Light at the end of the tunnel, or light of an oncoming train?

Thu Mar 24, 2011

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There is good reason for everyone in the hedge fund community to be both optimistic and apprehensive right now


By Nick Evans

There is good reason for everyone in the hedge fund community to be both optimistic and apprehensive right now – about markets and the economy, about regulation and politics, about the state of the world at large and the prospects for the hedge fund industry itself.

On the upside, it is clear that the industry’s recovery is gathering pace. As our new fund and asset surveys for 2010 show, hedge funds are bouncing back quickly from the upheavals of 2008 and 2009.

Inflows are accelerating fast, from all sorts of investor types. The environment for new fund start-ups is improving all the time – and the list of planned launches is growing by the day.

Some of the new financial regulations coming down the line – such as the ban on bank prop trading – should breathe new life into the industry through the creation of a number of big new hedge fund entrants. And high levels of market and macro volatility and uncertainty should continue to create a rich and varied opportunity set across most strategy areas.

But there is plenty of downside risk, too – and not just at the macro event level, where the uprising in Libya and the horrific disasters in Japan are the latest severe escalations in a world of fast-rising instability and danger.

Another global market crisis would have a very significant impact on investors – and there is no reason to suppose that the money that is invested in hedge funds now would prove to be any stickier than it was in 2008, when investors (as they usually do) ran for the hills at precisely the wrong moment.

But perhaps the biggest risk of all, though, is political. And there are two areas where this is most clearly manifested right now.

The first is in the growing chorus of rhetoric (much of it from the banks) about the supposed risks of the ‘shadow banking’ system, by which people who use that opaque and menacing phrase generally mean to imply hedge funds – even though hedge funds only form a very marginal part of a world that was almost entirely the creation of the banks themselves.

And the second is in the insider-trading investigations in the US and elsewhere, which seem to form part of a calculated move by policy-makers to throw as much mud at the hedge fund industry as possible at the moment – in the hope that at least some might stick. Guilt by association seems to be the tactic – and a pretty nasty one it is too.

The SEC now apparently plans to investigate all hedge funds that consistently produce above-market returns – as if alpha per se were somehow an illegal substance. The FSA has been getting in on the act too – arresting in a blaze of publicity a ring of alleged insider-dealers last year as part of an inquiry that has since gone deafeningly quiet.

And pretty much everyone you meet outside the industry now feels entitled to offer the view – fuelled deliberately by all these so far unproven regulatory actions and insinuations – that hedge funds only make money by systematically rigging markets and trading on privileged or inside information.

“Kill the bad hedge funds and regulate the rest.” That was reputed to be the US Treasury’s attitude under former Goldman banker Hank Paulson in the depths of the crisis in 2008, as revealed in emails between senior Lehman management at the time.

How real that supposed strategy seems now – and how depressingly typical it should be that the banks themselves are now rallying to the cause, doing their best to fuel unease about the all but non-existent systemic risk posed by hedge funds and to shift the focus away from their own intrinsic and largely unresolved structural and cultural flaws.

Quite why anyone should ever be forced to listen to a banker again on the subject of risk is a mystery. It was they who blew the roof off last time – not hedge funds. It was they who nearly bankrupted most major governments – not hedge funds. And it will be they who cause the next financial crisis too – you can bank on it.

So the industry’s increased influence and visibility may have good and bad consequences. Investors are clearly keen to put more and more money into hedge funds. But supervisors are clearly keen to exercise more and more control.

The future for hedge funds should be very bright – as long as regulators do not fall either for the self-interested posturing of the banks, or for the ignorant twaddle of the politicians.

But that’s a big if. Right now you wouldn’t want to bet on the outcome. That growing light in the tunnel may yet be an oncoming train.

ISSN: 2151-1845 / CDC10004H