By: Australian Fund Monitors

Feedback from two recent hedge fund conferences, one in Hong Kong and one in Sydney, have confirmed that the next three months will create significant challenges for hedge fund managers around the world.

As a result of the crisis in all financial markets, and the damage done to corporate balance sheets around the world, there has been widespread deleveraging as investors, banks, investment banks and other financial institutions rush to get their balance sheets in order, and reduce debt wherever possible. One keynote speaker at the AsiaHedge conference in Hong Kong last week claimed that investment banks had increased their leverage over the past few years from a factor of 10 times to over 40 times. This was now in the process of being unwound. In addition many of those investment banks operate (or operated) prime broking facilities for hedge funds, which also included leverage of up to 5 to 10 times for the underlying funds in some instances .

Many hedge funds and fund of funds, especially the large ones based in the US and Europe, operate with 12 month lock-ups to 31 December each year, and also require 90 days notice for redemptions. Those redemption notices will have hit at the end of September and reports are coming through which indicate that possibly 25% or more of investors' funds might be recalled either through necessity or in order to reallocate to other managers or strategies.

Very few of these have been made public as yet, and it is unlikely that too many managers will want to publicise the fact for fear of triggering additional redemptions from other investors. However it is more than likely that some managers will invoke the gate clauses in their management agreements, and halt redemptions come 31st of December or otherwise face the prospect of closing the shop.

In any event the de-leveraging that has been such a powerful downward force in equity markets over the past 3 to 6 months is likely to continue. Hedge fund selling to meet redemptions will add to the downward pressure and certainly create some headlines in the media.

By: Australian Fund Monitors

ASIC has extended the ban on covered short selling for non-financial securities until 18 Novemeber 2008 while the ban on covered short selling for financial securities is expected to remain in place until 27 January 2009.

Full ASIC Statement

ASIC today said it would extend the ban on covered short selling for non-financial securities for a further 28 days until 18 November 2008, when it expected the ban would be lifted.

In its announcement of 21 September ASIC said that the ban on covered short selling for non-financial stocks would be reviewed in 30 days. In the case of financial stocks, ASIC said that its review would be in line with time limits imposed by other international regulators.

Following the 30 day review, ASIC has decided to maintain the ban on covered short sales for non-financial stocks until 18 November 2008. ASIC expects to lift the ban from opening of trading the next day.

The ban on financial stocks will continue until 27 January 2009, and while the US has lifted its bans, other jurisdictions such as the UK are maintaining bans on financial stocks.

ASIC Chairman, Tony D'Aloisio, said market conditions since the bans were imposed remained difficult. "While the various Government actions and packages introduced in Australia and overseas are positive developments, they are yet to work through the financial system. The financial markets are still fragile, so we feel the reopening of covered short sales should be done in stages and in a measured way over an extended period and have regard to systemic issues, particularly for financial stocks."

Key changes

In summary:

1. The ban on financials will continue until 27 January 2009. For the purposes of the Australian market, ASIC has taken a pragmatic approach to the definition of financials as entities in the S&P/ASX 200 Financial Index (which will include property trusts and five other APRA supervised listed entities not in this index).



2. ASIC expects to lift the ban on non financials from opening trade on 19 November 2008. ASIC cannot, however, provide greater certainty than that because of the state of the markets.



3. As part of lifting the ban on non-financials, ASIC with ASX have been putting in place disclosure and reporting arrangements that will apply from the time the ban is lifted. These will be announced to the market later this week.

For clarity, no changes have been made to the exemptions and facilitations which ASIC has granted. In short, all current arrangements will continue.

ASIC will, at least three trading days before 18 November 2008, issue a further release on its expectation of lifting the ban on non-financials.

By: Australian Fund Monitors

As expected initial September performance reports from Australia's Absolute Return and Hedge Fund sector are showing considerable diversification. However given the significant volatility across a range of underlying financial markets and asset classes, plus the ban on short selling equities, there have been some positive results.

Best results to date (as of 7th October) include Blue Fin Capital’s Currency/FX with 9% (5.83% YTD); Apeiron Global Macro’s +7.22% (+13.55% YTD); TechInvest's market neutral Intercept Capital Fund +3.44% (+11.97% YTD); Commodity Strategies’ long/short fund +3.27% (+11.9% YTD) and Wallace Funds Management’s equity market neutral +0.85% (+29.73% YTD).

On the negative side Plato Investment Management’s Equity 130/30 was down over 12% (-27.48% YTD) reflecting the problems experienced in the equity sector and the ban on short selling.

By: Australian Fund Monitors

Australia's Reserve Bank (RBA) exceeded market expectations by cutting rates by a full percentage point, to 6.00%, double the 50 basis points that the market was expecting.

Citing weakening economic activity in major economies, and evidence of moderation in growth in Australia's trading partners in Asia as indications that global inflation will moderate in 2009, the Board chose to ignore their expectations of a CPI figure of around 5% for the year to September, and introduce an unusually large movements in the cash rate to bring about a significant reduction in costs to borrowers.

However the RBA's statement was careful to point out that it did not expect this movement to establish a pattern for future decisions, and that they were all continue to set monetary policy as needed to bring inflation back to the 2 to 3% target over time.

By: Australian Fund Monitors

Australia's Absolute Return & Hedge Funds continued to weather the storm in financial markets and outperform the broader equity benchmarks on a year to date (YTD) basis to the end of August. The ASX200 was down over 27% over this period, while the average hedge fund return in AFM's database of over 200 funds was down 4.16%.

To date approximately 90% of all funds surveyed by Australian Fund Monitors have reported August results and the average return for the month was +0.90% against a rise of +3.08% for the ASX200 and +1.20% for the S&P500. During the month 55% of funds achieved a positive return after fees with 30% outperforming the ASX200.

It has been a turbulent year in the industry across all strategies with most funds finding it hard to avoid at least one negative month. The best performing strategies continue to be non-equity based, including Commodities, FX, Global Macro and Futures. However, Commodity strategies have been retracing in recent months while Equity Market Neutral funds continue to perform well. The only fund manager to achieve a positive result every month since January is Fortitude Capital (AIMA Hedge Fund of the Year 2008) implementing an equity market neutral strategy.

To read the full report download the file below.

By: Australian Fund Monitors

Everest Babcock & Brown Alternative Investment Trust (EIB) plans to delist from the ASX to address EBI's trading discount to NTA which is currently 33%. EBI is a fund of hedge funds and has exposure to a portfolio of international absolute return funds and selected direct investments.

The proposal is to be voted on by its security holders on October 3 and EBI plans to put in place redemption facilities ahead of and after its de-listing.

EBI Chairman, Trevor Gerber said: "The trading discount to NTA is an issue of concern to many listed investment vehicles in the market today. The Board has been looking at potential solutions for some time and in developing our proposal we have been mindful to balance the needs of Unitholders who would like reasonable levels of liquidity in the short term, with those of investors who have invested for the longer term, by ensuring the value of the underlying investments are not compromised.

The proposal allows Unitholders who wish to exit to progressively redeem from EBI at a price closer to the underlying value of their units."

To view EIB's statement to the ASX click here or to read commentary on the delisting, including a comparison to similar moves by hedge fund manager Ellerston, click here.

By: Australian Fund Monitors

ASIC has released a statement to clarify uncertainty around the short-selling ban. This statement addresses the disclosure requirements and exemptions to the ban including the use of short selling to hedge derivative positions.

In summary, exemptions to the short-selling ban include:

• Hedging for existing positions pre-22 September 2008
  
• Dual listed entities
  
• Exercise of exchange traded options
  
• Index arbitrage transactions
  
• Certain covered short sales by Market Makers
  
• Hedging corporate underwriting risk

To read the full ASIC statement click here.

By: Reuters

Australia's share market watchdog has eased its blanket ban on short selling to allow investors trading the difference between share prices on dual-listed stocks to make covered short sales.

The move by the Australian Securities and Investments Commission (ASIC) largely affects funds trading in the dual-listed shares of top miners BHP Billiton Ltd/plc and Rio Tinto Ltd/plc.

Market operator ASX said on Tuesday the regulator would allow investors doing arbitrage trades on dual-listed stocks to use covered short sales on those stocks in Australia.

By: Australian Fund Monitors

The term "short" has been in use since at least the middle of the 19th century and refers to the deficit position that a short seller has with their brokerage firm. The practice has been around for centuries and has often been used a scapegoat when financial markets are going through a difficult period.

The first recorded instance of short selling is believed to have occurred in 1609 when a merchant arranged short sales on stocks of the Dutch East Indies Company VOC which was listed on the Amsterdam stock exchange. This also prompted the first attempt to ban the practice. In 1610, directors of the company persuaded the government to declare shorting illegal as bearish speculators were "incommensurably damaging innocent shareholders, among which are widows and orphans". Illegal short selling continued anyway, so in 1689 the Dutch government imposed a tax on profits from the activity.

A similar pattern recurred in 1720 in Great Britain when the speculative South Sea Bubble burst. Shares in the South Seas Company jumped from 325 pounds to 1200 pounds as merchants rushed to acquire the rights to trade with Latin American countries. When shares in the company later fell to just 86 pounds short sellers got the blame. A law banning short selling was introduced in 1734, but as it was never applied it was repealed in 1860.

New York state unsuccessfully banned short selling in 1812 following heavy speculative activity that occurred at the outbreak of war with England but was repealed during the 1857-59 depression. The US government tried to rein in short selling in 1864 with the Gold Speculation Act, however in just two weeks the price of gold rose from $200 to nearly $300 and the ban was lifted.

Bank failures and panic in the British financial markets in 1866 was blamed on short selling and a law was passed forbidding short sales on banking shares. Once again the law was never used and testimony to a Royal Commission in 1868 showed that the problems had been caused by irresponsible banking practices and poor asset quality.

Short selling continued throughout the 20th century, but so did the animosity toward its practitioners. In 1929 such was the fury of ruined shareholders that one short seller had to hire bodyguards.

The very first hedge fund employed short selling as part of its strategy. Established in 1949 by Australian-born Alfred Winslow Jones with $100,000, the fund combined long positions on undervalued shares with short positions on overvalued shares. The early 1980's saw the creation of the first companies that specialising in short selling, and hedge funds with focus on the practice became more attractive after the stock market crashes of 1987 and 2000.

It remains to be seen whether the regulatory reaction to recent market hysteria is any more successful than previous attempts to curtail short selling.

By: Australian Fund Monitors

ASIC has gone further than other regulators in banning short selling in all stocks not just financials. ASIC released a statement on Sunday (21 September 2008) banning all covered short selling in all stocks (subject to limited authorised market-maker exception). This ban is to be re-assessed after 30 days with possible rollback permitting covered short sales in non-financial stocks.

This action follows on from an ASIC release last Friday where the following 3 measures were implemented:
1. Banned all naked short selling.
2. Clarify, and in so doing, narrow the permitted class of covered short selling.
3. Introduce reporting regime for permitted covered short sales. 

Today, the ASX open was delayed 1 hour due to some confusion about how the ban would affect the hedging of existing positions. ASIC issued a statement effectively saying the ban does not require current short positions to be unwound or closed but rather prohibits any new or increase in net short positions. However, it is still unclear whether new short positions as part of hedging arrangements can be entered into, presumably this would be allowed for market-makers under the exemption mentioned.

Why has ASIC gone further than FSA & SEC?

Tony D'Aloisio, of ASIC, stated: "These measures are necessary to maintain fair and orderly markets in these exceptional times of global crises of confidence in financial markets. Because of the relatively small size and the structure of the Australian market, it is necessary to extend the prohibition to all stocks. To limit the prohibition to financial stocks, as has been done in the UK, could subject our other stocks to unwarranted attack given the unknown amount of global money which may be looking for short sell plays".

Further, ASIC emphasised that it sees a legitimate place for short selling in markets (e.g. to assist with price discovery). Mr D'Aloisio went onto say: "However, in the current climate and, in light of the actions taken by other regulators, we need a circuit breaker to assist in maintaining and restoring confidence. Our measures do that as they will operate for a limited time and in the case of non-financial stocks, will be reviewed in 30 days. In the case of financial stocks, the review will be in line with the time limits imposed by other international regulators such as the US and UK". 

Immediate Reaction

Predictably once trading opened the market rallied around 4%. Banning short-selling might result in a quick rally, but will it be sustained or solve the underlying problem? The rally will be more the result of false confidence and a "short squeeze" rather than fundamentals where those with existing shorts (i.e. apparently only hedge funds!?) will be forced to buy-back stock to close out their positions and limit or avoid losses. 

Solvency

With three statements in three days from ASIC it appears to be a quick and crude attempt to bandaid the prevailing market conditions. The fact remains that the current solvency situation still exists and is due to a number of factors not least the failure by Regulators to oversee complex financial products and the abusive application of leverage on company balance sheets. Initiating this emergency action could indeed lead to more uncertainty and panic as evidenced by the opening of the ASX. 

Liquidity, Price Discovery & Market Efficiency

Banning short-selling will ultimately reduce the liquidity, price discovery and efficiency of the market. While some may argue the effect of a reduction in liquidity will by minimal & outweighed by an anticipated reduction in volatility it is also good to remember that volatility is often associated with illiquid markets so you want to get the balance right. Additionally rather than adding volatility, historically short selling tends to smooth out price fluctuations.

Derivatives

Liquidity will also be reduced by the knock-on effect from the derivatives market where participants (other than the exempted market makers) will not be able to hedge their derivatives exposure (i.e. options or futures) by taking positions in the underlying market. Shorting is a widely used and legitimate tool in derivatives strategies to hedge risk (e.g. delta hedging).

Further, the ability to take short positions in CFDs is effectively stopped as CFD providers will be unable to hedge their clients' CFD positions in the underlying market. In the case of DMA (Direct Market Access) providers the stoppage of shorting will be immediate as these providers hedge via straight through processing into the underlying market. It is also likely the stoppage will be implemented by Market Makers as most hedge their clients? CFD positions on an aggregate basis.

Transparency

The ASX currently provides a daily list of what percentage of a company's stock is short-sold - it cannot be greater than 10% as per market rules. However, for full transparency short sales should be marked as such at the time of trade (e.g. just as cross trades are). Further it would be interesting and informative to see what percentage of daily turnover is actually attributable to short-sellers. Transparency is the key in averting a situation where fear overtakes, however unpopularly it may also reveal that the scapegoat (i.e. short selling and by proxy hedge funds) is simply just that - a scapegoat.

Hedge Funds

There is media speculation this could be the ruin of the industry. The short answer is No. The affect on hedge funds will most notably be in the area of equity-based strategies and particularly, market neutral, long/short, 130/30, convertible arbitrage, and dedicated short. With approximately 57% of hedge funds in Australia employing equity-based strategies the effect on performance could be noticeable over the next month. Some funds may choose to sit on the sidelines, reduce exposure or perhaps even unwind their positions (both long and short) so while the stock price of some companies might benefit others won't.

It is important for all to heed the gravity argument that "whatever goes up must come down" - maybe those in financial markets should rediscover this gem and get more in touch with their physical assets rather than those paper assets!