Hedge Fund Regulation the Purpose

In the first-round survey, a majority of investors cited diversification as their main objective in allocating to hedge funds. Among the second-round interviewees who were planning to increase their target allocations by 10% or more, half named diversification as the motivating factor. Among the approximately one in ten who were planning to decrease allocations by at least 10%, concern with a lack of transparency was the most frequently cited reason.

(4) Institutions are thinking and acting as long-term investors. While almost a quarter of second-round interviewees said they have liquidated some investments or plan to do so, overall the investors surveyed showed no inclination toward a long-term exodus from hedge funds. This is understandable, considering that 93% of all interviewees said they make hedge fund investments with a time horizon of at least three years, and more than half have a time horizon of five years or more.

(5) Investors are, however, realigning the strategies they pursue. Overall, investors said they most prefer multi-strategy, event-driven, global macro, and market-neutral funds for investment in the next 12 months. Convertible arbitrage funds and emerging markets funds of all major regions were most often identified as strategies they intend to avoid. Second round interviewees also reported planning a moderate shift in allocations toward investing in both funds of hedge funds and single-manager hedge funds, rather than single-manager hedge funds alone.

(6) Institutions express growing concerns with their hedge fund investments, topped by “poor performance.” Between the first and second surveys, the number of investors naming performance as their biggest worry about hedge funds rose from 67% to 84%. In the 2007 SEI-sponsored survey of U.S. institutional investors, “poor performance” was only the third ranked concern and was named by fewer than one in six of those interviewed. Other top-ranked concerns identified in the current survey were a lack of liquidity, funds not accomplishing their stated goal, and headline risk.

(7) in response, institutions are significantly tightening their investment criteria and intensifying their scrutiny of funds. “Capability of investment professionals” was named a very important factor in the selection of hedge fund managers by 82% of first-round respondents, followed by “firms management team,” “clarity and consistency of investment philosophy,” and “clarity of investment decision-making process.” When asked which criteria they will give more emphasis to in light of market conditions, second-round interviewees identified several criteria, led by “portfolio transparency.” Concerning the minimum standards for consideration of hedge funds, investors said they most commonly apply minimum standards concerning a funds track record and assets under management.

(8) While increasingly concerned with “institutional quality,” investors define it in varying ways. Overall, “pedigree and reputation” was the top-ranked “quality” factor, named by more than half of all respondents, followed by length of track record and assets under management. U.K. investors stand out as gauging institutional quality based on a wide range of factors, while U.S. investors indicated more focus on assets under management and length of track record.

(9) a focus on operational quality also is revealed in the pattern of survey responses. Operational factors including portfolio transparency, communication, and reporting were all ranked among the top selection criteria given added weight in light of current market conditions. Respondents expressed ambivalence when it came to internal fund administration vs. independent, external administration. However, in light of recent scandals, it seems likely that investors will increasingly demand a separation of duties, accelerating the trend toward independent administration and custody.

(10) Expect more stringent due diligence. Always concerned with the factors that drive the pattern of portfolio returns, investors are intensifying their scrutiny of hedge fund investment processes and company structures. Additionally, the Lehman insolvency and the fundamental nature of the Madoff allegations have highlighted issues related to hedge fund operations, counterparty risk, and risk management generally. (Greenwich Associates, 2008)

It is reported that the responses to the surveys provide confirmation of these observations through identification of portfolio transparency and headline risk as top concerns. The survey responses confirm these observations, identifying portfolio transparency and headline risk as top concerns. As the survey results indicate, the events of 2008 assure that investors will be conducting wider-ranging and more in-depth evaluation of hedge funds than before. Investors will have an intensified focus on operations, risk management, and key non-investment functions in addition to investment processes.

Survey results further are stated to have revealed clearly the focus of investors on the fundamentals — people, process, philosophy, and performance as their top concerns.

While other processes and functions are still important the drivers of future success are the fundamentals. Furthermore, it is likely that investors will prefer on an increasing basis a “separation of investment and noninvestment functions as it contributes to operation quality and risk management.” (Greenwich Associates, 2008)

There should be anticipation of an increase in client communication, reporting and transparency requirements and it is reported that the second round of responses to the survey revealed that portfolio transparency was ranked “as the top criterion given increased emphasis in light of recent market conditions.” (Greenwich Associates, 2008)

The survey responses are stated to indicate that hedge funds are viewed by institutional investors on a continuing basis as “important vehicles for portfolio diversification and absolute return potential.” (Greenwich Associates, 2008)

The report of Greenwich Associates includes the prediction that “in the years to come will be those that stand up to intensified due diligence by exhibiting institutional quality, providing more transparency, and delivering consistent, non-correlated returns over time.” (Greenwich Associates, 2008)

In a testimony before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises before the House of Representatives on May 7, 2009, Orice M. Williams, Director of the Financial Markets and Community Investment states that the GAO found that under the “…existing regulatory structure, the Securities and Exchange Commission and Commodity Futures Trading Commission can provide direct oversight of registered hedge fund advisers, and along with federal bank regulators, they monitor hedge fund-related activities conducted at their regulated entities. ” (Dawn and Young, 2009)

Although some examinations found that banks generally have strengthened practices for managing risk exposures to hedge funds, regulators recommended that they enhance firmwide risk management systems and practices, including expanded stress testing.” (Dawn and Young, 2009) While private sector investment in hedge funds is not specifically limited nor is it monitored by the federal government the fiduciaries must, under federal law, meet compliance “with a standard of prudence” however there are no specific or explicit restrictions on hedge funds which exist.

Hedge funds are inherent with challenges and risks that are “beyond those posed by traditional investment” and the example stated it that some investors are in possession of very little in the way of information on the underlying assets of funds and of their value which is said to limit the potential for oversight.” (Dawn and Young, 2009)

Disclosure and transparency has improved among hedge fund advisers as related to their operations due to the guidance provided by the industry as well as investors and creditors along with counterparties applying pressure.

Regulators report that creditors and counterparties “…have generally conducted more due diligence and tightened their credit standards for hedge funds. However, several factors may limit the effectiveness of market discipline or illustrate failures to properly exercise it. Further, if the risk controls of creditors and counterparties are inadequate, their actions may not prevent hedge funds from taking excessive risk and can contribute to conditions that create systemic risk if breakdowns in market discipline and risk controls are sufficiently severe that losses by hedge funds in turn cause significant losses at key intermediaries or in financial markets.” Dawn and Young, 2009)

It is additionally reported that concern remains among financial regulators and industry observers in regards to the credit risk management of counterparties at primary financial institutions since it is a critical factor in “controlling the potential for hedge funds to become a source of systemic risk. Although hedge funds generally add liquidity to many markets, including distressed asset markets, in some circumstances hedge funds activities can strain liquidity and contribute to financial distress. In response to their concerns regarding the adequacy of counterparty credit risk, a group of regulators had collaborated to examine particular hedge fund-related activities across entities they regulate, and the Presidents Working Group on Financial Markets (PWG). The PWG also established two private sector committees that recently released guidelines to address systemic risk and investor protection.” (Dawn and Young, 2009)

The work of Silverblatt (2009) entitled “Kanjorski Discussers Hedge Fund Regulation” states that hedge funds have emerged as a “key puzzle piece. And nearly a year after disgraced financier Bernard Madoffs Ponzi scheme ran out of gas, legislators are considering draft proposals that would tighten the leash around the secretive industry.” (Silverblatt, 2009) it is reported that that the drafts were released by Democratic Paul Kanjorski of Pennsylvania, would require private pools.

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