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Misunderstood hedge funds suffered in mid-match rule change

Date: Tuesday, November 25, 2008
Author: Miles Costello, Timesonline.co.uk

Hedge fund managers are spivs and speculators, directly responsible for creating carnage in the world's financial markets and threatening the future of high street banks. At least, that's what some argue.

But it is, emphatically, not true, according to Christopher Fawcett, the hedge fund executive who has taken on the role of de facto cheerleader for Britain's embattled alternative investment industry.

Such criticism is misplaced, he argues. Investment banks, rather than hedge funds, were behind the surge in gearing, or leverage, that pushed markets to breaking point in the middle of last year. Hedge funds were actually more conservative and only moderately geared.

He goes further: the Financial Services Authority's “draconian” restrictions on the short-selling of financial stocks threaten to undermine the strength of London as a financial centre: the regulator should allow bets on falling share prices to be placed again.

And, after the worst year in memory for hedge fund performance, he boasts that the once-lauded investment market is poised to rise from the ashes. “Capital is still there for funds. By the second quarter, it will become active again,” Mr Fawcett said. “You can see it in the high-quality traders that are being laid off by the investment banks. The next generation of hedge fund stars is being created as we speak.”

As chairman of the Alternative Investment Management Association (AIMA), the industry body, you would expect Mr Fawcett to speak out on behalf of his members, but his words carry the weight of a man who practises what he preaches. He is chief executive of Fauchier Partners, the London-based hedge fund of funds that he co-founded with Patrick Fauchier in 1994. Fauchier is 50 per cent-owned by BNP Paribas, the French bank.

He is also an articulate advocate. Rather than opting for their cloak of secrecy, hedge funds, particularly those American businesses at the frontier of the industry during the 1980s, had it thrust upon them, he believes. “When hedge funds started in the US, there were very strict rules on non-solicitation. The advice that was given, often legal advice, was for them not to advertise. They were not even allowed to put their prices in The Wall Street Journal. They got used to not saying anything and thinking that people were not interested in what they were doing.” Times have changed, clearly.

In the UK hedge funds are still not permitted to market their products directly to retail investors. After a review last year, the FSA signalled its willingness to allow the practice but has yet to set a date for its introduction.

Mr Fawcett acknowledged that hedge funds have been front-page news for all the wrong reasons this year, but he refused to identify them as responsible for market instability. He dismissed as impossible, for example, the idea that short-selling by hedge funds was behind the near-collapse of HBOS, the high street bank that was particularly vulnerable at the time as it was in the process of carrying out a £4 billion rights issue.

“The amount of money being managed by individual hedge funds was simply not large enough to threaten banks. When the FSA introduced its total ban on shorting banks and the regulatory disclosures began to appear, the positions were very small,” he said. “Funds had positions worth 0.8 per cent of Royal Bank of Scotland's market cap and 2 per cent of HBOS. They had been reducing their presence for months. The real reason that these banks went the way they did was that the long-only managers began to sell.”

Mr Fawcett blamed the restrictions on shorting, “it's like changing the rules in the middle of a match”, for much of the disastrous performance of hedge fund strategies in the third quarter. He insisted that, until the collapse of Lehman Brothers, the Wall Street bank, in September, hedge funds were actually performing well this year.

“The irony of bringing in a short-selling ban is that you are raising a flag that says the UK financial system is weak. Making it permanent would risk relegating the UK market to second- degree status.”

Mr Fawcett said that he was not opposed to disclosure, but any crackdown by market regulators should apply to everyone, not only alternative investors. “Hedge funds are subject to market rules, just like any other investors. If they were breaking the rules, they would have been found out by now. Why should they be treated any differently from anybody else?

“If the market rules are wrong, then they should be changed for everyone — for insurers, pension funds, banks, mutuals, money market funds and all investors.”

Mr Fawcett's contention is that the main problem with hedge funds is one of perception rather than reality. To back up his claim that they have been unfairly vilified, he cited the relatively limited number of high-profile blow-ups this year, despite recent predictions that one in four funds will have been shut by the end of the year.

Ospraie Management, the commodities fund, Peloton Partners, run by former Goldman Sachs bankers, and several funds managed by RAB Capital, the London fund manager, are among the few fatalities of the past 12 months.

Nevertheless, there are still some harsh realities to inject. The hedge fund industry as a whole is heading for a loss for 2008, marking only its second year in the red since records began.

Almost $500 billion (£332 billion) has been wiped off the value of its assets in the past 12 months. Market movements and redemptions mean that assets under alternative management stand at $1.56 trillion, having peaked at $2 trillion, according to Hedge Fund Research (HFR), the Chicago-based research firm. Performance has been sobering. HFR's daily updated global hedge fund index was down 21.9 per cent for the year to date on Friday.

In many instances funds have been forced to shut the gate on redemptions in order to prevent asset fire sales. This time last year, few would have predicted such measures.

Mr Fawcett argues the case for the former masters of the universe with eloquence, but the debate will, inevitably, go on.