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Jurisdiction Special Focus: Hedge Funds: Into The Unknown

by Jeremy Hetherington-Gore, February, 2011
18 February, 2011


Hedge funds often boast that their investment strategies flatten out the more extreme gyrations of the markets; but they weren't proof to the financial tempests of 2008 and 2009, although figures for 2009 and 2010 show that the industry as a whole has largely recovered its poise. It remains to be seen, however, how investors and the hedge fund industry will respond to the challenges posed by the growing weight of regulation in the aftermath of the financial crisis.

After the annus miserabilis of 2007, which saw such world-scale disasters for the hedge-fund sector as the demise of Amaranth, hedge funds had delivered a fairly unremarkable performance in the first half of 2008, so it was all the more shocking that they fell out of bed with such a bump towards the end of the year, losing a record 21.44% in the year according to the Barclay Hedge Fund Index compiled by BarclayHedge.

What a difference a year makes! 2009 marked the best annual hedge fund performance in a decade, according to a research piece released by the Credit Suisse Tremont Index. Overall, the Credit Suisse Tremont Index was up nearly 19%, with 83% of all funds posting positive performance as of December 31, 2009. The report shows that overall, more than three-quarters (77%) of hedge funds recouped their 2008 losses suffered since peak performance levels or “high water marks" were hit.

In 2010, hedge funds posted solid, if unspectacular returns and could not match 2009's stellar performance. According to BarclayHedge, which tracks more than 5,800 hedge funds, funds of hedge funds, and managed futures programs, hedge funds gained 2.88% in December 2010 to finish the year up 10.86%, undershooting equity market returns. Nonetheless, Sol Waksman, founder and president of BarclayHedge, said that close to 64% of the hedge funds that report data to BarclayHedge have now recovered from losses in 2008. Overall, 17 of Barclay’s 18 hedge fund indices had a positive return in 2010.

“Equity markets rallied as bullish sentiment returned in December, with investors focused on upward revisions of GDP growth estimates for 2011,” said Waksman. "Global rallies in equity and fixed income markets in 2010 and compression of credit spreads were the main drivers of returns across all hedge fund strategies other than short equities."

Despite the more muted returns, an increasing appetite for risk, falling volatility in the markets and a generally more optimistic outlook for the global economy led to a surge in new hedge funds assets at the back end of 2010 as the industry concluded the year with its largest quarterly increase in assets in its history, according to Hedge Fund Research. Total industry assets stood at USD1.917 trillion by the end of 2010, reflecting a quarterly increase of nearly USD149 billion, topping the previous record increase of USD140 billion in the second quarter of 2007.

“The second half of 2010 was a historic time in the hedge fund industry, characterized by powerful and pervasive trends shaping the institutional landscape of the hedge fund industry”, noted Kenneth J. Heinz, President of Hedge Fund Research. “As the industry is positioned to surpass its previous asset peak, global investors are focused on the dynamics of inflation protection, strategic specialization, enhanced liquidity, improved structure and transparency for accessing hedge fund performance in coming years.”

By comparison, 2008 saw a fall of some 35% in total hedge fund assets from the high-water mark of USD2.3 trillion, while the number of funds fell more than 10% to fewer than 9,000.

While hedge funds have responded positively to improved trading conditions, major challenges lie ahead for the industry on the regulatory front and regulators on both sides of the Atlantic are taking advantage of the general anti-market climate to strengthen their grip on the finance industry, and this applies to the hedge fund sector as much as elsewhere. Two key pieces of legislation were approved last year:

  • The European Union's Alternative Investment Fund Manager Directive, approved in October 2010. An Impact Assessment commissioned by the European Parliament estimates one-off costs of up to EUR22bn and almost EUR4bn of ongoing annual costs associated with the Directive, concluding that the EU "playing field would be more level," but at the expense of competition and innovation in the hedge fund sector. The Assessment describes the AIFM Directive proposals as "premature" and "misguided", sentiments which are shared by most industry associations. The most controversial aspect of the directive is that AIF managers from 'third countries' will have to obtain an EU 'passport' to sell their funds within the EU.
  • The US Dodd-Frank Act. In the United States, the Securities and Exchange Commission (SEC) has proposed a rule to require advisers to hedge funds and other private funds to report information for use by the Financial Stability Oversight Council (FSOC) in monitoring risk to the US financial system. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) established the FSOC for the purpose of monitoring risks to the stability of the US financial system. Working with other regulators, the FSOC will gather information from many sectors of the financial system for this purpose. Under the proposal, larger private fund advisers managing hedge funds, unregistered money market funds ("liquidity funds") and private equity funds would be subject to heightened reporting requirements.

The new rules are in response to calls for the hedge fund sector to come under greater public scrutiny, but the industry counters that it is already the subject of strict regulations in many territories. “All the major jurisdictions where hedge fund managers operate - whether in North America, Europe or Asia-Pacific - have rigorous regulation of the industry," says Andrew Baker, CEO of the Alternative Investment Managers Association. "And this already rigorous regulation is being increased by new legislation introduced since the crisis – for example the Dodd-Frank Act in the United States, and the Alternative Investment Fund Managers Directive in the European Union."

Although hedge funds have not managed to out-perform the equity markets in either 2009 or 2010, they continue to outperform equity indices over a longer time span, according to the data from HedgeFund Intelligence. The HedgeFund Intelligence Global Composite Index, which currently tracks nearly 4,000 single manager hedge funds, was up 102.59% over the past decade, while the MSCI World Index (net) was up 25.62% and the S&P 500 Index down 4.74% over the same period.

So what's the truth of it? Does a good year mean that the industry has grown up? Have we seen the last of the good times of 20-40% returns? Are hedge funds heroes or villains?

Well, it's a lot easier to ask the questions than it is to answer them; and it is not even safe to try. What we can do, though, is to point to some of the basic features of hedge funds, which won't change overnight, and suggest some precautions to take before jumping head first into (or clambering expensively out of) what is a very complex and diverse investment sector.

What is a hedge fund?

From the amount of speculation and debate that has surrounded hedge fund investment in recent times, you could be forgiven for thinking that hedge funds were a relatively new development in the investment world. However, you would be wrong.

The first fund to be dubbed a 'hedge' fund was the A.W. Jones Group in 1949. The fund derived its nickname from its strategy of taking long and short positions in the stock of companies (a strategy which continues to be central to many hedge fund managers, and which will be explained in greater detail in the next section). This meant that it could hedge against macro-economic factors, while at the same time benefiting from the individual performance of specific companies.

Hedge funds offer the potential for attractive returns, and are a lot more nimble than traditional mutual funds or other investment structures, which makes them an especially suitable option in volatile or falling markets. Until recently, they required high minimum investments (many still do), and until very recently, were only allowed to accept 'accredited', or 'qualified' investors.

It has only been in the last ten to fifteen years that the industry has really taken off. According to estimates, in 1990 there were as few as 300 hedge funds in existence. However, by the year 2000, this number had multiplied to over 3,000 funds controlling around $400 billion. By 2005, hedge fund assets had more than doubled, with estimates placing the size of the industry at more than 8,000 active hedge funds. Growth has slowed somewhat in the last five years - the turbulent, uncharted waters of 2007-2009 having shaken out some of the smaller and weaker hedge funds - but it is estimated that there are about 10,000 hedge funds active in 2011.

Are regulators a good thing or a bad thing for hedge funds?

Marketing of hedge funds to the general public has been severely restricted in most countries, and the authorities have tended to leave the funds alone, to make or lose money at will. But a number of factors are forcing regulators to take a greater interest in hedge funds, including the sheer size of the industry, the pressure to allow retail sales, and the growing volume of institutional investment into hedge funds.

The SEC attempted to tighten registration rules for hedge funds in 2005 by changing the definition of a "client" under the Investment Act of 1940 so that hedge funds managing more than $30 million in assets with more than 15 clients would be obliged to register as investment advisers. A senior SEC official revealed that hedge funds, particularly those considered by the regulator to be high risk, could expect regular inspections from compliance officers. Hedge funds whose businesses are deemed high risk would face inspections at least once every three years, while low risk hedge funds which registered with the SEC might face inspections at random.

Between 700 and 800 hedge funds were expected to have registered with the SEC, including more than 100 hedge funds based outside United States, by the time that the new rules came into force in early 2006.

After a series of legal see-saws, however, Christopher Cox, then chairman of the United States Securities and Exchange Commission, announced in August, 2006, that the SEC would not seek to appeal a court decision which overturned the regulator's registration rule.

In June 2006, a three-judge panel of the US Court of Appeals for the District of Columbia Circuit unanimously struck down the SEC's hedge fund adviser registration rules under the Investment Advisers Act, in the case Phillip Goldstein, et al. v. Securities and Exchange Commission.

Based on advice from the SEC's Solicitor and General Counsel, Cox said in a statement that it would be "futile" for the Commission to appeal against the decision since the ruling was based on multiple grounds and was unanimous.

Instead, Cox explained that the SEC had changed its tack to concentrate on "moving aggressively" on an agenda of rulemaking and staff guidance to address the legal consequences following from the invalidation of the rule. "Among the significant new proposals will be a new anti-fraud rule under the Investment Advisers Act that would have the effect of 'looking through' a hedge fund to its investors," Cox stated.

"This would reverse the side-effect of the Goldstein decision that the anti-fraud provisions of the Act apply only to 'clients' as the court interpreted that term, and not to investors in the hedge fund. At my direction, Commission staff are also considering whether we should increase the minimum asset and income requirements for individuals who invest in hedge funds."

The financial crisis of 2007 to 2009 has changed the regulatory landscape however, and in 2010 Congress voted to approve Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which numbers among its many provisions the requirment for the SEC to set a rule to require advisers to hedge funds and other private funds to report information for use by the Financial Stability Oversight Council (FSOC) in monitoring risk to the US financial system.

Under proposed rules announced by the SEC in January 2011, larger private fund advisers managing hedge funds, unregistered money market funds ("liquidity funds") and private equity funds would be subject to heightened reporting requirements. Large private fund advisers would include any adviser with USD1bn or more in hedge fund, liquidity fund or private equity fund assets under management. All other private fund advisers would be regarded as smaller private fund advisers and would not be subject to the heightened reporting requirements. Although this heightened reporting threshold would apply to only about 200 US-based hedge fund advisers, these advisers manage more than 80% of the assets under management.

Smaller private fund advisers would file the form only once a year and would report only basic information regarding the private funds they advise. This would include information regarding leverage, credit providers, investor concentration and fund performance. Smaller advisers managing hedge funds would also report information about fund strategy, counterparty credit risk and use of trading and clearing mechanisms.

Large private fund advisers would file the form on a quarterly basis and would provide more detailed information than smaller advisers. They would report on an aggregated basis information regarding exposures by asset class, geographical concentration and turnover. In addition, for each managed hedge fund having a net asset value of at least USD500m, these advisers would report certain information relating to that fund's investments, leverage, risk profile and liquidity.

The US Commodity Futures Trading Commission (CFTC) will also approve similar reporting requirements for private fund advisers that are registered with the SEC and also with the CFTC as commodity pool operators or commodity trading advisors. Such advisers would also be required to file a similar form.

"The data collection we propose will play an important role in supporting the framework created by the Dodd-Frank Act and is designed to ensure that regulators have a view into any financial market activity of potential systemic importance," said SEC Chairman Mary L. Schapiro.

The Treasury has also tightened its grip on hedge fund investors. It already required certain investors with foreign bank accounts and offshore mutual funds to file a so-called 'Report of Foreign Bank and Financial Accounts,' also known as an FBAR, and in August, 2009, it said unexpectedly that US investors in offshore hedge funds must make FBAR filings.

"Expect US investors in off-shore hedge funds in places like the Cayman Islands, who failed to properly report earnings to the IRS, to be the next target of US tax authorities," said Shahzad Malik, partner at lawyers and tax advisers TroyGould in Los Angeles. "There are indications that the US may be taking steps to target off-shore hedge funds by asking them about their US partners and investigating their earnings."

Across the pond, the UK's financial regulator, the FSA, says that while the risk posed by hedge funds to the overall stability of the financial system is low, their growing holdings of illiquid assets might nevertheless present a danger that markets could be destabilised at a time of future crisis. In its Financial Risk Outlook report for 2006, the FSA noted that although there were now several large multi-billion hedge funds, none of these came close to the size of Long Term Capital Management, which imploded spectacularly in 1998 sparking fears of a collapse in the US banking system.

Nonetheless, the FSA went on to observe that hedge funds appeared to be increasing their investments in a range of asset classes which were "inherently less liquid than conventional assets, or whose liquidity is more likely to be reduced in times of market stress". This could contribute to further volatility in times of an economic shock or other events causing panic in the markets, the FSA warned, presciently.

The authority also cautioned that conflicts of interest may arise when hedge fund managers are trying to value particularly complex instruments, leading to a temptation to over-state the value of assets, especially as assets under management are one of the key criteria governing fund managers' performance fees.

Lord Turner's review into the causes of the global financial crisis, published by the FSA in March 2009, concluded, among other things, that increased reporting requirements for unregulated financial institutions such as hedge funds, are needed to forestall another crisis, although specific restrictions on hedge funds have not been legislated for in the UK, which remains Europe's hedge fund capital.

In 'Old Europe', the financial authorities viewed hedge funds as on a par with nuclear waste. Jaime Caruana, Chairman of the Basel Committee on Banking Supervision, told Reuters that more transparency was needed in the hedge fund industry given that many banks now have exposure to the lightly regulated industry. "Efforts to improve the level and the quality of the information disclosed are necessary in order to allow investors and market participants to properly assess the risks they are assuming," Caruana stated. He urged banking institutions to exercise caution in their dealings with hedge funds, which have come under the spotlight of many regulating institutions because of their unaccountability, despite controlling billions of dollars in assets in the world's markets.

"As banking supervisors, we should emphasize that banking organisations measure and control their exposures to hedge funds accurately," he stated.

While Caruana acknowledged that hedge funds play a positive role by improving the efficiency of markets, he cautioned that there are two sides to the coin because hedge funds often buy risky assets from regulated entities such as banks, which must set aside reserves to cope with any potential loss.

"Hedge funds ... are active players in risk transfer markets, where risks are transferred from credit institutions to other investors. There could be a risk of hedge funds engaging in regulatory arbitrage, leading finally to the financing of high risk profile borrowers," he observed.

Edgar Meister, chairman of the Banking Supervision Committee of the European Central Bank (ECB), warned that the rapidly growing hedge fund industry had the power to destabilise European financial markets, and hinted that the potential risks posed by hedge fund trading activity warranted closer scrutiny. Presenting the ECB's annual report on banking stability, Mr Meister noted that hedge funds could "seriously affect" financial stability through their largest creditors and counterparties - in other words, banks. He went on to add that the "opacity" of hedge funds affected banks' ability to "aggregate their exposure to hedge funds," meaning that "monitoring" of the situation might be necessary where EU banks are concerned.

Mr Meister's words joined a growing chorus from many regulators that hedge funds now wielded too much power over the workings of financial markets. Jochen Sanio, head of German financial supervisor BaFin, repeatedly warned that hedge funds "pose a big threat" to financial stability, while the International Organization of Securities Commissions (IOSCO), the global securities markets regulator, busied itself drafting new rules aimed at controlling the increasingly influential $1 trillion hedge fund industry.

The Amaranth debacle in 2006 led to a renewed push by regulators for stringent control of hedge funds, but once again the industry seemed to have remained free of the controls that would probably sap its life-blood, and took significant steps towards improved self-regulation, with the development of a unified set of global 'best practice' standards.

Denying strenuous efforts by the prominent European politicians and bankers to rein in the hedge fund sector, US Securities and Exchange Commissioner Paul Atkins said in September, 2007, that no new regulations on hedge funds were needed. He said the SEC would continue its probe into whether Amaranth misled investors, but that rules to prevent a widespread systematic failure in the market had worked. "It looked like the system worked" with the broker "getting nervous about exposure and taking steps to ensure it did not grow," Atkins told reporters in Brussels.

Needless to say, the cataclysm of 2008 brought new pressures for additional regulation of the free-wheeling hedge fund sector. In December, the Commission launched a wide-ranging public consultation on policy issues arising from the activities of the hedge fund industry, in view of developing appropriate regulatory initiatives. The results of the consultation were discussed at a high-level conference in Brussels in late February 2009, and served as the basis for European input into the parallel reflections on hedge funds at international level by the G20.

The consultation was part of the Commission's comprehensive review of regulatory and supervisory arrangements for all financial market actors in the European Union, which was finalised in 2009 upon consideration of the report of the High Level Expert Group chaired by Jacques de Larosière. It also responds to recent reports by the European Parliament, which raise a number of concerns that have come into sharper international focus as hedge funds have, like many other financial actors, been heavily affected by the current financial crisis.

In November 2010, the European Parliament (EP) adopted the directive which will introduce, for the first time, European regulation on the marketing of alternative investment funds (AIF), including hedge funds and private equity.

This is the final hurdle for the directive, whose rules are to take effect by 2013. The European Securities and Markets Authority (ESMA) and the European Commission will now have the considerable task of fleshing out the details of how the directive works, through guidelines and implementing legislation.

The directive will impose registration, reporting and initial capital requirements on a financial industry sector which until now has been subject only to "light touch" regulation. It is hoped that, following its introduction, the enhanced regulatory oversight over AIF managers will enhance investor protection and financial stability.

Under the directive, a European AIF manager with a portfolio of more than EUR100m (USD136m) will be required to obtain authorization from national authorities to operate. This permit, or ‘passport’ will entitle them to market funds throughout the EU single market, without first having to seek permission from each member state and comply with different national laws.

The most controversial proposal in the directive has been that AIF managers from 'third countries' would be able to obtain that EU passport to sell their funds within the EU. This, the EP says, was a bone of contention between the EP and some member states, with the EP pushing for a marketing passport to be granted to non-EU players.

The EP has allayed those member states' fears by proposing the provisions now in the text whereby AIF managers will obtain passports only if the non-EU country they are located in meets minimum regulatory standards and has agreements in place with member states to allow information sharing.

The EP has also insisted on the insertion into the directive of rules to deal with asset stripping, and the agreement now includes a number of provisions to this end, relating primarily to limits on distributions and capital reductions within the first two years that a company is taken over by a private equity investor. This is intended to deter private equity investors from attempting to take control of a company solely in order to make a quick profit.

The EP has also introduced information and disclosure requirements to be imposed on private equity investors, particularly regarding the information to be provided to employees and their representatives on the planned strategy for the company. The intention is to oblige investors to develop longer-term strategies for the companies that they take over.

Industry associations, which had tended to be insouciant about the dangers of their proteges, no longer feel able to stand out against the pressure. "The Commission is right to address areas of concern about the hedge fund industry," said AIMA’s CEO, Andrew Baker, adding: "I would say that many of these issues are not unique to hedge funds and should not be looked at in isolation. It is also important to stress that the hedge fund industry in Europe is currently regulated and that regulatory framework has shown itself to be robust in very difficult market conditions."

"The hedge fund industry in Europe and elsewhere has been hit very hard by the current crisis, but has responded in an orderly way and has not triggered any systemic risks. Hedge funds did not cause the present market turmoil and because they have an essential role in providing liquidity to the markets, are important in assisting any eventual recovery."

Baker concluded: "We look forward to working with the Commission and other bodies to formulate a regulatory framework for the future and we believe the active cooperation and leadership we are providing on behalf of the industry will prove helpful.”

By February, 2009, AIMA was being noticeably more complaisant, saying that it would support the principle of full transparency and supervisory disclosure of systemically significant positions and risk exposures by hedge fund managers to their national regulators.

The initiative, announced by AIMA on February 24, is one of a series of policy positions in the association’s new platform. Other key new strands of the platform include an aggregated short position disclosure regime to national regulators, support for new policies to reduce settlement failure (including in the area of naked short selling), and a global manager-authorisation and supervision template based on the model of the United Kingdom's Financial Services Authority (FSA) and a call for unified global standards for the industry.

The association is representing the global hedge fund industry in on-going international discussions about the future regulatory framework for the industry, notably with the organisations tasked by the G-20 to address the issue, such as IOSCO and the Financial Stability Forum.

The policies in AIMA’s new platform include:

  • Regular reporting and increased transparency of systemically significant positions and risk exposures by managers of large hedge funds to their national regulators (the regulator of the jurisdiction in which the manager is authorised and registered to operate).
  • An aggregated short position disclosure regime to national regulators.
  • Support for new policies to reduce settlement failure (including in the area of naked short selling).
  • Support for a global manager-authorisation and supervision template based on the UK’s FSA model.
  • A call for unified global standards for the industry based on the convergence of existing industry standards work, such as that authored by AIMA, the Hedge Funds Standards Board, IOSCO, the President's Working Group and the Managed Funds Association.

Said Andrew Baker: “We want to dispel once and for all this misconception that the hedge fund industry is opaque and uncooperative. That’s why we are declaring our support for the principle of full transparency of systemically significant positions and risk exposures by hedge fund managers to their national regulators through a regular reporting framework. We are confident that our members recognise that it is in everyone’s best interests if we cooperate fully in the important on-going international efforts to examine and improve the supervisory framework of the future.”

Responding to the European Securities and Markets Authority consultation on the AIFMD, AIMA has called for the implemented form of the directive to be "flexible, proportionate and based on the principles of openness and transparency."

AIMA set out its recommendations in a consultation response sent to the ESMA (formerly known as the Committee of European Securities Regulators) released a Call for Evidence in December 2010 ahead of the rule-making “Level 2” of the AIFMD process. The industry was asked to respond in January 2011 to the main issues raised in the document and AIMA immediately established a working group of member firms to study the proposals and contribute to the response.

“We welcome the opportunity to engage constructively in AIFMD implementation and are happy that ESMA is taking stakeholder consultation extremely seriously. We commend the high level of their professionalism in this complicated process with tight deadlines,” said Jiri Krol, AIMA’s Director of Policy and Government Affairs.

AIMA said it hoped that ESMA would implement the AIFMD in such a way as to take account of one of the most striking features of the hedge fund sector – its great diversity.

“Flexibility, proportionality and openness are three key features which the regulation should retain if it is to succeed in delivering the policy objectives while preserving the existing breadth of business models and strategies,” said Mr Krol.

AIMA pointed out that while some of the larger hedge fund firms may employ several hundred staff and manage over USD10 billion, the majority are smaller businesses, with much fewer staff and managing assets of less than USD1 billion in many cases.

The advantages of hedge funds

As previously mentioned, hedge funds are a lot more nimble than their mutual fund counterparts. This is because they are governed under a different (and much more permissive) regulatory system than traditional funds, which means that they are permitted to use instruments and strategies beyond the reach of conventional mutual funds, in order to secure the highest possible profit for investors and best manage investment risks.

Broadly speaking, hedge fund managers (or general partners, as they are more usually known), unlike mutual fund managers, are able to change the style or strategy used by the fund without prior investor consent, and the spectrum of styles available is enormous. The following (by no means exhaustive) list outlines some of the main strategies utilised by hedge fund managers, and the way in which each hopes to affect the performance of the fund:

  • Event-Driven. This strategy involves taking different positions in companies which are involved in takeovers, mergers, or acquisitions, or are in distress, in the hopes of predicting the effect that the event will have on their share prices.
  • Global International. Investing either in established markets, or in more risky emerging economies.
  • Global Macro. Seeks to benefit from global macro-economic changes and developments.
  • Sector. Investing in a specific sector, for example financial services, real estate, or technology and communications.
  • Long/Short. Taking a long position in a stock is what most traditional investors and mutual fund managers do - they predict that the value of the stock will rise. However, in a hedge fund, alternative financial instruments can be used. Shorting involves finding overvalued companies, and selling borrowed stock in them in the hopes of buying it back later at a lower price.
  • Market Neutral. This involves taking both long and short positions in the same market or sector in order to offset risk - basically like betting on two sides of the same coin.
  • Fund of Funds. Funds of funds (FOFs) don't invest directly in market instruments, but take positions in selected funds, meaning that they can use a mixture of strategies, or specialize in just one.

There are many more strategies open to hedge fund managers, of course, and they are able to chop and change as market conditions dictate.

Hedge fund managers are usually highly skilled and experienced, as the system and rates of compensation for successful managers tend to be very attractive. Although a successful mutual fund manager may well be able to afford a weekend home with a pool on his earnings, a successful hedge fund manager is more likely to have a weekend home with an island. Or so the saying goes.

General partners are compensated in a very different way to mutual fund managers, as the majority of their fee is based on how well the fund performs. Generally, their fee is something like 1-2% of the total assets of the fund, plus a performance or incentive based fee. Some funds also stipulate a 'watermark' or 'hurdle' which the fund must outperform in order for the manager to profit. Hedge fund managers are also usually more heavily invested in the funds they run themselves, and so have more of a vested interest in ensuring that the fund performs exceptionally. Mutual fund managers usually base their fees on the volume of assets managed, regardless of performance.

Disadvantages of hedge funds

Which brings us neatly onto the possible disadvantages of hedge fund investment. Although the way in which hedge fund managers are compensated can, and in the majority of cases does, encourage excellence and shrewdness, it can also sometimes encourage greater risk-taking in order to ensure that the fund is productive.

The relative lack of regulation in the hedge fund sector of most countries is something of a double-edged sword, and the ability to invest in 'volatile' sectors or instruments can sometimes present a risk. The occasional demise of very large hedge funds has enhanced the public perception of this risk. At the end of 2008, the Bernard Madoff investment scandal highlighted more than ever the need for independence in the administration and valuation of hedge funds.

“The Madoff scandal highlights just how important it is to have independence of process in relation to administration of the fund and the valuation process," said Antonio Borges, chairman of the Hedge Fund Standards Board. He added: "It also highlights the need for robust governance practices and oversight via independent boards, which will challenge management procedures and behaviour."

Bernard L. Madoff, who ran Bernard L. Madoff Investment Securities LLC – considered to be one of the most successful hedge funds in the world – was arrested after being jointly charged by the Securities and Exchange Commission and the Justice Department for allegedly orchestrating a giant Ponzi scheme. According to the charges, Madoff admitted to senior employees that his fund was "one big lie" which had been paying 'returns' to certain investors out of the principle capital invested by newcomers to the fund.

It is thought that losses from the fraud could reach USD50bn, and it has since emerged that many high profile banks still reeling from sub-prime losses may have lost large stakes in Madoff's fund. It has also come to light that regulatory checks by the SEC in 2006 and 2007 failed to uncover anything suspicious, while questions have also been asked as to why Madoff did not use a custodian to hold the fund's assets, and why he chose to employ a little-known New York-based auditor while funds of a comparable size would employ a much larger audit firm.

Universal hedge fund standards are intended to reduce the risk of such events. "The hedge fund standards are designed to address exactly these issues to help prevent such events from happening, and to provide investors with the necessary transparency. This is why an increasing number of managers are signing up to the HFSB standards," said the Hedge Fund Working Group (HFWG), a group of leading hedge funds based mainly in London, whose report on best practice standards was published in late 2009.

However, many experts feel that the risky nature of hedge fund investment has been overstated. Although managers are generally somewhat secretive about investment strategies, and reporting to investors does not take place as frequently as with conventional investment vehicles, there is no fundamental and necessary reason why hedge funds should present more of a danger. On the contrary, academic research conducted over the past few years has shown that hedge funds have had higher historical returns than traditional stock and bond investments of similar risk.

In reality, less than 5% of the world's hedge funds utilise 'risky' investment strategies such as global macro or emerging markets. Most hedge funds only use derivatives for offsetting market risk, and many do not use leverage at all. (Leverage is the extent to which an investor, business, or fund is using borrowed money to finance transactions).

Be that as it may, securities regulators have always been keen that inexperienced domestic investors are not exposed to any more risk than is strictly necessary, and one area in which they do impose strict regulation for hedge funds is in the barriers they place in the way of investors themselves.

As well as passing muster in terms of investment knowledge and experience, a potential investor must be prepared to stump up a sizeable minimum investment, and must be able to demonstrate a substantial net worth. This is in part to deter the unwary, and in part because as hedge funds are limited by the authorities in the number of investors that they can accept, a large sum is needed from each investor in order to make the venture worthwhile.

The criteria for accredited, or qualified investors have been defined as follows in America, and it is safe to assume that similarly stringent definitions exist in other countries, although consultation with an independent financial advisor will clarify exactly what the situation is in your country of residence:

  • Must have an individual net worth, or joint net worth with spouse exceeding USD1 million, or;
  • Must have had an individual income of USD200,000 (or joint income of USD300,000) in the two years preceding, and have a reasonable expectation of a similar level of income in the current year, or;
  • Must be an institution, employee benefit plan, partnership, or foundation which meets the accredited investor criteria.

(A rule proposed by the SEC in Janaury 2011 would, however, exclude an investor's primary residence from this calculation).

At this point you may be wondering why, if all but the super-rich are excluded from investing in hedge funds, we have bothered to write a primer on hedge fund investing. Well, as the 'mass affluent' group continues to grow, so does the popularity of hedge funds, a trend which has meant that service providers are beginning to see the possibilities inherent in the sector, and are looking at ways in which to offer the increased profitability found in hedge funds to the individual investor. In the next section, we will be looking at the investment opportunities open to those unfortunately excluded from the Forbes list, but not quite in the poorhouse!

The days of online deep discount hedge fund brokers and hedge fund supermarkets are still some way off. Despite, or perhaps because of, growing investor curiosity, regulators are still cautious, and will allow hedge fund providers and managers opportunities to attract more mainstream investors only as they prove their trustworthiness.

There are however a growing number of hedge fund portals and one-stop sites for investors, advisors, and the industry alike, and they tend to offer a variety of services, including the provision of news, performance data, topical articles, and sometimes databases of contact information for service providers. As a result of still stringent regulation in the majority of countries, in order to access sensitive information (such as contact details or performance data) it is usually necessary to register.

For the moment at least, there are basically three ways to access hedge fund investment opportunities:

  • Invest directly. This is only really an option for accredited investors (using the definition described above) and institutional investors due to fairly prohibitive investment criteria, although a number of countries are beginning to introduce rules for retail level hedge fund investment.
  • Invest through an investment management company, wealth manager, or independent financial advisor. Probably a more suitable option for the mass affluent investor, as an outside financial consultant is more likely to be 'in the loop'. (Because of the restrictions on advertising, a great deal of hedge fund information is circulated by word of mouth, or on designated news sites, so contacts are important. Investing in this way also offers an added advantage (well not really an advantage, more of a necessity actually); an advisor will be able to take you through the appropriate options for your country of residence, personal circumstances, and net worth.
  • Invest through a third party firm. As interest in hedge funds grows, a number of financial service providers are offering opportunities to invest in what are essentially funds of hedge funds, thus spreading both the perceived risk and the cost of minimum investment.

The United Kingdom's financial regulator, the Financial Services Authority (FSA), is one of those that has been toying with retail distribution for hedge funds. It announced in February, 2008, that a Consultation Paper confirming the policy of introducing retail-oriented Funds of Alternative Investment Funds (FAIFs) into the FSA’s regulatory regime had been published.

Dan Waters, FSA Director Retail Policy and Themes and Asset Management Sector Leader, commented that:

"Permitting consumers access to a wider range of innovative investment strategies through authorised onshore vehicles will allow more choice and a better opportunity for risk diversification, while maintaining consumer protection through our proportionate rules on the operation of the product. We aim to make the final adjustments to the new regime before the end of the year, including the additional areas on which we are consulting today."

He continued: "As we have previously stated, there are a number of difficult tax issues involved in the operation of onshore FAIFs regime. Following constructive discussions with the Treasury on tax issues we welcome the publication today of their tax framework, setting out a new elective regime which aims to allow FAIFs to operate competitively within the UK retail market.”

To avoid any regulatory regime being used to gain unintended tax advantages the FSA also proposes to include a ‘genuine diversity of ownership’ condition in its rules. This condition is similar to those proposed in the Property Authorised Investment Funds discussion paper issued by the Treasury in December 2007.

On 22 February, the Treasury announced a new elective tax regime that would facilitate the introduction of FAIFs. The announcement coincided with a consultation paper issued by the Financial Services Authority outlining the regulatory framework for FAIFs. The Government issued the draft regulations for the implementation of UK authorised FAIFs on the same day.

Are hedge funds still the best play in town?

Although there are doubts about the construction of the metrics quoted on hedge funds, for instance because of what is called 'survivorship bias', which tends to measure only surviving hedge funds and ignores those that closed, and there are concerns that 2005 saw the end of the hedge funds' glory days, the returns obtained by hedge funds have been superior to most market instruments over a long period of time.

Hedge funds do particularly well during market downturns. For instance, while the benchmark S&P 500 index lost 14%, 17.8% and 21.1% in 2000, 2001 and 2002, the Van Global Hedge Fund Index, which measures performance across approximately 5,800 funds, gained 8.4%, 6.3% and 0.1% over the same periods. The events of 2008 are an apparent exception to this rule, but may turn out to have been exceptional.

There is risk, of course. However, many experts feel that the risky nature of hedge fund investment has been overstated. Although managers are generally somewhat secretive about investment strategies, and reporting to investors does not take place as frequently as with conventional investment vehicles, there is no fundamental and necessary reason why hedge funds should present more of a danger. On the contrary, academic research conducted over the past few years has shown that hedge funds have had higher historical returns than traditional stock and bond investments of similar risk.

Funds of hedge funds, as the name suggests, offer diversification across a range of hedge funds at lower minimum investments. They are able to do this because they pool the resources of multiple investors - it has been estimated that to gain proper diversification, an individual investor would need to invest in at least 5-6 hedge funds, a feat which all but the very richest individual would find it difficult to achieve. Funds of funds can do just this because of their greater purchasing power. Typically, funds of funds will include a variety of asset classes such as equities, bonds, cash, alternative strategies, and real estate, but obviously the make-up varies considerably from product to product, and increasingly there are funds of hedge funds (FoHF).

Another, not inconsiderable advantage to investing in hedge funds in this way is that investors are able to take advantage of the expertise and resources of a number of industry professionals, as FoHF investment by necessity takes a multi-manager approach. FoHF investing may also provide access to hedge funds which would otherwise be closed to new money due to regulatory and capital restrictions.

Critics of this type of investing point to the likelihood of a higher fee structure in order to absorb both the management costs of the underlying hedge funds and of the FoHF itself, as a significant disadvantage. However, the costs involved although higher than with ordinary mutual fund investment, are unlikely to be doubled, as many fund of hedge funds providers have agreements with the hedge funds to reduce the amount of fees paid, a saving which is then passed on to the investor.

Asset management fees for most non-traditional asset classes have fallen following increased scrutiny from cost-conscious investors, according to a report by Mercer.

The Mercer report found that fees for hedge funds, private equity, infrastructure and real estate have all decreased, whilst fees for traditional asset classes have varied, with some increases observed in long-only equity and fixed income strategies.

Mercer’s 2010 Asset Manager Fee Survey is a bi-annual report analysing fee data on more than 20,000 asset management products from over 4,000 investment management firms.

The survey covers asset managers in a range of geographies and across numerous products including pooled and separately managed accounts. The study is intended for use as a reference when assessing asset management fees.

Divyesh Hindocha, Global Director of Consulting said that this is evidence of the impact of the global financial crisis continuing to be felt by companies and investors.

“Although not universal, subdued investment returns have taken the edge off many alternative asset products. Combined with an increased focus on operational costs this trend has put growing pressure on asset managers to reduce the complexity of their products and lower their fees in the already pricey alternatives arena,” Mr Hindocha said.

“We believe there is room for further simplification and larger reductions in the overall fees charged by asset managers,” he said.

Global emerging markets equity remains the most traditionally expensive asset class category with median fees averaging around 1% - up from 0.90% in 2008. Small cap equity also continues to be an expensive category with fees averaging around 0.89%. Global and regional equity strategies average 0.70%, whereas fixed income continues to be the cheapest traditional active asset class with average fees around 0.35%.

“The observed fee increase for long-only fixed income strategies is somewhat surprising given there is no shortage of high quality strategies in this area. Fees charged for niche equity strategies, such as small cap and emerging markets continue to be higher than for most fixed income strategies, reflecting the value-added potential of the mandates,” Mr Hindocha said.

With an average fee of 0.68% pooled funds are more expensive than segregated fees across all comparable mandate sizes. There was no change in average fee levels for pooled vehicles between 2008 and 2010 - across all mandate sizes. Average fees for mandate sizes of USD25 million have decreased whereas for mandate sizes between USD100 million and USD200 million average fees have increased. Segregated fees have increased by on average 0.7 basis points, with the larger mandates increasing by slightly more.

“One explanation for the increase in segregated fees is that managers are using fees to ration out demand for those asset classes where there are capacity issues,” said Mr Hindocha.

When comparing the data by regions, Canada is the least costly, with average fees of around 0.3%. The UK and Australia follow with average fees of 0.46% and 0.47% respectively. Emerging markets remains the most expensive, at around 0.87%, with Asia-Pacific a close second at 0.83%. Japan, Europe and US all range between 0.57% and 0.7%.

Due diligence

Although due diligence is a must prior to each and every investment decision, for hedge funds it is doubly so, for all the reasons previously mentioned. If you choose to invest in a fund of funds, a lot, although not all, of the work will have been done for you, but there are still some basic issues to be addressed before you part with your hard-earned (or inherited!) cash. The following is not a comprehensive list, however, so here again, professional advice is necessary.

The Fund (Or Funds…)

  • Volatility - look at the fund's volatility over monthly (or weekly) periods if these figures are available. Also look at whether the annual return was generated evenly throughout the year, or whether it is the result of one or two large gains in specific periods.
  • Breadth - if possible, check whether the general partner turned an even result on all issues, or whether one lucky trade accounted for good results.
  • Repetition - is the investment process repeatable, or were good returns the result of dumb luck?
  • Strategy-specific risk - important if you are investing directly in just one hedge fund, but slightly less so if you choose to invest in a fund of hedge funds due to the greater diversification offered. Still, you should make sure you understand the particular risks inherent in each hedge fund manager's strategy.
  • Leverage - look at to what extent the fund uses leverage to make transactions, the fund's rationale for this device, and whether leverage has ever been revoked for any reason. Obviously, the extent to which a hedge fund uses borrowed money, and the rationale behind it, will affect the riskiness of the investment, so this is an important one.

The Key Personnel

  • Background - look into the general background of the hedge fund, including the division of responsibility, its formation and structure, fund terms and relationships, and possible conflicts of interest. Manager profile - look into the background, qualifications, employment history and track record of the manager or managers.
  • Reporting - Ascertain who the custodian of the fund's assets is, and also who the prime broker is. (And beware of any fund or hedge fund which asks you to send funds directly to it - they should always go to the prime broker or custodial bank.)
  • Administration. Find out whether the hedge fund manager uses a third party administrator to calculate monthly returns, and ask for background on the fund, their calculation methods, where their data comes from, and what procedures they have in place for ensuring that the terms of the fund are being upheld. However, concentration on the terms of the fund is more crucial with mutual fund investing than hedge fund investing given the fact that hedge fund managers can change strategies at a moment's notice to fit market conditions
  • Other investors. Although to a certain extent, you will already be aware of the general profile of other hedge fund investors (i.e. middling to filthy rich!), ask for any information that is available on the breakdown of institutional vs. individual investors, average investment amounts, etc. It may give you a clearer idea of whether the particular fund, or fund of funds, is suitable for you.

Hedge fund investment, although it appears to be slowly becoming more accessible, is never going to be the poor man's choice, and regulatory nervousness on the part of many authorities will mean that there is unlikely to be a headlong rush for the bandwagon. However, this is, in many ways, a good thing, as long experience (south sea bubbles, Dutch tulips, technology stocks, etc), has shown that a sudden rush of interest from the general public can often be too much of a good thing. Also, the vast majority of hedge funds, by their very nature, would lose a great deal of their nimbleness if they became over-subscribed.

However, the increasingly diverse opportunities within the sector, and the ever growing body of knowledge surrounding the subject mean that for a relatively wealthy and experienced investor in the right circumstances, hedge fund investment, or more realistically, investment in a fund of hedge funds, could be a financially exciting alternative.

If you do decide that this is the way forward for you, it is always strongly advisable to consult with a qualified financial professional before proceeding. Not only will they be able to help you choose the fund that is right for you, but they may well have access to information regarding performance and cost which is simply unavailable to lone individual investors.




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