Competing will smarten hedge funds

By Michael Coote

Friday 23rd July 2004

The managed funds industry is coming under the regulatory hammer in the wake of its own Enron-style scandals in the US. The Securities and Exchange Commission (SEC) has been passing a raft of new rules, most contentiously of late a requirement that from the end of 2005, US mutual funds must have an independent chairman and at least three quarters of its directors must also be independent.

Given the litigious climate of the US, one that has worsened since the mutual funds scandals blew up, fund managers will no doubt be ransacking corporate America in search of people willing to expose themselves to the onslaught of a braying pack of lawyers.

Anyone they find will be able to name his price for the job. Their higher remuneration will come straight off the bottom line for investors. While well-intentioned, the SEC's rush to regulate has engulfed mutual funds in expensive compliance costs.

Not being content with socking it to conventional mutual funds, the SEC is now training its sights on hedge fund managers. Hedge funds have long operated with a free hand because formerly they have been the preserve of the rich. The rationale has gone that if supposedly sophisticated rich investors get burned on hedge funds, then so what? Caveat emptor.

But the climate has changed for hedge funds for two main reasons. First, they were unmasked as being some of the villains in the piece in such mutual funds scandals as market timing and late trading. Market timing involves giving privileged clients the best intraday prices for their trades, while late trading entails allowing such clients the option to place orders after 4pm when fund unit prices are set.

The SEC and others, such as New York state attorney-general Eliot Spitzer, flushed out some hedge funds as recipients of these illicit favours at the expense of other mutual fund investors, which made it inevitable that hedge funds would been seen as a problem that needed fixing.

Second, the rich punter is being joined increasingly by mom-and-pop retail investors and stodgy institutional clients such as pension funds in hedge fund investing. The changing nature of the hedge fund client base encourages regulatory creep.

The new crop of clients is just the sort that regulators exist to protect, so where it goes thereafter follows the likes of the SEC. The very success of hedge funds in opening up new client markets has created a threat of higher compliance costs courtesy of industry regulation.

Hedge fund managers come in for enough flak anyway about the fees they charge. Moreover, as more hedge fund players have emerged and more clients have poured money in, it has become harder in at least some securities market activities to turn a dollar due to rapid convergence of trades.

Too many hedge funds are chasing the same assets in some areas like distressed debt. Greater use of leverage has helped ratchet up shrinking profits in over-traded areas but that tactic is not without its own risks.

What hedge funds need now like a hole in the head is the SEC barging in to save investors from themselves. Higher compliance costs will place further pressure on fund manager margins and the profit squeezing occurring in some markets. It is likely that some hedge fund managers will exit the industry as a consequence, which will take some heat out of the situation, perhaps.

The Economist reports that no less a luminary than US Federal Reserve chairman Alan Greenspan testified before a senate committee in February to the effect that regulators should butt out of the hedge funds industry because its players provided significant market liquidity and also because regulation tended to expand of its own accord once imposed.

The SEC has its own ideas and wants hedge funds to register with it under the Investment Advisers Act 1940, which would make the funds subject to spot audits by the authority and disclosure requirements for fees and conflicts of interest.

However, many hedge fund managers already voluntarily register under the act or are compelled to do so if they want to win pension fund money.

Other types of compliance qualifications are sought by hedge funds of their own accord.

One, UBS-owned GAM (www.gam.com), which is the largest fund-of-hedge-funds operator in the world, has just recently announced that its multi-manager team which selects the underlying hedge funds that go into GAM's fund-of-funds portfolios has been reconfirmed in its ISO 9001: 2000 rating by Lloyds Register Quality Assurance. The team was assessed on all of its processes, including research, manager selection, investment due diligence, performance monitoring and manager analysis, and whether these processes were clearly defined, documented and adhered to at all times.

Voluntary compliance with tough external standards will give a hedge fund manager the competitive edge over less compliant rivals.

Whether uniform regulation with its attendant escalation in compliance costs adds any additional value above competitive peer pressure to conform with industry best practice is a moot point. Regulation dumbs down, while competition smartens up.

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