The European Union’s Markets in Financial Instruments Directive, which took effect on Thursday, could end up harming the interests of the investors it is supposed to protect, according to
The European Union’s Markets in Financial Instruments Directive, which took effect on Thursday, could end up harming the interests of the investors it is supposed to protect, according to John Godden, chief executive of hedge fund consultancy IGS Group.
The extra costs entailed by the legislation are likely to boost the polarisation of the industry between big and small players, he says, while the new liabilities associated with the dissemination of information are likely to strengthen an existing shift to a more conservative and risk-averse mindset, he believes.
Godden sees a significant change in the relationship between hedge funds and their investors. ‘Up to now most investors in hedge funds have been naturally deemed to be professional investors possessing all the necessary skills in areas such as risk monitoring and risk management,’ he says. ‘The standards which hedge funds needed to apply to their marketing process were at the lower end of the scale, because a great deal of the liability remained with the investor.
‘With the hedge fund world still dominated by relatively small boutiques with two or three traders and a handful of operations staff, a lot of marketing functions are outsourced to third-party agencies. Before MiFID, third-party marketers could take the information given to them by the management company and transmit it to potential investors, but this can’t happen any more. Third-party agencies must now undertake rigorous examination of the information they are given. There’s a big change in standards for information flow, but more importantly in liability.’
This, Godden says, will require a significant step-up in resources for hedge fund marketing operations and/or third-party firms, and either way managers will bear the cost. For instance, under MiFID investment firms must formally recategorise not only their client relationships through a formal exchange of correspondence, but relationships with providers of services such as administration, custody, marketing and advisory.
‘There must be a formal written acknowledgement by both sides of what that relationship is,’ Godden says. ‘For instance, we are receiving letters from everyone we are advising, pointing out what our responsibilities and liabilities are, and we need to respond in a formal fashion. It’s a huge amount of paperwork.
‘Long-only investments have been marketed along these lines for a long time, but now hedge funds are having to step into the standardised world. Even if you’re marketing offshore hedge funds, if you’re doing so to financial institutions within the European Union you are now subject to MiFID and to standards of procedure and information accuracy on your own account, not just relying on a third party to do it.’
The impact of these changes, he says, will be lower profitability in the short to medium term, and higher barriers to entry in the medium to long term. ‘This has been happening already for various other reasons,’ Godden says. ‘I was discussing recently how difficult it is to be a USD250m to USD300m fund of funds today, and this is yet one more issue they have to wrestle with.
‘If you’re a sub-USD1bn hedge fund or fund of funds, your revenues are probably insufficient to maintain the infrastructure you need. You will need at least a couple of people in the middle and back office, and these are not GBP30,000 a year people. There will also be additional legal and compliance advisory fees for the hedge fund community to bear, and it will lead to further polarisation between big and small players.’
Godden also believes the result will be to increase the conservatism of hedge funds. ‘In the past few years we’ve seen hedge funds underperform because this big wave of institutional money coming on board has forced to be more conservative than in the past,’ he says. ‘Now, these increased liabilities and higher operational standards are set to make people more conservative still.
‘At the bottom end that might avoid a few blow-ups, but that seems more a US than a European problem anyway. At the top end it may take some of the edge off the industry. Hedge funds were originally designed to be fairly free in what they were trying to do – the only rules were those set by the investors, and the priority was keeping them happy. Now you have the regulators stepping in, which may not always be in the investors’ best interests. Removing all risk is something they may not like.’
At the same time, MiFID will probably bring some benefits for the industry, Godden concedes. ‘The liability shift may make people a little more careful from an operational perspective,’ he says. ‘In the past the industry may have been a little patchy in terms of standards of reporting. There are sometimes questions about how much reliance an investor can place on the stream of data a hedge fund or fund of funds is giving them.
‘While most managers provide a proper and honest representation of what’s gone on, there has been reporting that’s not been up to standard. For instance, we’ve seen calculations of Sharpe ratios that have been wrong, through naïveté rather than misrepresentation. Forcing the industry to take more care in that area is a good thing.’
