Hedge Funds Get Cleaner Bill Of Health

The U.K.'s Financial Services Authority, in a departure from past warnings about the danger of hedge funds, now suggests they pose relatively little risk to the stability of the financial markets. In its 2006 Financial Risk Outlook, the FSA says that, while there are now some pretty big hedge funds, "none of them match the size or leverage of Long-Term Capital Management, whose near failure caused significant market disruptions in 1998." And although the FSA notes that hedge funds appear to be continuing to increase their investments in a asset classes that are less liquid than conventional assets or whose liquidity drops in times of market stress, such as credit derivatives, it says hedge funds are learning to offset risks by "adjust[ing] their redemption periods to reflect changes in the liquidity of their portfolios."

The U.K. regulator, in its outlook, recommends that hedge funds could further reduce risk overvaluation by using third-party administrators, price providers and independent boards of directors, among other things.

The FSA did express concern, however, that with the expansive size and complexity of instruments they trade in, hedge fund managers "may no longer have adequate systems and staff to create an effective control infrastructure."