Hedge fund managers show disapproval towards EU short-selling proposals

by Charles Guber, COO Connect

Hedge fund managers have expressed their disdain for the European Union’s (EU) proposed short-selling disclosure requirements.

Forcing fund managers to publicly disclose their net short positions could distort financial markets and hinder sound risk management, according to the report by Oliver Wyman, the international management consulting firm.

The study, which was based on interviews with 35 fund managers and investor groups, was commissioned by the Alternative Investment Management Association (AIMA) – the global hedge fund association, and sponsored by Deutsche Bank.

The report comes as European lawmakers consider changes to the European Commission’s draft on short-selling regulations – a vote on amendments by the European Parliament’s Economic and Monetary Affairs Committee could take place on February 14.
Demanding the disclosure of individual managers’ net short positions above a threshold of 0.5% of outstanding share capital “is not effective in meeting the needs of the public, regulators or industry participants.”

There is evidence that disclosure requirements could result in lower market liquidity and an increased likelihood of short squeezes with 69% of respondents acknowledging the latter issue was a cause for concern.

Alarmingly more than 75% of those polled believed the requirements would prompt managers to pull out their equity capital from Europe. “We will absolutely be pulling assets out of Europe and shifting them elsewhere. We cannot run the risk of a disclosure situation, so places like Asia immediately become more appealing because we know there are fewer risks,” stated one fundamental firm forthrightly.

Many believe Hong Kong stands to benefit from the European proposals. The jurisdiction’s regulators have been widely praised for their constructive and conducive attitude towards the alternatives industry.

“It will be increasingly hard to ignore Hong Kong as it seems to beckon alternative funds especially with its sensitive and sensible approach to short selling,” said one respondent.

It has been widely reported that Hong Kong regulators and Asian prime brokerage outfits feel that Europe is handcuffing funds and “are forcing a monumental migration.”

More than 60% of funds fear that publicly disclosing their shorts could lead to copy cat trades. Again this is likely to distort the market – “Like short squeezes, copy cat trades create situations where a security’s market price does not equal the fair value of a security, so it is possible that the security is trading at a manipulated premium,” said the report.

Less sophisticated investors may also start trading based on the short selling information they gather through the proposed public disclosures – often without knowing the full details of the trade. “Disclosure proposals could lead to less sophisticated investors trying to formulate correlations between multiple parameters and trading on these assumptions, thereby decreasing efficiency and distorting markets,” One fund said this could increase headline risk and position uncertainty as investors will only have “half of the story.”

The report said market distortions could become more commonplace, for example, if retail investors approach mutual fund managers complaining that a hedge fund has a large long/short position in a particular equity security and question why that mutual fund manager is long in that stock. “Long only managers will therefore receive mixed signals and might not be aware of long convertible positions as a significantly meaningful part of a trade,” it added.

“The abundance of information in the market will be fragmented such that the whole story is not apparent to unsophisticated investors. Most copy cat traders lack the ability to fully link positions or fundamental stances and consequently decrease the integrity of the market,” highlighted the report.

If unsophisticated investors copy the positions of large hedge funds’ short positions, this could distort the fair market value of securities – given everything that has happened since 2008, it could potentially have a major impact in another future possible financial downturn – this could be especially grave when financial institutions are dependent on market confidence.

The study’s authors counteract that while transparency on short positions is a welcome development, it could be achieved more effectively by publishing aggregated or anonymous short positions. The study recommends European policymakers adopt a regulatory framework more in line with other major financial jurisdictions like in the US and Hong Kong – neither of which rely on public disclosures by individual managers. Private disclosure to regulators and public disclosure of, for example, short interest, has proven to be a “balanced” approach, said the study.

“As the findings of this study highlight, there are serious unintended consequences of disclosing individual managers’ positions to the market – including a decrease in liquidity, lower returns for end investors including retail investors, and the likelihood that investments will move to other jurisdictions where returns are not constrained by inappropriate regulations,” said Andrew Baker, chief executive officer of AIMA.


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