Last week, five of the largest hedge fund managers (Caxton Corporation, Kingdon Capital Management, LLC, Moore Capital Management, Inc., Soros Fund Management LLC, and Tudor Investment Corporation) published a report entitled, “Sound Practices for Hedge Fund Managers.” The report is a response to the May 1999 President’s Working Group on Financial Markets report, “Hedge Funds, Leverage and the Lessons of Long-Term Capital Management.”     

What’s Not Being Said     

The stated objective of the report is to “contribute to a continuing evolution of hedge fund manager practices.” Its unspoken objective is to keep the regulatory wolves at bay by suggesting how hedge fund managers can improve their business practices.      

There is no doubt that hedge fund managers could certainly benefit by adopting the practices recommended in the report. Yet I was surprised by the naivet? of the most of the suggestions. Here is an excerpt of some of these recommendations:      

Hedge Fund Managers should clearly define the investment objectives and risk parameters for each Fund, and the trading policies and risk limits necessary to achieve these objectives. Hedge Fund Managers should adopt an organizational structure that ensures effective monitoring of compliance with investment and valuation policies by allocating defined supervisory responsibilities and maintaining clear reporting lines. Suitably qualified personnel should be retained and adequate systems established to produce periodic reporting that permits Senior Management to monitor trading activities and operations effectively. Internal procedures and periodic independent review processes should seek to ensure the enforcement of policies and identify deviations from those policies. Appropriate controls, reporting and review processes should apply to internal and external managers or traders. Third-party service providers that perform key business functions (such as NAV calculation) also should be subject to appropriate controls and review processes. (p.8)      

Nice Try But . . .     

These recommendations do not represent a high-water mark in business practices. Rather, they represent the minimum acceptable practices any investment manager should follow. The entire document contains such elementary recommendations that it leads me to wonder why an investor would give their money to a manager that did not adhere to the recommended sound practices.      

Certainly investors have come to expect (and demand) many of these recommended practices from their mutual fund and separate account managers. There is no reason why hedge fund managers should be allowed to operate under a different, less rigorous standard, especially when investors typically pay these managers more for their services.      

Size Does Not Matter     

But the authors circumvent this issue by relying on a convenient but fallacious argument: size matters. “Given that the practices recommended were developed by larger hedge fund managers based on their views and business models, many may not be applicable to smaller hedge funds.” (P. 1)      

Accepting the argument that the recommendations apply only to the larger firms basically means accepting that smaller managers (and given the asset base of the signatory firms, this means almost every other hedge fund manager) present investors with additional market and/or business risk. It also means that the barrier to entry to becoming a hedge fund manager might be set so low that the regulators might want to raise it. Neither conclusion is satisfactory.      

Investors Will Ultimately Win.     

While hedge funds might benefit from the report, the true, and unintended, beneficiaries will ultimately be hedge fund investors.     

The report provides an unusually candid assessment of the current state of the hedge fund industry. It shows how weak the current business practices are and articulates what issues investors should include in their due diligence process. The document spells out what questions prospective investors should ask about such topics as risk management, organizational structure, leverage, and compliance and what answers are acceptable. Giving this information to the consumer will go farther to improving the business practices used in the hedge fund industry than any government mandate.      

In a rather perverse way, the report may achieve its desired goal of to contributing to a continuing evolution of hedge fund manager practices. But this evolution will not be the result of a newfound desire for self-improvement. Rather it will be the result of investors demanding and getting more for their money.





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