Institutional Investor's Alpha Magazine - March 2008 - (Page 44) Liquidity Crisis causing volatility to drop, and since it looks like the risk has been reduced, why not take more of it? So you do it again and again and again, until one day — snap! — the rubber band finally breaks.” The calls for less reliance on leverage and for more transparency are joined by demands for greater government oversight — a clamor that has grown as the hedge fund risks have become more widely publicized. In London an industrybacked governance code championed by Sir Andrew Large, a former deputy governor of the Bank of England, is aiming for hedge funds voluntarily to disclose more information — such as what strategies are used to withstand sudden market jolts — in hopes of fending off morestringent governmental regulation. But the U.K.’s Financial Services Authority is arguing that tougher rules are required, and the — JACKI ZEHNER, FOUNDING agency plans a review of PARTNER, CIRCLE FINANCIAL GROUP a cross-section of hedge funds “to assess formally their market abuse systems and controls.” The IMF’s Dodd agrees that the industry should consider applying universal limits on leverage and on complex derivatives to determine if such oversight could help prevent market catastrophes. Policymakers should also consider establishing reporting requirements for hedge funds, he adds, as well as extending measures obliging dealers to act as market makers to prevent the rush to cash out that started last summer’s meltdown. But although regulation may solve some problems, it has the potential to create others, says MIT’s Lo. “If we were simply talking about preventing fraud or limiting leverage, regulatory changes may be effective,” he explains. “However, hedge funds now provide an extraordinary amount of liquidity to the global financial system, and because they’re unregulated, they can withdraw that liquidity without notice.” This may be benign if it occurs rarely and randomly, but Lo — who founded hedge fund firm AlphaSimplex Group in 1999 and sold it last year, though he remains chairman and chief scientific officer — says a simultaneous withdrawal of liquidity across an entire sector of hedge funds could have disastrous consequences for the financial system. Government crackdowns, he adds, may only make things worse: “If we attempt to impose regulatory requirements on their provision of liquidity, we risk driving them offshore to jurisdictions with less stringent regulations.” Instead, Lo advocates establishing what he calls a capital markets safety board, a group that would be made up of accountants, lawyers and fi nancial professionals. By monitoring systemic risk, studying financial blowups and developing guidelines for improving methodology and modeling, such a group could offer a more direct way to deal with the systemic risks of the hedge fund industry, he argues. Nor, he says, should a tightening of lending standards be out of the question. Critics like William Gross, chairman of Newport, California–based bond giant Pacific Investment Management Co., have railed perennially against what they call Wall Street’s shadow banking system and its arcane menu of securitized-debt products, which were good enough to pass muster with rating agencies despite the ambiguous value of the underlying assets. The CAIAA’s Asche says he can only agree. “These lenders got a bit too complacent with what was at the time a very comfortable liquidity environment,” he asserts. “They did make a lot of transactions that didn’t make much sense from a fundamentals standpoint, and the assumptions on which they were based were much too optimistic. When the pendulum swings, it tends to swing too far in one direction.” Because it is profitable to lend — and equally profitable, if not more so, to borrow — Darden’s Bruner predicts a return to liquidity normalcy before long. He avoids, however, putting a specific time frame on the change and says it will be accompanied by greater attention to risk management and more transparency between lenders and hedge funds. The bottom line, Asche notes, will be a smaller appetite for complexly structured products. “Anyone who has a fiduciary responsibility as an institutional investor has to err on the side of caution,” he says. But it is hardly as if hedge funds are suffering from across-the-board flights of capital, and not all institutional investors agree with Asche. Michael Travaglini, executive director of Massachusetts’ Pension Reserves Investment Management Board, says he isn’t giving up on alternatives investing just yet. Despite losing $30 million in the Sowood collapse, the Massachusetts fund ended 2007 up 11.9 percent, well above its annual target of 8.25 percent. “I know people don’t like to hear this, but you can have a situation like Sowood, and there aren’t always real lessons to be learned,” says Travaglini. “Obviously, if Jeff Larson knew what was going to happen in advance, he would have acted much differently. But that’s the intrinsic challenge of investing: We don’t always know what’s going to happen tomorrow.” Lo thinks that even if much-needed changes are made, market globalization all but ensures more shocks like last summer’s. “We’ll never be able to eliminate such risks entirely,” he says. “But we can certainly improve the way we handle them by educating the public.” Additional reporting by Staff Writer Imogen Rose-Smith. “The system is so complex and interconnected that it is absolutely impossible for anyone, any firm, any anything, to get their arms around it.” 44 • INSTITUTIONAL INVESTOR’S ALPHA • MARCH 2008
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