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ECB Brings Seasonal Cheer To Hedge Funds Industry

by Ulrika Lomas,, Brussels

24 December 2009

The latest December issue of the European Central Bank's (ECB) six-monthly Financial Stability Review at last brings a positive gloss on events for the hedge fund industry.

The Review stated that a general recovery of risk appetite had benefited the hedge fund sector. By end October 2009, according to the ECB, most hedge fund investment strategies had already recouped a substantial part, or even all, of the losses they suffered in 2008. Cumulative average year to date investment returns at end October 2009 of all hedge fund investment strategies had almost all signs opposite to those reported for the whole of 2008.

At the same time, after significant investor outflows in earlier quarters, the ECB preliminary estimates for the third quarter of 2009 suggested that the second quarter of 2009 possibly marked the end of sector-wide investor outflows, when institutional investors had needed to rebalance their hedge fund allocation in order to maintain their fixed percentage asset allocations.

The ECB indicated that, because in 2009 many hedge funds still remained below their high watermarks and could thus not charge incentive fees, this had also contributed to an impressive recovery in standard net of all fees returns.

The ECB found that redemption restrictions to prevent a run on hedge funds may have run their course, as all the investors who wanted to exit from their investments had probably already done so. Assets Under Management had remained stable over the past quarter.

The ECB considered that hedge funds were actually one player among many and played a relatively minor role in the credit derivatives market. Between 2006 and 2008, they had been the only net seller of credit protection that actually decreased their involvement in this asset class.

The Review mentioned the euro area long-term bond yields decline over the past six months, but, in late November 2009, the slope of the euro area yield curve remained steeper than at any point in time since the launch of the euro, due to the past declines in short-term market rates.

Intra-euro area sovereign spreads, as well as euro area sovereign CDS spreads, had narrowed further, in some cases to pre-Lehman levels, until very recently, when a few widened again, according to the Review.

The Review pointed to the continued recovery of euro area equity markets from the severe decline experienced during the financial crisis, supported by market optimism about the economic recovery and diminishing risk aversion.

Valuation measures based on price/earnings ratios using long-term trailing earnings figures suggest that the markets were not particularly overvalued, according to the ECB. However, the ECB felt that risks for stock market prices remained, in particular those associated with an economic recovery that could turn out to be weaker than expected by markets.

As is to be expected in a review of this nature, the prognosis was not all rosy, and the ECB identified that the main risks outside the euro area financial system included the possibility of:

  • Vulnerabilities being revealed in non-financial corporations' balance sheets, because of high leverage, low profitability and tight financing conditions;
  • Greater than expected household sector credit losses if unemployment rises by more than expected;
  • The surge of government indebtedness raising concerns about the sustainability of the public finances, as well as the crowding out of private investment; and
  • An adverse feed-back between the financial sector and public finances as a result of government financial system support measures, fiscal stimuli and weak economic activity.

Within the euro area financial system, important risks included the possibility of:

  • Renewed financial strains and that the recent recovery of bank profitability will not prove durable;
  • Vulnerabilities of financial institutions associated with concentrations of lending exposures to commercial property markets and to central and eastern European countries being unearthed; and
  • A setback for the recent recovery of financial markets, if macroeconomic outcomes fail to live up to optimistic expectations.

A comprehensive report in our Intelligence Report series giving a country-by-country analysis of offshore investment funds, stock exchanges and trusts, with an analysis of the US QI regime, is available in the Lowtax Library at and a description of the report can be seen at

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