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Hedgeweek Commentary: Behind the hedge fund news


The Securities and Exchange Commission’s ban on short selling of financial stocks may have expired, but hedge funds continue to face calls for incr

The Securities and Exchange Commission’s ban on short selling of financial stocks may have expired, but hedge funds continue to face calls for increased regulation from the likes of French President Nicolas Sarkozy. Many of the proposals threaten to damage not only funds, their managers and investors but other parts of the financial industry, although few go as far as Italian Finance Minister Giulio Tremonti, who called on leading countries to consider banning hedge funds altogether. That would be tough on Italy’s own (well regulated) hedge fund industry, which has so far flourished under the benign supervision of Tremonti’s ministry.

The Italian job

Suggestions from Italian Finance Minister Giulio Tremonti that Italy could push for the abolition of hedge funds has the industry baffled. Speaking to Italian media at the G8 meeting in Washington, Tremonti said the rewriting of financial market rules should target "absolutely crazy bodies, like hedge funds which have nothing to do with capitalism". Asked if he was suggesting that hedge funds should be banned, he said: "We have to launch a discussion about this."

These comments came despite plans by the Italian treasury department – part of Tremonti’s ministry – to launch a public consultation on a draft regulatory document reviewing current rules that prohibit pension funds from investing in hedge funds.

Tremonti’s comments were promptly rebutted by representatives of the global hedge fund industry. Florence Lombard and Richard Baker, chief executives of the Alternative Investments Management Association and Managed Funds Association respectively, said in a joint statement that it would be a serious mistake to consider eliminating innovative private pools of capital that are an essential source of investment capital, in Italy as elsewhere in the world.

They added that the hedge fund industry in Italy was a model of successful regulation, provided excellent risk-adjusted returns for investors and was an important source for job creation. In particular, Lombard and Baker added, this was no time to think about abolishing an industry that was an essential source of liquidity.

Did Tremonti simply get a bit over-excited in Washington? Let’s hope that when he and his colleagues sit down to think about any new financial world order, spirits are calmer and no-one tries to play to the grandstand.

The new investors

With massive redemptions sweeping the hedge fund industry and vast changes occurring across the industry, it is highly probable that many fund managers are seeking new investors and vice versa. But who will these new investors be, and how will hedge funds adapt to entice them into their funds?

One response is to look at market and geographic trends. Lately many large new hedge fund investors have emerged including non-US entities, sovereign wealth funds and Asian investors. Other interest is specifically coming from Russia and other large oil-producing countries in the Middle East, which are awash with cash looking for a productive home.

They may be new kids on the block, but they are becoming big players and, as a result, hedge fund managers are seeing the need to move more resources to these increasingly important geographical regions.

In this new financial world, every business faces the need to adapt in order to survive, and hedge funds are no different. In these markets, it will be the survival of the fittest – and the biggest. Experts are advising new investors to first look at size – does the manager have enough scale to pay and incentivise a high-quality team? Size matters because if assets under management are inadequate, the management’s focus may lean toward fund-raising or taking care of cash flow rather than performance.

New investors will no doubt be willing to take some risk in search of the outsize rewards to be obtained as a result of the market turbulence, but they will seek alpha and will certainly focus on funds that are capable of handling the pressure. In this situation, size matters.

Bargain-hunting among the hedge funds

Recent falls in the value of stock market-listed hedge funds and an increase in investors anxious to exit the sector in order to raise cash might present opportunists with a timely opportunity to reap rewards.

The Financial Times has described as "panic selling" the cause of the fall in the share prices of listed hedge funds in recent weeks, although the net asset value of the vast majority of hedge fund and fund of funds vehicles listed in London has also fallen this year.

However, average discounts to NAV have now surged from 1 per cent in early September to 20 per cent, and according to Alan Brierley, director of investment companies at Collins Stewart, in some cases discounts to NAV have reached 30 per cent.

Perhaps not coincidentally, fund of hedge funds manager Permal Investment Management Services is seeking to buy shares in hedge funds at sizeable discounts to their market value as more investors become distressed sellers.

Permal, which has USD34bn in assets under management, is reported to be launching a fund of funds that aims to purchase investments in hedge funds from other managers forced to sell their holdings, for instance because of their own investors’ redemption requests. Permal hopes to negotiate discounts of between 25 and 30 per cent of NAV.

As with other assets, hedge fund shareholdings are likely to go on the auction block as the deleveraging of asset managers and their investors continues. But one person’s distress is another’s golden opportunity.

After the ban

Last week, the temporary ban on short selling US financial stocks implemented by the Securities and Exchange Commission came to an end, greeted by a general consensus that it added to market confusion and didn’t do much to halt the slide in the share price of financial services companies.

Since the ban was introduced on September 19, trading volume on the New York Stock Exchange dropped 35 percent and the Chicago Board Options Exchange Volatility Index surged to 57.53 on the day the ban ended.

The prohibition on shorting of more than 900 financial services stocks since the middle of September has also hampered the ability of hedge fund managers to protect their portfolios from losses in equity markets. According to Hennessee Group, the SEC’s short-selling ban was a big factor in funds losing an average of 6.24 per cent in September.

But at least the SEC has realised that extending the ban made little sense. The question is whether the UK’s Financial Services Authority, which has banned short selling of banking, insurance and related stocks until January, in the UK will take the same view. From past experience, it is likely to follow its US counterpart.

In both the US and the UK, politicians, regulators and exchanges are considering other ways of limiting short selling in an effort to prevent market manipulation. Hedge funds can only hope that future efforts are more carefully considered than those introduced to date.

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