UK Watchdog Says Hedge Fund Defaults Pose Minimal Systemic Risk

(July 28, 2011) — Britain’s Financial Services Authority (FSA) has said that while hedge funds are not systemically risky, the industry is gaining in influence in certain areas, suggesting a growing presence in the global convertible bond market and in the “much larger and more systemically important” interest rate and commodity derivative markets.

According to the FSA’s report published yesterday, the average fund returned 7% over six months to March 31, well above the 2% during the corresponding period before its September 2010 survey.

The watchdog’s findings are based on its most recent Hedge Fund Survey, which polled 50 investment managers with a total of $390 billion in assets under management. The watchdog estimated that the survey represented about 20% of global hedge fund industry assets under management.

“Funds’ footprint remains modest within most markets, so that current risks to financial stability through the market channel seem limited at the time of the latest surveys,” the FSA said in its report. Assets below their highwater mark have declined considerably and remain low, the report stated. According to funds surveyed in the HFS they have declined from 43% of aggregate net assets under management (NAV) in the October 2009 survey and are now less than 5%.

Furthermore, the FSA found that roughly 60% of hedge fund portfolios could now be liquidated in less than five days. The group noted: “Some potential risks to hedge funds remain, particularly if they are unable to manage a sudden withdrawal of liabilities during a stressed market environment, potentially resulting in forced asset sales. If this occurs across a number of funds or in one large highly leveraged fund, it may exacerbate pressure on market liquidity and efficient pricing…In a stressed market environment, market liquidity may deteriorate significantly and rapidly relative to the current portfolio liquidity.”

As investors continue to allocate new capital to hedge funds despite volatile markets, separate data from Hedge Fund Research — which tracks asset flows and performance figures — has shown that global hedge-fund assets rose to a record $2.04 trillion by the end of the second quarter.

Meanwhile, the firm found that investors put $30 billion of new money into hedge funds during the second quarter, down slightly from the $32 billion they added in the first quarter. The firm also noted that inflows in the first half of 2011 were in excess of $62 billion.

“Strong second-quarter inflows offset a modest performance-based asset decline,” according to a news release accompanying HFR’s second-quarter performance and flows report. “Financial markets continue to be dominated by uncertainty and volatility and investors are allocating to hedge funds, expecting…this uncertain environment to persist,” Kenneth J. Heinz, president of HFR, said in the news release.