Europe Sends Conflicting Signals on Hedge Funds

Regulatory ashes threaten to cut off Europe.

April 29, 2010

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1020368_62453515In Europe, the trains are superior. But European financial reform is a two-track system, some hedge funds are learning.

Last week, the Canadian chapter of the Alternative Investment Management Association (AIMA) lodged a protest against a proposed European Commission directive at threatens to cut off Canadian hedge fund managers from a major source of capital. How major? For Canadians who are used to the dominance of energy plays on the stock indexes, this is nothing more than beta – its part and parcel of their lived universe. But for Europeans looking to diversify their portfolios away from beaten-down banks and challenged consumer stocks, Canada, and by extension Canadian hedge fund managers, represent a source of alpha (I thank my colleague Tristram Lett for this insight).

AIMA Canada Chairman Gary Ostoich says: “In its current form, the directive will significantly restrict the ability of alternative fund managers from non-EU countries such as Canada to do business and raise capital in the EU, as well as having negative effects on the ability of institutional investors in the EU to access investment management expertise outside the EU.”

At issue is who gets access to the European market. European funds registered with their local regulator would get a free pass to market to EU investors and manage money for them. Non-EU funds would be able to do so only if their local regulator established reciprocal agreements with each European countries’ regulator – and if they used a European depositary bank as their prime broker. And European pension funds would be forbidden from investing in funds that didn’t meet these qualifications.

Oddly, the directive comes at the same time as another set of regulations, Undertakings for Collective Investments in Transferable Securities III, potentially expands the reach of  hedge funds to the retail level. While  curtailing the use of  leverage and derivatives is apparently at the heart of the EU’s Alternative Investment Funds Manager directive, UCITS III actually prefers derivatives for short exposure while forbidding actual short-selling, thus authorizing swaps, futures and stock-specific contracts for difference (CFDs), as Business Week reports. Of course, derivatives are inherently leveraged.

Two trains, it appears, on tracks that intersect. Let’s hope they avoid a collision.

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