Impact of the Sovereign Debt Crisis and Regulation on Hedge Fund Portfolios

by Sarah Corran

  • 09 Jul 2012
  • HF

With the outcome of Europe’s sovereign debt crisis far from certain, political and macroeconomic risks loom large. Despite the uncertainty surrounding Europe’s current economic climate, a recent Preqin study of around 50 European institutional investors revealed that, of the surveyed investors, 77% believe the sovereign debt crisis has yet to have any impact on their hedge fund portfolios. However, a small minority of investors stated that the crisis may impact their portfolios in the future, leading to a decrease in their exposure to European funds, or the euro in general, through their hedge fund allocation. The largest potential impact investors cited in regards to the sovereign debt crisis is that it may lead them to search for more liquid funds. In times of economic uncertainty they do not wish to be exposed to funds with unnecessary lock-ups or exposure to illiquid assets, which they cannot exit from due to imposed fund gates. In addition, several investors interviewed specifically expressed their concern over the sovereign debt crisis, with one UK-based public pension fund stating that long/short equity and distressed debt strategies in particular had been affected. In contrast, a UK-based private sector pension fund had a more positive outlook on the crisis, noting that the current market had created more opportunities for investors.

The survey also revealed the impact of European regulation on investor’s hedge fund portfolios. EU regulation is increasingly driving change in the hedge fund industry, with a wave of regulation set to make even greater demands on hedge fund managers’ operations and transparency. The Alternative Investment Fund Managers Directive (AIFMD), scheduled to come into force in 2013, the Markets in Financial Instruments Directive (MiFID II), and Solvency II are all major pieces of European legislation affecting the hedge fund industry. Therefore, Europe’s hedge fund industry is set to become among the most heavily regulated in the world, in addition to the US, which is regulated by the US Dodd-Frank Wall Street Reform and Consumer Protection Act and the US Foreign Account Tax Compliance Act. Despite this imminent increase in regulation, the bulk of European investors surveyed (95%) stated that their hedge fund portfolios had not yet been impacted by these regulatory changes. However, with much regulation still to come into effect, we are yet to see if there will be any impact in the long term. In order to succeed in this new highly regulated world, hedge fund managers must look to adhere to the requirements of investors and regulators through improved governance and controls.

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