Saturday, July 07, 2012

In Comment Letter on EU Green Paper on Shadow Banking, Hedge Fund Standards Board Extols Investor Choice Offered by Alternative Funds

Hedge funds and other alternative investment funds provide more financing options for companies and more choice for investors, said the Hedge Fund Standards Board in a comment letter on the European Commission’s Green Paper on shadow banking. With more investment choices, reasoned the Board, risk can be better managed. Thus, alternative investment funds help spread risks more widely, rather than allowing risk taking to be concentrated in a small number of large banks.

While the EU is still strongly reliant on the banking sector, noted the Board, the US provides a fairly different picture, relying a great deal more on capital markets. The Board emphasized that it will be important for Europe to develop and attract more non-banking forms of financing, including asset management, in order to attract the required investment for economic growth.

The Hedge Fund Standards Board is the guardian of the Standards drawn up by international investors and hedge fund managers to create a framework of discipline for the hedge fund industry. The Board’s mission is to promote the Standards through collaboration with managers, investors and regulators.

The Board acknowledged that fund liquidations are not unusual and happen if investors collectively decide to redeem. Such liquidations happen without any concern for systemic risk. Under normal circumstances, the price formation in the market place and for the fund provides a mechanism for balancing supply and demand with all investors being treated fairly.

Liquidations and closures of funds are not undesirable per se, said the Board, adding that the crucial distinction between banks and funds is that a hedge fund does not guarantee a repayment amount. The redemption price is determined by the underlying market price of the assets in the fund, or in the event of a liquidation, the liquidation value of the assets in the fund. Also, funds do not have deposit taking characteristics, and therefore do not give rise to the type of systemic issues arising in banks or bank-like deposit taking investment vehicles.

However, a run on a fund can arise if investors fear unfair treatment or expect a loss from holding on to a fund investment. This situation can arise, for example, when parts of the underlying assets become illiquid and long term investors, who under normal circumstances would stay invested in the fund, have an incentive to redeem for fear of being "stuck with the bottom of the barrel."

This rational incentive for the individual investor to redeem causing a run on a fund can be mitigated by ensuring fair treatment of investors, said the Board, ensuring that the redemption process is slowed down, or gates are enacted. The HFSB has developed Standards focusing on strong liquidity risk management practices, governance arrangements to deal with such situations, and adequate disclosure to investors or the mechanisms available to ensure fair treatment in situations of liquidity distress. The Board believes that a strong bottom up risk management approach, along with adequate tools to ensure fair treatment of investors, are crucial in mitigating concerns about runs on funds.

The concept of leverage has been intensely debated in the context of the EU Directive on Alternative Investment Fund Management, said the Board, and a key lesson from this discussion is that leverage can have different meanings in different contexts. There are many different types of leverage, ranging from balance sheet leverage, such as in the context of a bank, to leverage in market-based finance, which arises in the context of securities lending and the use of derivatives.

The HFSB has often highlighted that leverage is usually not a standalone risk measure, but needs to be seen in the context of the respective investment strategy and portfolio. Fixed income funds can exhibit higher and fluctuating leverage, if classical balance sheet measures are employed, than equity funds with no relation to actual risk. Therefore, the Board emphasized the importance of explaining and categorizing the types of leverage properly in order to assess the risk accordingly.