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Trading Under the Spotlight: Can Regulation offer Opportunities for Hedge Fund Managers?

Date: Friday, November 23, 2012
Author: Parin Shah, ProHedge.co.uk

At an HFMWeek breakfast yesterday, the “spotlight” remained firmly fixed on the obstacles and opportunities on offer to hedge fund managers in an industry that will become increasingly regulated. “We’re just at the beginning of regulation,” remarked Northern Trust’s Tony Glickman. “There is a long way to go.”

There are some prominent concerns that incoming regulation may be overly onerous on hedge funds. Abigail Bell from international law firm Dechert cited some high profile examples, the proposed EU Transaction Tax being drafted for 2014 and incoming MiFID II regulation which will gain further colour as 2012 draws to an end. The EU Transaction Tax in its current form is likely to impact returns for retail investors through directly affecting pension funds. According to Bell, the headline 0.01% tax figure could actually amount to an effective rate of 1% due to the nature of inter-broker deadling. On derivatives the tax appears punitive as it is levied on the notional amount of the contract. MiFID II furthermore seeks to enforce disclosure of algorithms across a broad sweep, from execution through to trading in its current form and may force funds employing high frequency trading to act as market makers, meaning such funds are unable to exit the market when conditions become unfavourable.

But regulation has also had its benefits. Improved execution, increased flexibility in cost structure and a huge change in the Emerging Markets space over the past 10 years, with great variety in terms of geographic location, strategies and asset classes have all been catalysed by regulation, according to Penny Aitken of FQS Capital. “In tough periods there is tough medicine, that is, natural attrition”. But the industry can emerge stronger as a result. Opportunities for the hedge fund industry, such as the closure of bank prop desks, have perhaps not materialised as intended and have actually removed an active market participant impacting liquidity, market capacity and returns. Aitken considers that there is far more “risk inhibition” as a result, but looking at the thriving structured credit market at the longer end of the liquidity spectrum, perhaps funds should look more closely at the quality of returns they are able to generate.

While innovative approaches to risk management have proliferated post-crisis, Oleg Ruban of MSCI warns risk managers to be careful what they measure. Measured asset correlations, for example, tend to rise in high volatility regimes even though the underlying return distribution remains unchanged. It is in fact the dispersion of returns that you need to measure. “Crowding” – the use of similar risk models across the industry has been “blamed for pretty much everything post-crisis,” states Ruban. “People have not gone to great lengths to actually define portfolio similar and measure crowding and what it means.” Controversially, he proposes that crowding should actually enhance idiosyncratic returns (or real alpha). The argument goes that the misalignment between value signals in the portfolio and signals in the risk model are the source of unique returns. So such “structured” portfolio construction can create a unique return profile.

Ruban’s analysis highlights that problems in the past were partly due to an over-reliance on a small set of numbers to capture the motion of an entire portfolio. People are no embracing the multiple perspectives within risk with for example tail risk and stress testing, in a manner that is situation dependent. Statistical tools are exactly that: tools. “And they need to be used well,” Ruban observes. He maintains that it’s not a question of White Swans or Black Swans. “All swans are black when it’s night, and so you need to be aware if what you observe.”