Hedge funds urged to accept oversight

The global hedge fund industry had already been working to increase transparency and oversight, but now Bernard Madoff's alleged $50 billion fraud has some organizations, like the CFA Institute, urging the industry to adopt a uniform set of ethical standards.

In the absence of one single global hedge fund standards body, the CFA Institute has particular pull on this issue, because the large bulk of the practitioners of alternative investment strategies are Chartered Financial Analyst charter holders.

Kurt Schacht, managing director for the Institute's Centre of Financial Market Integrity, says the Madoff scandal underscores the need for the adoption of the institute's Asset Manager Code of Professional Conduct (AMC). The voluntary adoption of the AMC would require hedge fund firms to acknowledge compliance in their marketing information and other client communications.

Schacht says the AMC was created essentially with hedge funds in mind, particularly those in the U.S., which are not subject to the SEC regulations. Already, the Institute's Global Investment Performance Standards (GIPS) have been widely adopted; the AMC would function as an adjunct to that, adopted by firms who seek to comply with best ethical practices in the investment management industry.

Hedge funds have generally been able to avoid SEC oversight because they were believed to be primarily investment vehicles for institutions and sophisticated/accredited investors. Schacht points out that the spillover from the Madoff scandal into pension funds, retail investors and charitable foundations is proof that hedge funds have a much broader influence and therefore need a more rigorous code of conduct.

"The sort of second-hand involvement by even the least sophisticated retail investors on the totem pole, who are beneficiaries of public pension funds around the country, highlights just how significant [an] allocation retail investors have to the alternative space," he says.

Organizations like the Alternative Investment Management Association (AIMA) have recognized for some time that a common set of guidelines needs to be adopted that increases transparency for clients. In particular, the organization announced earlier this year that it was working on a standards of practice guide for fund-of-hedge fund vehicles — which have a high proportion of retail investors.

"In addition to AIMA, there has also been the U.K.-based organization called the Hedge Fund Standards Board, and last year there was the President's Working Group on Financial Markets, which also produced policies and procedures similar to sound practices," says Phil Schmitt, chairman of AIMA Canada. "They all overlapped, but there were items that were touched by some groups but not other groups. AIMA centralized and created a matrix for all these sources so they could all be used."

Schmitt adds that these guidelines are in addition to the local regulations hedge funds are subject to around the world.

"We're not accredited, and we're not a self-regulatory organization. We are just an industry body. We don't think the industry needs to be self-regulated, because we are already regulated. The primary jurisdiction that defeats that is in the U.S., where registration with the SEC is voluntary," he says. "In most other developed countries, it's regulated through the securities regulator. It's a misnomer in the press that it's not a regulated industry."

Schacht contends that, despite the best efforts and coordination of industry groups within the hedge fund world, there are a number of guidelines, and firms can pick and choose which ones to follow.

"There are probably six or seven rule books out there that profess to be the best operational guidelines for hedge funds. I think [the industry] has been successful in making the case to regulators that those are adequate," he says. "They worked, but it doesn't work very well now in light of the Madoff situation. There have been a number of prominent hedge fund blow-ups, but none of the scale of Madoff in terms of its size and reach to all sorts of different kinds of investors, most importantly the number of charitable foundations that may be wiped out by this."

Given the global scope of the CFA designation's purview, Schacht believes if the AMC was adopted by hedge fund managers globally, it could provide one single relatable benchmark that hedge fund investors, including fund-of-fund firms and pensions, could use to gauge the risk management and ethical standard of prospective firms.

What has shocked him most about the Madoff scandal is the number of well-respected fund sponsors that touted their due diligence, but have been nonetheless burned by Madoff.

"If you're an institutional investor for our pension fund, we want to have some basis of comparison for your firm with other hedge funds. We want to understand you have a rigorous process in place for ethics and integrity, which includes client-focused disclosure and valuation," he says. "In order to adopt the AMC, you have to ensure you're in compliance with all of the guidelines. That's a major difference between our group and other organizations like AIMA, the U.S.-based Managed Funds Association, or even the President's Working Group papers that have been out recently."

Schmitt says he's already seeing the shift within the industry. Investors are wanting more disclosure, and it's in the interest of firms to provide it.

"There will be more disclosure and transparency. We all learn each time one of these crises or breaches happens. You learn from it," he says. "Frankly, the association has always felt you should be able to access enough information to judge the quality of your investments. It's never been dictated anywhere that full transparency is required, nor is full transparency the answer to everything. That balance of power is shifting, as it often does, through market cycles. The buyer now has greater abilities to say we need to have greater knowledge of what's going on."

(12/18/08)