Stick it to hedge funds, says ESMT

esmt_hedgeHedge funds pose a serious threat to investors and the financial system, and need to be regulated more not less, according to new research released today by the Berlin-based European School of Management & Technology (ESMT).

ESMT’s research, which covered 1,543 hedge funds over 10 years and was carried out in collaboration with the Rotterdam School of Management, shows that hedge fund investors typically make the age-old mistake of using past performance as a guide to the future. The research also shows for the first time that investors apply this principle to style.

Hedge fund investors systematically reward investment styles that have performed well over the previous three quarters, the ESMT research reveals, with potentially significant ramifications both for investors themselves and the financial system as a whole. Investors also tend to reward very extreme movements in style, which are often associated with the riskiest areas of hedge fund investment – giving the lie to the comforting idea that they know what they’re doing.

“Despite the perception that hedge fund investors are more sophisticated, our research suggests that this is not the case and that investors are overly reliant on yesterday’s performance,” says Guillermo Baquero, assistant professor at ESMT and one of the authors of the research. “This is particularly worrying at a style level, as investors are, in effect, moving in and out of strategies irrespective of whether they are exposing themselves to higher or inappropriate levels of risk for their needs.”

And, of course, hedge fund investors are getting less ‘sophisticated’ – and therefore more likely to cause havoc – all the time. “Given that the minimum investment thresholds for hedge fund investing have come down substantially in recent years, expanding the market and opening it up to retail investors, it is important to consider the level of risk hedge funds – and misinformed capital flows – may pose,” says Baquero.

This all being the case, ESMT is basically coming out as a fan of the much swung-at Alternative Investment Fund Managers (AIFM) directive, whose provisions, it says, “ought to be welcomed”.

In a statement that will send a chill down the spines of London hedge fund managers in particular, Baquero sets out the way forward: “We should not be scared to tighten the regulatory screw on the hedge fund industry and force considerably greater disclosure. Now is the time to discuss deep, substantial and effective regulation that will genuinely be of use to investors and protect our financial system for the future.”

Copies of the report are available from the Martha Ihlbrock, ESMT European School of Management and Technology, Schlossplatz 1, 10178 Berlin, Germany, Tel: +49 (0)30 21 231-1043, email: [email protected]

Fiona Rintoul, Editorial Director
©2010 funds europe