11 December 2002

 

Mr. Ashley Kovas
Financial Services Authority
25 The North Colonnade
Canary Wharf
London E14 5HS
United Kingdom

 

Re: Discussion Paper 16 - "Hedge Funds and the FSA" (Ref. FSA DP16)

 

Dear Mr. Kovas:

 

The European Advocacy Committee ("EAC" or the "Committee") of the Association for Investment Management and Research ("AIMR")¹ is pleased to comment on the Financial Services Authority's ("FSA" or the "Authority") discussion paper, Hedge Funds and the FSA ("DP 16" or the "Paper"). The EAC is a standing committee of AIMR charged with reviewing and responding to major new regulatory, legislative, and other developments that may affect investors, the investment profession, and the efficiency and integrity of European financial markets.

 

General Comments

 

AIMR is supportive of the regulatory approach the FSA has taken to date with regard to these funds. Permitting investors with sufficient knowledge of the risks they are taking to utilize all legal and ethical investment strategies available in a quest for superior returns is part of any investment process.

 

However, as the FSA points out in the Paper, the issue at hand in DP 16 is not whether to permit the existence of hedge funds, but whether such funds, in their current forms, are appropriate for less-sophisticated investors and, if so, in what form. If they are not appropriate, then are there certain types of hedge fund strategies that can be made appropriate for these investors?

 

Such questions are relevant for all types of investments and strategies. Even traditional buy-and-hold equity or long fixed-income strategies are not always appropriate for every type of investor. For example, growth stocks are not appropriate for most retirees living on pensions. Such questions are even more relevant for hedge funds, given the recent history of some funds.

 

Traditionally, regulators have made distinctions about appropriateness of certain classes of investments based on the relative sophistication of the individual investors involved. In general, investors have been categorized as either sophisticated - including people known as high-net-worth individuals ("HNWIs") with sufficient financial resources to hire the sophistication of advisers and to absorb potential losses - or unsophisticated - those lacking the financial resources, experience and understanding to engage in certain high-risk types of investing activities.

 

To determine whether an investment is appropriate for a given customer, AIMR members are guided by the organization's Standards of Professional Conduct (the "Standards"). Specifically, under Standard IV, Section B.2, of the Standards, members are required to:

 

a. Make a reasonable inquiry into a client's financial situation, investment experience, and investment objectives prior to making any investment recommendations and shall update this information as necessary, but no less frequently than annually, to allow the members to adjust other investment recommendations to reflect changed circumstances.

 

b. Consider the appropriateness and suitability of investment recommendations or actions for each portfolio or client. In determining appropriateness and suitability, members shall consider applicable relevant factors, including the needs and circumstances involved, and the basic characteristics of the total portfolio. Members shall not make a recommendation unless they reasonably determine that the recommendation is suitable to the client's financial situation, investment experience and investment objectives.

 

c. Distinguish between facts and opinions in the presentation of investment recommendations.

 

d. Disclose to clients and prospects the basic format and general principles of the investment processes by which securities are selected and portfolios are constructed and shall promptly disclose to clients and prospects any changes that might significantly affect those processes.

 

Beyond these Standards, the Committee also is charged with following the principles mandated by the AIMR Board of Governors for its advocacy committees throughout the world. These principles not only serve to create a uniform message to rules-makers throughout the world, but also create a process by which those committees seek to ensure that inappropriate investment advice is not given to clients. Those principles are:

 

• That there should be reasonable disclosure of information to the capital markets to permit well-informed decision-making is a paramount objective; but the benefits of this disclosure must be weighed against the cost of gathering and reporting the information and the cost of competitive disadvantage unless the result is inadequate information for decision-making.
  
• All markets should be transparent and regulation should operate to this end.
  
• Regulation should be designed and enforced to maintain and enhance market credibility, openness, and investor confidence, thereby helping to lower the cost of capital.
  
• There should not be a two-tiered disclosure system. The same information should be available to all market participants at the same time.
  
• Investors should have a voice in corporate governance.
  
• All markets and market participants should be ethical. They should strive to abide by the principles set forth in the AIMR Code of Ethics (the "Code") and the Standards (collectively referred to as "the Code and Standards"); but, at a minimum, they must abide by the International Code of Ethics and International Standards of Professional Conduct issued by the International Council of Investment Professionals (ICIA).
  
• AIMR members should foster self-regulation of the market in lieu of government-imposed regulation.

 

Hedge Funds for Sophisticated and High-Net-Worth Individuals
The Committee was in agreement with the FSA that the current regime employed by the FSA to monitor hedge funds as they are currently marketed in the United Kingdom is appropriate and acceptable for sophisticated investors and HNWIs. Specifically, as described below, these investors have the experience, knowledge and access to information to make the risks inherent in certain of these investment vehicles manageable.

 

In part, the growing interest in hedge funds over the past 20 years is due to the reputation these funds have gained for superior returns. While equity indexes declined by nearly 19.5% during the first eight months of 2001, returns for some hedge funds topped 25%. Hedge-fund managers achieve these returns through a combination of superior knowledge and strategy, and by taking greater risks than are permitted for more traditional funds. The risks taken are the result of the use of varying combinations of leverage, industry focus, stealth and flexibility.

 

Leverage is achieved primarily through the use of derivatives, short selling and loans, all of which are restricted or even barred for more-traditional investment vehicles. In general, the use of leverage raises the volatility of returns of an investment portfolio by enhancing the magnitude of both gains and losses.

 

At the same time, hedge funds subject their investors to other risks that can cause sudden changes in performance. For example, many over-the-counter derivative instruments rely heavily on other entities or financial institutions - referred to as counterparties - to perform duties specified in the contract creating the derivative. If the counterparties fail to perform, then the funds' returns will suffer.

 

Some fund managers also look for superior returns by taking advantage of their specialized knowledge of specific industry sectors and by concentrating their investment activities in those sectors. These strategies make their funds vulnerable to adverse moves in those sectors. Likewise, a significant position in a relatively few securities could create a liquidity issue for the fund by making it difficult for the fund's managers to unwind their positions should economic or operational events turn against them. As such, the fund could face losses as the process of unwinding those large positions sends shares moving against the fund.

 

Finally, hedge-fund managers typically keep information about their strategies and holdings out of the public view, allowing them to act on their beliefs about the most appropriate strategies without having to alert the market about those intentions through public disclosure. But this added level of flexibility also means that a fund's strategy can change quickly without individual investors' knowledge. For example, a fund can change its risk level quickly by moving from a relatively conservative market-neutral strategy to a highly leveraged, high-risk strategy in a short period of time based on the manager's outlook.

 

For investors with a high degree of sophistication or sufficient wealth to hire advisors with the requisite sophistication, such risks and strategies are manageable. They or their advisers are able to recognize and adequately gauge the risks associated with the investment vehicles and strategies used. They also are able to judge the competence of the managers through background checks on past performance and employment records.

 

Investors with these qualities also are able to supplement their financial sophistication with direct access to and, in some cases, control over fund managers. In many cases this is because the investors are limited partners who are chosen due to their expertise and knowledge about specific market and economic sectors.

 

In return for their efforts, managers are paid fees that surpass those of more traditional investment strategies. In some cases, management fees run between 1% and 4% of assets under management, while performance fees for other funds typically average around 20% of their funds' gains.

 

Despite the sophistication of the investment strategies used, together with the degree of risk involved with them, the Committee agrees that hedge funds are a recognized and appropriate investment strategy for sophisticated investors and HNWIs. More importantly, as a result of their access to fund managers, these investors can demand the types of disclosures that will supplement their already-well-developed ability to make informed investment decisions and therefore pass the tests set by the Standards and by AIMR's advocacy principles.

 

Hedge Funds for Unsophisticated Investors
Ultimately, though, the issue posed by the FSA is not about whether hedge funds are appropriate for sophisticated investors or HNWIs. That matter was resolved well before the issuance of the Paper and the FSA has done an adequate job, within its authority, overseeing such activities Rather, the issue at hand in the Paper is whether such funds, as currently structured, are appropriate for unsophisticated investors. On this issue, the Committee is divided.

 

Some members pointed out that even though hedge funds entail a higher-degree of perceived risk than more traditional investment fund vehicles, risk is an inherent and unavoidable part of any investment regimen. Indeed, someone who bought bonds or equities of many dotcom or telecom companies over the past five to seven years might have experienced losses amounting to all or nearly all of their original investments. There was also a feeling among some of the Committee's members that all investors should have access to the potentially high returns offered by some hedge funds and that limits on their availability for people of modest means are a way to make hedge funds a private club reserved solely for the wealthy few.

 

Those same members also argued that, if done well and correctly, certain hedge fund strategies were not only acceptable as retail products, but could provide investors with a lower-risk option to traditional mutual funds. For example, some saw the diversification provided by a "fund of funds" as a way to potentially limit the risks retail investors would have to accept. Likewise, a straight-forward long/short hedge fund strategy with a higher threshold for short selling than more traditional mutual fund strategies might actually achieve lower risk and higher returns for retail investors.

 

Others on the Committee saw hedge funds as totally inappropriate for unsophisticated investors, however. To a large degree, the views taken by these Committee members were the result of a belief that many of the advantages available to sophisticated investors and HNWIs - namely sufficient financial resources, expertise and access - would be unavailable to retail investors.

 

Lack of Access
Should unsophisticated investors invest in hedge funds, it is unlikely that the size of their investments would afford them the same level of access enjoyed by large investors in funds marketed to a select few large investors. Moreover, because it is unlikely that most unsophisticated investors could bring a level of expertise about a specific strategy, sector or investment vehicle, it is equally unlikely that they will have the ear of fund managers in the way that sophisticated investors would.

 

In traditional companies, such a lack of access is overcome with regulations that call for frequent, timely and substantial financial reporting and disclosures. For hedge funds, there are currently no such regulations and, even if there were, the ability of regulators such as the FSA to impose such requirements on off-shore hedge funds is debatable.

 

Because of the lack of disclosure, lack of access and the limited ability of regulators to require financial reports and disclosures, hedge funds as they are currently marketed would not meet the appropriateness requirements of sub-section d. of Standard IV, Section B.2. Nor would they meet the transparency, equal disclosure and corporate governance principles of AIMR's advocacy program.

 

Lack of Expertise
As part of their investment programs, hedge funds routinely use not only derivative products and leverage to enhance returns, but also frequently engage in complicated strategies that require simultaneous and seemingly contradictory trades using a wide variety of securities that are traded in different markets. In most cases, unsophisticated investors will not have the experience or background to understand such strategies and instruments. Due to this lack of understanding, it is unlikely unsophisticated investors will have the ability to gauge the degree of risk such activities pose to their investments.

 

Compounding this lack of understanding is that hedge funds benefit from their ability to move swiftly among different positions, different investment vehicles and different strategies, all without disclosing these moves to investors. As such, investors expecting lower-risk strategies may find themselves invested in a fund that is in a higher-risk category than is comfortable for them.

 

As a result, hedge fund strategies as they are currently marketed do not meet the test for appropriateness of sub-section d. of Standard IV, Section B.2. as they relate to unsophisticated investors. This deficiency also would fail the transparency and disclosure principles created for AIMR's advocacy program.

 

Lack of Financial Resources
Retail investors, as a general rule, do not have the financial means needed to absorb losses created by higher-risk investment vehicles or strategies. Again, AIMR members would have to consider the suitability of such investments for their clients as set out in the Standards.

 

Lack of Regulatory Protection
As noted in the Paper, most hedge funds operate offshore and, therefore, beyond the regulatory reach of most securities regulators, including the FSA. As such, securities regulators are not able to require these funds to provide retail investors with the kinds of information they would need to adequately assess the strategies, performance and risks involved in such investments. As such, this deficiency runs counter to AIMR's advocacy principle regarding regulation operating for the purpose of producing transparency.

 

Taken together, the lack of transparency, the use of sophisticated investment instruments and strategies, the ability to change risk profile without notifying investors ahead of time, the potential for significant losses and the difficulties associated with thousands of investors obtaining access to fund managers make hedge funds, as currently marketed in the United Kingdom, unsuitable for unsophisticated investors as determined by AIMR's Standards and advocacy principles.

 

How to Make Hedge Funds Appropriate to Retail Investors
Funds of funds. One way the FSA proposed to permit the marketing of hedge fund vehicles to unsophisticated investors is through funds of funds. This suggestion is based largely on the belief that through the purchase of interests in multiple hedge funds that a fund of funds is able to reduce overall risk through diversification.

 

Indeed, modern portfolio theory has proven that overall risk of a portfolio declines below that of the riskiest holdings, even if the holdings have equal risk measures. Nonetheless, diversification into securities whose returns are correlated to each other may not achieve the kind of risk reduction that unsophisticated investors may expect from diversification. For example, if a fund of funds invests in several opportunities that all focus on the performance of the financial services industry, it is unlikely that a fund of funds will achieve the kind of risk reduction normally expected from a diversified portfolio.

 

As such, to make such funds suitable for investors who may not understand the risks associated with correlated funds, the FSA would need to consider imposing rules that prevent funds of funds from taking concentrations in correlated sectors, strategies or holdings. Likewise, it would need to ensure that the funds' strategies are stable as a means of preventing movement from a conservative, risk-reduction strategy into a high-risk one. Finally, such funds of funds would need to adhere to the same kinds of disclosures - performance, holdings, risk and managers' history - as would be required of traditional mutual funds.

 

General Requirements
To make hedge funds appropriate for unsophisticated investors, the Committee would need assurance that they meet the transparency and disclosure requirements of AIMR's Standards and advocacy principles. Such disclosures might include

 

• discussions of risk at the time of offering and on an on-going basis, as described in the Paper;
  
• regular information about performance of the fund on an absolute basis and against an appropriate benchmark.
  
• on-going updates about strategies employed. Indeed, the FSA might need to consider requiring managers to stick to one strategy or, at the very least, providing participants advanced notice of changes in strategy;
  
• full, fair and accurate discussion of the manager's investment fund history and performance at the time of offering;
  
• require such funds to separate the compliance function from that of the manager;
  
• subject funds to audits as a way of preventing managers from engaging in activities for their personal benefit at the expense of the funds' investors;

 

Finally, the FSA would have to ensure the enforceability of such standards. Because the hedge fund industry operates largely beyond the regulatory reach of the Authority, the FSA would need to find a way to achieve these goals - through its regulation of hedge fund managers is one possible way - before these proposals could provide the appropriate safeguards unsophisticated investors would need.

 

Closing Remarks

 

All in all, the Committee believes hedge funds can and do provide value and service to certain classes of investors who are sophisticated enough to understand their complicated and risky strategies, and who are wealthy enough to absorb the losses that such investments might create. However, for the whole Committee to accept such investments as appropriate and acceptable vehicles for unsophisticated investors, the FSA would have to raise the level of disclosures, impose tighter restrictions on the activities of funds and ensure enforceability of these requirements.

 

The EAC appreciates the opportunity to comment on the FSA discussion paper 16 on Hedge Funds and the FSA. If you or your staff have questions or seek amplification of our views, please feel free to contact James C. Allen, CFA, by phone at +1.434.951.5558 or by e-mail at james.allen@cfainstitute.org.

 

Sincerely,

 

Luigi Gubitosi, CFA Chair European Advocacy Committee Advocacy

James C. Allen, CFA Associate, AIMR Professional Standards & Advocacy

 

¹ The Association for Investment Management and Research is a global, non-profit organization of over 61,000 investment professionals from more than 113 countries. Through its headquarters in the U.S. and 117 Member Societies and Member Chapters worldwide, AIMR provides global leadership in investment education, professional standards, and advocacy programs.