Hedge funds consider code of conduct

Date: Tuesday, July 12, 2005
Author: http://money.cnn.com/2005/07/12/markets/hedgefunds.reut

Move would alleviate concern over high risk and lack of transparency in the fast-growing business.
July 12, 2005: 7:01 AM EDT

LONDON (Reuters) - Hedge funds are to consider adopting a code of conduct to alleviate concern over high risk and lack of transparency in the fast-growing business, the leading industry body said Tuesday.

The Alternative Investment Management Association (AIMA) is forming working groups for discussions in the next few weeks that will include proposals for an code aimed at boosting investor confidence in the $1 trillion industry.

The move comes after the UK Financial Services Authority (FSA) warned in June that hedge fund activities might provoke "volatile and potentially disorderly markets." A code of conduct, it said, would be an alternative to regulation.

"AIMA is going to review the issue of a code of conduct as raised by the FSA," said AIMA Director Emma Mugridge. "We are aware of the increasing importance that regulators attach to this issue and are going to look into it."

Hedge funds have come under intense scrutiny in recent months amid concern that high leverage and risky strategies may lead to price swings that could destabilize financial markets.

According to the FSA, hedge funds are often ready to take huge risks to boost returns, with some "testing the boundaries of acceptable practice concerning insider trading and market manipulation."

It is also a worry that only 5 to 10 percent of the world's 6,000 hedge fund managers can be considered highly skilled, or able to add significant value after fees, consultant Watson Wyatt said in March.

Currently, UK hedge fund managers are subject to FSA rules, but the funds themselves, often located offshore, are bound only by local regulation.

In the United States, meanwhile, there have been moves toward imposing greater transparency. Hedge funds must register with the Securities and Exchange Commission after 2006, and the regulator will have power to collect information, order compliance controls and boost disclosure.

Recent concern over hedge funds peaked in May, when the downgrade of General Motors debt rating to "junk" status and subsequent market volatility raised the specter of large funds going bust as investors dumped them for safer strategies.

Subsequent critics included German Chancellor Gerhard Schroeder, who pushed for global action at this month's G8 summit in Scotland, and European Central Bank President Jean-Claude Trichet, who this month warned banks must focus on hedge fund risk.

Advances in risk management "should be given priority as they are the first way to respond to the increased challenge stemming from hedge funds," Trichet said.

Still, given the global nature of the industry, a regulatory response should only be adopted on the basis of an international consensus, he added.

That view will have been welcome in Britain, home to about 70 percent of Europe's hedge funds, where the regulator has made clear it does not want to impose regulation that may have the effect of moving the problem to another jurisdiction.

While a code of conduct would carry the handicap of being non-binding, the FSA said, it would have "the core benefit that it may lead to an overall reduction in risk." Also increased investor confidence would mean that "the risk of overreaction to market developments may be mitigated."

Much of the criticism of hedge funds has focused on the lack of information provided by managers to investors, and many hedge fund managers recognize that a code of conduct is likely to require greater openness.

"What it comes down to is how much disclosure is appropriate," said Charles Beazley, head of institutional and alternative investments at Gartmore Investment Management. "It's a matter of remembering that the money belongs to the client, not the manager."

Others warn, however that trading strategies may be compromised if rival funds are able to access trading data.

"If we are talking about historical disclosure of positions, we don't have a big issue with that," said Nick Tyler, a manager with Adelphi Capital in London. "But the problem with immediate transparency is that you are leaving yourself open to being squeezed on short positions."

In addition, hedge fund openness should be complimented by greater disclosure from prime brokers, Tyler said. These are often investment banks, which provide the hedge funds with seed capital and the loans on which they build their leverage.

"The problem is not so much hedge funds going down," he said. "It's who they may take down with them."

The once high-flying funds are struggling.