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New York—The standards outlined by the Hedge Fund Working Group in its recent consultation paper illustrate a principles based approach to best practice consistent with the group’s London base.  From a research perspective, the salient topics in the paper relate to disclosure relating to investment strategy.  From a broader perspective, the HFWG’s proactive approach to disclosure is beneficial to markets, especially if it successfully wards off more prescriptive regulatory measures.

The HFWG, comprised of 14 prominent UK hedge funds, released a consultation paper last week outlining proposed best practices.   In part prompted by this summer’s liquidity crisis, the primary focus is on financial stability, with recommendations relating to valuation, risk management, and fund governance.  The HFWG is soliciting comments from other hedge funds and interested parties through December, and plans to publish final recommendations in January. 

The HFWG was formed in June of this year, partly in response to pressure from Germany and the European Central Bank to increase regulation of hedge funds.  The HFWG was reportedly organized by Marshall Wace, a successful UK hedge fund with an estimated $12 billion in assets under management.  The HFWG is headed by Sir Andrew Large, former deputy governor of the Bank of England, who is also chairman of Marshall Wace’s Tops fund, the fund that extracts ‘best ideas’ from over 230 research sources.

One of the key elements of the proposals is a principles based approach.  The paper cites the FSA’s 11 principles (including integrity, customers’ interests, etc.) and links each recommendation back to specific FSA principles.  Although the working group is UK based, and thus potential subject to the FSA, there is a broader logic to such an approach, which would clearly be more appealing to the global community of hedge funds than the typically prescriptive approaches taken by US regulators.  Nevertheless, whether the working paper finds any traction with smaller hedge funds, or non-US hedge funds is unclear, and will depend on the reaction of large hedge fund investors and how real the regulatory threats are.

The 104-page document is split into two parts—a general discussion of hedge fund governance and transparency and specific recommendations.  The issues are grouped into four categories: 1) disclosure of investment policy, risk and commercial terms; 2) valuation; 3) risk; and 4) activism.  The choice of these topics predated the bankruptcy of Bear Stearns mortgage funds, but their failure underlines the timeliness of the HFWG’s recommendations.

Understandably, there is little in the consultation relating to research, nor should there be.  Research is appropriately part of the ‘secret sauce’ for hedge funds.  One of the reasons for hedge fund success has been their consistent search for new and innovative sources of research, which is evidenced in the proliferation of differentiated forms of alternative research.  Perhaps most germane for the research community is the HFWG approach—focusing on disclosure and best practices, which resonates with many of the regulatory issues facing research and commission transparency.

The full report can be viewed at http://www.hfwg.co.uk/?section=10365