UN PRI says discussion over governance in hedge funds growing amid high-risk behavior and recent cases of fraud
The Principles for Responsible Investment (PRI) Initiative, the UN-backed international network of investors pushing for responsible investment, has issued a series of suggestions to help investors learn to judge hedge funds according to responsible investment principles and to help hedge funds ensure they are investing responsibly.
Controversial investment strategies such as high-frequency trading (HFT), shorting, certain derivative instruments and leverage, increased discussion over leveraging and other hedge fund practices have come under greater scrutiny since the financial crisis of 2008.
According to the PRI, this has sparked rising concern in the investor community about the sustainability of hedge fund investments. At the same time, the growing involvement of retail investors with hedge funds, added to the increasing ‘remoteness’ of hedge funds from their ultimate investors, make issues of responsible investment in these funds more urgent than ever.
‘A number of recent high-profile incidents relating to hedge funds, including a few serious frauds, have caused governance to be raised to the top of the list of concerns for hedge fund investors,’ the PRI report concludes. ‘To date, there is little consensus on the relevance of incorporating ESG information into hedge fund decisions, or how it may meaningfully apply to different hedge fund instruments and the widely divergent strategies that exist. This paper seeks to illuminate this debate and move it forward.’
To help ensure good governance in hedge funds, the PRI says investors can insist on at least enough transparency to allow them to perform due diligence, risk analysis and portfolio monitoring. The report also says short-selling ‘is an integral part of efficient and well-functioning markets’ although it suggests that hedge fund investors strive to understand the potential market implications of the strategy.
With regard to leveraging, the PRI further suggests that investors seek assurance hedge fund managers ‘have procedures in place to accurately evaluate, monitor and limit economic leverage, financial leverage, derivative exposure and counterparty risk.’
On the subject of HFT, which has been ‘accused of destabilizing markets, increasing volatility and providing only a mirage of liquidity’, the PRI notes that ‘hedge funds account for only a relatively small proportion of total HFT in the market.’ The report does suggest, however, that hedge fund investors strive to better understand HFT and its implication for hedge funds and the market as a whole.
With regard to derivative instruments such as forwards, futures, swaps and options, the PRI says hedge fund investors can educate themselves on ‘risks that might arise in extreme situations. They may also seek to ensure managers have adequate procedures to mitigate and manage these risks.’
