Hedge funds not systemically risky, but UK regulator issues caveats

Britain’s financial regulator says the low footprint hedge funds have in most capital markets means overall they pose a low systemic risk, but it has warned of a greater influence by the industry in areas such as convertible bonds and commodity and rates derivatives.

The Financial Services Authority paints a generally improved picture for hedge funds two years since the crisis ended, after surveying about 50 regulated managers with $390bn assets in March.

In its report published today, the watchdog found the average fund returned 7% over six months to 31 March, far above the 2% during the corresponding period before its September 2010 survey.

At most, 5% of net industry assets are still below their previous high value – called the high water mark. After this has been reached, managers can recommence collecting performance fees on further gains. In October 2009, 43% were below previous highs.

The UK watchdog said: “Funds’ footprint remains modest within most markets, so that current risks to financial stability through the market channel seem limited at the time of the latest surveys.”

Hedge funds do not represent more than 2% in any of 11 asset classes the FSA categorized.

But it found larger proportional ownership in convertibles and rate and commodity derivatives – between 7% and 4% – and did not rule out funds being largest aggregate players there.

The findings are mixed news for the industry, and for its trade body the Alternative Investment Management Association, which earlier this month called for no hedge fund to be dubbed ‘systemically important’.

Among other findings, the FSA said about 60% of hedge fund portfolios could now be liquidated in a working week, covering over fivefold investor and financing liabilities falling due over the same period.

But the watchdog said: “Some potential risks to hedge funds remain, particularly if they are unable to manage a sudden withdrawal of liabilities during a stressed market environment, potentially resulting in forced asset sales. If this occurs across a number of funds or in one large highly leveraged fund, it may exacerbate pressure on market liquidity and efficient pricing.

“In a stressed market environment, market liqudity may deteriorate significantly and rapidly relative to the current portfolio liquidity.”

While portfolio and investor liquidity remained “largely unchanged” from a year earlier, terms of financing for managers had been extended in aggregate, with a reduction in short-term financing of between five and 30 days and an increase in terms of 31 to 180 days, found a separate survey of 14 regulated UK banks by the FSA in April.

“To the extent that the term of financing received has increased, hedge funds will have potentially reduced the risk of a sudden withdrawal of funding from their leverage providers,” the study said.

In cases of emergency, about 85% of funds retain the power to suspend redemptions or create side pockets – a corporate governance practice causing intense irritation among investors during the crisis.

But illiquid fund assets, including those in side pockets, have remained largely unchanged recently, at just over 10% of aggregate NAV, the FSA said.

It will next survey funds and their bankers in September and October.

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