From Mr David Shubotham
Sir, At a time when the financial system is being subjected to much scrutiny, it may be appropriate to comment on some aspects of the rapidly growing hedge fund industry that cause me concern. Although risk warnings appear in prospectuses and hedge fund operations are clearly described, are investors truly aware of the potential pitfalls lurking in many of these funds?
Each hedge fund is the subject of one or more prime brokerage agreements. These documents frequently run to more than 100 pages and are rarely fully understood, even by the professional investor community.
Prime brokerage agreements frequently permit the prime broker to access the assets of a fund and effectively remove the segregation of these assets and put them on the balance sheet of the prime broker.
This rehypothecation of assets, when it occurs, results in the assets of the fund being exposed to the credit worthiness of the prime broker. The shareholder in the fund seldom knows on a day-to-day basis the extent of this operation, and in my view the risks far outweigh any rewards.
Because the industry has expanded so rapidly and fund managers are anxious to establish their funds as quickly as possible, they are forced to accept the terms of the larger institutions that offer these prime brokerage agreements. Even among regulators there is some evidence that competitive pressures between the jurisdictions has forced the acceptance of less than full segregation of assets among many hedge funds.
In the matter of net asset value calculation, the emergence of many, previously boutique style, administrators seems to have led to extraordinary norms. Recently I have observed a cross-section of hedge funds and administrative groups that do not provide NAVs on their funds until T+20 (T being transaction day) and beyond. With a fund of funds this has a contagion effect so that NAV calculators stretch out up to 30 days. It is difficult to explain, and yet I am aware of at least one large administrative group that can calculate the NAV on T+1.
The rapid growth of the hedge fund industry is no doubt welcomed by both investors and investment managers. Nobody wishes to suppress its growth. However, in these two areas it is time that investors were given details of the risk exposure and the timeliness of NAV calculation in the annual and semi-annual accounts.
This way, investors can make an accurate assessment as between different funds and can never accuse managers of not highlighting the risks in these areas.
One significant failure of the hedge fund industry will have disastrous consequences, not just for other funds, but for the financial industry as a whole.
David ShubothamDirector, Davy Stockbrokers, Dublin 2, Republic of Ireland
Reproduced from original letter published in Financial Times