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Hedge funds after Dodd-Frank

Now that the Dodd-Frank Act has been passed by both houses of Congress, we finally know its broad implications for hedge funds. As expected, it requires all large hedge fund advisers to register with the SEC. Also the new rules on derivatives trading have an additional impact on many hedge funds. However, since the Act leaves many specifics up to the regulators, considerable uncertainty remains about the exact form of the new rules. The main tradeoff is between the government's desire to learn more about hedge funds, both to assess systemic risk and to protect investors, and the compliance costs this imposes on funds and investors. Overall, how economically sensible is hedge fund regulation in the Act, and how well does the Act resolve this tradeoff?

The main economic argument for regulating hedge funds is based on their potential to generate systemic risk. Systemic risk can arise from counterparty exposures when a large fund (or group of similar funds) uses leverage but subsequently runs out of cash and thus cannot meet its obligations, either because of a negative net asset value or temporary lack of liquidity. The classic example is Long-Term Capital Management in 1998, which had almost a trillion dollars in notional exposures but only $4 billion in equity. The secondary argument for regulating hedge funds is based on protecting unsophisticated investors. However, hedge fund investors are already restricted to a small subset of "accredited investors" for this reason, which makes the case for further investor protection much weaker.

How much systemic risk do hedge funds really generate? The recent financial crisis represents an extended period of real-life "stress testing" which was more extreme than in 1998 and certainly should have exposed most fragilities in the system. Yet hedge funds held up relatively well: the average fund did fall 20%, but the equity market fell twice that much, and there were no major hedge fund blow-ups due to the crisis. Prime brokers and other hedge fund counterparties appear to have learned from 1998: leverage was lower throughout and counterparty risk did not seem a significant threat. Hedge funds also appear to have been prepared, as many of them put up gates to suspend withdrawals, which significantly curtailed the threat of runs on illiquid assets. Rather than causing or contributing to the recent crisis, hedge funds helped mitigate the crisis by taking some illiquid assets off the balance sheets of other institutions and by providing liquidity in general (Aragon and Strahan, 2010). Hence, the new hedge fund legislation is not so much about fixing newly discovered flaws as it is about preventing potential problems from arising in the future.

The Dodd-Frank Act requires all hedge fund advisers above $150 million to register with the SEC. They have to maintain extensive records about their investment and business practices, provide this information to the SEC, hire a chief compliance officer to design and monitor a compliance program, and be subject to periodic SEC examinations and inspections. The SEC is also given considerable power to expand its own authority in the future: it has the power to request any additional information it deems necessary, it can define "mid-sized" private funds and require them to register as well, and it can impose separate recordkeeping and reporting requirements on all other hedge funds. However, "family offices" are exempt from registration.

Also the derivatives section of the Dodd-Frank Act affects hedge funds. For example, a hedge fund trading OTC derivatives may be deemed a "major swap participant" and thus be subject to additional regulation described in the derivatives section of the Act. Again, a lot of the important details are left for the regulators to decide later.

Overall, we would like to see a broad but light regulatory approach to hedge funds. It would be reasonable to require all hedge funds to register with the SEC and to file Form ADV to provide useful information to investors. Particularly troubling is the family office exemption which has the potential to turn into a loophole that encompasses a large fraction of the industry. However, compliance costs should be kept low, and the SEC's mandate should be limited to collecting information on the items explicitly mentioned in the Act. In its current form, the Act gives the SEC essentially an open mandate to regulate and to define the scope of its own authority over the industry. Because regulators in general have an incentive to expand their own power and because the SEC in particular has an unimpressive track record of discovering even simple fraud, any additional powers granted to the SEC should be more narrowly targeted toward a specific task.

Protection of hedge fund investors is now something the SEC is also officially authorized to engage in. We hope that any such future rules would focus on disclosure, such as requiring explicit disclosures of all expenses charged to the fund and differential tax treatment of investors. Beyond that, it should be up to the accredited investors themselves to make their own investment decisions. Fiduciaries should bear more responsibility for doing due diligence and pay a high price for neglecting this fundamental duty.

The sensibility and impact of the new hedge fund legislation will almost entirely depend on the specific rules that will be written later by the regulators, so we cannot pass our final judgment yet, especially given the considerable leeway the Act has left for the regulators. It may even take a year or two before we will really see how the hedge fund rules have changed.

In the future, the hedge fund sector will only grow in size and importance, since the Volcker rule of the Dodd-Frank Act requires banks to spin off their proprietary trading desks and their internal asset management divisions into stand-alone hedge funds. As a result, hedge funds will be the only source of sophisticated and relatively unconstrained capital, thus making them perhaps the main liquidity providers across a variety of markets. Efficient allocation of capital is the key function of the financial market, so it is all the more important that the subsequent rules following the Dodd-Frank Act will not stifle hedge funds or reduce the intense competition between them.

Proposed legislative and regulatory changes

Private Fund Investment Advisers Registration Act (H.R. 3818)

  • Everyone Registers. Sunlight is the best disinfectant. By mandating the registration of private advisers to hedge funds and other private pools of capital, regulators will better understand exactly how those entities operate and whether their actions pose a threat to the financial system as a whole.
  • Better Regulatory Information. New recordkeeping and disclosure requirements for private advisers will give regulators the information needed to evaluate both individual firms and entire market segments that have until this time largely escaped any meaningful regulation, without posing undue burdens on those industries.
  • Level the Playing Field. The advisers to hedge funds, private equity firms, single-family offices, and other private pools of capital will have to obey some basic ground rules in order to continue to play in our capital markets. Regulators will have authority to examine the records of these previously secretive investment advisers.

The Obama administration presented the U.S. Congress with its far-reaching recommendations to overhaul the U.S. financial regulatory system (the "Plan") on 17 June 2009. Among other things, the Plan calls for the registration of investment advisers to private pools of capital, including hedge funds, private equity funds and venture capital funds, with assets under management above a "modest" amount. On 15 July 2009, the Obama administration delivered to the U.S. Congress the Private Fund Investment Advisers Registration Act of 2009 (the "Private Advisers Bill"), draft legislation that is intended statutorily to implement certain aspects of the Plan.1 In addition, shortly before the Plan was unveiled, Senator Jack Reed introduced into the U.S. Senate the Private Fund Transparency Act of 2009 (the "Private Fund Bill" and, collectively with the Private Advisers Bill, the "Bills").2 These two pieces of legislation generally are consistent and, if either is adopted, would significantly expand the number of investment advisers required to register with the U.S. Securities and Exchange Commission ("SEC"), including non-U.S. investment advisers.

The Plan and the Bills are the latest efforts by U.S. politicians eager to subject private funds and their managers to closer regulatory scrutiny.3

The Obama Administration Plan

The Plan recommends that investment advisers to private pools of capital whose assets under management exceed some "modest threshold" be required to register with the SEC. Although the Plan does not call for the direct registration of funds, the Plan does recommend that investment funds advised by SEC-registered advisers be subject to recordkeeping requirements and disclosure requirements with respect to investors, creditors and counterparties. Presumably, the investment advisers to these funds would be required to ensure that these requirements are met, and the Plan recommends that the SEC conduct regular, periodic examinations of these funds to monitor compliance.

The Plan also recommends that registered investment advisers be required to report to the SEC information on the funds they manage, and that such information should be sufficient to assess whether any fund poses a systemic threat. The SEC would be required to share this information with the U.S. Federal Reserve Board (the "Fed").

Under the Plan, the Fed is charged with supervisory authority over financial firms posing systemic risks, which may include hedge funds, private equity funds and venture capital funds. The Fed would identify such funds based on criteria to be established by the U.S. Congress, which would likely include the fund's "size, leverage and interconnectedness". Funds that pose a systemic risk would be designated as "Tier 1 Financial Holding Companies" ("Tier 1 Funds") and would be subject to strict capital, liquidity and risk management standards. The possible substantive regulation of Tier 1 Funds represents a break from the current trend in U.S. hedge fund and private equity fund regulatory efforts, which to date have focused on disclosure as opposed to substantive regulation.4

The Private Advisers Bill and the Private Fund Bill

Either Bill, if enacted, would amend the U.S. Investment Advisers Act of 1940 (the "Advisers Act") to require: (i) the registration of many investment advisers that have heretofore been able to rely on certain exemptions from SEC registration; and (ii) periodic reporting by advisers of fund-specific information.

Adviser Registration

Under the current U.S. regulatory regime, an "investment adviser" is defined as "any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing or selling securities." The Advisers Act generally requires that any person so defined register with the SEC, unless the adviser can rely on an exemption from the registration requirement. The most common exemption relied on by advisers to hedge funds, private equity funds and other pooled investment vehicles is Section 203(b)(3) of the Advisers Act (commonly known as the "Private Adviser Exemption"), which currently is available to any adviser that:

  • has advised fewer than 15 clients in the course of the preceding 12 months;
  • does not hold itself out generally to the public as an investment adviser; and
  • does not advise any U.S.-registered investment company or business development company.

Each Bill would amend the Private Adviser Exemption such that a U.S.-based adviser generally would be required to register with the SEC, regardless of the number or type of clients advised, if the adviser has US$30 million of assets under management.5

In addition, the Private Advisers Bill specifically addresses the status of a U.S.-based adviser of a "private fund", which is defined as (i) an investment fund that relies on either of the two exceptions from regulation as an investment company on which hedge funds, private equity funds and venture capital funds generally rely, and (ii) which is either organized or created under the laws of the United States (or any state thereof) or has 10 percent or more of its outstanding interests owned by U.S. persons. The adviser of such a private fund generally would be required to register with the SEC if the adviser has US$30 million of assets under management, and could not rely on the intrastate adviser exemption in Section 203(b)(1) or the commodity trading advisor exemption in Section 203(b)(6), which are two other exemptions from investment adviser registration on which some hedge fund managers rely.6

Application to Non-U.S. Investment Advisers

While generally rescinding the Private Adviser Exemption, each Bill introduces the concept of a "foreign private adviser" ("FPA"), which may continue to rely on a limited exemption from registration. Under each Bill, an FPA is defined as any investment adviser that:

has no place of business in the United States; during the preceding 12 months has had fewer than 15 clients in the United States; and assets under management attributable to clients in the United States of less than US$25 million; and neither holds itself out as an investment adviser generally to the public in the United States, nor acts as an investment adviser to a U.S.-registered investment company. Therefore, a non-U.S. adviser with only a limited number of U.S. clients generally would be required to register with the SEC only if assets attributable to such clients exceeded US$25 million.

Potential Limits with Respect to U.S. Clients

When counting U.S. clients for purposes of the new FPA exemption, current Rule 203(b)(3)-1 under the Advisers Act (the "Counting Rule") generally would permit, among other things, any FPA to count a U.S. private fund as a single client, rather than each individual investor in such a fund. In addition, FPAs currently would not be required to count non-U.S. funds as clients under the Counting Rule, even if those non-U.S. funds have a significant number of U.S. investors.

However, each Bill explicitly grants the SEC authority to redefine "client" for purposes of the Counting Rule. In light of prior SEC efforts to expand hedge fund adviser registration, it is possible that the SEC would adopt amendments to the Counting Rule with the effect that FPAs will be required to "look through" funds and count U.S. investors in a fund as clients of the adviser for purposes of determining compliance with the 15 U.S. client limit.7 If the SEC were to adopt such amendments, FPAs may be required to strictly limit the actual number of U.S. investors in their funds (and the amount of their investments) in order to rely on the FPA exemption contemplated in either Bill. However, the Private Advisers Bill appears to be primarily intended to require the registration of investment advisers to "private funds" (i.e., U.S. funds or non-U.S. funds with a significant U.S. client base). Accordingly, while their ultimate treatment remains unclear if the Private Advisers Bill becomes law in its current form, non-U.S. advisers to non-U.S. funds may be able to avoid investment adviser registration in the U.S. by strictly limiting the level of investment by U.S. clients, or they may be able to rely on the commodity trading advisor exemption in Section 203(b)(6) of the Advisers Act.8

In addition to the potential change of status of U.S. investors in a fund, each Bill also would effect another major change with respect to the current terms of the Private Adviser Exemption by imposing the requirement that an FPA must source less than US$25 million from U.S. clients. No such asset limitation currently exists, and non-U.S. advisers may have to register with the SEC as a result of a single significant U.S. private client or U.S. investor if either Bill is enacted as proposed.

Effect of Registration on Non-U.S. Advisers

Presumably, non-U.S. advisers required to register with the SEC under either Bill would be permitted to rely on existing guidance excepting registered non-U.S. advisers from certain provisions of, or rules under, the Advisers Act with respect to non-U.S. clients. However, registered non-U.S. advisers must comply with the substantive provisions of the Advisers Act with respect to the firm's U.S. clients.

Registration under the Advisers Act imposes a number of requirements that could significantly impact adviser operations and compliance costs. In addition to registering with the SEC and meeting various disclosure obligations, registered advisers generally are required to, among other things, comply with extensive recording-keeping requirements and maintain a compliance program reasonably designed to prevent violations of the Advisers Act. Registered advisers are also subject to the SEC's adviser inspection program, which is designed to ensure that the adviser is in compliance with the Advisers Act and other U.S. federal securities laws, and that the adviser's business activities are consistent with its disclosure.

Periodic Reporting of Fund-Specific Information

Each Bill also attempts to implement the Plan's recommendations with respect to periodically reporting fund-specific information. Each Bill would require U.S.-registered advisers to submit such reports as are necessary or appropriate for the evaluation of systemic risk posed by funds managed by the adviser. The disclosure requirements of the Private Advisers Bill are more detailed, and specify that an adviser disclose assets under management (including off-balance sheet leverage), counterparty credit risk exposures, trading and investment positions and trading practices with respect to each private fund managed by the adviser. Under the Private Fund Bill, these reports also would include information about funds sponsored by the adviser or its affiliates, or funds for which the adviser or its affiliates act as underwriter, distributor, placement agent or finder. Currently, U.S.-registered advisers are not required to disclose information about their clients.

In order to alleviate concerns over confidentiality, each Bill makes clear that the SEC is not required to publicly disclose information reported by advisers with respect to the funds they manage. In addition, each Bill limits the availability of this information pursuant to requests under the U.S. Freedom of Information Act. However, the SEC would be permitted to share this information with Congress, other Federal departments or agencies or self-regulatory organisations.

In addition, the Private Advisers Bill (but not the Private Fund Bill) authorises the SEC to adopt rules requiring that private fund advisers provide designated reports, records and other documents to investors, prospects, counterparties and creditors. However, the Private Advisers Bill does not detail the types of information that private fund advisers may be required to disclose with respect to the funds that they manage.


The Private Fund Bill has been submitted for consideration to the Senate Committee on Banking, Housing and Urban Affairs. To date, no action has been taken with respect to the Private Advisers Bill. Given that each Bill appears to reflect the suggestions of the Plan, either Bill may gain more momentum in the U.S. Congress than the legislation that was previously introduced. However, it is difficult to predict at this time whether or when either Bill will be debated or passed, or the content of any final legislation.

Notwithstanding the uncertain future of the Bills, managers of U.S. and non-U.S. funds should carefully monitor the progress of the Bills or any other effort to implement the Plan, and consider the potential impact of the same on the operations of their businesses, funds and investors. It is important to note that each Bill's fund-specific reporting requirement would go beyond the scope of the current disclosure obligations associated with SEC investment adviser registration. If such a disclosure obligation is ultimately enacted, advisers may want to revisit their funds' offering documents and management agreements. In addition, an investment adviser may wish to consider the appropriateness of disclosing in its funds' offering materials that the adviser may be required to disclose to the SEC and other regulators certain information about the funds. Even though the Plan and each Bill contemplates that this information should be provided to regulators on a confidential basis, current fund investors (especially non-U.S. investors) that are concerned about confidentiality may be concerned regarding any type of regulatory disclosure obligation.


1 The Private Advisers Bill is available here.

2 The Private Fund Bill is available here.

3 In addition to the above, the Hedge Fund Adviser Registration Act of 2009 (the "Capuano Bill") was introduced into the U.S. House of Representatives in January and, if enacted, would also require the registration of many advisers to funds that currently are able to rely on an exemption from registration. In addition to the registration of investment advisers, U.S. politicians have also targeted the funds managed by such investment advisers for registration. The Hedge Fund Transparency Act of 2009 (the "Grassley Bill") was introduced into the U.S. Senate in January and, if enacted, would require the registration of all private pools of capital with US$50 million or more in assets under management. For a more detailed discussion of the Capuano Bill, please refer to the February 2009 DechertOnPoint.

For a more detailed discussion of the Grassley Bill, please refer to the February 2009 DechertOnPoint.

4 However, in 15 July 2009 testimony before the U.S. Congress in support of the Private Fund Bill, the director of the SEC's Division of Investment Management suggested that substantive regulation of such funds through registration with the SEC or through expanded SEC rulemaking authority was a possible alternative to regulation of unregistered fund advisers.

5 In many instances, a U.S. adviser may elect to register with the SEC if it has at least US$25 million of assets under management.

6 The "intrastate adviser exemption" in Section 203(b)(1) of the Advisers Act exempts from the requirement to register under the Advisers Act any investment adviser all of whose clients are located in the same state within which the adviser maintains it principal place of business. The "commodity trading advisor exemption" in Section 203(b)(6) of the Advisers Act exempts from the requirement to register under the Advisers Act any investment adviser registered with the Commodity Futures Trading Commission as a commodity trading advisor (i) whose business does not consist primarily of acting as an investment adviser (as defined in Section 202(a)(11) of the Advisers Act) and (ii) who does not act as an adviser to a U.S.-registered investment company or business development company.

7 In 2004, the SEC adopted amendments to the Counting Rule and added a companion rule under Section 203(b)(3) (together, the "2004 Rule"), which required investment advisers to look through certain funds and count investors in the fund as clients of the adviser for the purposes of determining compliance with the Private Adviser Exemption. However, the 2004 Rule was subsequently vacated by the U.S. Court of Appeals for the District of Columbia. See Goldstein et al. v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006).

8 Section 203(b)(6) of the Advisers Act provides that an investment adviser registered with the Commodity Futures Trading Commission as a commodity trading advisor, whose business does not consist primarily of acting as an investment adviser (as defined in Section 202(a)(11) of the Advisers Act) and who does not act as an adviser to a U.S.-registered investment company or business development company, is exempt from registration under the Advisers Act.

Senate legislation

Senate hearing, July 15th

Regulating Hedge Funds and Other Private Investment Pools Securities, Insurance, and Investment Subcommittee Wednesday, July 15, 2009, 02:30 PM 538 Dirksen Senate Office Building, room 538


  • Mr. Andrew J. Donohue, Director of the Division of Investment Management, U.S. Securities and Exchange Commission
  • Mr. James S. Chanos, Chairman, Coalition of Private Investment Companies
  • Mr. Trevor R. Loy, General Partner, Flywheel Ventures
  • Mr. Joseph Dear, Chief Investment Officer, California Public Employees’ Retirement System.

Other witnesses may be announced.

Global oversight

UK and EU diverge on hedge rules

George Osborne will tomorrow be forced to accept tougher regulations on the UK's highly profitable hedge fund industry as European leaders press ahead with plans to crack down on the sector.

On his first visit to Brussels as chancellor, Osborne had hoped to resist plans which he and his predecessor Alistair Darling were strongly against.

But after months of threats and deliberations, French, German and Spanish leaders within the EU are expected to push ahead with a directive which is aimed at clamping down on speculators who they believe contributed to the global credit crunch and more recently pushed Greece to the brink of collapse.

In another attempt to stop market jitters, financial services commissioner Michel Barnier promised to deal "very severely" with the use of credit default swaps, the instruments that investors buy to protect themselves against a potential default, but were used to bet against a country's ability to pay its debts.

Barnier said: "These people don't like to come out in the light of day. We are going to flood them with light."

This regulation will be proposed in October after the hedge fund and private equity directive has been agreed by finance ministers, the European parliament and the commission, a process that may take three months. Under the new rules, hedge funds will be forced to hold more capital and non-European hedge funds will have to gain a "passport" to operate within the EU.

"We will approve regulation on hedge funds ? I think this will all contribute to more stability," Spain's finance minister Elena Salgado said .

Britain has strongly opposed the plans as it hosts about 80% of the European hedge fund industry, which contributes 5.3bn in tax revenues to the UK economy every year, according to the thinktank Open Europe. "Forcing through the directive could cause serious damage to the UK's economy and jeopardise billions in funding to developing countries," the thinktank said.

The move would also be a blow to Osborne and his colleagues in the coalition government, Open Europe said. "The decision is being taken by the bloc's finance ministers only one week after the new UK government has taken office, leaving it virtually no room to prepare for the negotiations," the think tank said.

Former prime minister Gordon Brown managed to persuade Spanish prime minister Jos? Luis Rodrguez Zapatero to withdraw the vote at the last Ecofin meeting [1], but a similar plea, on Friday, by George Osborne, the new chancellor, was to no avail. European Union leaders, facing the worst crisis in the EU since the euro was created a decade ago, are now in a rush.

The new directive comes as the single currency dropped to its lowest level against the US dollar in four years as weaker economies in the zone continue to come under pressure on the markets.

However, hedge funds deny any wrong-doing and say they only profit from volatility created by politicians' mishandling of the economy. "Markets are markets hysterical, schizophrenic, paranoid, whatever you want but politicians live in a dreamland," said a hedge fund manager. "Politicians have spent everything they wanted over the past few years, and now they can't spend less, when they need it so they are prisoners of the markets."

Hedge funds and other financial institutions have enjoyed a year of market volatility and trading opportunities while politicians were deliberating how to punish them. The axe is now out and the first consequences are being felt. Man Group, the biggest publicly traded fund manager, based in London, agreed to buy rival hedge fund GLG Partners, also based in London, to expand its product offer.Although the merger had been planned for a long time, more consolidation is expected as the industry weathers the effects of tougher regulation and higher costs, said Peter Clarke, chief executive of MAN Group. "It makes the competitive environment quite tough," Clarke said in a conference call. "Some people will have to decide whether they're out of Europe or in -the barriers of entry will be much higher."

European leaders also blame hedge funds for causing trouble for smaller companies: activist hedge funds, in the past, have bought the debt of a troubled company, only to boycott a debt restructuring deal in order to gain control of the assets and sell them at a hefty profit. Activist hedge funds argue they push beleaguered companies into efficiency and much-needed change.

The global hedge fund industry, mostly based in London and New York, manages about $2tn in assets. In Britain, it employs 10,000 professionals directly and 30,000 service providers, such as lawyers and accountants, indirectly.

EU delays new hedge fund rules

"E.U. finance ministers delayed a decision on new rules for hedge funds Tuesday in a reprieve for Britain, which fears that too-tight regulation could drive the industry from London.

The ministers, meeting in Brussels, decided to take a couple more months to try to reach consensus on the issues, according to E.U. diplomats. The diplomats spoke on background before an official announcement by ministers.

“It’s a good outcome for U.K.,” said an official from the British Treasury, who added that the British government was focused on “getting a deal that makes the system stronger without sacrificing competitiveness.”

Alistair Darling, the British finance minister, was expected to address reporters later Tuesday.

Opposition to the measures has also come from the United States. Earlier this month, Timothy F. Geithner, the U.S. Treasury secretary, warned that the proposed rules could discriminate against U.S. funds, raising the specter of trade friction.

The proposed law would have required even funds based outside the 27-member European Union to comply with E.U. rules, including restrictions on bonuses and leverage, if they wanted to market themselves to investors inside the bloc.

Regulators and lawmakers worldwide are tightening their scrutiny of hedge funds and private equity firms on the grounds that they may have been partly to blame for the worst financial crisis in a generation.

Many in Europe also see the industry as too opaque and secretive.

But Britain has led a determined fight against elements of the crackdown, fearing that the rules threaten the position of the City of London as a global financial hub, while doing little to protect the financial system from risk.

About 70 percent of hedge funds operating in Europe are based in Britain.

Gordon Brown, the British prime minister, and Nicolas Sarkozy, the French president, discussed the proposed law in London last week. They said they had narrowed their differences but gave no further details.

Once E.U. governments agree to the measures, the European Parliament still would need to give its approval, a process that could take months.

Geithner's letter to the EU Commissioner

The above is a letter sent by US Treasury Secretary Tim Geithner to Michel Barnier, the newly installed EU Internal Markets Commissioner, concerning the controversial AIFM directive and obtained exclusively by the Financial Times.

Geithner makes it fairly clear that many elements of the directive are no-go areas for the US. The main issue is that of equivalence: under the current draft being debated by the EU council, in order to sell to EU investors, non-EU (i.e. US/Cayman) hedge funds will need to show they comply with rules equivalent in nature to those of the EU.

Note the thinly-veiled threat in Mr Geithner’s letter:

We are concerned with various proposals that would discriminate against US firms and deny them access to the EU market that they currently have. We strongly hope that the rules that you will put in place will ensure that non-EU fund managers and global custodian banks have the same access as their EU counterparts. You will see that our approach in the US maintains full access for EU fund managers and custodians to our market.

Hedge funds don’t pose ‘destabilizing risk,’ FSA says

U.K. hedge funds, facing a regulatory onslaught from lawmakers worldwide, received a boost from a report by Britain’s financial regulator that said they posed no “destabilizing risk.”

The 50 largest hedge fund firms operating in the U.K. had borrowings of about double their $300 billion of assets under management, according to an October 2009 survey released by the Financial Services Authority today. The study showed that no hedge fund borrowed more than $500 million from a single bank without collateral. The biggest hedge fund questioned had about $1 billion of credit spread across a number of banks.

“Major hedge funds did not pose a potentially destabilizing credit counterparty risk,” the FSA said. “Data shows a relative low level of ‘leverage’ under our various measures.”

Hedge funds and private equity firms are under the scrutiny of regulators and lawmakers worldwide, who say they are partly to blame for the worst financial crisis in a generation. The Group of 20 Nations in April agreed to tighter oversight of funds. FSA Chairman Adair Turner said last year that hedge funds may require capital and liquidity thresholds if they are shown to be systemically important.

The British regulator has instead moved to place the onus on hedge funds’ counterparties to guard against extra risk. Banks will have to find an extra 29 billion pounds ($45 billion) to protect their trading books against potential losses, the FSA proposed in December.

President Obama

Funds won’t be able to get investment from U.S. banks under proposals announced last month by President Barack Obama. The European Commission in Brussels has also proposed a law governing hedge funds in the 27-nation European Union, of which the U.K. is a member. As many as 40 percent of the world’s hedge funds won’t have access to EU investors if those plans are passed in their current form, the FSA has said. The U.K. is home to 80 percent of Europe’s hedge fund management industry.

Governments must agree on the final wording of the so- called Alternative Investment Fund Managers Directive with lawmakers at the European Parliament, who today discussed possible changes to the rules at a meeting in Brussels.

‘Proportionate And Sensible’

Today’s FSA survey “certainly backs the approach taken by the U.K. Treasury and FSA up until now over the directive, which is that regulation should be proportionate and sensible,” said Darren Fox, a regulatory lawyer who advises hedge funds at London-based Simmons & Simmons. “Why they’ve chosen to publish this time around could be that it’s politically helpful.”

Hedge funds controlled 0.9 percent of European equities, the survey showed. They also owned fewer derivatives than estimated by the Bank of International Settlements, the FSA said, without giving details. One area where hedge funds were “significant participants” was in convertible bonds, with positions worth about 10 percent of the global market, according to the FSA.

“It’s quite difficult to interpret the report as a series of percentages,” said Fox. “Some statistics could be misinterpreted.”

The FSA study replaces the watchdog’s twice-yearly survey of prime brokers, which provide stock lending and trade clearing for hedge funds. While the FSA oversees individual managers who are based in the U.K., the funds themselves tend to be based in offshore jurisdictions beyond the FSA’s reach, such as the Cayman Islands.

Shared data for US and UK hedge fund oversight

"From a regulatory perspective, one of the lessons from events of the last two years is the importance of a more joined-up framework for collecting and sharing systemically important information to allow assessment and mitigation of risks to financial stability. As our Chairman, Adair Turner, underlined in his review – and in line with the G20 commitments – regulators need information about the activities of systemically important players in the markets, including hedge funds, that will enable them to take a view of their potential impact on the wider financial markets, or particularly vulnerable sectors of the market.

Since the publication of the Turner Review, we have been working hard to design an appropriate framework for the collection and sharing of this systemically important information. As David Vaughan mentioned earlier, I am therefore particularly pleased that we announced yesterday our commitment to working with the US Securities and Exchanges Commission (SEC) to identify a common, coherent set of data which we will collect from those hedge funds advisers and managers located in our respective jurisdictions.

As the regulators of two of the world’s major financial centres – in which the vast majority of hedge fund assets are managed – harmonising the collection and sharing of this information reduces the compliance burden on fund managers while allowing the SEC and FSA to better identify risks to their regulatory objectives and mandates.

The commitment we made yesterday underlines our support for the proportionate and efficient regulation of the alternative investment fund management sector. Using our experience in working with the SEC, we are activity engaging in the debate over the design of the framework for the collection and sharing of this type of information between supervisors at a European level to ensure it also delivers these objectives."

Largest global hedge funds

Firm Assets (billions)

  • JPMorgan Chase $53.5
  • Bridgewater Associates $43.6
  • Paulson & Co. $32
  • Brevan Howard $27
  • Soros Fund Management $27
  • Man Group $25.3
  • Och-Ziff Capital $23.1
  • D.E. Shaw* $23
  • BlackRock/Barclays Global $21
  • Farallon Capital $20.7
  • Baupost Group** $20
  • Goldman Sachs Asset $17.8
  • BlueCrest Capital $17.3
  • Canyon Partners $17
  • Landsdowne Partners* $15
  • Renaissance Technologies $15
  • Fortress Investment $13.8
  • Moore Capital $12.4
  • Viking Global* $12.4
  • Citadel Investment $12.2
  • SAC Capital $12
  • GLG Partners $11.5
  • Tudor Investment $10

IOSCO publishes systemic risk data requirements for hedge funds

The International Organization of Securities Commissions’ (IOSCO) Technical Committee has published details of an agreed template for the global collection of hedge fund information which it believes will assist in assessing possible systemic risks arising from the sector. The template was developed by the Task Force on Unregulated Entities (Task Force) following requests from the Financial Stability Board (FSB) as well as from IOSCO members.

The purpose of the template is to enable the collection and exchange of consistent and comparable data amongst regulators and other competent authorities for the purpose of facilitating international supervisory cooperation in identifying possible systemic risks in this sector. IOSCO believes that participants are best monitored through their trading activities, the markets they operate in, funding and counterparty information, amongst others.

IOSCO publishes "high level" principles

Source: http://www.bobsguide.com

Six "high-level principles" for guiding the regulation of hedge funds have been put forward by the International Organization of Securities Commissions (Iosco).]

The final report of the body's Task Force on Unregulated Entities said the proposals would help regulators to monitor the systemic risk created by the investment pools within their own markets, while also aiding the development of a consistent global approach for overseeing funds, managers and advisers.

Iosco's guidelines call for all hedge funds, managers and advisers to face mandatory registration and ongoing assessment of their conduct of business, investor disclosure, prudential regulation and operational standards.

The report also recommends mandatory registration for the banks and prime brokers that provide financing to the sector and for these bodies to provide regulators with data to aid the monitoring of systemic risk.

To ensure the potential risk created by global fund managers and investment pools is controlled across borders, market supervisors should be allowed to share this information where necessary, the body said.

Last week, Iosco published its final report calling for international controls and reporting measures to ensure the effective regulation of short selling.

"A global regulatory body backed compulsory registration of hedge fund managers to restore investor confidence, saying the $1.3 trillion sector did not cause the credit crunch but may have amplified its effects.

The International Organisation of Securities Commissions (IOSCO) represents regulators from over 100 countries, including the U.S., Japan and the 27-nation EU. Its final principles flesh out a pledge from the G20 in April that all hedge fund managers should be registered and directly supervised.

There are already signs that full convergence on global hedge fund rules may be difficult to achieve. The EU has put forward a draft law that goes much further than the final principles adopted by IOSCO.

The U.S. is also planning mandatory registration of hedge funds but so far in a less extensive way than the EU. IOSCO’s six principles include mandatory registration of hedge fund managers who should disclose a range of information to regulators and investors.

Prime brokers who provide funding to hedge funds, typically banks, should also be subject to mandatory registration and supervision.

IOSCO stopped short of saying there should be mandatory registration of all underlying hedge funds as well as their managers, a step some countries have called for. The Alternative Investment Management Association (IAMA), a global hedge fund lobby, said it backed registration and reporting of relevant information by large hedge funds to supervisors. “A few notes of caution, however. We would stress that it is hedge fund managers, rather than the funds themselves, that should be registered,” AIMA said In a statement.

It was also concerned that regulators may seek “quantity rather than quality of data.”

Regulatory oversight should be more focused on systemically important and higher risk hedge fund managers, IOSCO said. Some policymakers say direct supervision is needed because big hedge funds pose a risk to financial stability. The industry says it has been made a scapegoat because of activist hedge funds and no fund has needed bailing out with taxpayer cash. “We all recognise that there are vast numbers of hedge funds that might not pose a systemic risk at all,” Ross said.

The EU draft law lays down thresholds for “systemically” important funds and for applying capital requirements but IOSCO said more work was needed on both issues before taking a final position. “We obviously need to make sure we just don’t focus on hedge funds in isolation... It’s very clear we don’t view the current crisis as a hedge fund crisis,” Ross said.

The Cayman Islands Monetary Authority (CIMA), which oversees most of the world’s hedge funds, joined IOSCO this month. “That will create greater confidence across the globe that there are common standards being implemented as to the supervision of hedge funds and hedge fund managers,” Ross said. CIMA said it was planning to reveal more information about hedge funds it supervises as offshore centres face pressure from the G20 to be more transparent. IOSCO said the sector provided liquidity, price efficiency and risk distribution but regulation was needed because there are questions over the effectiveness of industry codes."

France wants tougher hedge fund rules

Source: July 2, 2009, Reuters News

"France said it will not allow draft EU rules to regulate hedge funds to pass unless they are toughened up, putting it at odds with Britain which has been trying to dilute them. “The [European] Commission’s project [on hedge funds] is a step forward, but it is not up to my ambitions,” finance minister Christine Lagarde said. “I will not let this directive be adopted in this state.”

She said hedge funds located in non-cooperative tax centres should not be allowed to operate in Europe. Britain and the hedge fund industry say the draft rules make it difficult for non-EU managers and funds to operate in the EU. Lagarde also proposed a new EU directive to harmonize clearing house rules. “For our financial stability, I want credit derivatives [denominated] in euro to be cleared by clearing houses located and supervised in the euro zone and that they are able to access European Central Bank liquidity,” she said.

Britain is the EU’s biggest centre for trading off-exchange derivatives and dealers warn the market could be fragmented by many clearers. Lagarde also favours the creation of a euro zone data warehouse that would store copies of credit default swap contracts, in an effort to make the market safer."

Australia issues consultation paper

Hedge funds likely to relocate to Switzerland

Geneva? Zurich? Perhaps even Zug, Switzerland? Between deciding whether to be long or short of the dollar, or pondering whether we are in the middle of a bear rally or a new bull market, London’s hedge funds also need to decide which Swiss canton they want to move to.

A new top income-tax rate of 50 percent, coupled with heavy-handed regulations planned by the European Union, are prompting the funds to quit the British capital for somewhere more sympathetic to their hypercompetitive brand of capitalism.

That will have a greater impact on the global financial system than anyone yet appreciates. Sure, at the moment, it is just a few funds. But there are two larger forces at work. Hedge funds are a cluster industry: They like to be where all their competitors are. More significantly, while the hedge funds used to go where the investment bankers were, that will go into reverse in the next five years.

If many of the hedge funds relocate to Switzerland, investment bankers will follow them. Switzerland will be the winner, and London’s loss may be permanent.

Right now, it is only a handful of funds that are making the switch from London to Switzerland. Amplitude Capital LLP recently moved its head office from London to Switzerland. Brevan Howard Asset Management LLP recently said its offshore unit was considering opening an office in Geneva.

Consulting firm Kinetic Partners LLP says it has helped 23 hedge-fund firms make the move from London to Switzerland in the past 18 months. There were 957 single-manager hedge funds in the U.K. at the end of 2008, according to EuroHedge figures.

“Since April, we’ve started moving another 15 managers, all of a significant size,” David Butler, a founder of Kinetic, said in a telephone interview. “I believe 20 percent of the hedge-fund managers will leave London in the next two years, and many of them will go to Switzerland because there is already a club there for them to join. Once something like this gets momentum, it is very hard to stop.”

It isn’t that hard to see why they are making the switch.

From April next year, the U.K. will impose an income-tax rate of 50 percent on anyone earning more than 150,000 pounds ($237,000) a year, along with restrictions on tax-friendly pension contributions. That will be one of the toughest tax regimes in Europe. Nor can they expect any reductions in the near future. The Conservative Party, which is likely to win the next election, has no plans to repeal that.

It isn’t just their pockets that will be hit. Tough new EU regulations, which will restrict the amount that hedge funds can borrow as well as force them to use banks domiciled in Europe, will make their businesses harder to run as well. The mayor of London, Boris Johnson, said last month the rules may allow non- EU nations such as Switzerland “to claim business and jobs that would otherwise stay in the European Union.”

He’s right to be concerned. The exodus to Switzerland can’t be easily reversed and a few hedge funds may soon become a lot of hedge funds.

The combination of high taxes and new EU regulations poses the biggest threat in a generation to London’s pre-eminence as Europe’s financial hub.

There are two reasons for that.

Like sheep, which they sometimes resemble in their investment strategies as well, hedge funds like to hang out with their own kind. They thrive on mixing with one another, swapping ideas, strategies, staff, technology, investors and advisers. That is how they grow, how they find new ideas, and how they maintain their competitive edge.

Once a few move to Switzerland, there will be more and more incentive for other funds to follow them. And once they are there, there will be little reason for them to return. It would take something like Switzerland raising taxes to 50 percent to force them out. And how likely is that?

Next, over the next five years the hedge funds are going to grow in importance within the financial system.

The funds have two advantages over the investment banks.

Even with the new EU directive, they will be a lot less heavily regulated. Of course, the Swiss-based funds won’t be subject to those EU rules. Closely monitored by governments, the post-credit-crunch banking industry will be conservative and slow-moving. Its main objective will be to avoid risk and stay out of trouble. That means it will grow slowly, and gradually become less and less competitive.

By contrast, the hedge funds will be able to try out new ideas, and raise new funds, much as they please.

The funds will be the hubs of innovation, and increasingly the one real source of spare capital. The bankers will need to be close to them because that is where the business will be.

The true measure of how competitive a financial center is will be how successful it is at attracting hedge funds.

On that score, Switzerland is making up a lot of ground on Britain. In time, investment bankers will follow hedge funds to Geneva, Zurich or Zug -- and London may find it impossible to tempt them back.

Kanjorski and Shelby meet with EU counterparts

Source: US takes row over EU hedge funds directive to Brussels The Guardian, August 31, 2009

A delegation of American congressmen is flying into Brussels this week to dispel mounting trade tensions between the US and Europe over hedge funds.

Worries centre on the European Commission's directive on alternative investment fund managers. The hedge fund industry claims that if it is enacted according to the current draft, it could cost European pensioners up to €25bn a year by shutting out American and other non-EU based investment vehicles. That would result in a major reduction of choice for large investors, who as a consequence would suffer increased costs and lower returns.

Among the disputed provisions are proposals to make US hedge funds submit to a three-year waiting period before being allowed to market themselves in Europe. It would also subject hedge funds, private equity and other alternative investments to a battery of tests.

These include limits on how much debt such funds can take on; a requirement to hold capital to cover potential losses and redemptions; and strict disclosure requirements for private-equity portfolios. The directive would apply to all funds and financial firms wanting to market themselves in the EU. It is feared that the so-called "equivalence test" will freeze out US companies, because the directive goes much further than proposed changes across the Atlantic...

...The Brussels-bound delegation is led by Congressman Paul Kanjorski, who chairs the financial services subcommittee on capital markets. He and his colleagues will meet members of the European Parliament's economic and monetary affairs committee, chaired by British MEP Sharon Bowles. The visit follows a Senate delegation on Friday led by Richard Shelby,the top Republican on the banking committee."

Regulatory issues

Part of what gives hedge funds their competitive edge, and their cachet in the public imagination, is that they straddle multiple definitions and categories; some aspects of their dealings are well-regulated, others are unregulated or at best quasi-regulated.

US regulation

The typical public investment company in the United States is required to be registered with the U.S. Securities and Exchange Commission (SEC). Mutual funds are the most common type of registered investment companies. Aside from registration and reporting requirements, investment companies are subject to strict limitations on short-selling and the use of leverage. There are other limitations and restrictions placed on public investment company managers, including the prohibition on charging incentive or performance fees.

Although hedge funds fall within the statutory definition of an investment company, the limited-access, private nature of hedge funds permits them to operate pursuant to exemptions from the registration requirements. The two major exemptions are set forth in Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940.

Those exemptions are for funds with 100 or fewer investors (a "3(c) 1 Fund") and funds where the investors are "qualified purchasers" (a "3(c) 7 Fund").[2]

A qualified purchaser is an individual with over US$5,000,000 in investment assets. (Some institutional investors also qualify as accredited investors or qualified purchasers.)[3]

A 3(c)1 Fund cannot have more than 100 investors, while a 3(c)7 Fund can have an unlimited number of investors. However, a 3(c)7 fund with more than 499 investors must register its securities with the SEC.[4]

Both types of funds can charge performance or incentive fees.

In order to comply with 3(c)(1) or 3(c)(7), hedge funds are sold via private placement under the Securities Act of 1933. Thus interests in a hedge fund cannot be offered or advertised to the general public, and are normally offered under Regulation D. Although it is possible to have non-accredited investors in a hedge fund, the exemptions under the Investment Company Act, combined with the restrictions contained in Regulation D, effectively require hedge funds to be offered solely to accredited investors.[5]

An accredited investor is an individual person with a minimum net worth of US $1,000,000 or, alternatively, a minimum income of US$200,000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year. For banks and corporate entities, the minimum net worth is $5,000,000 in invested assets.

The regulatory landscape for Investment Advisors is changing, and there have been attempts to register hedge fund investment managers. There are numerous issues surrounding these proposed requirements. One issue of importance to hedge fund managers is the requirement that a client who is charged an incentive fee must be a "qualified client" under Investment Advisers Act of 1940 Rule 205-3.

To be a qualified client, an individual must have US$750,000 in assets invested with the adviser or a net worth in excess of US$1.5 million, or be one of certain high-level employees of the investment adviser.[6]

For the funds, the tradeoff of operating under these exemptions is that they have fewer investors to sell to, but they have few government-imposed restrictions on their investment strategies. The presumption is that hedge funds are pursuing more risky strategies, which may or may not be true depending on the fund, and that the ability to invest in these funds should be restricted to wealthier investors who are presumed to be more sophisticated and who have the financial reserves to absorb a possible loss.

In December 2004, the SEC issued a rule change that required most hedge fund advisers to register with the SEC by February 1, 2006, as investment advisers under the Investment Advisers Act. [7]

The requirement, with minor exceptions, applied to firms managing in excess of US$25,000,000 with over 15 investors. The SEC stated that it was adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning industry.[8]

The rule change was challenged in court by a hedge fund manager, and in June 2006, the U.S. Court of Appeals for the District of Columbia overturned it and sent it back to the agency to be reviewed. See Goldstein v. SEC.

Although the SEC is currently examining how it can address the Goldstein decision, commentators have stated that the SEC currently has neither the staff nor expertise to comprehensively monitor the estimated 8,000 U.S. and international hedge funds. See New Hedge Fund Advisor Rule.

One of the former Commissioners, Roel Campos, has said that the SEC is forming internal teams that will identify and evaluate irregular trading patterns or other phenomena that may threaten individual investors, the stability of the industry, or the financial world. "It's pretty clear that we will not be knocking on [hedge fund] doors very often," Campos told several hundred hedge fund managers, industry lawyers and others. And even if it did, "the SEC will never have the degree of knowledge or background that you do."

In February 2007, the President's Working Group on Financial Markets rejected further regulation of hedge funds and said that the industry should instead follow voluntary guidelines.[9] [10] [11]

Comparison to private equity funds

Hedge funds are similar to private equity funds in many respects. Both are lightly regulated, private pools of capital that invest in securities and compensate their managers with a share of the fund's profits. Most hedge funds invest in relatively liquid assets, and permit investors to enter or leave the fund, perhaps requiring some months notice. Private equity funds invest primarily in very illiquid assets such as early-stage companies and so investors are "locked in" for the entire term of the fund. Hedge funds often invest in private equity companies' acquisition funds.

Between 2004 and February 2006 some hedge funds adopted 25 month lock-up rules expressly to exempt themselves from the SEC's new registration requirements and cause them to fall under the registration exemption that had been intended to exempt private equity funds.

Comparison to U.S. mutual funds

Like hedge funds, mutual funds are pools of investment capital (i.e., money people want to invest). However, there are many differences between the two, including:

  • Mutual funds are regulated by the SEC, while hedge funds are not
  • A hedge fund investor must be an accredited investor with certain exceptions (employees, etc.)
  • Mutual funds must price and be liquid on a daily basis

Some hedge funds that are based offshore report their prices to the Financial Times, but for most there is no method of ascertaining pricing on a regular basis. Additionally, mutual funds must have a prospectus available to anyone that requests one (either electronically or via US postal mail), and must disclose their asset allocation quarterly, while hedge funds do not have to abide by these terms.

Hedge funds also ordinarily do not have daily liquidity, but rather "lock up" periods of time where the total returns are generated (net of fees) for their investors and then returned when the term ends, through a passthrough requiring CPAs and US Tax W-forms. Hedge fund investors tolerate these policies because hedge funds are expected to generate higher total returns for their investors versus mutual funds.

Recently, however, the mutual fund industry has created products with features that have traditionally only been found in hedge funds.

Mutual funds have appeared which utilize some of the trading strategies noted above. Grizzly Short Fund (GRZZX), for example, is always net short, while Arbitrage Fund (ARBFX) specializes in merger arbitrage. Such funds are SEC regulated, but they offer hedge fund strategies and protection for mutual fund investors.

Also, a few mutual funds have introduced performance-based fees, where the compensation to the manager is based on the performance of the fund. However, under Section 205(b) of the Investment Advisers Act of 1940, such compensation is limited to so-called "fulcrum fees".[12] Under these arrangements, fees can be performance-based so long as they increase and decrease symmetrically.

For example, the TFS Capital Small Cap Fund (TFSSX) has a management fee that behaves, within limits and symmetrically, similarly to a hedge fund "0 and 50" fee: A 0% management fee coupled with a 50% performance fee if the fund outperforms its benchmark index. However, the 125 bp base fee is reduced (but not below zero) by 50% of underperformance and increased (but not to more than 250 bp) by 50% of outperformance.[13]

VCs get exemption from registration

Venture capitalists breathed a collective sigh of relief Thursday when a proposal from the House Financial Services Capital Markets Subcommittee did not seek to treat them like private equity firms or hedge funds.

Venture capital investors had been lobbying against such a measure, saying that being required to register with the Securitiesand Exchange Commission like hedge funds and other private pools of money was unnecessary and expensive.

The Private Fund Investment Advisers Registration Act, announced by subcommittee chairman Paul Kanjorski (D-Penn.), "recognizes that venture capital firms do not pose systemic financial risk and that requiring them to register under the Advisers Act would place an undue burden on the venture industry and the entrepreneurial community," said Mark Heesen, president of the National Venture Capital Association, which represents about 400 venture firms."

Venture capital investors have been making regular visits to Capitol Hill lately to try to influence legislation that would treat venture capital firms as hedge funds.

A bill expected to come out of the House Financial Services Committee aims to require hedge funds and other private pools of capital to register with the Securities and Exchange Commission in order to add more oversight to an industry that has been at the center of the economic crisis. The committee plans to hold a hearing on the issue on Tuesday. The Treasury Department has supported the measure.

Venture capitalists say having to register as formal advisers with the SEC would put enormous financial burdens on their industry. They would have to hire a compliance officer and install new computer systems to meet the government’s reporting requirements, costing firms more than a quarter of a million dollars. And they say that is money that should instead be invested in entrepreneurs and new startups. They also say they should not be treated as a hedge fund, because they do not deal with trading, derivatives or “other sources of systemic risk,” said Emily Mendell, vice president of strategic affairs for the National Venture Capital Association.

Instead, venture investors are proposing an exemption under which they would report all the information the SEC seeks without having to formally register. Typically, venture investors only report that information when they raise a new fund — anywhere from every two to 10 years. They say they are willing to file that information on an annual basis.

“The issue we face is that our ecosystem is very fragile right now,” said Joshua Green, partner at Mohr Davidow Ventures in Silicon Valley. “Tiny regulatory changes can affect the rate of capital going to innovators.”

Venture capitalists have been hit hard by the recession. They depend on pension funds and other large investors in order to come up with the money to invest in young companies. Many of those funding sources sank with the stock market.

These private investors often invest in higher-risk ventures, including Facebook and eBay, and pay large dividends to investors when companies make it big. But other regulations, namely the Sarbanes-Oxley law that places stringent reporting standards on public companies, have discouraged startups from going to the public markets. As a result, investors say they have less of a chance to get a decent return on their investments.

Roger Novak, a partner with Novak Biddle Venture Partners in Bethesda, said the unintended consequences of financial regulation could put so many firms out of business that the venture capital industry would “become inoperable.”

“We’re not asking for anything,” he said. “We’re just saying, don’t fix what isn’t broken.”

Offshore regulation

Many offshore centers are keen to encourage the establishment of hedge funds. To do this they offer some combination of professional services, a favorable tax environment, and business-friendly regulation.

Major centers include Cayman Islands, Dublin, Luxembourg, British Virgin Islands and Bermuda. The Cayman Islands have been estimated to be home to about 75% of world’s hedge funds, with nearly half the industry's estimated $1.225 trillion assets under management. [14], although statistics in the Hedge Fund industry are notoriously speculative.

Hedge funds have to file accounts and conduct their business in compliance with the requirements of these offshore centres. Typical rules concern restrictions on the availability of funds to retail investors (Dublin), protection of client confidentiality (Luxembourg) and the requirement for the fund to be independent of the fund manager.

Many offshore hedge funds, such as the Soros funds, are structured as mutual funds rather than as limited partnerships.

U.S. investigations

In June 2006, the U.S. Senate Committee on the Judiciary began an investigation into the links between hedge funds and independent analysts.[15]

The SEC is also focusing resources on investigating insider trading by hedge funds.[16] [17]

"The first tip from inside Intel reached Raj Rajaratnam more than a decade ago — from the same source who has now turned against him in the biggest insider-trading case in a generation.

As far back as 1998, before he rose to prominence in the rarefied world of hedge funds, Mr. Rajaratnam was passed confidential information from an Intel employee who, the authorities now say, went on to play a crucial role in a vast insider-trading scheme involving some of the nation’s largest technology companies. That source, Roomy Khan, is a central government witness in the case against Mr. Rajaratnam, who maintains his innocence.

But years before the current case erupted, Ms. Khan was caught passing information to a representative of the Galleon hedge fund, who, according to a person with knowledge of the case, was Mr. Rajaratnam. Ms. Khan was prosecuted in federal court in 2000, but the authorities did not pursue Mr. Rajaratnam or his firm, Galleon, in connection with that case.

On the surface, it would seem to be another example of a missed opportunity by authorities to break up a nascent insider trading ring. Jack Gillund, a spokesman for the United States attorney’s office in San Francisco, declined to answer questions about why the Galleon representative’s identity has remained a secret or if prosecutors ever considered a case against Galleon or its employees in the matter. A spokesman for the Securities and Exchange Commission declined to answer the same questions.

A spokeswoman for the United States attorney’s office in the Southern District of New York, which is handling the prosecution of Mr. Rajaratnam, also declined to comment."

Debates and controversies

Systemic risk

Hedge funds came under heightened scrutiny as a result of the failure of Long-Term Capital Management (LTCM) in 1998, which necessitated a bailout coordinated (but not financed) by the U.S. Federal Reserve.

Critics have charged that hedge funds pose systemic risks highlighted by the LTCM disaster. The excessive leverage (through derivatives) that can be used by hedge funds to achieve their return[18] is outlined as one of the main factors of the hedge funds' contribution to systemic risk.

The ECB (European Central Bank) issued a warning in June 2006 on hedge fund risk for financial stability and systemic risk: "... the increasingly similar positioning of individual hedge funds within broad hedge fund investment strategies is another major risk for financial stability which warrants close monitoring despite the essential lack of any possible remedies. This risk is further magnified by evidence that broad hedge fund investment strategies have also become increasingly correlated, thereby further increasing the potential adverse effects of disorderly exits from crowded trades."[19] [20]

However the ECB statement has been disputed by parts of the financial industry.[21]

The potential for systemic risk was highlighted by the near-collapse of two Bear Stearns hedge funds in June 2007.[22]

The funds invested in mortgage-backed securities. The funds' financial problems necessitated an infusion of cash into one of the funds from Bear Stearns but no outside assistance. It was the largest fund bailout since Long Term Capital Management's collapse in 1998. The U.S. Securities and Exchange commission is investigating.[23]

To learn more about hedge fund controversary go to Wikipedia.

Hedge funds and liquidity

Much has been written about the consequences of the liquidity crisis on the hedge fund industry: if there is one thing everyone learned is that no matter how stable, how great one's reputation, or just which cool Greenwich, CT building one is based in, when the global liquidity tide ebbs, everyone is left without speedos (and, of course, that fund of funds are the most worthless things ever conceived by man).

For those who recall the dire days at the bottom of the crisis, the consensus was that the hedge fund industry as such would not survive in 2009, let alone 2010. Well, courtesy of Obama's wealth transfer agenda, it not only survived, but flourished. Yet is it identical to before?

The attached study by Citi's Prime Brokerage Services analyzed the impacts of the liquidity crisis on hedge fund industry participants, explores the participants’ responses to these issues over the past 18 months, assesses the likely impact of recent changes on the industry. A must read for everyone in the business, we were particular taken by the following chart which is truly at the core of every hedge fund investment philosophy nowadays: liquidity, liquidity, liquidity, or why 20 stocks will soon account for 80% of all volume.

Hedge funds are no longer hedging in the true sense of the word, as investors no longer wish to take on liquidity risk. Everything has to be liquid, and has to be sellable at a faxed-over redemption notice. It is only a matter of time before credit and maturity risk are seen as the other two concepts that hedge funds are massively mispricing. Until then, happy 2 and 20s.

Also, here are some of the borader responses from the hedge fund industry over what the key items learned have been:

“We were in bed with [two largest prime brokers]. People were like, ‘Okay, that’s a good diverse place to be.’ In September 2008, our prime brokers said you have to be in fully paid securities or out. There were points we thought we’d be out of business. Every day we were getting calls to take down our levels.” – <$1.0 Billion AUM Hedge Fund

“What came out of the crisis was that managers had positions in the portfolio that were to the detriment of the investors in a stress period. Assets like private equity or unrated corporate debt. Many times, these assets were not even in the manager’s mandate.” – Fund of Fund & Seeder

“The biggest lesson learned in the past 18 months has been that the agreed upon liquidity terms of a subscription agreement don’t really matter when the markets are in distress—it’s not a guarantee of when you’ll be liquid.” – Pension Fund

“Now we are focused on obtaining investor allocations from Sovereign Wealth Funds and Pension Funds outside the U.S. Previously, we had a higher percentage of Fund of Fund money because we were a relatively young hedge fund. Now, we’re trying to broaden that set of investors to have more geographic diversity and more diversity by type of investor.” – >$1.0 Billion AUM Hedge Fund

“We came away from 2008 with a greater ‘know your customer’ emphasis and a commitment to diversify our marketing footprint. We are now much more interested in having a mix of investors.” – >$10.0 Billion AUM Hedge Fund

“Top of the list in terms of lessons learned has to be the requirement to have multiple prime broker relationships.” – <$1.0 Billion AUM Hedge Fund

“We addressed our investor liquidity concerns by offering them more options. You can continue to do business with us at the same terms and the same fees, but if people are willing to pay up on fees for more liquidity, we are offering them an opportunity to do so through new series.” – >$1.0 Billion AUM Hedge Fund

“We developed our own proprietary risk application and have integrated our risk system as part of the research and investment decision-making process.” – <$1.0 Billion AUM Hedge Fund

“We invested heavily in IT … We built a parallel system that captures a mirror accounting process and a mirror reporting process. We’re not relying on one individual or one team. We want dual sets of eyes on everything.” – >$1.0 Billion AUM Hedge Fund

“Another thing we get kudos for is documenting every single procedure … We don’t hand it out, but when we pull out a 200-page document with that much detail, people go, ‘Wow!’” – <$1.0 Billion AUM Hedge Fund

Yet this pearl takes the cake, as it basically confirms that for the longest time the entire industry was a Ponzi scheme:

“There were accepted practices going on in the industry up until 2008 that in retrospect look like a problem. Funds were using the liquidity of incoming investors to pay out the established investors without testing the investments themselves. It was hard to see this until everyone hit the exit at once and everyone starting asking for their money back at the same time.” – Fund of Fund & Seeder

Full report The Liquidity Crisis Its Impact on the Hedge Fund Industry (July 2010) Citigroup, July, 2010

SEC develops data mining techniques to map insider trading

"Federal investigators are gearing up to file charges against a wider array of insider-trading networks, some linked to the criminal case against billionaire hedge-fund manager Raj Rajaratnam that shook Wall Street last week, people familiar with the matter said.

The pending crackdown, based on at least two years of investigation, targets securities professionals including hedge- fund managers, lawyers and other Wall Street players, the people said, declining to be identified because the cases aren’t public. Some probes, like the one that focused on Rajaratnam, rely on wiretaps. Others stem from a secret Securities and Exchange Commission data-mining project set up to pinpoint clusters of people who make similar well-timed stock investments.

Investigators have struggled for years to build cases against large institutional investors such as hedge fund managers, who often deflect regulatory queries about suspiciously timed bets, arguing they’re statistical flukes amid their millions of trades. The case against Rajaratnam, built on recorded conversations within a web of alleged conspirators, offers a glimpse of how U.S. investigators are using more aggressive tactics to cut through the blizzard of trading and trace the flow of information.

“If you’re going to shoot the king, you better shoot to kill,” said Bradley Bennett, a partner at Baker Botts in Washington who formerly focused on insider-trading cases as an SEC investigator. “If they’re going to take on a billionaire, they need to have the strongest possible cases. The defendant’s own words are the strongest possible evidence.”

SEC spokesman John Nester declined to comment, as did Alejandro Miyar, a spokesman for the Justice Department.

Intel, McKinsey, IBM

Rajaratnam, who founded the Galleon Group hedge fund in 1997, was arrested with five alleged conspirators on Oct. 16 in what prosecutors called the biggest insider-trading ring targeting a hedge fund. Prosecutors said he and his firm reaped as much as $18 million by investing on tips from a hedge fund, a credit-rating firm and employees within companies including Intel Capital, McKinsey & Co. and IBM Corp.

He hasn’t yet entered a plea. Rajaratnam’s lawyer, Jim Walden, said last week that prosecutors are misconstruing the evidence against his client and that the case isn’t as strong as prosecutors allege.

U.S. senators including Pennsylvania Democrat Arlen Specter have pressed regulators for years to more aggressively scrutinize hedge funds. Some of those concerns were spurred by the SEC’s decision in 2006 to close an insider-trading probe of Pequot Capital Management Inc., once the world’s biggest hedge- fund manager, after investigators said they lacked evidence to bring the case.

‘Blue Sheets’

The SEC later reopened part of the inquiry focusing on whether Pequot abused information from a former Microsoft Corp. employee. In August, Pequot and founder Arthur Samberg, 68, said they may be sued by the agency. Insider-trading claims would be “without merit,” they said.

Many cases begin when stock exchanges send the SEC reports on traders who place profitable bets shortly before corporate announcements. Someone who rarely trades may have difficulty explaining later what prompted an uncharacteristic investment. Hedge funds, on the other hand, can more plausibly attribute their windfalls to skill or chance.

To overcome that hurdle, the SEC began using computer software about two years ago to sift hundreds of millions of electronic trading records, known as blue sheets, attached to the stock exchange reports about suspicious incidents, according to people familiar with the project. By looking for patterns in the library of data, they identified groups of traders who repeatedly made similar well-timed bets.

UBS, Blackstone

Once investigators find a cluster of correlated trades, they tap other sources of information to unravel how its members obtain and share tips, the people said. For example, if a group profits on trades before a series of corporate takeovers, the SEC may check so-called league tables listing which investment banks or law firms advised the deals. If one firm was involved in all of them, an employee there may be the source of the leak.

The data-mining strategy yielded one of its first cases in February, when the SEC and U.S. prosecutors charged takeover advisers at UBS AG and Blackstone Group LP with taking part in an $8 million insider-trading case, people familiar with the inquiry said. Authorities used a “novel” technique to detect the scheme, the SEC’s lead investigator on the case, Daniel Hawke, said at the time, without elaborating.

While the investigation of Rajaratnam didn’t stem from the data-mining project, it did start with the SEC’s identification of suspicious trades, people with knowledge of the case said.

Massive insider trading alleged by SEC

"The Securities and Exchange Commission today charged billionaire Raj Rajaratnam and his New York-based hedge fund advisory firm Galleon Management LP with engaging in a massive insider trading scheme that generated more than $25 million in illicit gains. The SEC also charged six others involved in the scheme, including senior executives at major companies IBM, Intel and McKinsey & Company.

The SEC’s complaint, filed in federal court in Manhattan, alleges that Rajaratnam tapped into his network of friends and close business associates to obtain insider tips and confidential information about corporate earnings or takeover activity at several companies, including Google, Hilton and Sun Microsystems. He then used the non-public information to illegally trade on behalf of Galleon.

“This complaint describes a web of fraud that has been unraveled,” said SEC Chairman Mary L. Schapiro.

“What we have uncovered in the trading activities of Raj Rajaratnam is that the secret of his success is not genius trading strategies. He is not the astute study of company fundamentals or marketplace trends that he is widely thought to be. Raj Rajaratnam is not a master of the universe, but rather a master of the rolodex,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. “He cultivated a network of high-ranking corporate executives and insiders, and then tapped into this ring to obtain confidential details about quarterly earnings and takeover activity.”

J.P. Morgan merges prime brokerage and custody

"J.P. Morgan has combined the equity prime brokerage business it acquired with Bear Stearns (in March 2008) with J.P. Morgan's existing Treasury & Securities Services to form a new Prime-Custody Solutions Group that will provide integrated prime brokerage and custody to hedge funds and asset managers.

"Challenging market conditions have underscored the importance of partnering with a prime brokerage that can safeguard assets in a separate depository," said Devon George-Eghdami, managing director and head of the new unit. George-Eghdami, previously the head of Hybrid Capital Trading, is based in New York and will report jointly to Michael Minikes, CEO of J.P. Morgan Clearing Corp. within Prime Services, and Sandie O'Connor, global head of Financing and Markets Products within Treasury & Securities Services.

J.P. Morgan's creation of the Prime-Custody Solutions Group comes at a time when hedge funds are launching long-only funds and seeking structures that allow them to house certain assets with custodians, while traditional asset managers are executing long/short strategies that require financing through a prime broker. Among other benefits, J.P. Morgan's integrated approach is designed to streamline client onboarding, improve execution and collateral management, reduce financing costs, and consolidate reporting.

Since 1997, Bear Stearns was one of the only prime brokers that had offered custody benefits to clients. Since being acquired by J.P. Morgan, the prime brokerage has thrived, according to the firm. Clients now have access to the products and trading capabilities of J.P. Morgan's Investment Bank as well as Treasury & Securities Services' custody, fund services and agency lending offerings. J.P. Morgan's Treasury & Securities Services division houses $13.7 trillion in assets under custody.

Shareholder activism by hedge funds

  • Source: The Rise and Fall (?) of Shareholder Activism by Hedge Funds John Armour, University of Oxford - Faculty of Law; Oxford-Man Institute of Quantitative Finance; European Corporate Governance Institute (ECGI), and Brian R. Cheffins, University of Cambridge - Faculty of Law; European Corporate Governance Institute (ECGI) (from Securities Law Prof Blog)

The paper was recently posted on SSRN.

Here is the abstract:

Shareholder activism by hedge funds has over the past few years become a major corporate governance phenomenon. This paper puts the trend into context. The paper begins by distinguishing the “offensive” form of activism hedge funds engage in from “defensive” interventions “mainstream” institutional investors (e.g. pension funds or mutual funds) undertake. Variables influencing the prevalence of offensive shareholder activism are then identified using a heuristic device we call “the market for corporate influence”. The rise of hedge funds as practitioners of offensive shareholder activism is traced by reference to the “supply” and “demand” sides of this market, with the basic chronology being that, while there were direct antecedents of hedge fund activists as far back as the 1980s, hedge funds did not move to the activism forefront until the 2000s. The paper brings matters up-to-date by discussing the impact of the recent financial crisis on hedge fund-driven shareholder activism and draws upon the market for corporate influence heuristic to predict future trends.

Standard reporting metrics needed for hedge funds

Hedge-fund returns are worse than industry figures would suggest because many funds on the brink of failure stop reporting on their performance, according to a new academic study.

These omissions create a “hidden survivorship bias” because funds in their last 12 months of existence are left out of the data, the study found. The gap in returns between these failing funds and others averaged 0.54 percent a month, or about 6 percent annually, for 1994 through the first quarter of 2009.

The CHART OF THE DAY shows the average monthly percentage differential for each full year studied as a white bar. There is also a blue line, depicting a similar return gap between failed funds as of March 2009 and survivors. The average for the latter was just 0.26 percent a month.

Both gauges were relatively low in 2008 as a credit crisis sent stocks and bonds plunging and weighed on returns across the industry, according to Seton Hall University Professor Xiaoqing Eleanor Xu and her co-authors on the study, TIAA-CREF’s Jiong Liu and Seton Hall’s Anthony L. Loviscek.

They found that 31 percent of all funds failed that year, more than double the annual average of 12 percent for the study period. There were 1,089 that collapsed, according to a database compiled by the University of Massachusetts Amherst and used in the research. Failures among funds of hedge funds and commodity trading advisers brought the total to 1,983.

Hedge funds should “be subjected to standard reporting procedures, including random audits,” to increase the accuracy of data on their performance, the authors concluded. Their study was posted March 17 on the Social Science Research Network and cited yesterday on Seeking Alpha, a financial blog.


A hedge fund is an investment fund open to a limited range of investors that is permitted by regulators to undertake a wider range of investment and trading activities than other investment funds and pays a performance fee to its investment manager.

Each fund has its own strategy which determines the type of investments and the methods of investment it undertakes. Hedge funds, as a class, invest in a broad range of investments including shares, debt and commodities.

As the name implies, hedge funds often seek to offset potential losses in the principal markets they invest in by hedging their investments using a variety of methods, most notably short selling. However, the term "hedge fund" has come to be applied to many funds that do not actually hedge their investments, and in particular to funds using short selling and other "hedging" methods to increase rather than reduce risk, with the expectation of increasing return.

Hedge funds are typically open only to a limited range of professional or wealthy investors. This provides them with an exemption in many jurisdictions from regulations governing short selling, derivative contracts, leverage, fee structures and the liquidity of interests in the fund. A hedge fund will typically commit itself to a particular investment strategy, investment types and leverage levels via statements in its offering documentation, thereby giving investors some indication of the nature of the fund.

The net asset value of a hedge fund can run into many billions of dollars, and this will usually be multiplied by leverage. Hedge funds dominate certain specialty markets such as trading within derivatives with high-yield ratings and distressed debt.[24]


Sociologist, author, and financial journalist Alfred Winslow Jones is credited with the creation of the first hedge fund in 1949.[25]

Jones believed that price movements of an individual asset could be seen as having a component due to the overall market and a component due to the performance of the asset itself. To neutralize the effect of overall market movement, he balanced his portfolio by buying assets whose price he expected to be stronger than the market and selling short assets he expected to be weaker than the market.

He saw that price movements due to the overall market would be cancelled out, because if the overall market rose, the loss on shorted assets would be cancelled by the additional gain on assets bought and vice-versa. Because the effect is to 'hedge' that part of the risk due to overall market movements, this became known as a hedge fund.

Industry size

Estimates of industry size vary widely due to the lack of central statistics; the lack of a single definition of hedge funds; and the rapid growth of the industry. As a general indicator of scale, the industry may have managed around $2.5 trillion at its peak in the summer of 2008.

The credit crunch has caused assets under management|assets under management (AUM) to fall sharply through a combination of trading losses and the withdrawal of assets from funds by investors.[26]


A hedge fund manager will typically receive both a management fee and a performance fee (also known as an incentive fee) from the fund. A typical manager may charge fees of "2 and 20", which refers to a management fee of 2% of the fund's net asset value each year and a performance fee of 20% of the fund's profit.

To learn more about hedge fund fees see Wikipedia.


Hedge funds employ many different trading strategies, which are classified in many different ways, with no standard system used.

Learn more at Wikipedia.

Hedge fund risk

Investing in certain types of hedge funds can be a riskier proposition than investing in a mutual fund, despite a "hedge" being a means of reducing the risk of a bet or investment. Many hedge funds have some of these characteristics:

Leverage - in addition to money invested into the fund by investors, a hedge fund will typically borrow money, with certain funds borrowing sums many times greater than the initial investment. If a hedge fund has borrowed $9 for every $1 received from investors, a loss of only 10% of the value of the investments of the hedge fund will wipe out 100% of the value of the investor's stake in the fund, once the creditors have called in their loans.

In September 1998, shortly before its collapse, Long Term Capital Management had $125 billion of assets on a base of $4 billion of investors' money, a leverage of over 30 times. It also had off-balance sheet positions with a notional value of approximately $1 trillion.[27]

Short sales - due to the nature of short selling, the losses that can be incurred on a losing bet are theoretically limitless, unless the short position directly hedges a corresponding long position. Therefore, where a hedge fund uses short selling as an investment strategy rather than as a hedging strategy it can suffer very high losses if the market turns against it. Ordinary funds very rarely use short selling in this way.
Appetite for risk - hedge funds are culturally more likely than other types of funds to take on underlying investments that carry high degrees of risk, such as high yield bonds, distressed securities and collateralized debt obligations based on sub-prime mortgages.
Lack of transparency - hedge funds are secretive entities with few public disclosure requirements. It can therefore be difficult for an investor to assess trading strategies, diversification of the portfolio and other factors relevant to an investment decision.
Lack of regulation - hedge funds are not subject to as much oversight from financial regulators as regulated funds, and therefore some may carry undisclosed structural risks.

Investors in hedge funds are, in most countries, required to be sophisticated investors who will be aware of the risk implications of these factors. They are willing to take these risks because of the corresponding rewards: leverage amplifies profits as well as losses; short selling opens up new investment opportunities; riskier investments typically provide higher returns; secrecy helps to prevent imitation by competitors; and being unregulated reduces costs and allows the investment manager more freedom to make decisions on a purely commercial basis.

One approach to diagnosing hedge fund risk is operational due diligence.

Analysis and discussion with Managing Director on Alternative Investments at Bank of New York Mellon Marina Lewin; The hedge fund industry faces transformational crisis and it is important to focus on what is next for the hedge fund industry.

Hedge fund structure

A hedge fund is a vehicle for holding and investing the money of its investors. The fund itself has no employees and no assets other than its investment portfolio and cash. The portfolio is managed by the investment manager, which is the actual business and has employees. To say that a person works at a hedge fund is not technically correct, as they are employed by the investment manager.

See Wikipedia here for further information on hedge fund structure.

Hedge fund indices

There are many indices that track the hedge fund industry, and these fall into three main categories. In their historical order of development they are Non-investable, Investable and Clone.

In traditional equity investment, indices play a central and unambiguous role. They are widely accepted as representative, and products such as futures and ETFs provide investable access to them in most developed markets. However hedge funds are illiquid, heterogeneous and ephemeral, which makes it hard to construct a satisfactory index. Non-investable indices are representative, but due to various biases their quoted returns may not be available in practice. Investable indices achieve liquidity at the expense of limited representativeness. Clone indices seek to replicate some statistical properties of hedgefunds but are not directly based on them. None of these approaches is wholly satisfactory.

Non-investable indices

Non-investable indices are indicative in nature, and aim to represent the performance of some database of hedgefunds using some measure such as mean, median or weighted mean from a hedge fund database. The databases have diverse selection criteria and methods of construction, and no single database captures all funds. This leads to significant differences in reported performance between different indices.

Although they aim to be representative, non-investable indices suffer from a lengthy and largely unavoidable list of biases.

Funds’ participation in a database is voluntary, leading to self-selection bias because those funds that choose to report may not be typical of funds as a whole. For example, some do not report because of poor results or because they have already reached their target size and do not wish to raise further money.

The short lifetimes of many hedge funds means that there are many new entrants and many departures each year, which raises the problem of survivorship bias. If we examine only funds that have survived to the present, we will overestimate past returns because many of the worst-performing funds have not survived, and the observed association between fund youth and fund performance suggests that this bias may be substantial.

When a fund is added to a database for the first time, all or part of its historical data is recorded ex-post in the database. It is likely that funds only publish their results when they are favorable, so that the average performances displayed by the funds during their incubation period are inflated. This is known as "instant history bias” or “backfill bias”.

Investable indices

Investable indices are an attempt to reduce these problems by ensuring that the return of the index is available to shareholders. To create an investable index, the index provider selects funds and develops structured products or derivative instruments that deliver the performance of the index. When investors buy these products the index provider makes the investments in the underlying funds. This makes an investable index similar in some ways to a fund of hedge funds portfolio.

Only Hedge Funds that agree to accept investments on terms acceptable to the constructor of the index are included in the index, so that the provider can sell products based on it. This guarantees that the indices are investable, which is an attractive property for an index because it makes the index more relevant to the choices available to investors in practice.

However, investable indices do not represent the total universe of hedge funds. Most seriously they may under-represent the more successful managers because these may find the index terms unattractive, for example due to reduced fees or onerous redemption terms being demanded by the provider.

Clone indices

The most recent addition to the field approach the problem in a different manner. Instead of reflecting the performance of actual hedgefunds they take a statistical approach to the analysis of historic hedgefund returns, and use this to construct a model of how hedgefund returns respond to the movements of various investable financial assets. This model is then used to construct an investable portfolio of those assets. This makes the index investable, and in principle they can be as representative as the hedgefund database from which they were constructed.

Unfortunately they rely on a statistical modelling process. As clone indices have are relatively short history it is not yet possible to know how reliable this process will be in practice.


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