Rapid hedge fund growth creates concern

Date: Wednesday, July 6, 2005
Author: James Langton- Investmentexecutive.com

The rapid growth of the hedge fund industry poses systemic risks, Standard & Poor's Ratings Services says in a report released Wednesday. But it believes that better risk management and due diligence practices should help lessen the chance that the industry will precipitate financial crises.

S&P says that by the end of first-quarter 2005, total hedge fund assets under management surpassed US$1 trillion, after expanding by approximately 20% in 2004. Some sources indicate AUM of closer to US$1.3 trillion when privately managed accounts are included in the total, it says. Funds of hedge funds, which assemble investments in hedge funds with diverse strategies, have grown even faster.

It notes that this rapid growth, and recent poor performance within the industry, has increased concerns about hedge funds' impact on financial markets and the financial institutions that do business with them. Some fear that the industry’s growth is helping diminish returns, which could in turn, spur managers to take ever-greater risks. These fears have led to calls for more transparency and tighter regulation, S&P notes.

However, it says the direct effects of poor performance of any hedge fund are expected to be minimal. "Systemic risks are a greater concern," says Standard & Poor's credit analyst Tom Foley. The report notes that there "is plenty of anecdotal evidence" that hedge fund managers have a herd mentality. "This can create volatility in certain markets that has a destabilizing influence when coupled with large amounts of leverage."

However, the report suggests that the potential for system-wide liquidity crises, as occurred with the demise of Long-Term Capital Management in 1998, are ameliorated by improved risk management and better due diligence practices of the prime brokers that service the hedge fund industry. "In our opinion, sound risk management within and across financial institutions is the key component to reducing systemic risk from the hedge fund industry."

"We recently conducted detailed reviews of risk management practices, policies, and procedures at large financial institutions, and believe that those brokers who service the needs of hedge funds, by and large, have sufficient risk management capabilities.

"The systemic risks are real, but this does not necessarily imply a bad ending. Hedge funds and brokerage firms recognize the risks they face and strive to manage these risks properly. The hedge fund industry is now in its third decade, and, like most industries, rapid growth should give way to a more sustainable pace at some point. It is not clear of course whether sustainable growth must await another major blowup such as was the case with LTCM. We will continue to monitor how the activities of the hedge fund industry affect brokers, the markets in general, and the hedge funds that we rate."

The firm does not view the risks related to the hedge fund industry as significant enough to warrant credit rating changes for hedge funds or securities brokers.