A helping hand?

As pension funds and other investors become more au fait with hedge funds, an increasing number of fund of hedge fund groups offer advisory services on top of their off-the-shelf and bespoke products.

If you don't want our mainstream product, so the marketing push goes, we can create a portfolio just for you, or help you with due diligence, manager selection and ongoing monitoring.

The FSA will not look to broaden the horizon of its legal remit by seeking to regulate institutional investment advisors. However, this area of the industry has been highlighted as a potential conflict of interest by Hedge Funds Review, as FoHF groups launch advisory services, and some consultants plan funds of hedge funds.

An 'advisor' is broadening in definition over time. It can be a consultant advisor offering pension funds and others advice on which hedge fund to invest in. Increasingly such consultant advisors are also running FoHFs.

The issues thrown up by those with a foot in each camp are many and complex, but mainly revolve around uncertainty, conflict and, perhaps in the future, litigation over which side of the advisory/fund management business is given priority when sought-after but finite capacity in single funds becomes available.

One suspicion is that the established fund management business will be seen as the group's core, and its priority, with clients on this side benefiting from the capacity at the expense of advisory clients such as pension funds. It is in FoHF groups' interest to offer off-the-shelf and bespoke advice, in case pensions opt for one but not the other. But, inevitably, conflicts arise.

The idea that 'Chinese walls' within FoHF/advisory groups create a level playing field for the two sides of the business and their clients to compete fairly for the business is regarded by many as a nonsense. In any case, each side of the firm, in a world such as that of hedge funds, would hear independently who is opening soon and how much headroom is on offer.

Added to this tangled web, in some instances, is a case of a director at the group having his own wealth tied in one of the group's own FoHFs, normally demanded by end-investors for its perceived benefits of aligning the manager's interests with those of the investor. In such an instance, who would bet against that fund getting first refusal on any reputable fund capacity?

Regulated firms running long-only funds and general investment banking will have set procedures following regulation for who gets what, when. Not necessarily so with hedge funds, but investor pressure may lead to more policy documents from FoHF groups in the future. This will be a welcome thing.

hard marketing

Similar issues arise when a group markets third-party funds to clients. Even with the best intentions, such a firm that did not invest in, or withdrew investment from that fund itself, might incur the displeasure of clients if performance is poor. Or divested, for whatever reason, just before liquidation...

The first line of defence against such conflicts is the financial nous of the sophisticated investor, and his or her ability to ask questions to reveal where conflicts lurk. Anecdotal evidence suggests investors - institutional and individuals alike - are becoming increasingly sophisticated, as more and more gain first-hand experience of the industry.

This is set to continue, and with luck will play a role in reducing the threats posed by the industry's less reputable bodies. As a result, companies that do not neutralise such conflicts will suffer.

Others who may suffer as more investors look for more oversight are those who do not register with regulatory authorities.

As 2005 heads to its close, ushering in the era of SEC registration for many hedge funds from 1 Jaunary 2006, the topic of regulation is not far from our minds. Funds domiciled and managed beyond US soil will find themselves under the eye of America's regulator, while those in the UK may feel more scrutiny from the FSA, which last month established its own hedge funds unit.

Refco's meltdown will doubtless lead to calls for increased regulation. The FSA so far has declined to comment on Refco's fate. However, Refco Capital Markets, the unregulated subsidiary of Refco that quickly became insolvent after the whistle had been blown on its chairman, Phillip Bennet, is domiciled in Bermuda, so it may be the Bermuda Monetary Authority that will face the questions.

However, the key question is what regulation will help to eradicate cases like this in the future? Legislating against something is no guarantee it will not happen. Just as the SEC registering hedge funds will not prevent some of the world's 8,000 being run by charlatans, and just as making theft a punishable offence would not eradicate burglary. Regulators would do well to be careful in considering what the appropriate response to the scandal is.