Following the Credit Crunch the EU is reviewing the use of VaR for UCITS funds and is also considering increased hedge fund regulation. For UCITS funds the latest proposals allow the use of the âRelative VaRâ measure with a maximum ratio of two, which means that a UCITS fund would be permitted to have twice the risk of, e.g., a technology index. Think of the losses made by some technology funds in 2000-2003, now double them, and consider that this is deemed suitable for the investing public. In relation to hedge funds, the European Commission has proposed a new Directive which, among other restrictions, calls for limits on leverage at the fund level. In both cases, the proposals appear to confuse leverage and risk.
Since the purpose of the UCITS rules is investor protection and the advantage of hedge funds is their investment flexibility, the thrust of the proposals would appear to be contrary to the interests of the investing public.
While the concern about leverage is a legitimate one in that an increase in leverage leads to an increase in risk, leverage and risk arenât the same because it depends what is being geared up. The total risk depends on the degree of leverage and the riskiness of the underlying investment strategy, as shown in the graph below. Compare a low risk strategy (investing in a broad based portfolio of bonds) with a high risk strategy (investing in a concentrated portfolio of equities). Without leverage, the latter strategy in our example is about twice as risky as the former. So, leveraging the bond strategy two times will make it as risky as the ungeared equity strategy. If, however, our leverage is less than 2 (although geared), it will be less risky than the ungeared equity portfolio. Hence a more leveraged low risk strategy can be less risky than an unleveraged high risk strategy and the relevant measure that needs to be controlled for investor protection is the total risk, typically estimated using VaR (âValue at Riskâ).
Paul Myners, the Financial Services Secretary to the Treasury, made the same point in a breakfast address to the Alternative Investment Management Association on 7th July 2009. He said: âif the intention [of the proposed hedge fund regulations] were to try to limit the risks fund managers can take with their investorsâ money, leverage caps would be the wrong approach since leverage is at best only a partial measure of a fundâs risk exposure.â