Hedge fund group proposes tighter liquidity and anti-fraud rules

Hedge fund managers should use independent administrators to prevent fraud, and should impose limits on redemption requests, the Hedge Fund Standards Board (HFSB) recommended on July 1.

The London-based HFSB said recent cases of fraud and mismanagement, including the Bernard Madoff fraud, meant independent oversight of fund administration had become vital. Without it, "concerns could arise about the risk of fraud by the manager, such as misrepresentation of assets (overstating the value of the portfolio) or even misappropriation of assets (cash, securities). Usually, the smaller an organisation and the fewer people involved in such activities, the larger the risk of such fraud."

As well as a separate prime broker, in charge of transaction processing and asset custody, hedge fund managers should use independent valuation and an independent administrator, responsible for calculating the net asset value and fees, the HFSB said.

The board also highlighted the damage done to the industry by sudden drops in liquidity: high-liquidity funds which do not restrict redemption requests suffer particularly badly when investors are panicked into seeking liquidity, and "might eventually go out of business even despite good performance".

The current rules also create an incentive to panic: "In the current environment, non-redeeming investors may fear being left with the illiquid remainders of a portfolio, while redeeming investors are paid off from the proceeds of the sale of the liquid portions of a portfolio," the HFSB said.

Thirdly, fund investors have been taking advantage of notice periods by filing redemption requests and then revoking them, essentially gaining a free option to redeem at the expense of fund performance, which suffers as the manager is forced to prepare for the redemption by selling off assets.

It suggested funds invested in potentially illiquid assets should generally have restrictions around redemptions to prevent unfair treatment, and investors should pay a fee for revoking a redemption request. Both suggestions would improve the industry's overall performance, the board said, adding that fund managers should disclose detailed information about their redemption policies - a change which it admitted "would place more onerous disclosure requirements on managers regarding possible restrictions on withdrawals".

Both proposals are open for comments until August 21.

See also: Iosco recommends compulsory registration of hedge funds
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