under the recently enacted German Modernization Act. He has authored many articles on a number of legal topics affecting investment funds and their regulation, and is a frequently consulted expert on this area of German law.

Part One: From an Economic Perspective

On Myths, Bubbles and New Paradigms in the Hedge Fund Industry Alexander M. Ineichen

Introduction To some, hedge fund investing is a bubble, to others absolute return strategies is a New Paradigm in asset management. Reality is probably somewhere in between. Expectations of high positive absolute returns from hedge funds when equity markets fall are probably exaggerated. However, the balancing act of managing investment opportunities with capital at risk might be in the process of replacing the relative return approach.

Demystifying Hedge Funds In the first section of this paper we highlight some myths regarding hedge funds and more importantly regarding the investment in hedge funds. Occasionally hedge funds are considered secretive. This is actually not a myth but true. The hedge funds industry—to some extent—is secretive. One of the reasons for this secrecy is that there are no talking heads of the industry who appear on CNBC or CNN on a regular basis. Information started to flow more efficiently only in the year 1998. The reason for the absence of talking heads or regular hedge fund manager forums is to some extent obvious. Hedge fund managers have different incentives than Wall Street talking heads where self-promotion is a key to success. If you have a trading strategy or investment process with superior risk/reward trade-off in absolute return space, why do you want to tell it to the world for free or for a small fee?

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Myth: Investing in Hedge Funds Is Unethical According to the myth, investing in hedge funds is speculative and therefore unethical. We would like to turn the argument around and postulate that for a fiduciary not considering investing in alternative investment strategies (AIS) in a portfolio context in general or absolute return strategies in particular is, if anything, unethical. The empirical evidence from absolute return managers exploiting inefficiencies and producing high risk-adjusted returns is overwhelming, and academia is in the process of confirming that market inefficiencies exist (i.e., migrating to a very weak form of market efficiency).1 Views and definitions of ethics vary across countries and cultures. Any view, therefore, is subjective and has a strong home or cultural bias. The following view is based on the Prudent Expert Rule from the Employee Retirement Income Security Act of 1974 (ERISA) and the Code of Ethics from the Association of Investment Management and Research (AIMR)2. According to the AIMR Code of Ethics (AIMR 1999) members shall: 1. Act with integrity, competence, dignity, and in an ethical manner when dealing with the public, clients, prospects, employers, employees, and fellow members. 2. Practice and encourage others to practice in a professional and ethical manner that will reflect credit on members and their profession. 3. Strive to maintain and improve their competence and the competence of others in the profession. 4. Use reasonable care and exercise independent professional judgment. Under ERISA, fiduciaries must discharge their duties with respect to the plan: 3 1. Solely in the interest of plan participants and beneficiaries.

There are hardly any investment professionals who experienced the 1987 crash and believe in the efficient market hypothesis. 2 The AIMR is a global nonprofit organization of more than 41,000 investment professionals from more than 90 countries worldwide. Its mission is to advance the interests of the global investment community by establishing and maintaining the highest standards of professional excellence and integrity. » From AIMR (1999). 1

On Myths, Bubbles and New Paradigms in the Hedge Fund Industry

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2. For the exclusive purpose of providing benefits to participants and their beneficiaries and defraying reasonable plan expanses. 3. With the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims (the Prudent Expert Rule). 4. By diversifying the investments of the plan so as to minimize the risk of large losses, unless doing so is clearly not prudent under the circumstances. 5. In accordance with the governing plan documents, as long as they are consistent with ERISA. Assuming ERISA's Prudent Expert Rule is some indication of how a fiduciary should act and AIMR's Code of Ethics is a reference for ethical conduct and integrity of a financial professional, investing in hedge funds cannot be categorized as unethical. Taking this argument one step further, one could argue that, if anything, ignoring absolute return strategies and the benefits of its inclusion to a portfolio might be unethical.4 The fourth of ERISA's points listed states that a fiduciary should diversify and reduce risk of large losses. In a portfolio context, risk is reduced by increasing the allocation to less volatile assets or introducing assets with low or negative correlation to the core of the portfolio. The strategies by relative value managers exploiting inefficiencies have proven to be conceptually sound as well as empirically characterized by high risk-adjusted returns and low correlation to traditional assets.5 In addition, once risk to single hedge funds is diversified (idiosyncratic risk), large losses hardly occur especially when compared with traditional investments that are essentially long the asset class outright. Some U. S. and U. K. pension funds (mostly long-only investors) have gone from overfunded to underfunded (liabilities exceeding assets) in only three years after the equity market peaked in 2000. In the United Kingdom a precedent from 1883 dictates that the unpaid 4

Amin and Kat (2001), for example, stress that it is important to view hedge funds in a portfolio context and not in isolation, s The fact that nondirectional absolute return strategies have return distributions that do not match a normal distribution does not automatically mean that the strategies are conceptually unsound. Returns from equities or cash flows from insurance companies are not normally distributed, either.

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laymen who make up the majority of most trustee boards must take all the care " a n ordinary prudent man of business would take in managing similar affairs of his own." 6 In the first quarter of 2002 the Department for Work and Pensions issued three consultation papers, one of which is aimed at raising the quality of investment decisions taken by pension fund trustees. In the United Kingdom it is often noted that the average pension fund trustee spends around 12 hours per year7 thinking about themes related to investment management This fact introduces a lemming-like peer group driven investment process and a "tabloid bias." Putting it crudely: Equities and bonds are good, and derivatives and hedge funds are bad. This is why "conservative" is defined as having a 70 to 80 percent allocation to equities with the majority invested in the domestic market.8 This is probably the reason why the U. K. institutional involvement (on the demand side) in absolute returns is one of the lowest in Europe. However, there is a trend to the better. First, the government is aware of the issues arising from the world moving from defined benefit to defined contribution pension schemes. Second, the 6

A common market for pensions in Europe is a long-sought goal within the European Union (EU). The European Commission (EC) proposed to base pension regulation on the "prudent person" principle in October 2000. The United Kingdom, Ireland, Sweden, and the Netherlands backed the EC proposals whereas most of the remaining member states, led by France and Germany, have expressed some doubts. This despite the EC stressing that funds in member states where the prudent person principle has been applied—namely the United Kingdom and the Netherlands—have achieved returns over the past 15 years that were twice as high as those subject to quantitative restrictions. The Spanish delegation came up with the idea to create a "prudent person plus" principle. This new principle would combine the basic principle with some fortified quantitative restrictions.

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Occasionally a figure of 20 hours per year is quoted as the average time spent on financial matters by the average U. K. pension fund trustee. Given the complexity of asset/liability management and solvency issues it is unlikely that 12 or even 20 hours per year are sufficient. Note that during the technology, media, and telecommunications (TMT) expansion, some U. K. pension funds had a larger allocation to a single U. K.domiciled company than to the whole of the U. S. stock market. An allocation of more than 5-10 percent to a single stock could be in breach of modern portfolio principles, which state that idiosyncratic risk should be eliminated through diversification. It is probably also in violation of point four of AIMR's Code of Ethics and certainly in violation of ERISA's Prudent Expert Rule. In other words, running strongly concentrated portfolios and avoiding hedge funds because the local tabloids suggest they are dangerous is certainly not the result of a professional and prudent expert thinking about risk.

'

On Myths, Bubbles and New Paradigms in the Hedge Fund Industry

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Myners Report 9 suggests, among other issues, that U. K. pension funds should move away from finding comfort in the peer-group consensus and seek idiosyncratic solutions to their financial requirements, that is, become a little bit more open-minded with respect to the financial innovations of the past 30 years. The relationship between institutional funds and the agents engaged to manage the portfolio assets has always provided a fertile breeding ground for conflicts of interest. Yale endowment fund manager David Swensen puts it as follows: Institutions seek high risk-adjusted returns, while outside investment advisers pursue substantial, stable flows of fee income. Conflicts arise since the most attractive investment opportunities fail to provide returns in a steady, predictable fashion. To create more secure cashflows,investmentfirmsfrequently gather excessive amounts ofassets, follow benchmarkhugging portfolio strategies, and dilute management efforts across a broad range of product offerings. While fiduciaries attempt to reduce conflicts with investment advisers by crafting appropriate compensation arrangements, interests of fund managers divergefrominterests of capital providers even with the most carefully considered deal structures.10

Myth: Hedge Funds Are Risky Hedge funds, examined in isolation, are risky—as are technology stocks, or energy trading companies, or airline stocks. However, most investors do not hold single-stock portfolios. They diversify stock-specific risk (idiosyncratic or nonsystematic risk) by investing in a range of stocks with different characteristics. To most investors, it is regarded as unwise not to diversify idiosyncratic risk. It should be similarly unwise not to diversify risk to a single hedge fund. Note that many critics of hedge funds do not distinguish between systematic and nonsystematic risk when demonizing hedge funds. Schneeweis and Spurgin (1998) and many others have shown that hedge funds offer an attractive opportunity to diversify an investor's portfolio of stocks and bonds. This is true even if the returns earned by hedge funds in » The government sponsored Paul Myners (executive chairman of Gartmore Investment Management in the United Kingdom from 1987 to 2001) for an independent review of the United Kingdom pension fund industry. Myners is promoting the so-called Myners code of best investment practice, which fund management houses are supposed to sign up to by March 2003. 10 Swensen (2000), p. 5.

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the future are merely on a par with those of stocks and bonds. There is no need to see risk-adjusted returns as high as they have been to justify diversification benefits into hedge funds.

Myth: Hedge Funds Are Speculative Hedge funds are risky (as is any other investment when compared to U. S. Government bonds) but they are not speculative. The misunderstanding of hedge funds being speculative comes from the myopic conclusion that an investor using speculative instruments must automatically be running speculative portfolios. Many hedge funds use speculative financial instruments or techniques to manage conservative portfolios. Not everyone understands this. Popular belief is that an investor using, for example, leveraged default derivatives (a financial instrument combining the most cursed three words in finance) must be a speculator. The reason why this is a misconception is that the speculative instrument is most often used as a hedge, that is, as an offsetting position. The incentive to use such an instrument or technique (for example, selling stock short) is to reduce portfolio risk—not to increase it. This is the reason why most absolute return managers regard themselves as more conservative than their relative return colleagues. The decision of an absolute return manager to hedge is derived from whether principal is at risk or not. To them, preserving wealth is conservative. The protection of principal is not a primary issue for the relative return manager, as his mandate is outlined and risk defined differently. It is the absolute return manager who will think about all the risks and j udge whether to hedge or not to hedge. Relative return managers, more often than not, manage OPM (other people's money). So do hedge funds. However, hedge fund managers, more often than not, have their own wealth in their fund, that is, their capital, incentives and interests are aligned with those of their investors. Most people care about the risk of loss of principal—especially when it is their own. As Yale endowment fund manager David Swensen (2000) puts it: While any level of co-investment encouragesfund managers to act like principals, the larger the personal commitment of funds, the greater the focus on generating superior investment returns... The idea that a fund manager believes strongly enough in the investment product

On Myths, Bubbles and New Paradigms in the Hedge Fund Industry

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to put a substantial personal stake in the fund suggests that the manager shares the investor's orientation

Myth: Hedge Funds Generate Strong Returns in All Market Conditions Generally speaking, the correlation between hedge fund returns and the equity market is not zero. However, one cannot generalize across all hedge fund styles and managers. Some hedge funds do better than others during bear markets. The hedge fund industry is extremely heterogeneous. There is great diversity among different trading and investment styles and strategies. Figure 1 shows the ten worst quarters for the MSCI World index during the period from January 1990 to March 2003 and compares this with the HFRI Fund of Funds index that serves as a proxy for a diversified portfolio of hedge funds. The bars measure the total return (i. e., including dividends) in U. S. dollars for the calendar quarters. One quarter stands out: the third quarter of 1998 when Russia defaulted on its ruble-denominated debt and which caused the investment public to realize the sensitivity of spread risk12 in a flight-to-quality scenario and a drying up of liquidity. Most long/short managers regard being long-only as extremely speculative because the assets under management are fully exposed to the whims of the stock market. To them, having the same exposure to equities when equity volatility is 10 percent (as, for example, in the United States and United Kingdom in 1995) or 20 to 70 percent (as in most years since 1995) is a strange way of managing money. Figure 1 is an indication of what this translates to in periods of stress. The hedge funds from the 1960s did extremely poorly during the bear «

Swensen (2000), p. 267.

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Most hedge funds, especially nondirectional hedge funds, are long one financial instrument and short a related instrument. In other words, the fund is exposed to many different spreads, here called "spread risk." Spread risk has a nonsystematic as well as systematic risk element; that is, it cannot be perfectly immunized through diversification. The main characteristic of spread risk is that it causes the fat tails in the fund's return distribution. In rare occasions, in a flight-to-quality scenario, spreads have a tendency to widen all at the same time (as in the third quarter of 1998).

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Figure 1: Performance in worst quarters (Q1 1990 - Q1 2003) 10·

IMSCI World Index

• HFRI Fund of Funds

•m , Q3 2002

. . Q3 1990

Q3 2001

— Q1 1990

Q1 2001

Q3 1998

Q2 2002

Q1 1992

— Q4 2000

Q1 2003

Source: UBS Warburg (based on data from Bloomberg and Datastream) market of the 1970s. 1 3 Many managers went out of business, essentially because they were long, leveraged, and totally exposed to the market. However, the degree of sophistication of hedge funds employing relative investment strategies has increased since the 1960s. Anecdotal evidence from the bear market starting in spring 2000 indicates that many directionally biased hedge funds had deleveraged and were moving into cash as markets fell. Throughout 2002 and in the beginning of 2003, long/ short equity managers where still largely in cash. This fact introduces the debate of whether investors should pay a 1 percent management fee to someone investing in the risk-free rate.

Myth: The Lesson of LTCM Is Not to Invest in Hedge Funds Thomas Schneeweis (1998b) wrote: There are many lessons to be learned from LTCM: (1) diversify, (2) high-return investments are also potential low-return investments, (3) trading in illiquid secondary markets is potentially disastrous in extreme market conditions, (4) an asset that returns in excess of 30 % per year, as

«

The history of hedge funds is described in Chapter 1 of Ineichen (2003).

On Myths, Bubbles and New Paradigms in the Hedge Fund Industry

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LTCM did, is a very risky investment. These are, of course, lessons that are true for all investments, and have nothing to do with the fact that LTCM was a hedge fund.

A hedge fund is a business. Businesses, unfortunately, occasionally fail and go bankrupt for various reasons. This is one of the main reasons why investors diversify across businesses (i.e., diversify idiosyncratic risk). Although a repeat of a disaster such as LTCM is regarded as unlikely, 14 some hedge funds are likely go bankrupt in the future; they potentially could destroy wealth under management. However, a point can be made that entrepreneurs should have exposure to idiosyncratic risk whereas investors should diversify idiosyncratic risk, that is, be exposed to (and get compensated for) systematic risk. In other words, investors should hold portfolios of hedge funds as opposed to a handful of hedge funds. There are many ironies surrounding the collapse of LTCM. One is that the brightest academics in finance together with the most trading-sawy investment professionals on Wall Street could not avert one of the largest disasters in financial history. Another interesting aspect is that LTCM is the hedge fund that is most commonly known. The irony is that LTCM was a very atypical hedge fund. Its trading strategies were more in line with those of a capital market intermediary. When investors or issuers needed to change their positions or risk exposures, they would go to an investment bank or dealer to buy or sell securities or structured products. In turn, the dealer would utilize the capital markets to cover this exposure. LTCM was often on the other end of these transactions, in some sense wholesaling risk to the intermediary who was working directly with clients. LTCM viewed its main competitors as the trading desks at large Wall Street firms rather than traditional hedge funds. The late Leon Levy, co-founder of the Oppenheimer Funds and Odyssey Partners, in The Mind of Wall Street (2002) puts the limitation of scientific advice more boldly while discussing the failure of LTCM: What can be made of this chain of events ¡failure of LTCM]? First and foremost, never have more than one Nobel laureate economist as a partner in a hedge fund. LTCM had two. Having had one Nobel prize winner as a limited partner over the years, I can say that had our firm followed his advice, we too might have lost a lot of money.15 14

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A flight-to-quality scenario, however, is very likely to occur at one stage in the future. This quote is taken slightly out of context. There is more praise for LTCM in the book than there is criticism. Mr. Levy for example argues that the "willingness to take personal risk stands in refreshing contrast to all too many Wall

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Myth: Short Selling Is Bad The U. S. Securities and Exchange Commission (SEC) describes the economics of short selling as follows: Short selling provides the market with two important benefits: market liquidity and pricing efficiency. Substantial market liquidity is provided through, short selling by market professionals, such as market makers, block positioners, and specialists, who facilitate the operation of the markets by offsetting temporary imbalances in the supply and demand for securities. To the extent that short sales are effected in the market by securities professionals, such short sale activities, in effect, add to the trading supply of stock available to purchasers and reduce the risk that the price paid by investors is artificially high because of a temporary contraction of supply.16

The second benefit of short selling after increasing market liquidity is an increase in pricing efficiency. Efficient markets should price both, positive as well as negative information, that is, it require that prices fully reflect all buy and sell interest. The short sale of a short seller is the mirror image of another person's buy transaction. The former forecasts that the price will fall (or uses the short sell to offset other risk factors in the portfolio) while the latter bets on prices to rise. Both the purchaser and the short seller hope to buy low and sell high, that is, making money by buying the stock at one price and selling at a higher price. The distinguishing factor is that the strategies differ in the sequence of the transactions. Equity managers who believe a stock is overvalued sell the stock short in an attempt to profit from a perceived divergence of prices from true economic values. Pricing efficiency is increased because the market is informed about the short seller's negative evaluation of the future stock price performance. This evaluation is reflected in the resulting market price of the security. One of the main ingredients of any marketplace therefore is the presence of buyers as well as sellers. In other words, a marketplace needs heterogeneity, not homogeneity. One of the phenomena offinancialbubbles (as the recent Internet bubble showed) is that it is difficult for short sellers to

"

Street players." As many before him, Mr. Levy isolates hubris as the main catalyst for LTCM's failure. In other words, our interpretation of the lesson for investors is the following: A successful risk measurer comes up with an "objective" correlation matrix or any other metric for "risk". A successful risk manager, however, knows that the metric at best is a biased view on future relationships and at worst a tool that reliance upon could result in disaster. From SEC (1999).

On Myths, Bubbles and New Paradigms in the Hedge Fund Industry

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borrow stocks and sell them short. A bubble is a departure of prices from their intrinsic value and is caused by an imbalance between buyers and sellers. In addition, in a collapse long-only investors are more likely to start selling in a panic. The short seller is more likely to buy to close out the short position. The most significant error made with respect to short selling is to describe hedge funds as a homogenous mass of like-minded investors. In practice there is a multitude of different types of hedge funds, each with different investment criteria and different risk/reward objectives. However, in general, the majority of those investing in equities fall into two categories: arbitrage and long/short. The arbitrage hedge funds will be short a security as a hedge against a commensurate long in a closely connected security (say a convertible bond, a warrant, or a company being bid for where there is a share-for-share deal). Thus their activity may involve large transactions, but is neutral to the direction of the overall entity or market. The long/short investors are investing on the fundamentals of the companies, and in addition to holding short positions in overvalued companies they will hold long positions in undervalued companies. Thus, again, their activities may involve large transactions but are close to net neutral from a market perspective. There are some funds that are more directionally oriented: macro funds and short sale funds. However, these are actually a very small proportion of the hedge fund universe. Even accounting for leverage, the actual amount of net shorts run by hedge funds is negligible in the overall scheme of markets. The banning of short selling increases market inefficiencies: One of the characteristics of an efficient market is that new information is disseminated quickly and enters the price rapidly. Bad news (normally) decreases the price whereas good news increases the price of a security or an asset. This mechanism causes the price to reflect the available news at all times. Banning short selling causes good news to enter the price mechanism quickly, whereas it limits the price mechanism to adjust for the bad news. In other words, the price mechanism (i. e., the interaction of buyers and sellers) becomes dysfunctional, and market efficiency decreases. According to Staley (1997), sell-side analysts are not fully independent. They have, apparently, a positive bias. Staley finds that most brokerage stock recommendations range from buy to hold, with few analysts willing to rank stocks as sells. This bias causes the risk/reward trade-off for short selling to be more favorable, as the potential for negative surprises

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causing large swings in price is greater than positive surprises (as all the good news is already in the price). According to Staley, short sellers often disagree with Wall Street analysts. The apparent bias inherent in the job description of the latter apparently strikes short sellers as a consistent reason for flawed information. As with any other economic activity there are always individuals who do not play the game according to its rules. Short selling is no different. The main offense (and perhaps the one most practiced) is spreading rumors. Some short sellers will spread news with a negative content, hoping the market will react to the news and put pressure on the price. Another offense is spreading good news, such as a rumor of a merger just around the corner. Internet chat rooms have in the past sometimes been used as platforms for dissemination of false information. A further strategy could involve "talking d o w n " the price of a stock ahead of a hostile takeover. The takeover company circulates negative information that is either false or grossly exaggerated. Because it is inherently difficult for companies to combat bad news, this simple strategy can serve to drive down the share price of the target company to levels that allow the takeover company to accumulate cheap shares before the target company can correct its position in the market. Another example of manipulation is the "bear raid" where a stock is sold short in an effort to drive down the price by creating an imbalance of selling pressure. After the terrorist atrocities of September 2001, many articles appeared in the press about hedge funds exploiting the tragic events and how short selling has been driving markets lower. This has led to criticism of the stock loan market itself. Much of what has been said is at best ill-informed speculation and at worst arrant nonsense. It may well be h u m a n nature to look to blame someone when markets gap down, but blaming hedge funds and short selling is not only missing the point but also creating a danger of upsetting some of the better workings of the marketplace. Stock loans are needed in many areas of market activity: Any trader providing liquidity to a buyer needs to be able to borrow the stock in order to deliver on the sale; stock loans are required in order to ease the settlement process to prevent trades failing; anyone trading derivatives needs to be able to borrow stock to hedge positions. In addition, the majority of the professional stock loan market surrounds dividends and is traded between investors with different tax liabilities. And yes, stock loans are also used by hedge funds, when they want to sell short. If stock loans disappeared, the effects would be a dramatic drying up of liquidity, a vast reduction in

On Myths, Bubbles and New Paradigms in the Hedge Fund Industry

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the amount of derivatives available, and an increased friction cost in transactions due to delayed settlement. Staley (1997) quotes Bernard Baruch on the first page of her book. This quote summarizes the issues surrounding short selling and brings it to a point: Bears can make money only if the bulls push up stocks to where they are overpriced and unsound. Bulls always have been more popular than bears in this country [U. S.J because optimism is so strong a part of our heritage. Still, over-optimism is capable of doing more damage than pessimism since caution tends to be thrown aside. To enjoy the advantages of a free market, one must have both buyers and sellers, both bulls and bears. A market without bears would be like a nation without afreepress. There would be no one to criticize and restrain the false optimism that always leads to disaster.

Myth: The Financial Marketplace Must be Controlled Chances are, that the problems for which regulation is designed to cur are solved, but the inefficiencies introduced through the new rule, outweigh the benefits two to one. Regulation, probably by definition, is reactive as opposed to proactive. It is always possible, in hindsight, to see the mistakes that lead to chaos, havoc or collapse. It is often easy, ex post, to see where a simple rule or regulation might have prevented a catastrophe. Improving ones risk controls and analysis is always laudable. However, all possible losses cannot be prevented or ironed out—especially not through regulation. If no risk is taken in an economic system, most projects or products would remain unfunded. Growth requires investment in risky ventures. Risky ventures imply the possibility of loss. In 1994, George Soros was invited to deliver testimony to the U. S. Congress on the stability of the financial markets, particularly with regard to hedge f u n d and derivatives activity. 17 Soros believed that the banking committee was right to be concerned about the stability of markets, saying: "Financial markets do have the potential to become unstable and require constant and vigilant supervision to prevent serious dislocations." However, he felt that hedge f u n d s did not cause the instability. He blamed institutional investors, who measure their performance relative to their peer group and not by an absolute yardstick: "This makes them trend-followers by definition." "

From Chandler (1998).

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Alexander M. Ineichen

Persaud (2001) argues that regulatory and risk management systems do not prevent or warn from disasters such as the default of Argentina or Enron—that the regulatory mantras of common standards and marketbased risk management encourage the herd mentality that characterizes investment flows and increase the correlation between events that spread instability through financial markets. He uses the term "liquidity black hole" for situations where there is liquidity when you buy but no liquidity when you want to sell. One obvious conclusion is that turnover is not synonymous with liquidity. Technology stocks had high turnover during the bull run. However, when the time came to sell, there were no buyers, only sellers—or, put differently, the buyers all turned into sellers (otherwise the price would have not collapsed 80 to 100 percent). Persaud rightly notes that it is market diversity that increases liquidity in markets, and not turnover. In other words, a marketplace needs contrarians next to the traditional market participants who find comfort in high numbers, that is, the consensus. Market participants acting countercyclically (e. g., derivatives trading unit of investment bank, absolute return managers) should not be ruled out of existence by regulation.

Bubble or New Paradigm in Asset Management? Bubble Theory Some market observers view the increasing allocation to hedge funds as a bubble. More and more authors, experts and analysts expect the hedge fund bubble to burst any time soon.18 A bubble exists when investment horizons expand, expectations skyrocket, and everyone does the same thing at the same time. In other words, bubbles occur when the consensus view with respect to expected returns increases and investors cuddle in the comfort of the consensus view and de-emphasise sound research, due diligence and logical economic reasoning. The South Sea Bubble, Tulip Mania and the Internet 18

See for example 'Hedge Funds—The latest bubble?" The Economist, 1 September 2 0 0 1 ; 'SEC's Paul Roye Issues a Warning About a Hedge Fund 'Craze', Bloomberg News, 2 3 July 2001; 'The $ 5 0 0 Billion Hedge Fund Folly,' Forbes, 8 June 2001; "The Hedge Fund Bubble,' Financial Times, 9 July 2001; 'Hedge Funds May Become the Next Investment Bubble,' Bloomberg News, 30 May 2001.

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Bubble were good examples of this pattern. In all cases, expectations slowly diverged from fundamentals. The bubble bursts when expectations converge with reality. One of the main arguments for institutional investors investing in hedge funds is portfolio diversification. This, in essence, means reducing the expected volatility of portfolio returns without compromising expected returns. Adding asset classes with expected returns that have low correlation with traditional asset classes increases the efficiency of the portfolio.19 To some this might be like new wine in old wineskins. A few decades ago, investing in emerging markets was marketed as a new asset class with low correlation to assets in the developed world. Experiences in the 1990s have aligned the hype with reality. The obvious question is whether investing in hedge funds will suffer a similar fate. It is possible that diversification benefits are currently overestimated. Only a small segment of the hedge fund universe has low correlation with equities. It is debatable whether the industry as a whole can decouple completely from trends in equity markets or the whole economy. Figure 2 compares annual returns of the MSCI World total return index with the HFRI Fund of Funds Composite index. The numbers in brackets in the legend show the compound annual rate of return between January 1990 and March 2003. The chart shows that the opportunity set of hedge funds is not entirely decoupled from the state of the stock market.

Short-termism—a Red Herring? Every evolving industry goes through times of rapid change and innovation. Increased specialisation seems to be one of the constant variables in the field of investment management. In the early stages of the asset management industry, a single manager managed a balanced portfolio. Then equities and bonds were separated. Then equities were split into value and growth, or active and passive, or domestic and international, or developed and non-developed markets. The increased acceptance and current institutionalisation of hedge funds could be viewed as a further u

Note that hedge funds are also viewed as asset managers employing an alternative investment strategy within a traditional asset class (as opposed to be an asset class of there own). For example: a long/short portfolio is a different way of trading equities than a long-only portfolio.

Alexander M. Ineichen

18

Figure 2: Annual returns

ß MSCI World (4.2% p.a.)

• HFRI Fund of Funds Composite Index (10.2 p.a.)

Source: UBS Warburg (based on data from Bloomberg and Datastream) specialisation of the asset management industry between skill-based and market-based strategies.20 However, we do not believe that all of the recent developments are positive. Any investment that is fashionable has a tendency to attract short-term investors. Short-term investors have a tendency to buy last year's winners and have a less disciplined and rigorous investment process. This could have a negative impact on the industry if there is a sudden and unexpected mismatch between expectations and reality. Currently, a gap is potentially opening between expectations and reality. Given the strong inflow of assets to hedge funds, some market observers are asking whether the inflows into hedge funds are decoupling from realistic expectations, i.e., whether there is a pattern of a bubble in progress. In other words, is the hedge fund boom a bubble? If it is a bubble, it probably would not be comparable with the bursting of the internet bubble, where losses were in the region of 80-100 %. The first step could be an increase in dispersion of hedge fund returns. This is probably already happening. The dispersion between single managers is 20

The performance of skill-based strategies is attributable to the manager's skill. The performance of market-based strategies is attributable to the return of the market.

On Myths, Bubbles and New Paradigms in the Hedge Fund Industry

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extremely wide in the hedge funds industry as there is no benchmark for managers to hug. In addition, the increase in demand is resulting in an absolute reduction of quality, especially among lower quartile funds or funds of funds. Consequently, the dispersion between top and low quartile hedge funds or funds of funds widens. In addition, the hedge fund industry as a whole has a long equity bias. The absolute returns of the 1990s are unlikely to be matched in the 2000s when equity markets compound at 0-5% in the 2000s instead of 10-15 % as in the 1990s. In addition, volatility has been relatively high over the past five years. Lower volatility would mean fewer exploitable inefficiencies and fewer opportunities. Lower hedge fund performance in the 2000s, therefore, could potentially also realign expectations with reality. This realignment could happen gradually or instantaneously. A number of catalysts could be found for an instantaneous correction, i. e., a crash. These catalysts might include market dislocation, regulatory change, corporate governance breakdown or any other extreme event. However, these events are, by definition, not foreseeable. We, therefore, regard a gradual realignment of expectations with reality as the more likely scenario than a bubble bursting à la internet. Private equity has recently experienced such a realignment of expectations. Since the internet bubble has burst, exit strategies have become much more difficult. Many late 1990s vintages have single-digit IRRs to date. The vintages of 1999 and 2000 (peak of the TMT frenzy for venture capital funds could turn out to become what 1998 was for hedge funds). High demand led to a dispersion of performance. We believe that today the consensus view is that private equity only yields high risk-adjusted returns if one invests with the first or second quartile managers. Just being long the asset class is not enough. This could happen to the hedge funds industry. Not a collapse as in internet shares but a realignment of expectations with reality. In the long-term, such an adjustment is desirable. An adjustment could strengthen the business case for fund of funds managers. If the alpha in the hedge fund universe can only be unlocked through market participants with a competitive advantage, but not by simply being long or through random selection, then the case for funds of funds is strengthened.

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Alexander M. Ineichen

What is a New Paradigm? The opposite view of the current trend of hedge fund investing being a fad ending in the bubble bursting is the view that absolute return strategies involving risk management techniques is a new paradigm in asset management. Paradigm shifts happen when there are anomalies—disparate odd results that cannot be explained away by inadequate methodology alone. When sufficient anomalies occur, any street-smart individual, one could postulate, must begin to consider that the paradigm under which they are doing their work is no longer of use or is actually dysfunctional. Thomas Kuhn (1962) defines a paradigm shift as: "[Individuals who break through by inventing a new paradigm are] almost always.. .either very young or very new to the field whose paradigm they change... These are the men who, being little committed by prior practice to the traditional rules of normal science, are particularly likely to see that those rules no longer define a playable game and to conceive another set that can replace them."

Although Thomas Kuhn's quote fits with the energetic, unconventional median hedge f u n d manager, declaring hedge funds as new paradigm might be stretched. However, the investment management industry is a continuum and subject to change. Two changes in recent years are particularly worth pointing out. First, the perception of risk has changed. Market participants have begun to examine and analyse the downside tail of the return distribution more closely. This is a departure from being satisfied with mere statistical variance of returns as a measure for risk. Second, portfolio management is mutating into risk management. Longheld methodologies and investment styles are gradually being replaced with more scientificapproaches and tools to manage money, assets and risk.

Perception of Risk Since 1987, the far left-hand side of the return distribution has been getting more attention. The Ottober 1987 crash was probably the main catalyst for investors to start observing and modelling the far left-hand side of the return distribution more carefully. Since 1969 there have been three occasions when the daily S&P 500 returns were larger than seven standard deviations from the mean. There were outliers on both sides of the mean. Outliers have a great influence on the risk of the venture, in this case

On Myths, Bubbles and New Paradigms in the Hedge Fund Industry

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investing in equities. These outliers, by definition, are not foreseeable. Decision making with respect to the future will always involve uncertainty regardless of the approach used (fundamental economics, technical analysis, market psychology, astrology, etc). What we know for sure about equity markets and their volatility is uncertainty itself. There will always be uncertainty. 21 The above statement is not as fatuous as it may sound. It raises the question of what a money manager should focus on in the long term: expected return or risk. Looking at the world from the view of a risk manager it is obvious: risk. A risk manager would argue that one cannot manage expected return, but one can manage risk. Return is the byproduct of taking risk. Banks today do not manage portfolios, they manage risk. Their longterm investment strategy is to define the risk they want to be exposed to and manage that exposure accordingly. This implies that banks have an absolute-return focus as opposed to a relative-return focus. Potentially, asset management could be in the process of moving in the direction of banks and hedge funds, i. e., defining risk in absolute terms rather than relative terms. One could also argue that the asset management industry is moving back to an absolute return orientation and that the passion with market benchmarks was only a brief blip in the industry's evolution, driven perhaps by an increasing involvement of consultants and trustees.

Is the Asset Manager's Business Model Changing? Contrast business models A and Β in Table 1. Table 1: Two Different Business Models in Asset Management Business Model A (market-based)

Business Model Β (skill-based)

Return objective

Relative to benchmark

Absolute, positive return

This means:

Capture asset class premium Add value

Risk management

Tracking risk

This means:

Capture asset class premium Avoid destroying value

Total risk

Source: Ineichen (2003) 11

Or as John Maynard Keynes has put it: "It would be foolish, in forming our expectations, to attach great weight to matters which are very uncertain."

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Alexander M. Ineichen

The main difference between hedge funds and traditional long-only manager is the absolute return objective. Hedge funds, like banks, define their return objective in absolute terms, i. e., not relative to a market or peer-group benchmark. In addition, risk is understood as the probability of absolute losses, i. e., destruction of value. A long-only manager, also referred to as a relative-return manger, defines success and failure relative to a benchmark. A point can be made that this approach stems from a time where capturing the asset class premium (exposure to beta) was scarce. Given the huge diversity of indexed funds and derivatives this is not the case any more—at least not in information-efficient markets such as large cap equity markets in the developed economies. One could argue that anything that survived the wars, turbulence, crises and market volatility of the 1990s has a high probability of sustainability. What might disappear is the term "hedge fund.' The term "hedge fund' is, to some extent, a misnomer. Not all hedge funds are 'hedged.' However, the first hedge fund managers did not want their professional destiny and wealth to be dependent on chance, i. e., market risk. 22 That is the reason why the first hedge funds hedged market risk in the first place. Their goal was to hedge their exposure to chance and volatility and to ensure that performance was attributable to skill (stock picking). In addition, the term hedge fund is also, to some extent, contaminated. The term 'hedge fund' suffers from a similar fate as 'derivatives' due to a mixture of myth, misrepresentation, negative press and high-profile casualties in the 1990s. The reputation of derivatives has improved because parts of the writing guild have found a new product to demonise: hedge funds. Hedge funds are already in the process of being institutionalised. The traditional asset management industry has already started to offer what can best be described as absolute return strategies. The main characteristic of absolute return strategies is that the benchmark is cash. The more successful ventures have proven to be highly profitable for the launching asset management firm. In other words, the separation between skill-based and market-based strategies in the asset management industry has already begun. a

This is based on the assumption that market timing is about as difficult longterm weather forecasting. Both, weather as well as an economic system, are complex and their future, therefore, is best described through a probability distribution.

On Myths, Bubbles and New Paradigms in the Hedge Fund Industry

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Skill-based strategies are active while market-based strategies are passive approaches to money management. We believe that institutional investing in skill-based strategies will continue to gain momentum due to two trends. First, the focus on absolute returns and the fact that failure is defined as destroying value causes some strategies utilised by hedge funds to perform significantly better than traditional strategies in falling capital markets. With investors accepting the fact that returns are not normally distributed (i. e., have fat tails) and the fact that negative utility from falling markets is higher than positive utility from rising markets, we expect an increasing number of institutional as well as private investors to acknowledge the benefits from investing in skillbased strategies. Second, trying to beat an informationally efficient market, in what Charles Ellis (1998) calls 'The Loser's Game', might prove too mundane a strategy in the competitive environment of institutional asset management. A move away from traditional views and strategies should enlarge the scope for alternative views and strategies. This could result in a departure from simple capital markets indices to more tailored benchmarks that take into account idiosyncratic asset and liability characteristics. This could flatten any hurdles in the path of investing in what today are referred to as 'hedge funds.' A market benchmark changes the incentives of the manager to become diametrically opposed to those of the investor. We believe that the majority of investors see the disadvantages of limiting alpha generation by constraining a manager with a benchmark. Introducing a benchmark caused a lemming-like effect with indexation and what some refer to as closet-indexation. Closet-indexation or Tiugging* the benchmark means that most positions in an active portfolio are held to track the benchmark —often referred to as dead weight. Dead weight in a portfolio results from securities owned into which the manager has no insight. The proportion of the portfolio that is held to control residual volatility (volatility relative to the benchmark) is the proportion that will add no value. Hedge funds carry less dead weight and therefore manage invested capital more efficiently. In a hedge fund, in general, only positions about which the manager has conviction will be held or sold short. Portfolio volatility and higher-moment and residual risks are controlled with risk management instruments or other hedging techniques, most of which require

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Alexander M. Ineichen

less capital than holding dead weight positions in the cash market. Consequently, a higher proportion of the hedge f u n d manager's capital is invested in positions about which the manager has convictions. Hedge f u n d managers, therefore, should be able to provide higher alphas, since relative outperformance against a benchmark is not the primary objective. Absolute-return strategies are unlikely to replace relative-return strategies. One can view benchmarking as protection against unskilled managers. A relative-return manager might be more suitable than an absolutereturn manager if an investor has little time, inclination or ability to distinguish skill from luck from a portfolio manager. Benchmarking means that the manager cannot make investments that go horribly wrong —either by lack of skill or by bad luck. The dispersion of returns is small with relative return managers (and a function of the tracking error constraint given by the sponsor) and high with absolute return managers. By defining a market benchmark and a tracking error band, the plan sponsor gives the manager a risk budget in which he is expected to operate. Indexation and its modified variants (smart indexation, enhanced indexation, etc.) have many followers. One of the main advantages of indexation is its lower cost and subsequently superior performance. Fees are generally lower with passive investments. If 80 % of an active manager's positions are dead weight, then the portfolio is essentially 80 % passive and 20 % active. This means that a 50bp fee of funds under management is actually 250bp of the active portion. Hedge funds typically charge higher fees than long-only managers. However, the difference is not as extreme once the dead weight is taken into consideration. In other words, indexation (index funds, total return swaps) are the most cost-efficient form of getting exposure to a market. The ex-ante alpha is zero. Investing in hedge funds is, in theory, about getting (and paying for) alpha without getting beta (market exposure) that can be obtained elsewhere more cost efficiently. In other words, long-only asset management with a benchmark is a hybrid of the two extreme forms of asset management. Some take these arguments a step further. David Swensen (2000) argues: "If markets present no mispricingsfor active managers to exploit, good results stem from luck, not skill. Over time, managers in efficient markets gravitate toward closet indexing, structuring portfolios with only modest deviations from the market, ensuring both mediocrity and survival.

On Myths, Bubbles and New Paradigms in the Hedge Fund Industry

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In contrast, active managers in less efficient markets exhibit greater variability in returns. In fact, many private markets lack benchmarks for managers to hug, eliminating the problem of closet indexing. Inefficiencies in pricing allow managers with great skill to achieve great success, while unskilled managers post commensurately poor results."

On the most general level, investing in hedge funds is about alpha, investing in long-only funds is mixing alpha and beta (with a limit on tracking error), and pure indexation23 is all about beta. Alpha-generating strategies are normally skill-based strategies. If the flexibility of the manager is reduced to zero, the ex-ante alpha is zero as a result. However, as with every other industry, the asset management as well as the hedge fund industry will most likely transform (or converge) over time. A possible future scenario is that those asset managers with a competitive advantage will be offering skill-based strategies. One of the pillars supporting this belief is that a competitive advantage, to some extent, is determinable in advance whereas the path of a market is not. A firm with prudent, intelligent, experienced and hardworking managers will have an advantage over a firm with fraudulent, uneducated hooligans. However, if both follow a long-only strategy in an informationefficient market, the latter can outperform the former due to luck. In Figure 3 we have classified the most active and most passive investment styles into a two-dimensional grid, where the vertical axis is the level of fees and the horizontal axis the performance attribution. Absolute-return strategies are in quadrant I: fees are high and performance is determined by the manager's skill. The other extreme is quadrant m , where margins are low and performance is attributed to the market. Not only is there a trend for specialist strategies in quadrant I but also for passive forms of investing (quadrant m). Greenwich Associates estimates that 38 % of institutionally held assets in the US are indexed. Watson Wyatt estimates that the degree of indexation is 25 % for the UK, 20 % for Switzerland and 18 % in the Netherlands, with the rest of the world in the process of closing the gap. The reason for the increase in passive investment alternatives is primarily cost and, ultimately, performance. In price-efficient markets, passive strategies are cost-efficient. A cost-efficient investment vehicle is, ceteris paribus, superior to a cost-inefficient alternative. Passive strategies have u

The pure form of indexation (zero tracking error tolerance) is being replaced by less constrained forms of passive investment styles.

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Alexander M. Ineichen

Figure 3: Different Business Models High

Absolute-return strategies ¡¡¡¡¡F

I

II

IV

III

te S

Index fundsff'

Low Skill-based

Market-based Performance attribution

Source: UBS Warburg (2001)

become available outside the US only in the past couple of years as the liquidity in equities outside the US has increased. Increasing liquidity reduces the cost of execution and therefore increases the number of alternatives to get market exposure. Strategies in quadrant Π might be facing tough times ahead. Those strategies stem from a time when there was no passive, i. e., cost-efficient, alternative. Today even retail investors can participate in developed markets on a cost-efficient basis through ETFs or market-replicating delta-one investment vehicles. A point could be made that asset managers currently in quadrant Π will have to migrate either into quadrant I or ΠΙ. Remaining in quadrant Π might not be a sustainable option. No one inhabits quadrant IV and probably never will, as alpha will always trade at a premium. In the Anglo-Saxon biased investor universe this is already happening

On Myths, Bubbles and New Paradigms in the Hedge Fund Industry

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through the core-satellite approach, where the core is passive and active satellites are added. These satellites are mandates given to managers operating in areas where the market is less price-efficient and there is no cost-efficient passive alternative.

Conclusion There is still a lot of myth with respect to hedge funds. A lot of the myth is built on anecdotal evidence, oversimplification, myopia or simply a misrepresentation of facts. Although hedge funds are often branded as a separate asset class, a point can be made that hedge fund managers are simply asset managers utilizing other strategies than long-only managers. The major difference between the two is the definition of their return objective: Hedge funds aim for absolute returns by balancing return opportunities and risk. Long-only managers, by contrast, define their return objective in relative terms. Long-only managers aim to win what Charles Ellis (1998) calls "The Loser's Game', i. e., beat the market. Potentially, asset management could be in the process of moving in the direction of banks, and hedge funds, i. e. defining risk in absolute terms rather than relative terms. One could also argue that the asset management industry is moving back to an absolute return orientation and that the passion with market benchmarks was only a brief blip in the industry's evolution, driven perhaps by an increasing involvement of consultants and trustees. In other words, what we call hedge funds today could simply be the fireflies ahead of the storm about to be sweeping over the asset management industry. Whether hedge funds are a bubble or new paradigm in asset management is open to debate. However, it is difficult to imagine that what today is referred to as a Tiedge fund'—searching for alpha while managing risk —is a short-term phenomenon.

© UBS 2003-2004. All rights reserved. This article draws on material from Ineichen [2001a,b], and Ineichen [2003]. The views and opinions expressed in this article are those of the author and are not necessarily those of UBS Investment Bank. UBS Investment Bank accepts no liability

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Alexander M. Ineichen

with respect to the content of this article. It is published solely for informational purposes and is not to be construed as either a solicitation or an offer to buy or sell any securities or related financial instruments.

References AIMR (1999) Standards of Practice Handbook, Eighth edition. Amin, Gaurav S. and Harry Kat (2001), 'Hedge Fund Performance 1990-2000—Do the "Money Machines" Really Add Value?' ISMA working paper, Forthcoming in Journal of Financial and Qμantitative Analysis (July). Bernstein, Peter I (1999), 'Wimps and Consequences,'Journal of Portfolio Management, Vol. 26, No. 1, Fall, pp. 1. Chandler, Beverly. (1998) "Investing with the Hedge Fund Giants—Profit Whether Markets Rise or Fall". London: Financial Times Pitman Publishing. Ellis, Charles D. (1998), Winning the Loser's Game: Timeless Strategies for Successful Investing, 3 rd edition, McGraw-Hill: New York. Ineichen, Alexander M. (2001a) "Hedge Funds: Bubble or New Paradigm—The Asset Management Industry is Leaning Towards Absolute Return Objectives and Risk Management," Journal of Global Financial Markets, Vol. 2, No. 4 (Winter), pp. 5563. Ineichen, Alexander M. (2001b) "The Myths of Hedge Funds—Are Hedge Funds the Fireflies Ahead of the Storm?" Journal of Global Financial Markets, Vol.2, No.4 (Winter), pp. 34-46. Ineichen, AlexanderM. (2003) "Absolute Returns—Investing in Hedge Funds," New York: John Wiley & Sons. Kuhn, Thomas (1962), "The Structure of Scientific Revolutions", University of Chicago Press Levy, Leon with Eugene Linden (2002) "The Mind of Wall Street—A Legendary Financier on the Perils of Greed and the Mysteries of the Market," New York: Public Affairs. Persaud, Avinash. (2001) "Liquidity Black Holes." State Street Working Paper (December.) Schneeweis, Thomas (1998b) 'Dealing with Myths of Hedge Funds,' Journal of Alternative Investments, Winter. Schneeweis, Thomas and Richard Spurgin (1998) 'Multi-Factor Analysis of Hedge Fund, Managed Futures, and Mutual Funds Return and Risk Characteristics' Journal of Alternative Investment Investments, Fall.

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Securities and Exchange Commission. (1999) SEC Concept Release: Short Sales. No. 34—4-2037. www.sec.gov/rules/concept/34-42037.htmP39—7779s. Staley, Kathryn F. (1997) "The Art of Short Selling," New York: John Wiley & Sons. Swensen, David F (2000), 'Pioneering Portfolio Management—An Unconventional Approach to Institutional Investment,' The Free Press, New York. UBS Warburg research (2001) "The Search for Alpha Continues—Do Fund of Hedge Funds Managers Add Value?" September.

The Regulation of Hedge Funds: Financial Stability and Investor Protection Franklin R. Edwards

Introduction While hedge funds have been around at least since the 1940's, it has only been in the last decade or so that they have attracted the widespread attention of investors, academics and regulators. Investors, mainly wealthy individuals but also increasingly institutional investors, are attracted to hedge funds because they promise high "absolute" returns—high returns even when returns on mainstream asset classes like stocks and bonds are low or negative. This prospect, not surprisingly, has increased interest in hedge funds in recent years as returns on stocks have plummeted around the world, and as investors have sought alternative investment strategies to insulate them in the future from the kind of bear markets we are now experiencing. Government regulators, too, have become increasingly attentive to hedge funds, especially since the notorious collapse of the hedge fund LongTerm Capital Management (LTCM) in September 1998. Over the course of only a few months during the summer of 1998 LTCM lost billions of dollars because of failed investment strategies that were not well understood even by its own investors, let alone by its bankers and derivatives counterparties. LTCM had built up huge leverage both on and off the balance sheet, so that when its investments soured it was unable to meet the demands of creditors and derivatives counterparties. Had LTCM's counterparties terminated and liquidated their positions with LTCM, the result could have been a severe liquidity shortage and sharp changes in asset prices, which many feared could have impaired the solvency of other financial institutions and destabilized financial markets generally. The Federal Reserve did not wait to see if this would happen. It intervened to organize an immediate (September 1998) creditor-bailout by LTCM's largest creditors and derivatives counterparties, preventing the wholesale

The Regulation of Hedge Funds: Financial Stability and Investor Protection

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liquidation of LTCM's positions. Over the course of the year that followed the bailout, the creditor committee charged with managing LTCM's positions effected an orderly work-out and liquidation of LTCM's positions. We will never know what would have happened had the Federal Reserve not intervened. In defending the Federal Reserve's unusual actions in coming to the assistance of an unregulated financial institutions like a hedge fund, William McDonough, the president of the Federal Reserve Bank of New York, stated that it was the Federal Reserve's judgement that the " . . . abrupt and disorderly close-out of LTCM's positions would pose unacceptable risks to the American economy... there was a likelihood that a number of credit and interest rate markets would experience extreme price moves and possibly cease to function for a period of one or more days and maybe longer. This would have caused a vicious cycle: a loss of investor confidence, lending to further liquidations of positions, and so on." 1 The near-collapse of LTCM galvanized regulators throughout the world to examine the operations of hedge funds to determine if they posed a risk to investors and to financial stability more generally. Studies were undertaken by nearly every major central bank, regulatory agency, and international "regulatory" committee (such as the Basle Committee and IOSCO), and reports were issued, by among others, The President's Working Group on Financial Markets, the United States General Accounting Office (GAO), the Counterparty Risk Management Policy Group, the Basle Committee on Banking Supervision, and the International Organization of Securities Commissions (IOSCO). Many of these studies concluded that there was a need for greater disclosure by hedge funds in order to increase transparency and enhance market discipline, by creditors, derivatives counterparties and investors. In the Fall of 1999 two bills were introduced before the U. S. Congress directed at increasing hedge fund disclosure (the "Hedge Fund Disclosure Act" [the "Baker Bill"] and the "Markey/Dorgan Bill"). But when the legislative firestorm sparked by the LTCM's episode finally quieted, there was no new regulation of hedge funds. 1

Hearings of the U. S. House Banking and Financial Services Committee on Hedge Funds, 105 th Cong. (Oct. 1, 1998), Statement of William McDonough, President, Federal Reserve Bank of New York ("McDonough Statement").

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Franklin R. Edwards

This paper provides an overview of the regulation of hedge funds and examines the key regulatory issues that now confront regulators throughout the world. In particular, two major issues are examined. First, whether hedge funds pose a systemic threat to the stability of financial markets, and, if so, whether additional government regulation would be useful. And second, whether existing regulation provides sufficient protection for hedge fund investors, and, if not, what additional regulation is needed.

Hedge Funds as Legal Entities: Current Regulation There is no precise definition of the term "hedge fund," either in practice or in the U. S. federal securities laws. In practice, hedge funds are viewed as unregulated private investment vehicles for wealthy individuals and institutional investors. In the United States they are typically organized as limited partnerships and structured in a way that exempts them from most of the laws and regulations that apply to other investment vehicles, such as mutual funds and pension funds. It is this exempt legal status that gives hedge funds their uniqueness and makes them attractive to investors. Hedge funds are free to pursue whatever investment strategies they believe are profitable: they can buy and sell whatever assets or financial instruments they want to, trade any kind of derivatives instrument, engage in unrestricted short-selling, employ unlimited amounts of leverage, hold concentrated positions in any security without restriction, set redemption policies without restriction, and can employ any fee structure and management compensation structure that is acceptable to their investors. In addition, hedge funds have very limited disclosure and reporting obligations, to regulators, the public, and their own investors. It is important to recognize, however, that unless structured in a way to gain exemption, U. S. hedge funds may be regulated both by the Securities and Exchanges Commission (SEC) and by the Commodity Futures Trading Commission (CFTC). They also are subject to statutory and common law partnership principles and remedies that protect the interests of the limited partners.2 2

The Restatement (Second) of Trusts states that "[e]ach member of a partnership is in a fiduciary relationship to the other partners." See Restatement (Second) of Trusts, section 2(b): Meinhard v. Salmon, 249 N. Y. 458 (N. Y. 1928).

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To avoid regulation hedge funds must meet criteria laid out in four general exclusions or exceptions: (1) the exclusion from registration under the Investment Company Act of 1940 ("Company Act"); (2) the exemption from registration of the fund's securities under the Securities Act of 1933; (3) the exception from registration of the hedge fund manager under the Investment Advisors Act of 1940 ("Advisers Act"); and (4) the exception from reporting requirements under the Securities Exchange Act of 1934. To be exempt from the Company Act, which regulates mutual funds, most hedge funds rely on one of two exclusions to avoid registration. Section 3(cXl) exempts a hedge fund if it has no more than 100 investors. Section 3(cX7) exempts a hedge fund with more than 100 investors if its investors are "qualified purchasers".3 "Qualified purchasers" are individuals or companies who own at least $ 5 million in investments.4 Since both of these exclusions require hedge funds to sell their securities in non-public offerings, most hedge funds gain exemption from the 1933 Act by taking advantage of the "private offering" (or "private placement") exception under section 4{2) or the related "safe harbor" section under Regulation D of the Securities Act of 1933. These require hedge funds to restrict their sales of securities (or limited partnerships) to individuals and institution that qualify as "accredited investors".5 Accredited investors are individuals that have income in excess of U. S. $ 200,000 in each of the two most recent years, or joint income with that person's spouse in excess of $ 300,000 in each of those years, and have a reasonable expectation of reaching the same income level in the current year; or, they must have a net worth, or joint net worth with that person's spouse, that exceeds $ 1 million at the time of purchase. Accredited institutions must generally have assets in excess of $ 5 million, or be a bank, savings and loan association, a broker/dealer, an insurance company, an investment company, or a small business investment company licensed by the U. S. Small 3

While there is not a numeric limitation on the number of investors in a section 3(cX7) fund, the federal securities laws generally require any issuer with 500 or more investors and $ 10 million of assets to register its securities and to file public reports with the SEC, which most hedge funds do not want to do. In practice, therefore, most hedge funds stay below the 500 investor level. * Investment Company Act of 1940, sec. Z(aX51), and SEC Rule 2a 51-1. ' While Rule 506 does allow them to have as many as 35 "non-accredited" investors, it is not worth it for most hedge funds to involve themselves with such investors.

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Business Administration. The purpose of these restrictions, obviously, is to limit hedge fund investors to wealthy and financially sophisticated investors, who do not need the protections afforded by the federal securities laws. Hedge fund managers (or general partners [GP's]) also typically meet the "private manager" exemption from federal registration as an investment advisor under the Advisers Act, which requires that they have had fewer than 15 "clients" in the past 12 months, do not hold themselves out to the public as an investment adviser, and do not act as an investment advisor to a registered investment company or business development company. Each separate company (or hedge fund, investment partnership, managed account, etc.) that the GP manages is considered to be a single client if the manager bases its investment advice to the company on the company's investment objectives as opposed to the investment objectives of individual owners. Finally, hedge funds, like other investment funds, are subject to various regulatory reporting requirements. The SEC requires the reporting of all stock positions that exceed five percent of any class of securities issued by a publicly traded company. The U.S. Treasury requires all traders to report large positions in certain foreign currencies and in treasury securities; and, if hedge funds hold positions in exchange-traded derivatives they are subject to "large trader" reporting requirements. Many U. S. hedge funds also may be regulated by the CFTC if they trade futures or options contracts. They must register with the CFTC as a "commodity pool operator" (CPO) if they intend to invest in or trade one or more futures or options contracts on a regulated commodity exchange. The Commodity Exchange Act (CEA) subjects CPO's and their advisers (CTA's) to regulation, but not the commodity pools themselves. Once registered, CPO's and CTA's must comply with the rules of the National Futures Association (NF A), avoid conflicts of interest and protect customer funds, provide written disclosure to prospective investors of the risks of investing in commodity interests, adhere to restrictions on advertising, satisfy record-keeping and reporting requirements, and subject themselves to periodic inspections of their activities by the NFA. Hedge fund managers in the United States also are subject to common law remedies for fraud, as well as claims for fraudulent manipulation under section 10(b) and Rule 10b-5 of the Securities Act of 1934. Typically, prior to investing in a hedge fund, limited partners (LP's) are given for review

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and agreement an offering memorandum and partnership agreement. These documents provide investors with information on the potential risks associated with the fund and serve as a notice of caveat emptor, and form the basis for possible contractual law remedies at a future date. It is also important to keep in mind that the market discipline exerted by investors, creditors, and counterparties constrains hedge fund managers as well. Probably half of the hedge funds in the world are "offshore funds," or funds organized outside of the United States, generally in favorable tax jurisdictions such as the Cayman Islands. U. S. tax-exempt investors, such as pension funds and endowment funds, will normally only invest in offshore funds that are structured as corporate entities and hence not "tax transparent," so that unrelated business taxable income is not treated as arising directly to the fund's investors. Another reason for operating offshore is to insulate shareholders who are neither U. S. citizens nor residents of the U. S. from U. S. regulation and taxation. Thus, hedge funds exist because they fill a gap created by the many laws and regulations that restrict the activities of other investment vehicles. Unencumbered by these restrictions hedge funds are able to offer investors "alternative" investment strategies with return distributions unlike those provided by traditional investment institutions like mutual funds, which can provide investors with additional diversification benefits. However, it is important to keep in mind that, to achieve their exempt regulatory status, hedge funds in the United States must confine their client base to relatively wealthy individuals and institutions—investors which the law views as financially sophisticated and not needing the protection of government

Why Regulate Hedge Funds? The exempt regulatoiy status of hedge funds in the United States is premised on the philosophy that wealthy (or "qualified") investors should be free to make their own decisions unhindered by government regulation and its associated costs, and in return should have to bear the full consequences of their investment decisions—good or bad. In effect, this means that wealthy individuals and institutional investors are able to

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access non-traditional "alternative" investment strategies that may provide superior returns with possibly greater risk, while less well-off (or "unqualified") investors are protected by being excluded from participating in these investments. Despite limiting hedge funds to only "qualified" investors, there is still some debate about whether hedge funds should be subjected to greater regulation. This debate is generated by two concerns. First, there is a concern that hedge funds may at times destabilize financial markets and even cause a systemic meltdown. This concern was triggered primarily by the near-collapse of Long-Term Capital Management in September 1998 and by the Federal Reserve's intervention to facilitate a creditor-rescue of LTCM.6 The second concern is that recent hedge fund innovations have eroded investor protections by enabling less wealthy (retail) investors to participate in hedge fund investments. Indeed, some observers go even further and argue that greater government protection of hedge funds investors is needed even if hedge fund investors continue to be restricted to "qualified" investors. Even these investors, they argue, are unlikely to have the requisite financial sophistication to be able to understand and assess the risks associated with hedge funds. The remainder of this paper examines these regulatory issues.

Financial Instability: Lessons from LTCM LTCM employed trading strategies involving very high leverage and massive amounts of complex derivatives positions. On August 31, 1998, on an equity base of about $ 2.3 billion, LTCM held over $ 100 billion of assets on its balance sheet and had off-balance sheet derivatives 6

While there is some concern that speculative or manipulative trading by hedge f u n d s has caused large, destabilizing price moves, there is very little evidence to support this contention. See, for example, F. Edwards and M. Caglayan, "Do Hedge Funds Disrupt Emerging Markets?" in Brookings-Wharton Papers on Financial Services 2000, ed. by R. Litan and A. Sanatomoero, Brookings Institution Press, Wash., D.C., 2000, pp. 409-418; and "Hedge Funds and Financial Market Dynamics,international Monetary Fund, Occasional Paper 166, ch. V, pp. 55-61, May, 1998.

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positions with a notional value totaling more than U. S. $ 1.4 trillion. 7 LTCM financed these positions with an on-balance sheet debt-to-equity ratio of approximately 28-to-one 8 Its derivatives positions included OTC swap contracts with a gross notional value in excess of $ 750 billion, futures contracts with a gross notional value in excess of $ 500 billion, and options and other derivatives with a notional value in excess of $ 150 billion. At times LTCM had as many as 60,000 trades on its books and more than 75 derivatives counterparties. 9 Almost all of LTCM's positions were collateralized and subject to calls for additional collateral in the event that prices of the underlying securities moved against it. And that is exactly what happened. After sizeable losses in the Spring and Summer of 1998, by September 1998 LTCM had lost 50 percent of its equity and was in danger of not being able to meet collateral obligations on its derivatives positions. More importantly, had it failed to meet a collateral obligation, or missed a required debt payment, its derivatives counterparties had the legal right to terminate and liquidate their positions with LTCM, which they would have done in order to protect themselves against incurring greater losses. Not even LTCM's filing for bankruptcy protection could have prevented this. Only the timely intervention of the Federal Reserve in organizing a $ 3.6 billion creditorbailout of LTCM in September 1998 was able to prevent a "counterparty run" on LTCM's derivatives positions. According to William McDonough, the rush of more than 75 counterparties to close out simultaneously hundreds of billions of dollars of derivatives contracts would have adversely affected many market participants with no connection to LTCM and would have resulted in tremendous uncertainty about how far prices might move. 10 The creditor-consortium that recapitalized LTCM and took over the 7

For a discussion of the collapse of LTCM and the Federal-Reserve-led creditor rescue of LTCM, see Franklin R. Edwards, "Hedge Funds and the Collapse of Long-Term Capital Management, Journal of Economic Perspectives, Spring, 1999, pp. 189-210. β The President's Working Group on Financial Markets (the "Working Group"), Report at pp. 11-12; U. S. General Accounting Office ("GAO"), Report at p. 7. » Ibid.; and "McDonough Statement." 10 See "McDonough Statement." LTCM's own estimate was that its largest 17 counterparties, in closing out their positions with LTCM, would have incurred losses in the aggregate of between $ 3 billion and $ 5 billion, with some individual Arms losing as much as $ 500 million. See Paul N. Roth and Brian H. Fortune, "Hedge Fund Regulation in the Aftermath of Long-Term Capital

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responsibility and obligations of managing LTCM's portfolio and resolving its financial difficulties consisted of fourteen large banks and securities firms—most of LTCM's large creditors. In effect, the Federal Reserve organized an out-of-court creditor "work-out" of LTCM's positions. The Federal Reserve-led creditor-bailout of LTCM raises two issues. First, how did a single hedge fund like LTCM get to be so large and so highly leveraged that its bankruptcy could threaten global financial stability? Why did LTCM's creditors and counterparties fail to reign in its activities? Second, even if LTCM had failed to meet its obligations, why was it necessary for the Federal Reserve to intervene in order to organize a creditor work-out for LTCM? Why could not LTCM have filed for bankruptcy protection and prevented the immediate liquidation of its assets, as most other firms do? The failure of market discipline It is generally agreed that a failure of market discipline enabled LTCM to use excessive amounts of leverage to assume huge positions in certain financial markets. Reports on the LTCM debacle agree that LTCM's banks and derivatives counterparties failed to appreciate the magnitude of the risks they were taking in their dealings with LTCM, and that they consistently failed to enforce even their own risk management standards. 11 An obvious implication of the LTCM debacle, therefore, has been to strengthen the regulation and supervision of banks and securities firms, which were LTCM's primary creditors and counterparties. To a large extent this has already been done. In addition, banks and securities firms have tightened their credit standards with respect to hedge funds, and have demanded greater disclosure from hedge funds. Thus, in the future we hopefully will not see a repeat of the breakdown in market discipline that we saw in the LTCM case. There is, nevertheless, still disagreement over whether increased transparency of hedge funds is necessary for market discipline to be effective.

11

Management," in lain Cullen and Helen Parry, Hedge Funds: Law and Regulation, Sweet and Maxwell (London), 2001, ch. 5. Why LTCM escaped this discipline is a complex story of reputation, ignorance, psychology, greed, naivete, and hubris. See F. Edwards, "Hedge Funds and the Collapse of Long-Term Capital Management," op. cit.

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The IOSCO Report, for example, concludes that increased transparency of hedge funds is necessary to achieve effective market discipline and contain systemic risk, and recommends increased public disclosure by hedge funds in order to increase transparency. It is not clear, however, why banks and counterparties, when dealing with hedge funds, would not themselves demand whatever information they believe necessary to assess their risk exposures and monitor hedge funds, and to protect themselves generally. Mandated public disclosure by hedge fund is unlikely to meet the needs of banks and securities firms. The information provided in accordance with typical public disclosure requirements is unlikely to be either informative enough or timely enough to serve the needs of creditors and counterparties. Further, creditors and counterparties already have a strong incentive to demand sufficient information in order to protect themselves, and they have the power to force hedge funds to disclose this information: they can refuse to deal with funds that do not provide the necessary information. Indeed, hedge funds themselves have a strong incentive to disclose voluntarily the information that creditors and counterparties need in order to gain access to credit and other services. Thus, mandated public disclosure seems unnecessary and unlikely to provide the kind of information that creditors and counterparties need to be effective monitors of hedge funds. My position on mandated public disclosure is best summarized by a recent statement issued by a group of financial economists, of which I am a charter member: "It is hard to think of a market environment more conducive to allowing private markets to determine market disclosure practices than the hedge fund industry—an intensively competitive industry with sophisticated investors and creditors. In these conditions it seems reasonable to leave the determination of hedge fund disclosure practices and requirements to private parties and to the workings of the private market, rather than setting them by government mandate."12

Why was Federal Reserve intervention necessary? The intervention of the Federal Reserve to head-off the insolvency of LTCM raises a serious systemic concern that still exists and is not widely 11

The Financial Economists Roundtable, "Statement on Long-Term Capital Management and the Report of the President's Working Group on Financial Markets," Oct. 6,1999.

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understood. Further, this systemic concern is not specific to hedge funds but arises out of the pervasive use of derivatives by financial market participants. The fundamental reason that the Federal Reserve intervened in the LTCM case is that bankruptcy law in the United States (and in most other countries) does not treat derivatives counterparties as it does all other creditors. Specifically, current U. S. bankruptcy law exempts derivatives counterparties from the normal operation of the Bankruptcy Code, and in particular from the automatic stay provisions of the Code.13 As a consequence, had LTCM been unable to meet its obligations and filed for protection under Chapter 11, its derivatives counterparties could still have, and certainly would have, immediately terminated their contracts with LTCM, resulting in the " . . . abrupt and disorderly close-out of LTCM's positions which would [have] pose[d] unacceptable risks to the American economy." 14 Only the intervention of the Federal Reserve in arranging a creditorbailout enabled LTCM to avoid a bankruptcy filing which would have triggered the immediate liquidation of its positions. In principle, the same result could have been achieved without the intervention of the Federal Reserve had the Bankruptcy Code not exempted LTCM's derivatives counterparties from the automatic stay provision of the Code. In that case a bankruptcy filing by LTCM would have "stayed" LTCM's derivatives counterparties, as well as its other creditors, and would have resulted in a court-supervised creditor-workout of LTCM's positions. As subsequent events have shown, it was clearly in the joint interests of LTCM's creditors to avoid a "fire sale" of LTCM's positions and to facilitate a creditor "work-out" by putting in more capital and reorganizing the ownership structure of LTCM. Had the bankruptcy code allowed this, there would have been no need for the Federal Reserve to intervene. Ironically, the potential destabilizing role that bankruptcy law played in the LTCM crisis was the result of series of changes in the Bankruptcy Code made by the U. S. Congress in order to reduce the likelihood of systemic instability in off-exchange derivatives markets. The rationale for exempting "derivatives securities" contracts from the automatic stay provisions of the Bankruptcy Code is that this exemption is necessary to maintain the 13

14

See Franklin R. Edwards, "Insolvency Law and Financial Stability in OTC Derivatives Markets," Working Paper, March, 2003. See "McDonough Statement."

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liquidity and stability of derivatives markets—to prevent the "insolvency of one commodity or security firm (or derivatives counterparty ) spreading to other firms and possibly threatening the collapse of the affected market". 15 The U. S. Congress believed that: "The prompt liquidation of an insolvent's position is generally desirable to minimize the potentially massive losses and chain reaction of insolvencies that could occur if the market were to move sharply in the wrong direction".16 In interpreting (and ratifying) the scope of the exceptions to the Bankruptcy Code, the bankruptcy appellate panel for the Ninth Circuit cited the comments of Senator Dole during the Senate discussion on the amendment to section 362 of the Bankruptcy Code: "It is essential that stockbrokers and securities clearing agencies be protected from the issuance of a court or administrative agency order which would stay the prompt liquidation of an insolvent's positions, because market fluctuations in the securities markets create an inordinate risk that the insolvency of one party could trigger a chain reaction of insolvencies of the others who carry accounts for that party and undermine the integrity of those markets." 17

In retrospect, it seems clear that had LTCM's derivatives counterparties not been exempted from the automatic stay provisions of the Bankruptcy Code, there would not have been either an " . . . abrupt and disorderly close-out of LTCM's positions ..." or an " . . . unwinding [of] LTCM's portfolio in a forced liquidation...," and there would have been no need for the Federal Reserve to intervene to prevent a .. seizing up of markets . . . [that] could have potentially impaired the economies of many nations, including our own."18 Thus, the major systemic risk issue raised by the near-collapse of LTCM is whether recent revisions to the bankruptcy law in the United States and other countries have created another source of financial instability in financial markets by enabling a "counterparty run" on the positions of a financially-stressed counterparty. As LTCM illustrated, a "counterparty run" has the potential to result in a systemic liquidity shortage, with uncertain and potentially damaging economic effects. It is notable that some recent academic papers have argued that a "fire sale" of financial « « " 18

House Rep. No. 97-420, 97 th Cong., Sess., 3 (1982). House Rep. No. 97-420, 97