The EU and the hedge funds: the vendetta goes on

May 24, 2010

You might have thought that, with the Eurozone in turmoil, the EU would have its hands too full to pursue its vendetta against hedge funds.

Far from it, the latest proposals are even more wide-ranging than most observers anticipated, involving the establishment of a Europe-wide regulatory authority with the power (presumably) to dictate to the FSA how to police the UK financial sector, restricting the ability of hedge-funds based outside Europe to sell inside Europe and making it hard for European investors to invest in the rest of the world’s so-called alternative investment vehicles.

Although the proposals are aimed squarely at ending the predominance of London as a financial centre, the collateral damage will threaten every investor, pension fund contributor or life insurance buyer, and ultimately every taxpayer throughout the whole of Europe.

The proposals represent a major expansion of the power of the EU’s unelected and unaccountable bureaucracy and a commensurate reduction in the freedom of European investors, whether institutional or private. It is dispiriting to see how casually the EU can limit the right of investors to choose how and where to allocate their own funds. It is not as if there is any need for investor protection.

On the whole, hedge funds have not performed particularly well, and certainly not well enough to justify their high management fees. In particular, having failed to deliver on their promise to insulate their investors from loss in bear markets, several thousand have probably gone out of business in the last three years.

But their losses have fallen entirely on the shoulders of their investors, who are exclusively high net worth individuals or institutions themselves, costing taxpayers absolutely nothing. Moreover, while unspectacular, the performance of hedge funds has not been noticeably worse than the results achieved by more traditional collective investments, which have been left untouched – indeed favoured – by these proposals.

As for the restrictions preventing hedge funds from basing themselves wherever the tax and regulatory regime are most amenable, the net outcome is likely to be an alternative investment industry shorn of its hundreds of small funds and instead dominated by a handful of Too Big To Fail behemoths.

In other words, while the hedge funds pose no systemic risk at the moment, these proposals could well make them a threat in the future, if the burden of compliance is increased to the point where only the largest can bear the cost of operating in Europe.

The inconvenient truth is that, much as commentators and (especially) politicians pointed to the hedge funds as an accident waiting to happen, when the subprime storm actually arrived, its epicentre was in the mainstream banks, not the so-called alternative investment sector.

The big problems were squarely located in the large investment banks in the U.S. – notably Lehman Brothers and Bear Stearns – and in those UK high-street banks which had been acting like investment banks.

In fact, some of the earliest signs of trouble appeared in Germany’s own regional savings banks which had been behaving with all the recklessness of an old maid at an all-night rave, with predictable results.
Nor can the hedge funds be said to have played a major role in the euro’s crisis.

The Greek bail-out is unavoidable because of the implications of default for the major European commercial banks – in other words, it is a bank bailout in all but name. The hedge funds played no part in creating Greece’s budget deficit nor in concealing its true scale. Their only contribution (if any) was in announcing through the credit default swaps market that Greece was insolvent.

The EU’s vindictiveness is explained by the fact that, although the hedge funds are only bit-part players, their walk-on role often involves delivering bad news – hence the short-selling restrictions following only hours after the publication of the hedge funds proposals. The knee-jerk response of populist politicians to shoot the messenger is deplorably immature.

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