Could a regulatory squeeze bring about a change in the investment strategies of re/insurers? asks Maria Kielmas

They have been called the guerrillas of the investment world, the saviours of pensions and the money markets' very own Philosopher's Stone. Just over 2004 investment analysts, policymakers and regulators have attributed most of the volatilities in commodity prices and currencies to the presence or exit of the ubiquitous hedge funds. These investment vehicles have made large inroads into the catastrophe bond market as well as various reinsurance sectors. As regulators on either side of the Atlantic mull over greater regulation of hedge funds, is another Long Term Capital Management (LTCM) disaster waiting to happen?

A hedge fund is a pooled investment vehicle in high risk, and notionally high return, targets which is administered privately by professional managers and not widely available to the retail market. The funds aim to make a return on market volatility, no matter which way the market moves. Investors have been usually institutions and high net worth individuals. But fund access has now opened to individuals with over $1.5m in assets and who can invest a minimum of approximately $50,000 in one stake. Property price inflation has meant that investors now include an increasing number of average middle-class professionals, rather than the high stakes billionaire gamblers of the past. There have been moves within the European Union to broaden even further the retail side of hedge fund investments, permitting stakes as low as a few hundred euros, as is currently available in Germany. Some hedge fund managers oppose this, arguing that such individuals are in no position to understand the risks they take on. But increasingly re/insurers and pension funds are opting for the hedge fund route to boost their investment earnings. And one of the principal drivers of hedge fund growth has been US investors seeking to escape the plunging dollar.

LTCM collapse

But hedge funds not only are opaque to their own investors, they charge extremely high fees, known as performance fees and typically 25% of any return. LTCM was known in the 1990s as the "Rolls Royce" of hedge funds, with two Nobel prize-winners among its expert advisers. It charged a 2% annual fee (double the then average but today's average rate), 25% of any profits, and required a minimum investment of $10m. The fund built up accumulated assets of $125bn on a base of $4bn over four years. The Russian and Asian financial crises were the trigger for the fund's collapse. It lost 44% of its value in August 1998 alone. It was eventually baled out in September of the same years in a $3.625bn deal between the US Federal Reserve and 14 investment banks.

As hedge funds have recovered from the LTCM crash and become more popular than ever, the regulators are worried. In October 2004, William Donaldson, chairman of the US Securities and Exchange Commission (SEC) warned of a "gold rush mentality" as relatively unregulated hedge funds betting on high risk markets attract ever more money from pension funds and institutional investors. The same month Stephen Drayson, manager for wholesale investment banks at the UK's Financial Services Authority (FSA) told a London conference that the regulator is examining the potential risk from hedge funds as capital flows into them. Moody's Investment Services has warned of a "domino effect" as an increasing number of unregulated investor groups take on the same market bets. According to Moody's, the hedge fund industry ballooned to over $1trn in 2004. "There is a risk of a domino effect resulting from multiple failures of hedge funds engaged in the same directional bets," the agency said. The funds generated an estimated $7.5bn in equity-related fees alone in 2004.

Cat bonds and reinsurers

One of those directional bets over the past few years has been in catastrophe bonds. Today, hedge funds are blurring the distinction between catastrophe bonds and the traditional reinsurance market. Investor confidence has been boosted to such an extent that catastrophe bonds are now competitive in price with traditional reinsurance, noted a recent study on the market by Guy Carpenter. According to this study, total catastrophe bond issuance in 2003 was $1.73bn, a 42% increase on 2002. But this remains a minute proportion of the total world reinsurance market of some $300bn. If more investors such as hedge funds pile into the catastrophe bond market, this can only be a good thing some experts say. "I don't see any downside", says Thomas Russell, Professor of Economics at the Leavey Business School, Santa Clara University in California. "The entry of hedge funds will lower spreads and everyone will benefit. The market is going to be liquid."

Christopher McGhee, managing director of New York-based MMC Securities, thinks that the concern in the international media about hedge fund activity in the catastrophe bond market is overplayed. There continues to be a steady influx of money into this market, especially from dedicated investment funds. However, Thomas Russell can foresee one doomsday scenario. Over the past five years, hedge funds have been creating their own reinsurance entities and providing cover for some reinsurers at the top end of their modelled potential catastrophe losses. Though not quantified, some market reports have suggested that hedge funds now account for up to half of such extreme event cover on the reinsurance market. If the maximum expected loss from a Californian earthquake is say, $50bn, a reinsurer could sell a layer of $45bn to $50bn of its catastrophe cover to a hedge fund. Insured damages from Californian earthquakes have not exceeded $25bn, says Russell. But if the extreme event were to happen, and the hedge fund had insufficient assets to cover the event, the subsequent loss could travel through the entire investment chain.

Choose your return

The hedge fund/reinsurance investment partnership comes with different risks for either side. It makes sense for a reinsurer to invest some of his assets in a hedge fund to provide better returns from those available on the equities or bond markets. But for a hedge fund to become a reinsurer requires a major size and a lot of capital, says Francois-Serge Lhabitant, head of Investment Research at Kedge Capital in London. But both sides must be wary. There is little point in a reinsurer investing in an equities-based hedge fund if it has placed a large part of its assets in equities anyway. Equally, he as an investor is wary of some of the commodities-based funds because he is unable to control the risk. "For us it is extremely risky and I prefer to get a lower return," Lhabitant adds. There are lots of hedge fund opportunities in currencies and interest rates, especially in those currencies due to join the euro, where the risk is limited, he says.

Bermuda-based Max Re has had a policy of hedge fund investment since its creation nearly five years ago. As of 30 September 2004, some 30% of the company's assets were in hedge funds, says Max Re's chief financial officer Keith Hynes, though according to this domiciles regulatory limits the company can invest up to 50% of its assets in these. Max Re invests in some 50 different hedge funds but holds no more than a 5% stake in any individual fund. "Over the last four-and-three-quarter years our hedge fund portfolio was only down in the World Trade Center loss, and then it was only less than 1%", Hynes says. He adds that over the last 15 years, hedge fund returns have seriously fallen only twice; in 1994 during a period of sharply rising interest rates and in 1998 with the collapse of LTCM.

Low volatilities in the stock markets throughout 2004 have cut some hedge fund returns over the year to even less than some achieved by US mutual funds. Hedge funds have been active in the oil, copper and gold markets throughout 2004. Oil analysts argue that their presence in that market could account for as much as 30% of the spot market oil price. The private equity market has become a major hedge fund target, specifically those companies investing in oil and mineral properties. The flow of hedge fund finance has been so great that some oil and mineral companies have been able to raise money in the US and London markets from them on the back of fictitious assets.

The gathering storm

One London-based hedge fund manager says this flood of money is making the risks far worse for investors and could lead to a serious disaster within two to five years. "Investors cannot pick and choose. We have turned away more than $700m this year from investors who will now ask somewhere else until they find someone who will accept. In this kind of scramble, managers who would normally struggle to raise money can have as much as they want and average quality suffers," he says. This creates a vicious circle, he adds. While there are inflows, managers are buying more of position they already hold, raising prices, and inflating their apparent returns. "Of course, this is temporary, and when there are outflows the prices can fall very far, very fast," the manager says.

Risk management is possible, he says, but hedge funds have little incentive to do it well. If a fund makes a 20% return it pockets 4% through its performance fee. If the fund is offered a gamble where it has a 20% chance to make 80% and a 20% chance to lose 100%, they have an incentive to accept. The fund is likely to win several performance fees before it loses all of its clients' money and is kicked out of the market. Investors may be able to check for this kind of behaviour. But they need to know what to look for and the fund manager has to agree to hand over some information. Most of them won't, this manager adds.

He thinks that if all of these problems are put together, there is potential for a systemic event much bigger than the LTCM collapse in 1998. This is because it will affect a significant fraction of the hedge fund industry. The next big scandal will not be one fund, he says, but a group that has collectively come to dominate one asset class. There will be some kind of a trigger, leading to forced selling, and a spiral of falling prices and further sales.

The regulators are taking some action. In the US under new SEC rules to be adopted after Thanksgiving 2004, hedge fund managers have until February 2006 to register as investment advisers if they manage more than $25m and have 15 or more clients. They will also have to outline investment strategies, allocation of trades and the holding of fund managers. The industry grouping, the Managed Futures Association, unsuccessfully fought the changes. In the UK, the FSA is not commenting specifically about future rule changes but has been canvassing opinions from hedge fund managers.

Recent studies by the World Bank and the IMF have indicated that the hedge fund industry faces a "shakeout", or a "correction". Investors can only hope that this will not end up in disaster.

Maria Kielmas is a freelance journalist and consultant.