

	April 18, 2006 js-4187 Remarks of Treasury Assistant Secretary for Financial Institutions Emil Henry to the Federal Reserve Bank of Atlanta Thanks for that kind introduction, and I very much appreciate the chance to speak at this important conference. Before joining the Bush administration, I was Chairman and Co-Founder of an asset management business. We invested in many so-called `alternatives' including hedge funds, private equity, private mezzanine debt, and venture capital. I would like to speak with you today about a few trends I have observed in the hedge fund space. LIFE CYCLE OF ALTERNATIVE INVESTMENT CAPITAL Since the coming of age of alternative investments in the latter half of the 20^th century, for each of the major alternative segments--venture capital, real estate, private equity and, most recently, hedge funds--there has been an identical pattern of capital accumulation within each of these investment strategies. The progression has been as follows: The first investors to gravitate towards any alternative strategy--to show up to the proverbial `party', if you will--are high net worth investors. Unlike institutional investors, the wealthy investing class tend to make quicker investment decisions, they lack institutional risk aversion, they are often comfortable making investment decisions with little or no due diligence other than, say, the reference of a good friend. For an individual, there is typically little consideration given to so-called "headline" risk--the risk of embarrassment that can engulf an institution and lead to job loss from investing with a fund that ends up on the front page due to fraud or incompetence. When the wealthy investment class arrive at the `party', the buffet is full, the bar is well provisioned, and everyone is on their best behavior in eager anticipation of the festivities to follow. The second investor class is typically the endowment community. Endowments tend to follow the wealthy investor class because endowments' trustees, as you know, are the very same high net worth individuals who are already participating in the festivities. These trustees often bring real-time experience and recommendations to the investment process. When endowments show up to the party, the buffet table is still well provisioned, the host is still pouring champagne, and no one has yet to make a fool of themselves! Next to the party are corporate pension funds. Because of their institutional risk aversion and inertia, they require full validation of an investment space before getting involved. The risk of being wrong (losing money) and the potential for that headline risk simply eclipse the incentive to deliver excess return or alpha that might present itself in an alternative asset. Furthering my now strained and tedious party analogy, for corporate pension funds to head to the dance floor, the festivities must be in full tilt (the room must be full), there must be a track record of fun by many party-goers for many years, and a party advisor (otherwise known as "the consultant") must write the pension fund a full and thorough report about what a great party it is indeed. At this point, the party appears to be in full regalia, but, upon closer inspection, some early participants are leaving. They will get home safely. The premier offerings from the buffet are gone, but a hearty meal still remains. A few of the remaining revelers--exuding confidence and appearing bulletproof--are, in reality, no longer exercising their best judgment. The next to arrive are public pension funds. These are the most conservative, institutionally rigid investors. By the time these folks come to the party, most that remains of the buffet have been passed on by others. Questionable judgments are likely being made at this time. Right now, hedge funds receive capital from all these sources. We are at the stage where corporate pension funds are finding the space in droves. So, and I promise this is my last party analogy, what brought the corporate pensions to the party? Pensions were attracted to the space through the most unlikely of circumstances: when the equity markets suffered an unprecedented 3-year decline--2000-2002--that decline was thought by many to be the event that would `unclothe' the legions of newly-minted hedge fund stars and lead to the demise of hedge funds, or at least curtail their growth. One theory was that all the leverage in the system would amplify returns negatively in the downdraft in mirror fashion to the updraft of the ebullient equity markets of the latter 1990s. Indeed the opposite happened. It turned out that those institutions that were most heavily allocated to hedge funds turned in the best risk-adjusted returns. Some of the most forward thinking endowments, for example, had significant hedge fund exposure--on the order of 20-25% of assets--and turned in terrific results. They did not shoot the lights out, but just by posting positive performance in a time of such wrenching dislocation, they made clear the possibilities of hedge funds. Their hedge fund managers generated return by exploiting their natural ability to short stocks and, importantly, by moving to cash thereby limiting exposure and mitigating loss. Pension funds, by contrast, with traditional stock and bond exposures suffered greatly. The stark contrast of the endowment experience with the pension experience put a white hot light on the protection ostensibly afforded by hedge funds. And pension interest grew tremendously. So, with a continuing wave of capital still expected from the pension community, there are some questions now worth pondering: What risks are presented because of this development? Are our pensions and pensioners well served by such flows of capital? Do expected returns in the space warrant the attendant risks? Regarding systemic risks, I am of the view that-- as we sit here today--broadly speaking, there is less systemic risk in the hedge fund space than is generally perceived, and that such risk is really isolated in a few specific areas--areas which I will address in a moment. (One caveat: the pace of change is obviously so great that it would be folly not to acknowledge that new systemic risks might present themselves at any moment.) And why do I feel this way? For several reasons, but mostly related to the evolving institutionalization of the hedge funds business. INSTITUTIONALIZATION OF HEDGE FUNDS One of the natural outgrowths of institutional capital pouring into an asset class is the simultaneous institutionalization of the underlying investment businesses operated by investment managers accepting such capital. Investment organizations adjust their businesses in order to accommodate the demands of their investors. Pension funds demand institutional quality oversight of their capital. So, with increased investment from institutions, there is much to give us comfort that the business of hedge funds has been institutionalizing in response. And such institutionalization has served to mitigate risk on many levels. In fact, the shock and dislocation associated with the notorious demise of LTCM served as a catalyst for the institutionalization of the industry. Following LTCM's implosion, counterparties became much more disciplined about the extension of leverage and collateral requirements; In the past few years, capital has become much more reluctant to seed the proverbial "three guys in a garage" (You may remember that at the turn of the century, it was not uncommon for a 30-year old with perhaps 4 or 5 years of real experience to open his doors for business and be flooded with a billion dollars of capital on day one. Thankfully, this rarely happens today.); Investors now demand more transparency--so much so that debate among institutional investors is not whether transparency is necessary, but instead over the extent and value of such transparency. For example, some investors are comfortable with regular risk reports (delivered monthly, for example) while some argue that tick-by-tick, internet-enabled transparency is more useful. You may recall that LTCM principals provided little, if any transparency. There is now a profound recognition among hedge fund professionals that liquidity is indeed king and that in its absence all bets might be directional; Lastly, investors now recognize the infrastructure requirements of many of the arbitrage strategies and demand to see appropriate supporting infrastructure before committing capital. Such institutionalization has brought with it the broad recognition that the industry is now widely segmented among different strategies employing different securities across different markets. Thus, the industry is actually comprised of many sub-industries, with separate and distinct pockets of risk. I have found that a number of policymakers talk of the $1 trillion of unlevered hedge fund capital under management as if such sheer size constitutes one clearly-defined pool of risk. This is an oversimplification of the asset class. Risk is actually segregated across many strategies, each with its own risk profile. For example, long/short equity is a huge piece of the hedge fund space. It has been reported that about half of all hedge fund capital is deployed in long/short equity strategies. Such strategies have a natural risk manager premised in Regulation T which, as you know, limits the amount of leverage that can be used. The remaining hedge fund capital resides in silos across a number of separate and distinct strategies including convertible arbitrage, distressed debt, macro, and fixed-income. Each strategy carries its own set of risks that cannot simply be compared to the risks of other strategies. Each strategy can prudently withstand different levels of leverage. Each strategy has a different time horizon for investment and varying levels of volatility. And each strategy requires a different approach to make money on the short side implying further distinct types of risk. There are many multi-strategy hedge funds that traffic among many of these silos, yet, like all businesses that mature and institutionalize, there is increasing specialization of strategy, and such specialization further segments the industry of hedge funds which further leads to a `siloing' of risk. FUNDS OF FUNDS The growth of the private fund of funds industry has hastened the institutionalization of the hedge fund industry in so many ways. Funds of funds, of course, pool investor capital and invest in a number of hedge funds, often targeting a specific return objective and risk profile. Funds of funds are often the vehicle through which large pension funds make their first hedge fund allocation. The fund of funds typically offers pensions: diversification a chance to 'get one's feet wet' in a complex industry (many pension investors invest in a fund of funds in part to get up the hedge fund learning curve with the view that, after such education, they might invest direct with hedge funds rather than through a fund of funds); access to individual hedge funds that are closed to the broader investment community but where the Fund of Funds has negotiated capacity; the avoidance of headline risk (it is a fund of funds' job to avoid bad investments but, even when they do lose money via fraud or incompetence, the effects of such implosions aren't felt so directly due to the inherent diversification typically associated with a fund of funds); a tailored strategy (long/short equity vs. arbitrage strategies, low volatility vs. high volatility strategies, low leverage vs. high, etc), and most importantly: Outsourced risk management. On this last point--outsourced risk management--it is hard to overstate the impact on institutionalization that the risk management function of fund of funds has had on the industry. Consider the impact on risk mitigation of the following. These are some typical demands that funds of funds place upon a typical underlying hedge fund: The hedge fund must subject itself to the highest level of scrutiny of its business and of its principals: background checks, track record verification, infrastructure analysis, review of prime broker relationships, comparison of portfolio with custody accounts, etc. The hedge fund must exhibit a documented risk management strategy to which it is expected to adhere or be fired: targeted gross and net exposures, stop-loss guidelines, concentration and diversification limits, expected sector exposures, etc. The hedge fund must provide to the fund of funds detailed monthly risk reports including transparency on leverage, gross and net exposure, performance attribution, industry exposures, top ten positions, adherence to the risk management strategy, etc The hedge fund must agree to provide weekly telephonic estimates of NAV, quarterly detailed conference calls on strategy, and annual face to face visits. The hedge fund must agree to provide transparency to the portfolio level upon demand. Needless to say, these requirements define institutionalization and have the positive effect of mitigating risk--individually and systemically. There are many further examples of the institutionalization of hedge funds--most notably in the growth of the prime brokerage function and the discipline it imposes on its hedge fund counterparties through periodic credit analyses prerequisite for the provisioning of leverage. But, in general, I think it is safe to say that as pensions continue to invest in hedge funds, the industry will further adjust and further impose upon itself an institutional risk management regime which should--at some level--mitigate risk. FUTURE HEDGE FUND RETURNS Which leads, of course, to the great question of whether our country's pensions will actually be well served by their investment in the hedge fund space and whether going forward returns will justify such enormous investment of capital? Or stated more simply: will pension funds be better or worse off by virtue of their exposure to hedge funds? My answer will be unsatisfying to many but familiar to my friends at the Federal Reserve "it depends". Yet, on this subject, I do offer the following observations: First, underscoring the notion that at this point no one truly can predict the ultimate benefit from our pensions' exposure to hedge funds is the fact that there is a great debate as to (i) what exactly a pension is buying when it invests in hedge funds, and (ii) how pensions should classify their exposures to hedge funds. For example, many believe hedge funds are not properly classified when labeled an `asset class.' There is just too mush dispersion of strategy, leverage and exposure to codify the group as such. Further, should pension exposure to a long/short equity hedge fund be classified as `hedge fund exposure' or what it really is: more equity exposure? Is exposure to a fixed income hedge fund `hedge fund exposure' or simply additional bond exposure? Second, the elephant in the corner for marketers and managers of hedge fund products today is that hedge fund returns of the last few years are demonstrably lower than they were in the 1990s. The core question is whether this trend will continue and whether returns of hedge funds over the long term will ever actually exceed long term equity returns. (If they do not, I note that the sole legacy of the hedge fund boom will have been a massive wealth transfer to a group of fortunate entrepreneurial souls born of the late 20^th century.) I think there is evidence to support different answers to this question: One the one hand, it would seem logical that because the hedge fund practitioner has a much more robust tool kit than his long-only competitor, he should be able to drive higher long-term returns: For example, unlike his long-only mutual fund brethren, the hedge fund manager enjoys the flexibility to short, to deploy varying amounts of leverage, and he is not bound to invest in any one industry or security in the manner that a mutual fund's charter might impose. Importantly, he also has the flexibility to disinvest and go completely to cash to mitigate loss. Many long-only managers of course must stay close to 100% invested at all times. On the other hand: As risk is reduced through the institutionalization of hedge funds, returns should, by definition, reduce as well; It would seem logical that the steady flow of more and more capital will increasingly crowd out return; There is evidence that finding pure shorts--single stocks--is getting much harder and that increasing levels of short exposure are being accomplished through exchange traded funds and other pooled vehicles. Single stock shorts tend to produce return while shorted pooled funds tend to hedge exposure and mitigate risk; Many funds, finding an absence of public opportunities, are investing in private equity and private debt securities and the jury is out as to whether hedge fund practitioners have the skills necessary to create adequate returns in the private space. Third, regardless of where long-term returns ultimately settle in for hedge funds, our pensions have the potential to receive many benefits from their exposure to hedge funds. A properly structured hedge fund portfolio will provide pensions further diversification via exposures they do not currently have. A properly structured hedge fund portfolio will not correlate with anything else in a traditional pension's portfolio, a further means of risk reduction. A properly structured hedge fund portfolio may lower volatility of a pension's overall portfolio. Eexposures to hedge funds should raise the sophistication level of our pension fiduciaries and that must bring with it a modicum of societal good and further risk reduction. SYSTEMIC RISKS Regarding systemic risks, I am on record suggesting that Treasury should stay abreast of systemic concerns. I believe our time is best spent addressing the nexus of hedge funds and the OTC derivatives markets, especially credit derivatives. There has been much superb effort by policy makers outside the Treasury and private groups to address this market segment. Many of these efforts are focused on market infrastructure and operational risk. And there has been significant progress. But there is broader financial stability issues associated with credit derivatives, particularly as it regards hedge funds. Many questions need to be explored: Where are financial institutions in danger of getting their risk management rubric wrong? Namely, are some credit derivative transactions becoming so complex that internal risk models (such as VAR) are unreliable when it comes to certain trades? I call this `Model risk'. Think of the summer of 2005 when most counterparties were caught flat-footed by the inexplicable correlation of certain synthetic CDO trades that were not expected to have such correlation. Many risk management models were just plain wrong. What are the unintended consequences of hedge fund growth on competition for lending and the provision of private equity? Do our largest financial institutions properly value and disclose their derivative exposure? Do large counterparties take false comfort in their individual exposure to and collateral with an individual hedge fund when there is little transparency on the broader financial community's aggregate exposure to that very same fund? Is the settlement infrastructure--even with recent attention and modification--able to handle the current volume of activity? Can the regulatory regime keep pace with the quickly evolving marketplace? Will our oversight system devolve into tacit acceptance of the risk metrics they are provided by large counterparties for the most complex transactions? As prime brokerage grows to meet the needs of the hedge fund community, will such providers increase leverage and relax collateral requirements as these are their principal means of competition. I would be pleased to discuss any or all of these issues and greater length and look forward to your questions and our discussion. - 30 -