Hedge Fund Working Group Publishes its Final Report Outlining a Code of Conduct for Hedge Funds
Last week, the Hedge Fund Working Group published its final report outlining a code of conduct for hedge funds. Below are quotes from Brad Ziff, a member of the HFWG, and director of the hedge funds advisory practice at management consultancy Oliver Wyman.
"The standards outlined by the Hedge Fund Working Group are very much disclosure-based and are focused on assisting investors, regulators and creditors, but primarily investors with a set of principles and best practices to ensure that they understand how hedge funds should better manage risks. We divided those standards along five areas of focus: governance, disclosure, valuation, risk management and activism. And in each of those areas we mapped them back to the original set of principles articulated by the FSA.
"We believe that in a number of instances, hedge funds will have to make only minor adaptations to adhere to these new standards. Many hedge funds already have a number of these practices in place in some manner and will only need to sharpen them or be more careful in the manner in which they apply what they already do. Others will need to make certain investments in resources, technology, additional models or approaches to risk, to meet the best practices. And still others we anticipate will find that some of the practices are not well suited and will choose to explain why they are not complying. Essentially we have tried to create a set of standards that are market friendly and flexible.
"Investors will be better protected by the new standards only if they themselves go out and encourage their managers to adopt the practices. That is the first and most important step. The practices are only valuable to investors if there is support for the initiative. If this is the case, the practices increase the level of disclosure and transparency about the way that managers take on and manage risk so that investors have a much clearer set of information and background about the type of firms they are investing in and the ways those firms handle specific issues surrounding risk management.
"The new standards tackle the issue of valuations that has been a key debate for the market, particularly when it comes to complex financial instruments. It is critical that hedge fund managers are able to demonstrate independence and competence. There should be a process where the fund manager has an independent process in place where the complex instruments are valued independently from the trading arena and second we believe it is essential that the individuals charged with that valuation process are competent and have the capability of understanding the underlying securities. They must have the models to properly value them and the background and experience and familiarity to adjudge the results. If the latter is not the case, then we argue that the segregation in and of itself is not as valuable and the firm should consider a process which is less independent but still competent in constructing its balance, but ensure that this process is disclosed to its investors so they can make an appropriate judgment.
"We believe that the voluntary nature of the code will be successful. The drivers for hedge funds to sign up are manifold. Hedge funds will want to join because their largest peers already have and they realize it is important to be seen as part of a group who are committed to best practices; they will join because regulators already have argued this is an important step to forestall more substantive regulatory intrusion and a positive initiative associated with market discipline; and finally they will adopt and comply because their leading and investors and creditors will encourage them to be part of a marketplace that embraces best practices and will use this as the leading benchmark.
"The code is designed to help regulators understand the market and how market discipline can work effectively. We think these guidelines are a positive step in that regard. Industry transparency has not been a problem, but there are guidelines here which are set forth which clearly enable investors and managers to have structures in place for additional disclosures in a number of areas which should certainly enhance transparency for market participants which will clearly make it easier to understand how hedge funds operate and take and manage risk."
"We believe that in a number of instances, hedge funds will have to make only minor adaptations to adhere to these new standards. Many hedge funds already have a number of these practices in place in some manner and will only need to sharpen them or be more careful in the manner in which they apply what they already do. Others will need to make certain investments in resources, technology, additional models or approaches to risk, to meet the best practices. And still others we anticipate will find that some of the practices are not well suited and will choose to explain why they are not complying. Essentially we have tried to create a set of standards that are market friendly and flexible.
"Investors will be better protected by the new standards only if they themselves go out and encourage their managers to adopt the practices. That is the first and most important step. The practices are only valuable to investors if there is support for the initiative. If this is the case, the practices increase the level of disclosure and transparency about the way that managers take on and manage risk so that investors have a much clearer set of information and background about the type of firms they are investing in and the ways those firms handle specific issues surrounding risk management.
"The new standards tackle the issue of valuations that has been a key debate for the market, particularly when it comes to complex financial instruments. It is critical that hedge fund managers are able to demonstrate independence and competence. There should be a process where the fund manager has an independent process in place where the complex instruments are valued independently from the trading arena and second we believe it is essential that the individuals charged with that valuation process are competent and have the capability of understanding the underlying securities. They must have the models to properly value them and the background and experience and familiarity to adjudge the results. If the latter is not the case, then we argue that the segregation in and of itself is not as valuable and the firm should consider a process which is less independent but still competent in constructing its balance, but ensure that this process is disclosed to its investors so they can make an appropriate judgment.
"We believe that the voluntary nature of the code will be successful. The drivers for hedge funds to sign up are manifold. Hedge funds will want to join because their largest peers already have and they realize it is important to be seen as part of a group who are committed to best practices; they will join because regulators already have argued this is an important step to forestall more substantive regulatory intrusion and a positive initiative associated with market discipline; and finally they will adopt and comply because their leading and investors and creditors will encourage them to be part of a marketplace that embraces best practices and will use this as the leading benchmark.
"The code is designed to help regulators understand the market and how market discipline can work effectively. We think these guidelines are a positive step in that regard. Industry transparency has not been a problem, but there are guidelines here which are set forth which clearly enable investors and managers to have structures in place for additional disclosures in a number of areas which should certainly enhance transparency for market participants which will clearly make it easier to understand how hedge funds operate and take and manage risk."
