Strict conduct code needed for hedge fund managers

Date: Monday, August 20, 2007
Author: Kurt Schacht, Investment News.com

The opportunity for a self-regulatory approach for hedge fund managers has never been greater — or the need more urgent.

The matter of regulation is of particular interest, given several important trends. Daily reports about hedge fund failures continue to concern regulators.

Witness the impact on fund investors by recent problems with several funds from The Bear Stearns Cos. Inc. in New York due to subprime exposure. While these incidents are self-contained, their direct impact on investors in those funds and continued focus on systemic risks and hedge fund correlations remain a concern to regulators.

Another concern is the continued growth of the industry. Recent data from Hedge Fund Research Inc. in Chicago show record increases in hedge fund assets, reaching nearly 9,800 funds at midyear.

The enormous industry expansion amplifies concern about manager experience, professional conduct and ethics. Meanwhile, the hedge fund sector is attracting a deluge of pension fund money.

Industry Oversight

There is worry that these investors may be ill-suited for the very different risk/reward profile of many hedge funds. For these reasons, the issues of industry oversight and investor protection become all the more urgent.

Industry and global regulators have recognized that we are at an important juncture in the regulatory evolution of the hedge fund industry. Several groups are calling for industry-led forums with the goal of assessing the options for creating a self-regulatory framework.

While many of the largest fund managers are subject to regulatory oversight, a growing number of them — more than 9,000 — are subject to no such oversight and have few internal procedures in place that would help protect investors.

In our view, what is needed is a comprehensive, unbiased and ethically stringent code of conduct. So far, industry stakeholders have been unable to agree on an appropriate template, many hoping for fewer restraints and a looser set of standards. That may not be satisfactory to a growing number of institutional investors and regulators. More important, such an approach would likely fall short of succeeding as viable self-regulation.

A more substantial framework is indicated, as our organization, the CFA Institute in Charlottesville, Va., has experienced over the past 60 years. Our global membership of 93,000 now includes some 7,000 hedge fund professionals and countless other members whose firms invest in hedge funds.

We have led the development and successful implementation of self-regulatory frameworks, including the global investment performance standards, which are recognized as the industry standard in 27 countries around the world. We recently developed a number of initiatives related to the hedge fund industry.

This self-regulatory template, the Asset Manager Code of Professional Conduct, focuses on setting a baseline for compliance, professional conduct and investor protections.

In our experience, self-regulation requires certain components. In the case of hedge funds, it depends on developing an honest and verifiable template that covers client loyalty, trading practices and compliance procedures, as well as a comprehensive process for disclosures, portfolio valuation and performance reporting.

More important, once this framework is set, industry members who are serious about the approach must actually adopt and adhere to the framework — whatever it may be — in its entirety.

Partial adherence or variable adoption defeats the purpose of consistent application of basic industry standards; it makes enforcement of a template impossible.

As the various hedge fund stakeholders convene in the debate over proper hedge fund practice, we encourage attention to these elements. The success or failure of a self-regulatory approach hinges on market and investor confidence that the framework is adequate and employed consistently.

If the hedge fund industry can work to develop, administer and maintain a framework of professional conduct that meets the principles as outlined above, the true benefits of self-regulation can be realized. If not, we fear that self-regulation will be unsuccessful, leaving the hedge fund industry ripe for legislative intervention.

To be sure, this is by no means a protection against all further hedge fund failures. But it is important that markets, regulators and investors feel that the industry has taken its responsibilities seriously.

The opportunity is now.

Kurt Schacht, a chartered financial analyst, is managing director of the CFA Centre for Financial Market Integrity, the advocacy and policy development arm of the CFA Institute in Charlottesville, Va.