Edhec sees regulation threat to institutional investment in alternatives

The ability of institutions including insurance companies and pension schemes to invest in hedge funds and other alternative investments could be threatened by a European regulatory ruling that proposes a significantly higher capital charge for alternatives than traditional equity investments, according to the Risk and Asset Management Research Centre of French business school Edhec.

Within the equity risk sub-module of the third Quantitative Impact Study undertaken by the Committee of European Insurance and Occupational Pension Supervisors, a preamble to the Solvency II supervisory standard, all alternative investments are subject to a capital charge of 45 per cent, compared with the 32 per cent charge applied to regular equity exposures.

According to Edhec, its research indicates that this level of capital charge is totally inconsistent with the real risk profile of hedge funds, which it argues are far less risky as an asset class than stock indices.

Over the past 10 years, the centre says, funds of hedge funds have an empirical downside risk with a 5 per cent confidence interval of 3.69 per cent, just one third of the level of the S&P 500's downside risk of 10.73 per cent.

Edhec believes the supervisors' committee may have been influenced by some of the most prevalent fears about hedge funds, which are often accused of contributing to systemic risk, of being a threat to the businesses they target, and of being extremely risky for private investors because of the risk of fraud and a 'bet the house' attitude.

The centre says its research demonstrates that most of these preconceptions are statistically unfounded. Overall, investing in hedge funds is generally far less risky than investing in equities.

Edhec says that unless the committee's proposed calibration is corrected, it will be practically impossible for European insurance companies to continue to invest in hedge funds. This will in turn be detrimental toward good risk management, because previous Edhec studies have shown that hedge funds could improve asset-liability management for institutional investors, especially insurance companies.

Edhec Business School, which has campuses in Lille and Nice, specialises in asset management and alternative investment research. The Edhec Risk and Asset Management Research Centre brings together 34 researchers and implements six industry-sponsored programmes focusing on asset allocation and risk management in the traditional and alternative investment universes. The centre also calculates the Edhec Alternative Indexes.

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