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Alternative Investments - January 18, 2006

EDHEC disagrees with most of the conclusions of the FER statement on hedge funds

FER statement highlighted risks of hedge funds

Following its meeting in Sonoma, California on July 10-11, 2005, the Financial Economists Roundtable (FER), an international group of senior financial economists, issued a statement in which it warned about the risks involved in investing in hedge funds. The EDHEC Risk and Asset Management Research Centre, which has carried out a multi-faceted research programme on hedge funds over the past three years, has published a paper by Noël Amenc, PhD, and Mathieu Vaissié in response to the FER statement in which it comments on the FER’s recommendations.

Noteworthy points on the subject of the FER’s concerns include the following:

  1. Exit risk. The FER statement observes that partners can close a fund and start up a new one when returns fall below a certain level. In EDHEC’s view, exit risk is more threatening for fund managers than for investors, since (i) raising money implies high costs and (ii) the alternative arena has become extremely competitive with over 8,000 funds competing for investors’ attention and money, and more transparent (more information means an improved fund selection process).

  2. High-risk strategies. According to the FER, “hedge funds’ asymmetric remuneration contracts create an incentive for fund managers to adopt high-risk investment strategies”. For EDHEC, this does not take into account the fact that hedge fund managers weigh the extra performance that they can expect to generate through riskier strategies with the fact that the value of their own franchise (i.e., their reputation) is at stake.

  3. Hedge fund lifetimes. The FER statement refers to an average life for a hedge fund of around 3 years. EDHEC underlines that most studies of hedge fund lifetimes treat all fund exits as liquidation, whereas a significant proportion of hedge funds stop reporting to databases for other reasons. When only liquidations are taken into account, the average life-time increases to 5.63 years. The survival rate also depends on the capacity of the fund to generate alpha, suggesting that the relatively high attrition rate means that the market does not let the worst-performing funds survive long.

  4. Extreme risks. EDHEC feels that hedge funds should not be stigmatized in this area. The returns of traditional asset classes are not normally distributed either when typical holding periods are considered. If we measure the extreme risks of hedge fund strategies over the last ten years, we find that they are lower than those of equities for the vast majority of strategies.

  5. Operational risks. The FER statement surprisingly overlooks this issue. This is all the more surprising in that operational weaknesses have been shown to play a role in 8 out of 10 cases of hedge fund failures.

  6. Systemic risks. No study has been able to demonstrate the implication of hedge funds in any systemic crisis so far. It is also high time that market participants recognize the positive role played by hedge funds in financial markets as providers of diversification and liquidity and as contributors to the integration and completeness of financial markets. It is worth noting that systemic risks are already indirectly controlled by regulators. Hedge funds borrow money from regulated financial institutions, which must monitor and control their counterparty risk.

As far as the FER’s recommendations are concerned:

  1. Limitation on investment in hedge funds to a low percentage of assets under management. Traditional investors invest in hedge funds primarily for their diversification properties. EDHEC thus believes that constraining the hedge fund allocation to an insignificant portion of total assets is not the solution. An appealing solution for investors is to invest the appropriate amount of capital in investable hedge fund indices.

  2. Commitment by regulators not to rescue troubled hedge funds. EDHEC underlines that banking regulators were never meant to rescue hedge funds. They are the ultimate safeguards for the integrity of the financial system and must therefore intervene if the integrity of the financial system is at stake, whatever the origin of the crisis. This does not mean that they rescue troubled hedge funds.

  3. Standardization of performance and risk measures among hedge funds. We entirely agree that information is a crucial issue for the future development of the alternative industry. EDHEC recently published a study, the “Edhec Fund of Hedge Fund Reporting Survey”, which provided a series of measures for reconciling the often-conflicting interests of fund managers and investors.