The largest international hedge fund organization, the Alternative Investment Management Association (AIMA), says it wants to work with global regulatory initiatives to improve the transparency of hedge fund activity.

In light of high-profile blowups in the hedge fund space of recent, including frauds like the one committed by Bernie Madoff, there have been increased calls for tighter global regulation of alternative investment mandates.

AIMA, whose members manage more than 75% of the world’s hedge fund assets, says that’s fine, as long as it can work with regulators to create a transparency framework that does not unfairly single out hedge funds for excessive oversight.

The association has launched a new platform that proposes regular reporting and increased transparency of systemically significant positions and risk exposures by managers of large hedge funds to their national regulators.

AIMA recommends that the industry create an aggregate short position disclosure regime for national regulators, support new policies to reduce settlement failure and work to create a global manager-authorization and supervision template modelled on the U.K.’s Financial Services Authority (FSA).

It’s a big step forward for the hedge fund industry, which concedes that a lack of transparency in some instances has resulted in hedge fund failures, which have had a cascading impact on systemic risk in the global financial system.

“Regulators are about analyzing, exposing and understanding systemic risk. That’s not new; that was in place prior to this whole debacle. To understand systemic risk and understand what could have been avoided, the right information must be collected to ensure regulators have the raw data to assess [systemic] risk,” says Phil Schmitt, the chairman of AIMA Canada. “If regulators can determine which factors or variables they want reported, we think it’s worth reporting.”

Schmitt points out that AIMA wants to guard the industry against being unfairly singled out by regulators for transparency, and the group wants to create a system of reporting that protects proprietary information.

Ideally, global regulators working on a global hedge fund oversight, such as the International Organization of Securities Commissions, would use a framework similar to the one adopted in the U.K.

“The information provided by hedge funds would be for the regulator’s use only — it’s not to be made public. The FSA currently has in place a system where they collect an intense amount of data daily from the 40 largest managers in the U.K. That information is absolutely not available to the public,” he says. “The Ontario Securities Commission can also audit anybody at any time. Investors should realize regulators have a lot of these powers already.”

For investment professionals who work in the space, the industry’s proactive move to increase transparency seems to be viewed as a concession that will allow hedge funds to stave off stricter regulations that threaten to diminish the effectiveness of alternative trading strategies.

“We have to ensure that regulators don’t inhibit the true benefits that hedge funds can offer,” says Aaron Fennell, a CFA and commodities futures trader with MF Global Canada. “Hedge funds are the only way that sophisticated trading strategies can happen in the financial environment. Most mutual funds and banks and financial institutions are restricted in the types of trading systems they can employ.”

At the same time, Fennell says there is recognition by investors that transparency needs to be improved.

“If you go back and look at what caused the big hedge fund scandals, it really comes down to an issue of transparency. It’s not an issue of the methods of trading that are employed; it’s an issue of there being something wrong and hedge funds not being opened up for investors to see that,” he says. “Had the regulators had a better view of exactly what Madoff was doing, they would have seen he wasn’t doing anything — he was just spending the money. In the case of Amaranth, Brian Hunter, the trader there, took a position that was the equivalent of 100,000 natural gas contracts. That was way outside of their risk management parameters they’d expressed to the industry. It was also outside the limits of what an exchange traded futures contract would have allowed.”

Too much frequent disclosure, especially if it was made widely available, would effectively kill the hedge fund industry, Fennell believes. He suspects the market would manipulate the sectors and positions that large hedge funds were invested in if they had the daily trade data.

“You would run into serious problems if they had to disclose their positions to the general public because the market would use the information against that hedge fund,” he says. “Maybe regulators can look at some sort of disclosure after the fact, such as a quarterly report of the types of positions funds hold or perhaps the regulators could institute some parameters or size limits on the particular hedge fund strategies.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com
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