Hedge Funds Yet to Pass Stress Test

Complex hedge fund products may not be able to withstand an increase in market volatility, posing a threat to investors and financial market stability.

An OECD report on hedge funds says they provide a valuable role in world asset markets by providing liquidity for mispriced assets. However, it says their fastest-growing line – "structured products" – have not been adequately stress-tested.

The report, prepared by OECD's deputy director for financial affairs, Adrian Blundell-Wignall, says sales of structured products are growing rapidly in Australia. It estimates total hedge fund assets in Australia are worth US$47 billion, but says their influence is much greater, because hedge funds operate with a leverage ratio in excess of three times their assets.

Structured products seek to replicate the performance of an underlying market, while typically providing an element of capital protection. The most popular products use "constant proportion portfolio insurance", which ensures a fixed minimum return is achieved, by continuously rebalancing the portfolio between higher risk shares and lower risk bonds or cash.

"These CPPI products are difficult to understand for technical analysts, so there can be no doubt that the retail buyers of these products will not understand what they are buying."

The report says the sales promise is "very much like betting on the winner of a horse race after the race is run". It says provided volatility is normal, the level of promised return can be delivered, given a cost to the client of between 1% and 1.5%.

Over the past four years, sales of such products in the Asian region, including Australia, have grown from US$20 billion to US$100 billion.

The OECD estimates that the global size of the structured product market is about US$3.8 trillion, or about half the total size of the hedge fund industry.

The report says the structured products have helped to reduce market volatility. However, an external, sharp increase in volatility, known as a "gap event", would put them under stress.

"It is by no means clear that the CPPI and related products could cope with such a gap event, and positions would have to be closed."

The OECD says a fall in the market of 20-25% would be a major test of the hedge fund industry. The consequence for world financial stability would depend partly upon the extent to which investment banks had similar products and were forced to close positions simultaneously.

It would also depend upon the extent to which the sellers of portfolio insurance could meet their calls. "Any defaults would further accelerate the process.”

"Investment banks and hedge funds both need to be encouraged to stress-test their portfolios for an event like this, allowing for worst-case knock-on effects.”

"If the size of position closures required is a large proportion of daily trading volume, a severe liquidity crisis could emerge.”

"Investment banks in particular need to ensure that their capital remains sufficient to cover such a contingency."