Ryan Speaks At World Hedge Fund Forum

by Glen Shapiro, LawAndTax-News.com, New York

08 March 2007

US Treasury Assistant Secretary for Financial Markets, Anthony Ryan on Tuesday delivered a speech at the World Hedge Fund Forum in Connecticut, discussing hedge funds, their contributions and impact on capital markets.

The speech followed the release late last month by the President's Working Group on Financial Markets (PWG) of a set of principles and guidelines designed to guide US financial regulators as they address public policy issues associated with the rapid growth of private pools of capital, including hedge funds.

The principles are intended to reinforce the significant progress that has been made since the PWG last issued a report on hedge funds in 1999 and to encourage continued efforts along those same lines. The stated goals include:

• Private Pools of Capital: maintain and enhance information, valuation, and risk management systems to provide market participants with accurate, sufficient, and timely information.
• Investors: consider the suitability of investments in a private pool in light of investment objectives, risk tolerances, and the principle of portfolio diversification.
• Counterparties and Creditors: commit sufficient resources to maintain and enhance risk management practices.
• Regulators and Supervisors: work together to communicate and use authority to ensure that supervisory expectations regarding counterparty risk management practices and market integrity are met.

Speaking with regard to the new rules, My Ryan explained to those attending the Forum that:

"As policymakers, we do not view hedge funds as an asset class or as an industry. Rather, a hedge fund is a business model that asset managers have adopted to manage capital. The objective of the business model is to attract and grow capital, generating superior returns through a defined investment strategy. It is too simplistic to measure success for a hedge fund by using a single metric. But if we were to do so, we might measure the greatest absolute return for a given amount of risk as measured by volatility."

"If indeed maximizing return to risk is what a hedge fund manager is trying to do, how does one go about doing so? While there are many variations, successful hedge fund managers often have four elements in common: vested stakeholders, a well-defined philosophy, a well-executed process, and a commitment to ongoing evaluation."

"First are "vested" stakeholders. In addition to investors, who are obviously impacted by the hedge fund's return, the business model is explicitly geared to vest the manager's success to that of his or her clients. So, the stakeholders also include the fund's analysts, portfolio managers, traders and operations professionals."

"Second is a well-defined philosophy. Successful hedge fund managers have clearly established beliefs on how capital markets operate and how their strategies can generate superior returns. They also possess clear policies that define how they'll communicate and interact with their investors and counterparties, and how they'll address potential conflicts of interests."

"Third is a well-executed process. Successful managers have a framework. Their approach may be flexible, but it is based on sound principles, guidelines and rules enabling the manager to respond to dynamic market conditions in a disciplined fashion."

"Fourth is a commitment to ongoing evaluation. The most successful managers prove to be those who continually enhance their capabilities, systems and resources."

He continued:

"The objectives and framework I just outlined for defining successful hedge fund managers also serves as an interesting analogy to the broader issue of how the policymakers and regulators, comprising the President's Working Group on Financial Markets (PWG), define and evaluate our objectives regarding hedge fund policy...Broadly speaking, the objective is the same for both the hedge fund manager and the PWG. It comes down to enhancing rewards and mitigating risks. For the hedge fund manager, it is about having the highest return relative to risk; for the PWG, the highest benefit relative to cost."

In its guidance, Mr Ryan revealed, the PWG stated that, for more sophisticated investors, private pools of capital can be an appropriate investment vehicle. Hedge funds offer potential benefits to investors, including the opportunity to diversify their portfolios, as some hedge fund strategies have only modest correlations to traditional asset classes. In addition to diversification, these vehicles may offer investors the opportunity for potentially higher returns.

He observed that:

"Like any investment, these strategies also introduce risks. These risks range beyond volatility to opacity and complicated valuation and performance calculations. Investors need to evaluate the appropriateness of such investments. The risks associated with direct investment in these funds are most appropriately borne by investors with the sophistication to identify, analyze and bear these risks. As with all investment products, clear and meaningful disclosure is essential for investors to properly evaluate their investment decisions."

"Historically, those who invested in hedge funds were high net worth individuals. This has changed over the past five years and today the majority of assets in hedge funds belong to institutional investors, including endowments and pension plans. The PWG established that concerns about indirect exposure of less sophisticated investors to hedge funds through holdings of pension funds, fund-of-funds, or other similar investment vehicles can best be addressed through sound practices on the part of the fiduciaries who oversee such vehicles. Fiduciaries have an ongoing responsibility to perform due diligence. They must continually ensure that their investment decisions are prudent and conform to sound practices, including diversification."

"The PWG was also specific in prescribing guidelines for hedge fund managers. Hedge funds as a group have grown substantially over the past five years. They have doubled in number and have had a significant influence globally, and even locally. These deployers of capital exist in large financial services companies and in small boutiques; some are diversified across multiple strategies, others manage concentrated portfolios."

Mr Ryan continued:

"Their growth in number is a testament to the potential rewards that exist. The model creates the opportunity for managers to implement their best investment ideas. It also encourages and incentivizes managers to do so, often with few constraints. They have more flexibility across asset classes and sectors and are not held to an arbitrary benchmark. This flexibility enables managers to focus and take risks based on their specific skill. And if that were not enough, the financial rewards for success are great. Compensation of "2 and 20" can generate a lot of income on even a modest amount of assets under management. But, again there are risks. Besides the challenges associated with investing, including liquidity risk, credit risk and trading risk--there are others, including operational risk, valuation risk, reputation risk, and regulatory risk."

"In response to these challenges, managers should deploy sufficient resources to create and maintain information, valuation, and risk management systems that meet sound industry practices. In doing so, managers should provide accurate and material information to creditors, counterparties, and investors with appropriate frequency, breadth, and detail. Managers should also continue to strengthen and enhance their processing, clearing, and settlement arrangements, particularly for OTC derivatives."

He went on to state that:

"The PWG principles and guidelines address all market participants. Our focus is on enhancing market discipline since it is a combination of efforts that will most effectively address systemic risk. Here it makes sense to emphasize that, for financial stability purposes, the interests of policy makers and key counterparties are closely correlated. Thus, when these counterparties make appropriate self-interested assessments and decisions, these decisions help to make our system more stable and resilient."

"The combination of market discipline and existing regulatory authorities are well positioned to protect investors. The SEC continues to provide strong leadership on this issue. They have proposed raising the accredited investor standard, and already possess broad anti-fraud and anti-manipulation authority to investigate any manager--whether registered or not. I should add that the SEC is proposing an additional anti-fraud provision under its existing authority with respect to defrauding current or prospective investors."

"Tackling these issues is complicated. No group has a greater interest, has spent more time evaluating all of the potential options, or is more concerned with addressing the challenges most effectively, than the PWG. If the solution were as simple as granting additional regulatory authority, regulators would have certainly asked for it. The fact of the matter is--at this time, no regulator feels that it needs additional regulatory authority to achieve its goals of protecting investors or mitigating systemic risk."

In conclusion, the Assistant Secretary for Financial Markets announced that:

"While the challenges are real, we believe that implementing a coherent set of best practices is the best way to address them. All stakeholders must be accountable to ensure the integrity of our capital markets. Successful capital markets generate investor confidence."

"Investors, because they entrust their capital, deserve protection from fraud and manipulation. They expect nothing more, and should accept nothing less. Potential systemic risks must be identified and mitigated. High-quality standards of excellence must be established, implemented and continually enhanced by all market participants. Transparency matters and timely disclosure of information is critical. Competition is beneficial. In fact, we seek to encourage competition--but we will not tolerate anyone seeking to gain an unfair advantage by compromising the trust and integrity of the market."

"It is a privilege to work to ensure the vitality of our capital markets. With such a privilege comes responsibility. To achieve our goals we need to recognize that the responsibility is borne by both the private and public sectors. Building upon the efforts to date, all stakeholders must continue to do more. Collectively, we can strengthen the stability and integrity of our capital markets. The system works when all stakeholders recognize the benefits, mitigate the risks, and choose to be diligent. I urge you to do so."

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