June 5, 2006

ECB Warns on Herd Instincts

Convergence among hedge fund strategies increases risk

LONDON (HedgeWorld.com)--Growing convergence among hedge fund investment strategies and the industry's potential to use leverage pose an "additional major risk" without "any possible remedies," the European Central Bank warns in its latest semi-annual Financial Stability Review.

Including for the first time a separate section focusing on hedge funds, the review uses Lipper TASS data and the ECB's own calculations to conclude that 25.7% of the estimated $1.5 trillion in hedge fund assets were managed from Europe at the end of 2005. Using the same sources, the review concludes that only 7.1% of fund assets are domiciled in Europe. Lipper, a unit of Reuters, is the parent company of Lipper HedgeWorld.

The concerns over correlation draw on Lipper TASS data and ECB internal research. This shows, according to the review, that "median pairwise correlation coefficients of monthly hedge fund returns within some strategies remained high and even increased in 2005."

The review noted that capacity constraints and forced liquidations prompted by investor redemptions led to further increases in correlations among convertible arbitrage funds. It also observed that correlations among long/short equity and multi-strategy funds rose significantly. The review also argues that correlation is higher than during the period immediately preceding the LTCM crisis of 1998.

The ECB, citing the Counter Party Risk Management Policy Group, noted that "crowded trades" have become one of the most significant risks to be identified and mitigated. "The fact that correlations are trending higher not only within some strategies, but also among strategies, raises concerns that a triggering event could lead to highly correlated exits across large parts of the hedge fund industry."

The ECB's concern about the possible impact of the hedge funds on the global financial system contrasts with the less-alarmist approach to the industry of other financial authorities. The International Monetary Fund and the Bank of England, for example, have emphasized the utility of short-selling to preserve market stability, while acknowledging that hedge funds can incur risks.

The central bank's expanded analysis of hedge funds follows a proposal in May by Germany's Bundesbank for a cross-border system of enhanced self-regulation. The system would include public grading of hedge funds by ratings agencies and a code of conduct.

From a medium-term view, the ECB says the widening imbalances in the U.S. economy on trade and fiscal policy pose the biggest risks to financial stability. Further down the table of risk, the ECB says a disruptive asset price adjustment "could also be triggered by other financial sector shocks, such as the possibility of an idiosyncratic collapse of a key hedge fund or a cluster of smaller funds, fraud, adverse geopolitical news or an avian influenza pandemic."

The ECB says, overall, that the hedge fund sector has benefited from the global search for higher yield. It adds: "This also raises the risk that hedge fund managers may have underestimated investor redemption risk arising from global financial conditions that is not so apparent at the level of individual hedge funds."

To view the section on hedge funds in the Financial Stability Review please go to: http://www.ecb.int/pub/pdf/other/financialstabilityreview200606en.pdf (pp. 134?? 1/2 142).

BMcIntosh@HedgeWorld.com

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