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HEDGE FUND SERVICES


MARKET GUIDE 2007

Mainstream or
Alternative?

REGIONAL ANALYSIS - GIBRALTAR


OUTSOURCING - ADMINISTRATION
CANADIAN HEDGE FUNDS - PANEL DEBATE
COLLATERAL MANAGEMENT - COST BENEFIT
TREND ANALYSIS - ALTERNATIVE OR MAINSTREAM?
THE BENEFICIAL OWNER AND ASSET MANAGER’S
ANNUAL GUIDE TO HEDGE FUND SERVICIES
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HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 1

Foreword AIMA

AIMA, with nearly 1100 corporate members


The Alternative Investment globally, is the trade association that represents
Management Association (AIMA) managers, brokers, administrators, lawyers, the full
spectrum of those operating in the hedge fund
looks at what 2007 holds for the industry.
It is our role – and the industry’s collective
global hedge funds industry. responsibility – to focus on introducing positive
change to meet the attentions of institutional
investors, of regulators, of the media. It is our
collective strength that we work this way. Results
have been considerable.
The hedge fund industry is a community.
Through AIMA, it identifies the collective
challenges. It works together to meet with
regulators, investors and other interested parties to
find common ground, to share understanding and
to build on growth and to bring sound business
practices, transparency and education to hedge
funds and a wider audience. This includes initia-
Emma Mugridge, tives such as sound asset pricing policies, refine-
Alternative Investment ment of use of side letters and developing the
Management Association industry’s approach to communications.
Indeed, hedge funds and those in the industry
In the coming months and years, the hedge fund are often taken to task over the way that they com-
industry must consider how it will continue to municate, resulting in false perceptions that the
develop. Like any industry, hedge funds face new industry is opaque, funds are risky and unregulat-
challenges daily. The steep growth of hedge fund ed. Nothing could be further from the truth but
assets in recent years is expected to continue - because of constraints on communication - some
meaning that we will have to accommodate yet for legal reasons, some as a matter of business
more clients and more funds. It is estimated that practice - hedge funds often go unheard. This
pension fund allocations alone will rise from information vacuum gives their detractors a golden
USD400 bn in 2006 to USD950 bn by 2010: just opportunity to create negative and often distorted
on these figures, an extra USD550 bn will be look- comment about the industry.

The size and maturity of the industry means that when the occasional hedge
fund failure occurs it only causes ripples in the market place
ing for a home over the next four years. As expected from a ‘cutting edge’ discipline,
This influx of funds has been fuelled by the evi- hedge funds now attract the best talent from the
dence of good returns even when traditional mar- market place, who see its relative freedom and
kets slump. For example, during the period of mar- reward as highly attractive. Hedge funds are
ket difficulty in the early 2000’s hedge fund per- increasingly mainstream with institutional-strength
formance generally remained positive despite the controls and governance and are now perceived as
S&P 500 index dropping over 22 per cent in 2002. an integral part of the institutional investors’
From 1993 to the end of 2005, hedge funds armoury.
cumulatively produced an annualised return of
7.33 percent compare with 4.91percent for the Emma Mugridge joined AIMA in 1996 with responsibility for all
S&P 500 Index. external communications. She was made a Director in 1999 and is
The global industry has new reached almost now the liaison point for all member and other activities through-
10,000 hedge funds with assets in excess of out UK, Ireland, Benelux, Switzerland, North America (including
USD1.2 trillion; a colossal sum. However the size
AIMA Canada Chapter), the Middle East and South Africa.
and maturity of the industry means that when the
occasional hedge fund failure occurs it only cause
ripples in the market place, rather than the waves She is responsible for three of AIMA's five global committees:
of previous times. The increase in regulation and of Alternative Investment Research, Communications and Asset
sound practice guidelines, which the industry has Pricing. Her duties also include being Commissioning Editor for
progressively adopted, have played an important the AIMA Journal and she oversees the development and produc-
part in this new found maturity. tion of all educational material as well as responsibility for the
Association’s website.

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 1


HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 2

Foreword Hedge Fund Association

face, addressing issues such as whether the role of


The Hedge Fund Association third party marketers has changed, whether prime
(HFA) brokers have taken over the job, and what other
avenues are available to a manager looking to bring
their fund to the market.
The hedge fund industry has become truly global.
Over the past few years Hong Kong, Italy, and
Australia have seen increasing hedge fund activity.
Where does Canada stand in the global marketplace?
This Guide focuses on the Canadian hedge fund
industry and analyzes the developments going on in
David Friedland, President, Canada, the growth of that industry and takes a clos-
Hedge Fund Association er look at the size and breadth of the Canadian
and President of Magnum hedge fund industry.
Over the past year, bumpy equity markets, turmoil
U.S. Investments, Inc. in the Middle East, rising oil prices, rising interest
The hedge fund industry, once a cottage industry rates and continued threats of terrorism have made
that was the domain of ultra high net worth individu- it difficult for many traditional hedge funds to deliver
als and managed by a few hundred bright investment the type of returns they are accustomed to seeing.
managers, has undergone major changes over the This Guide features a panel debate which sheds light
past decade. Due to continued outperformance, par- on the numerous challenges and opportunities hedge
ticularly during times of market downturns, the fund managers, investors and service providers face
industry has undergone exponential growth, not only in the years ahead.
in terms of the number of hedge funds available but For those who are unfamiliar with the hedge fund
also in the types of investment strategies available, industry, this Guide provides an introduction to
and the number and type of hedge fund investors. hedge funds and the various services available. It
New concepts, new strategies, the global reach of also provides useful guidelines for investors, pointing
hedge funds and expanding regulation have made out what investors should look for when investing in
the hedge fund industry exciting, interesting and a hedge fund. Hedge funds can be the most effec-
challenging. The Hedge Fund Services Market Guide tive way for investors to preserve and grow capital,
takes a look at many of the cutting edge issues fac- but only when the proper precautions are taken.
ing hedge fund managers, investors and service With in-depth articles covering a wide range of dif-
providers – it is a must-read for anyone interested in ferent topics, written by many of the most experi-
keeping on top enced
of developing Due to continued outperformance, particularly during times of practition-
and changing market downturns, the industry has undergone exponential growth. ers in the
trends in the hedge
industry. fund industry, this Guide is a valuable tool for you,
What impact will the recent Amaranth debacle whether you are a hedge fund manager, hedge fund
have on the industry? Has this changed the way investor, or service provider to the industry. In an
investor look at the risks of hedge funds? These evolving and fast-growing industry that is fragment-
questions remain to be answered, and this Guide ed, and operating in a number of different countries,
takes a closer look. each with their own set of rules, and operating in an
This Guide analyzes the history and growth of the environment with an ever-changing set of rules,
industry, and the effect that this growth may have on where can an investor turn to for help? Associations
the industry. Many of the top performing funds have like the Hedge Fund Association and others are cer-
either closed their funds to new investment, or are tainly useful in providing guidance and education,
only accepting investments that are subject to long but in terms of a single resource to provide answers
lock-ups and high fees. Will this lead to a bifurcation to many of your questions, this Guide is an excellent
in the industry between the have’s and the have not’s? starting point.
Will we see one set of terms (i.e., liquidity, lock-ups
and fees) for those hedge funds looking to raise David Friedland is President of Magnum U.S. Investments, Inc.,
money, and another set of terms for those hedge funds which serves as a consultant to a number of funds of funds and
able to pick and choose their investors? These ques- hedge funds, as well as a number of banks and institutions. Mr
tions are carefully examined in this handbook. Friedland is head of new business development, client relations
The Guide analyzes the different routes that hedge and the legal department at Magnum and is a director of the
funds can take to bring their funds to market and Hedge Fund Association (HFA). He received a BBA in Finance
takes a closer look at some of the challenges they from the University of Miami, and is a member of the Florida Bar.

2 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007


HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 3

INTRODUCTION

HEDGE FUND SERVICES


MARKET GUIDE
2007

Welcome to the 2007 edition of Hedge funds have been thrust into the spot-
light in recent months and have been grabbing
ISJ’s annual Hedge Fund Services their fair share of headlines. In this dynamic and
Market Guide. The Market Guide exciting area of the market further growth and
evolution are expected in the years to come. With
is a resource and directory for all this in mind we welcome you to our Hedge Fund
hedge fund industry participants Services Market Guide for 2007.
Again we would like to extend our thanks to the
and, importantly, a quick reference Alternative Investment Management Association
handbook for hedge fund (AIMA) and the Hedge Fund Association for their
updates on the topics affecting the hedge fund
managers, prime brokers and industry this year and their forewords to this edi-
administrators on the changing tion. We also thank the Managed Fund
Association for their contributions to the Guide.
regulatory, technology and In this edition Brian Bollen analyzes the various
investor landscapes. routes to market for hedge funds and to what
extent these are opening up. Michelle Price
explores the changing face of the hedge fund
industry and the institutionalization of hedge
funds.
Ian Hamilton of Investment Data Services
Group looks at the development of the hedge
funds industry in EMEA. Robert Chin of ATC
Fund Services analyses whether hedge funds are
still alternative or have they become as main-
stream as mutual funds.
Hassan’s James Lasry dips his toes into the
warm waters of the Mediterranean, looking at
Gibraltar as an alternative fund jurisdiction. Felix
Oegerli CEO of IFBS looks at the technological
drive behind hedge funds services.
The challenges of hedge fund administration
and outsourcing are examined by Richard
Newbury of Telekurs, while Colleen Montain of
UBS looks at the benefits of the ‘single point of
contact’ model in the servicing of funds.
Our two Panel debates focus on the future of
the Hedge Fund Market, whether hedge funds are
still alternative, and the hedge fund industry in
Canada.
Finally we keep relevant to the industry at large
by receiving feedback from a wide range of par-
ticipants, we welcome all questions and sugges-
tions that you, the reader, would like to see and
any other comments.
Mark Latham, Managing Editor

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 3


HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 4

Contents - Section 1

3 Introduction Hedge Fund Services Market Guide 2007


Forewords
1 AIMA Community Spirit in the Industry
2 HFA The Low-down on our Hedge Fund Guide

6 Which Way? The Routes to Market


10 Hotting Up Ian Hamilton, IDS briefs us on the EMEA landscape
12 Can You Tell What it is Yet? ISJ looks at the Changing Picture of the Hedge Funds Industry

16 Pool Runnings HFA looks at Diversified Hedge Fund Portfolios


Special Feature
18 Discussion The Hedge Fund Services Panel Debate

Section One
24 Hedge Funds in the Main Are Hedge Funds still alternative or have they
become mainstream?

monitor
26 Sunny Side of the Street Is Gibraltar a foothold for Hercules in the
world of hedge funds?

30 Ask the Experts


- topical questions answered by fund managers and service providers....

Section Two
36 Statistics HFRI Stats and Analysis

40 Super Models Technology Solutions - IFBS


42 Administration Challenge Outsourcing the Administration of Hedge Funds
44 One on One Working with the ‘Single Point of Contact’ Model

Special Feature
46 Discussion The Canadian Hedge Fund Managers Panel Debate

Hedge Fund Guide


56 Introducing Hedge Funds - Background
- What Are Hedge Funds
- Strategies & Examples
- Hedge Fund Risk/Return Drivers
- Investing in Hedge Funds

62 Sound Practices for Hedge Fund Managers - Management & Internal Trading Controls
- Reponsibilities to Investors
- Valuation Policies & Proceedures
- Transactional Practices

Appendix
72 Glossary

74 Company Profiles
4 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2007
Let’s talk about
Canada.

Are you an asset allocator seeking information on


the Canadian market or on Canadian Alternative
Investment Managers?
Talk to us.
TD Securities Prime Brokerage is one of Canada’s leading service
providers to the Alternative Investment industry. The Canadian
landscape includes a large number of Hedge Fund Managers focused
on the domestic market across a wide range of strategies.
We can help you get to know them.
Contact Vicki Juretic: 1 416 308 1560 / vicki.juretic@tdsecurities.com or
Peter Boffo: 1 416 983 1356 / peter.boffo@tdsecurities.com

This document has been prepared solely for information purposes by TD Securities. It is not an offer, recommendation or
solicitation to buy or sell, nor is it an official confirmation of terms. Any transaction entered into is in reliance only upon
your judgement as to financial suitability and risk criteria. TD Securities does not hold itself out to be an advisor in these
circumstances, nor does any of its staff have the authority to do so. The information in this document is subject to change
without notice. Not intended for US distribution at this time. Approved in the UK and Europe by TD Securities Limited for
issuance to persons falling within Articles 19 and 49 of the Financial Services & Markets Act 2000 (Financial Promotion)
Order 2001. TD Securities Limited is authorised and regulated by the Financial Services Authority. TD Securities is a trade-
mark of The Toronto-Dominion Bank and represents TD Global Finance, TD Securities Inc., TD Securities (USA) LLC,
TD Securities Ltd and certain investment and corporate banking activities of The Toronto-Dominion Bank.
HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 6

REVIEW / ROUTES TO MARKET

Which Way? Are we seeing a new route to market open up


for hedge funds? The question is prompted by
Brian Bollen examines the feeling in the industry that what started as
something of a fad has now developed into a
whether routes to market clear trend, and that trend is set to develop
are opening up for hedge strongly over the next few years. The talk is of
an investment approach that sidelines the fund
funds... of funds manager, traditionally the route of
choice for the first-time investor in hedge
funds. Increasingly, according to David Aldrich,
managing director and business manager for
Bank of New York’s hedge fund services busi-
nesses, family offices and high net worth indi-
viduals, are looking to invest directly in hedge
funds, and are appointing individuals or private
banks to help them do so. “That way, they can

Fund of funds managers


won’t be thrown on the
scrap heap just yet
achieve an investment portfolio tailored pre-
cisely to their own risk-reward appetite,” he
says. They also, of course, remove the extra
level of management and performance fees that

6 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007


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HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 8

REVIEW / ROUTES TO MARKET

a fund of funds manager would charge. “The will remain the starting point for the majority of
movement is really developing momentum, and institutions initiating a hedge fund investment
is widespread in Andorra, Luxembourg and programme and predicts that half of global
Switzerland,” he adds. institutional flows will go to fund-of-hedge
There is no need, though, to take out one’s funds over the next five years.
handkerchief to stifle the sobs just yet. Fund of Slightly ironically, perhaps, running contrary
funds managers won’t be thrown on the scrap to the hyperbolic interest in hedge funds as a
form of investment, customer satisfaction is not
Less than a quarter of as great as one might expect. Another recent
pension schemes that report, this time from Mercer Investment
Consulting, indicates that few pension schemes
invest in funds of hedge satisfied with funds of hedge funds returns.
funds are satisfied with Despite growing interest in the asset class, less
than a quarter of pension schemes that invest
their investment returns in funds of hedge funds are satisfied with their
investment returns, according to a new global
heap just yet, if at all. According to a a new survey by Mercer Investment Consulting. The
study of leading institutional investors, invest- survey found that only 23 per cent are satisfied
ment consultants and hedge funds, published while 48 per cent are neutral and 28 per cent
recently by BNY and Casey, Quirk & Associates, are dissatisfied. When asked to rate overall sat-
direct investment will cannibalise FoFs only isfaction with their funds of hedge funds man-
marginally, and FoFs will still account for an ager, the survey of over 180 large pension
estimated 51 per cent of the hedge funds market schemes worldwide found less than half (47 per
in 2010, and that will be 51 per cent of a market cent) were satisfied.
that will be triple the size of today’s. The definitions of “routes to market” may be
Global institutional demand for hedge funds several, including the paths to becoming a
will triple by 2010, increasing from $360 bn cur- hedge fund, as well as the routes to the markets
rently to more than $1 trillion, according to the for executing orders, says Steven M. Simmons,
study, entitled “Institutional Demand for Hedge senior vice president, institutional sales and
Funds 2: A Global Perspective”. It found that by trading at Terra Nova Financial Group, an inde-
2010 institutions investing in hedge funds will pendent agency broker dealer. An article pur-
increase to nearly 25 per cent of all institutions, porting to cover said routes should also focus
up from 15 per cent today, representing a more on the methods of getting capital to the fund,
than 60 per cent increase. Retirement plans and getting the fund in front of the right people,
globally will account for the vast majority of he says.
asset flows, with corporate and public pension “When looking at driving forces within the
plans in the United States accounting for the industry, you can’t but help look to the latest
largest percentage increase overall. debacle at Amaranth Capital [which posted loss-
According to the study, institutional investors’ es of $6bn in September, following what the
experience with hedge funds has and will con- Financial Times descrived as a disastrous bet
tinue to profoundly influence the way they on natural gas prices] and realise that the topics
invest broadly, indicating that “less con- du jour will continue to revolve around hedge
strained,” active investment techniques will fund scrutiny and security, and inevitably, the
become a standard component of investing call will go up for increased regulation,” he con-
moving forward. tinues. “Additionally, the discussion will turn to
The study also found that institutional the idea that hedge funds again are the play-
investors’ ability to identify and assess quality grounds for the wealthy that can afford to lose
hedge fund managers will dramatically improve. money at the expense of greater upside
As a result, hedge fund providers increasingly rewards, whereas the lay public can not. The
will be required to demonstrate operational problem of course is when public pension plans
excellence and comprehensive risk oversight, as and endowments become involved.”
well as offer fee structures that are more closely “With some 7,000-plus hedge funds in the
linked to value and performance. United States alone, the competition for capital
The study found that the fund-of-hedge funds is as cutthroat as it gets. The previously roman-

8 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007


HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 9

Hedge Fund Services Market Guide

tic notion of working for a few years in a white nascent and existing fund managers have a
shoe firm a la Goldman Sachs, then taking your seven-minute forum to explain their fund’s
windfall and staking your own fund with the strategy, and to pitch a specific idea they like.
additional backing from friends and family, The audience is comprised of other funds as
chugging away for a few years with $10 million well as pension plans, foundations and qualified
under management, getting oversized returns investors. This allows funds a spotlight and a
chance to differentiate themselves, as well as
Helping the funds get in front allowing for a collegial sharing of ideas and
brainstorming afterwards with cocktails in a
of the proper investing public more loosened, albeit heightened atmosphere.”
is very much like getting a Having the right plumbing in place is also a
graduate student properly key component in reaching the market, and
does not necessarily reflect the scale of a would-
prepared for a job interview be provider. It is also integral to early days
strategic thinking, says Fabian Schonenberg,
and attracting outside investors to eventually Managing Director of Tromino Financial
run the fund up over $250 million, is slowly Services Ltd., a Bermuda-based provider of
being dispelled, and is more akin to the roman- highly personalised fund administration, prima-
tic notion of working on Wall Street for several rily within the hedge fund industry and the fami-
years and then opening up a bed and breakfast. ly office environment. “ It is crucial to market a
Like the strongest onion, when the layers are hedge fund hand-in-hand with its supporting
peeled back, the reality (or nightmare) of the infrastructure, most importantly its custodian
undertaking comes to the surface quickly.” and administrator, its auditor and perhaps the
“From my experience working with hedge fund’s legal advisers,” he argues.
funds and helping to raise capital, a wicked “When it comes to market a hedge fund in
Catch 22 ensues. Many investors will say to a this context, it is important for the manager to
fund, we love your strategy, results etc, call us realise that bigger is not necessarily better.
when you have over $50 million and we’ll talk Managers are often looking to appoint “brand
again. For a fund with $5- $10 million under name” administrators, believing that this will
management, getting to $50 million under man- make them less vulnerable to operational risk
agement is seemingly the equivalent of hitting and that it will facilitate to gain the confidence
70 home runs in a season. On the rare occa- of potential investors. While the latter argument
sion, it can be done, but quite possibly not with- may be a valid one in some cases, I believe it is
out the help of performance enhancing drugs no longer true that small administrators in gen-
(in this case, let’s just call that oversized bets or eral pose a higher operational risk – today’s reg-
enhanced strategies, both of which put the idea ulations under which fund administrators oper-
of mitigating risk to the test).” ate impose the same requirements to all
“We work closely with start-up hedge funds to providers, regardless of their size. The advan-
make sure everything is in place to make the tage of appointing a smaller provider is clearly
transition to the market place as smooth as their ability to provide services in a highly dedi-
possible. Enhanced electronic trading software cated, personalised way, especially when it
full of automated algorithmic trading strategies, comes to non-standard structures and start-
alerts and market minders, risk parameter con- ups. Larger providers often lack the flexibility
trols as well as software to monitor quality of and dedication that the business model of
execution (in a world obsessed with the idea of smaller providers is built on.”
best execution, the line is exceedingly blurred as “Obviously, technology is and continues to be
to what truly constitutes best execution) are just absolutely crucial for the successful operation of
some of the tools hedge funds need to be a hedge fund. However, in my view this aspect
armed with just on the trading side.” is often over-emphasised by service providers –
Helping the funds get in front of the proper nowadays it is just a necessity without which a
investing public is very much like getting a grad- service provider can’t operate, much like being
uate student properly prepared for a job inter- able to speak English. What is just as impor-
view, he argues. “We have created a popular tant, and often even more important, are the
programme called the Alpha Exchange whereby soft skills of the service provider.” HFSMG

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 9


HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 10

REVIEW / EMEA

HOTTING UP 2006 on introducing structures under the


Collective Investment Schemes Control Act
(CISCA). The reality is that CISCA is still seen
by the Regulator as something for retail invest-
ments such as unit trusts and not the broader

Most of the structures used


by South African hedge fund
Ian Hamilton
managers are classified as
unlisted or other types of
investments.
market of funds for institutional and profes-
sional investors. Single strategy hedge fund
Ian Hamilton, Investment managers in general do not want to be in the
realm of retail investments. The Financial
Data Services Group looks Services Board (FSB) and other South African
at the past year for hedge regulatory bodies are not keen to follow inter-
nationally accepted practice of having qualifi-
funds in EMEA. cations imposed upon the investors which
would raise the investment threshold.

2. Fund Management
It is not strictly correct to say that there are no
regulations dealing with hedge fund managers.
Currently all investment managers must be
The South African hedge fund industry has registered under the Financial Advisors and
had a strong year despite little happening on Intermediaries Services Act (FAIS). No distinc-
the regulatory front insofar as the establish- tion has been made for hedge fund managers.
ment of regulated vehicles is concerned. This is likely to change before the end of
Assets in single strategy funds are expected to 2006 (or early 2007) with the introduction of a
more than double to R20bn ($2,8bn) by the specific category for all investment managers
end of 2006 with Funds of Hedge Funds and managing and wanting to manage funds with
institutional investors accounting for at least alternative investment strategies. The pro-
half or more of the flow of funds. posed regulations cover additional experience
The AIMA South Africa Chapter has recog- and qualification requirements, as well as con-
nized the importance of the institutional mar- tractual disclosures.
ket and created a portfolio position on the
local board to deal with retirement fund and 3. Investor Restrictions
other institutional investor issues. This portfo- Investor restrictions apply to the institutional
lio covers the legal and regulatory aspects of investors such as retirement funds. A specific
these investors. restriction comes in the form of Regulations
28 which controls the asset selection of retire-
Regulations and Structures ment funds.
Regulations that affect hedge funds in South There is no specific category for hedge
Africa are divided into three areas: funds. Most of the structures used by South
1. Structure African hedge fund managers are classified as
2. Fund Management unlisted or other types of investments. Under
3. Investor Restrictions Regulation 28 this category of asset is restrict-
ed to 2,5 per cent of the total portfolio.
1. Structure Regulation 28 has been under review for the
To date little progress has been made during past five years. However, it is unlikely that a

10 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007


HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 11

Hedge Fund Services Market Guide

conclusion to this review will be achieved A further discussion paper has been issued
before 2008. covering the use of prime brokers by hedge
funds. This is an attempt to rectify some of
Taxation these conflicting issues. Closure of this discus-
There will continue to be a degree of uncer- sion paper is mid November.
tainty on the tax treatment of hedge funds and It is essential that an industry body such as
the various structures currently used by hedge AIMA become more involved in the region to
fund managers until approved structures are ensure that there is proper industry participa-
set up in South Africa. tion and feedback.

The Middle East has opened Why Dubai?


Wedged between Europe and Asia, buttressed
up to the hedge fund market by Africa, Dubai's encouraging tax regime in
through the introduction of the Dubai International Financial Centre (zero
tax for 50 years) make this an interesting alter-
Collective Investment Rules native to the traditional locations for the set-
ting up of funds, investment management and
Exchange Control investment administration.
A moderate relaxation of personal monies that Many readers will remember the old song:
South African citizens can invest international- "They've Got An Awful Lot Of Coffee In Brazil
ly was introduced in the 2007/2008 budget. ..." ?
The foreign investment allowance was raised Well, if you are going to sing anything about
to R2m ($300 000 at the exchange rate pre- the United Arab Emirates, the lyrics would go
vailing at the time of the Budget) per individ- something like:
ual. "They've Got An Awful Lot Of Money In
Foreign investors have few restrictions, but Dubai" !
are still faced with the uncertain tax issues and Ian Hamilton
the need to hedge the currency outside of the Chief Executive Officer,
Republic. Investment Data Services Group
Foreign domiciled funds wanting to register B Comm. LLb, MBA,
for sale in South Africa are still prohibited Advocate of the High Court of South Africa.
given that there are no domestic regulations
covering hedge funds. Ian is the Chief Executive Officer of Investment Data
Services, which he founded in 2003. He has a wealth of
expertise and an extensive network in the South African
Dubai and the Middle East investment market.
The Middle East has opened up to the hedge Ian has served as a director of the South African
fund market through the introduction of Association of Unit Trusts (now known as the
Collective Investment Rules by the Dubai Association of Collective Investments (ACI)), and cur-
Financial Services Authority in March 2006. rently sits on the Fund Management Committee of the
These regulations cover hedge funds as well South African Retirement Fund Association. Ian is also
and the first Dubai domiciled hedge fund, the a founder board member, and now Chairman, of the
Constans Crescent fund was launched in South African Chapter of Alternative Investment
September 2006. Management Association (AIMA South Africa).
It is never an easy task for a regulator to put Ian was appointed in June 2001 by the Minister of
out a discussion paper for the introduction of Finance, the Honourable Mr. Trevor Manuel, to the
new regulations when there is no established Advisory Board of the FSB. Ian has been actively
market to provide comment or feedback. involved in the debates surrounding the possible intro-
Therefore, the registration of hedge funds has duction of hedge fund regulations for the Collective
not been without difficulty. The Regulator has Investment Schemes Control Act.
adopted a very cautious approach to collective He is presently involved in the setting up of the hedge
investment schemes in general. As a result fund industry in Dubai, as an alternative domicile to
other off-shore jurisdictions.
some of the general provisions in certain
He has a number of hobbies which he would like to
instances clash with what are alternative invest- pursue if the hedge fund industry gave him some free time!
ment schemes generally accepted practices.
HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 11
HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 12

REVIEW / THE INSTITUTIONALIZATION OF HEDGE FUNDS

untied to market performance,


and targeted instead at an
absolute return.
Recently however, this picture
has become blurred around the
edges, with significant conse-
quences: as we will see, the
phenomenon known as ‘insti-
tutionalisation’, is serving to
significantly change the way in
which the hedge fund market
functions, its regulatory profile
and its future topography.
In the past two years, tradi-
Can You Tell What It Is Yet? tional equity returns have
shrunk. Consequently, institu-
tional asset managers, which
Evolution is rife in financial historically tended to favour ‘long only’ invest-
markets the world over. ment strategies, have begun to cast an envious
eye over their smaller, more nimble counterparts.
Michelle Price looks at the The resulting trend has seen alternative invest-
ment strategies gain rapid ground among
changing picture of the hedge swathes of the traditional buy side community, as
it attempts to compete in an increasingly cut-
fund industry. throat financial environment.
Despite the proliferation of material, and fre- Graham Phillips, European hedge fund practice
quency of debate, inspired by this section of the leader for PricewaterhouseCoopers, and author of
financial markets, no one, it seems, has grown a recent report on the development of the hedge
bored of discussing hedge funds. Now estimated fund industry, comments: “The institutional fund
to represent USD1,200 bn with more than 9000 managers' decisions are being driven by the
active funds, the bulging hedge fund industry con- institutional investors that wanted within their
tinues to command considerable attention, for portfolios some strategies which are absolute
reasons that the ill-fated Amaranth Advisors and return; that’s been an ongoing trend since about
Vega Asset Management have recently illustrated. 2002-2003, when institutions started moving
The very public downfall (or at least speculator away from more traditional investments such as
stumble) of two global hedge funds has given
shape to pressing questions that, until very What exactly is a hedge fund
recently, lingered in the background, unformed.
These relate to the stability of the hedge fund nowadays anyway?
space, and its wider risk to the financial markets:
are these isolated events, or sign of an overarch- equities, cash, bonds and property.” This trend is
ing market trend? How exactly, is the hedge fund bolstered by the fact that the fund managers run-
market evolving, and where will it take the word- ning these absolute return strategies are normally
wide economy? And, oh yes, what exactly is a amongst the brightest fund managers in the mar-
hedge fund nowadays anyway? ket, he adds: “So it is logical that institutions
In particular, the latter question is becoming would want some of their money run by such
ever harder to answer, as the traditional profile of managers and have benefited from moving away
a hedge fund has begun to change. from the institutional fund management scene
Historically, hedge funds received their start-up itself.”
capital from private equity investors and high net This development has prompted a spate of in-
worth individuals, giving rise to the image of the house hedge fund launches from a variety of
boutique fund populated by independent investment houses, such as Henderson Global
individuals, funded by sickeningly rich sponsors. Investors and Threadneedle Investments. In addi-
The latter were driven by the desire for capital tion, planned sponsors and pension funds, which
protection (which allows an investor some expo- have traditionally assumed a conservative
sure to financial assets while protecting the capital approach to their asset allocation, are now finding
invested) and annualised compound returns the hedge funds increasingly attractive investment
12 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007
HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 13

Hedge Fund Services Market Guide

vehicles, with around 11 per cent of Continental In short, therefore, many of the traditional asset
European pension funds now allocating to hedge managers have become more like hedge funds,
funds. and more of the hedge funds have become like
“Commentators, including the press, have criti- traditional asset managers. But what does this
cised trustees of pension funds or insurance convergence, in which the term ‘hedge fund’
funds, who appointed the institutional fund man- becomes, as best vague, at worst entirely nebu-
agers, for being too conservative in their invest- lous, mean for the hedge fund market, and why
ment strategies,” Phillips explains. In particular, should anyone care in any event?
the Myners report, the influential investment First, and perhaps most importantly, the hedge
Treasury research published in 2001, recommend- fund market, which, for so long, has languished in
ed that a “good portfolio strategy” involved more a near regulatory vacuum, will experience
than just traditional investments, Phillips points increased scrutiny by the regulators in future
out. Paul Myners, who is now chairman of Jersey- years. According to the Northern Trust survey
based fund of hedge funds Ermitage Group, mentioned above, 80% of respondents predicted
recently reiterated his recommendations in increased participation of institutional investors
October, urging pension funds to allocate
between 15 per cent and 30 per cent of their Institutional money now
money to the hedge funds. “So there has been
pressure on trustees and guardians of other peo-
accounts for a significant
ple’s money to follow a more diverse investment proportion of global
approach,” Phillips confirms.
In the US, these sources of asset allocation
hedge fund assets
have been significantly augmented by the univer- would bring an additional regulatory and report-
sity endowments. The latter currently account for ing burden, the likes of which is already beginning
a sizeable chunk of market-wide capital in the US to rear its head.
hedge fund space, having significantly accelerat- Most notably, abortive efforts made in June of
ed the proliferation of the market in the early this year on behalf of the US Securities and
1990s. Establishments like Harvard and Yale for Exchange Commission (SEC), in which it was pro-
instance, now manage more than 60 per cent of posed hedge fund managers be required to regis-
their portfolios in alternative assets, including ter with the financial market watchdog, have
property, private equity and hedge funds. undoubtedly served as the precursor to future reg-
Thus, institutional money now accounts for a ulatory action. It has also, as Matt Nelson, analyst
significant proportion of global hedge fund assets. at Towergroup argues, highlighted issues sur-
According to a recent survey conducted by IFI rounding best practices. “Part of the good that
Research for Northern Trust’s Global Fund came out of the short-lived SEC registration in the
Services, for instance, one in five institutional US, was that hedge funds can't be a fly by night
investors in Europe invested in hedge funds or operation, they need to have controls in place for
fund of hedge funds in 2003, a figure that their clients,” he contends.
increased to one in three by 2005, and this trend US regulatory rumblings are also being echoed
seems yet to peak. But it is not only the large in Europe. The Financial Times reported in
asset managers that are throwing off their tradi- October, for example, that Germany has deter-
tional investment profile. mined to put hedge fund transparency on the
Blurring buy side delineations further, many of agenda of next year’s summit of the eight leading
the hedge funds themselves are now looking to industrial nations (G8), due not in small part to
operate more traditional ‘long only’ strategies, as Amaranth Advisor’s latest calamities. Analysis and
fund managers who cut their teeth managing investigations of this nature will serve to highlight
portfolios at the giant asset managers, break free the glaring white regulatory space that the hedge
to set up their own start-up funds. And, at the funds have thus far occupied, and will no doubt
larger end of the scale, multi-billion-dollar hedge accelerate debates on filling that space with legis-
funds, such as Citadel, DE Shaw and Perry lation.
Capital, are now, in many respects, indistinguish- Even without legislation however, the develop-
able from the traditional asset management ments discussed above are already exerting pres-
firms. This is evident not only in their size but sure on the hedge fund managers. While inde-
also in their strategies, which have begun to pendent ratings agencies, such as Standard &
move away from the typical hedge fund model Poor’s and Moody’s, are also turning the screw,
that tends to emphasise more value, with less having recently announced their intention to rate
stress on asset gathering. hedge funds based on their facility for risk control,
HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 13
HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 14

REVIEW / THE INSTITUTIONALIZATION OF HEDGE FUNDS

the very nature of institutionalisation ensures con- management firm and big money, or to remain in
trols are, to a large extent, built-in. “To gain more the high net worth space, and enjoy fewer restric-
confidence of the institutional investor,” suggests tions. PricewaterhouseCoopers’ Phillips believes
Tim Todd, trading solutions product manager at the former strategy has several advantages, as he
SunGard, Front Arena: “You need to do things you details: “If a hedge fund manager wants to
wouldn’t otherwise to increase the transparency expand he’s got to change operations and adapt
of your fund.” them. If he aligns himself with the traditional
As Peter Salvage, vice president and product institutional fund management organization side
head of JP Morgan Hedge Fund Services con- that should bring him more assets to manage
firms, institutional investors are already demand- and will help him set up, support and seed new
ing more of their fund managers. “They’re looking funds, which will should in turn generate more
for more processes, procedures, and more con- fees and therefore enable you to scale up your
trols, and they are looking for more independence own operations: so there are is a win-win position
on pricing and audit trails. This means that cer- if you align.”
tain fund managers that may have done things in- The support offered by traditional, institutional
house previously, are now starting to look at their fund manager organisations, which often boast
processes and calculations and think ‘here’s a set sophisticated middle and back-office processes,
we should do in-house but our investors are say- could prove highly valuable to a hedge fund look-
ing we should do this with an outside party to ing for the skills, knowledge and processes
have some independence’.” required to scale up. By definition however, there
Furthermore, he adds, even before investors are is a risk that the hedge fund can become partly
committing their money to the fund, they are per- institutionalised, thereby becoming inhibited by
forming considerable due diligence on the fund’s procedural bureaucracy. “To be successful there is
administrators and outsourcing partners, giving a limit on how big you can get,” says Phillips. “If
weight to Nelson’s observation that, in actual fact, you’re doing even a long short equity strategy,
regulation is a “fund administrator's best friend”, very often that is focused on a few sectors of the
necessarily proving the value of their services. The overall equity market and, in this context, there is
implications of the changing hedge fund land- a limit as to how big particular fund can get.” He
scape for market players such as service providers adds a note of warning: “The hedge fund manag-
therefore, are potentially wide-ranging. er has to be careful that he doesn’t take on so
Surprisingly however, Northern Trust found that much money that the fund becomes too hard to
not all fund managers are thoroughly depressed manage and performance suffers.”
by this prospect, with 46 per cent saying they For some hedge funds, the complexities of scal-
would welcome regulatory supervision. ing-up to accommodate the inflows of institution-
Even so, says Marc Russell-Jones, vice president al money could prove too onerous, and several
at Northern Trust, Global Fund Services and hedge funds have now desisted from taking on
author of the report, this leaves a significant pro- more money in a bid to optimise their operations.
portion of apprehensive hedge funds, with 32 per For many managers, escaping the clutches of the
cent fundamentally opposed to increased supervi- large, and often cumbersome, buy side institu-
sion. This, he explains, could have far reaching tions was their raison d’etre for entering in to the
consequences for the hedge fund marketplace. hedge fund market in the first place. Such individ-
“Depending on who we spoke to, it was felt that uals will be loath to align with the very institutions
regulation could potentially stifle creativity as so they were trying to throw off, despite the signifi-
much structure around the investment manage- cant financial benefits.
ment process might discourage some funds from In this climate, it seems reasonable to predict
setting up because of the added infrastructure therefore, that, where hedge funds are concerned,
costs.” He continues: “We initially wondered if the big are going to get bigger, and the small are
this would mean the demise of the hedge fund going to have to adapt to different target markets.
industry, with regulation stifling creativity but the This divide however, could offer a healthy solution
research indicated that this will not be the case to a fluid market, meaning fund managers will be
and will lead, instead, to a split within the hedge better able to service their particular clients, and
fund industry.” investors will ultimately enjoy a better deal. In
Institutionalisation will mean therefore, that not turn, the introduction of regulation, to a large
only will a significant proportion of the hedge extent, might actually serve to inspire confidence,
fund market find itself, in due course, subject to offering the much-needed transparency that has
increased regulation, but it will also find itself fac- been lacking in this dynamic, but often
ing stark choices: to align with the large asset inscrutable, space. HFSMG

14 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007


HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 15

which was the only Hedge Fund Administrator in the world to have had been awarded a

Moody’s Management Quality Rating


is the creator of

“The Custom House Fund Formation Service“

Custom House Administration & Corporate Services Limited (“Custom House”) provides advice and
assistance in the design, incorporation and establishment of offshore funds, as a turn-key package.
Custom House prides itself on its personal service and will create a tailor-made specialist fund, designed
to suit a client’s particular situation and specific objective, taking care of all the documentation, as well as
all legal and statutory matters. Custom House will also liase with the payment and custodian banks, brokers
and other service providers, including the auditor, to ensure that the creation and ongoing operation of the
fund is carried out smoothly and efficiently. If required Custom House will also arrange for the shares
of the fund to be listed on an appropriate stock exchange.

and the

“The Custom House Fund Administration Service“

Once the fund has been organised, Custom House will then provide a full administration service to the fund
and oversee all aspects of the day-to-day operations, except for the actual investment of the fund’s assets.
Custom House will maintain all of the fund’s books and records, carry out the valuations, calculate the NAV
and handle all subscriptions and redemptions, as well as overseeing payment of the fund’s expenses. Custom
House will also be responsible for all investor (and potential investor) communications and for the publication
of the fund’s share price and performance data to investors, as well as the media services directly, or on the Web,
through the CHARIOT secure web reporting platform for managers and investors, as required.
Custom House’s main office is situated in Dublin. However, our long-term plan is to provide a 24/7 service
and, as a first step, opened its office in Chicago in June 2005. Custom House anticipates opening a South-East
Asian office before the end of the second quarter of 2007.

If you would like further detailed information on Custom House, please contact:
Dermot Butler or David Blair
dermot.butler@customhousegroup.com / david.blair@customhousegroup.com

Custom House Administration & Corporate Services Limited


25 Eden Quay, Dublin 1, Ireland
Tel: (353) 1 878 0807 / Fax: (353) 1 878 0827

For further detailed information on Custom House and CHARIOT, please visit our Website:

www.customhousegroup.com

Custom House Administration & Corporate Services Limited is authorised by


the Irish Financial Regulator under the Investment Intermediaries Act, 1995
HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 16

REVIEW / HFA

most hedge funds do manage their funds within


Pool Runnings written mandates, and generally keep their invest-
ments and strategy within an area of specialization.
This happens because many hedge fund investors
The Hedge Fund Association examines are sophisticated individuals, professionals manag-
the myths and market open to a hedge ing funds of hedge funds, or institutions, who
fund investor. demand that hedge fund managers invest within

“Unregulated pools of capital with high fees A diversified portfolio of


that are only available to those who have the stom-
ach to withstand high volatility and who can afford hedge funds generates more
to lose the entire investment.” This is the false, consistent returns than
single-dimensional portrayal of hedge funds that
has historically been perpetuated by the media and mutual funds/unit trusts
less informed participants in the financial industry their mandate as specified in the hedge fund’s
who may see hedge funds as a threat to their liveli- offering memorandum. For example, if our com-
hood. As a result, many investors are misinformed pany, a manager of funds of hedge funds, were to
about hedge funds and have a negative perception find a market neutral fund manager suddenly mak-
about what this investment alternative really is and ing unusual returns due to a large directional expo-
what it can do for them. Nonetheless, hedge funds sure in the equity market, we would redeem our
have continued to grow in popularity, and are now investment because we have other specialist man-
the investment of choice for many pension funds, agers who take a directional view on the equity
endowments, family offices and high net worth market. Investors can also take comfort in the fact
individuals. Should you be investing in hedge that the vast majority of hedge funds are audited,
funds? This article may help you better decide. are administered by an independent administrator,
A hedge fund is a term commonly used to and have their assets held by a reputable custodian
describe any fund that charges performance fees bank or prime broker.
and that isn't a conventional investment fund -- While media stories about hedge funds in the past
that is, any fund using a strategy or set of strategies have usually focused on funds generating exciting
other than investing long in shares (unit returns, the vast majority of hedge funds make con-
trusts/mutual funds), bonds, money markets sistency and stability of return, rather than magni-
(money market funds), real estate, venture capital tude, their primary goal.
or LBOs (leveraged buy-outs). Hedge fund strate- Historical data indicates that a diversified portfolio
gies, also referred to as alternative investment of hedge funds generates more consistent returns
strategies, include selling stocks short, hedging than mutual funds/unit trusts. Hedge funds, unlike
against market downturns by short selling or by unit trusts and mutual funds, have the ability to
using options, investing in asset classes such as make money in both up and down markets through
currencies or distressed securities, and utilizing the use of derivatives, short selling and other strate-
return-enhancing tools such as leverage, deriva- gies not available to traditional unit trusts. During
tives, and arbitrage. the bear market of 2001 and 2002, hedge funds,
There are over 9,000 hedge funds in the world unlike other long only investments, were able to offer
today, though the general investing public probably investors an asset class that preserved capital, and in
hasn’t heard of most of them as advertising and many instances appreciated. This, in contrast to unit
other regulatory restrictions attempt to keep hedge trusts and mutual funds, that experienced losses in
funds away from unsophisticated investors. line with, and often even greater than those suffered
Although many of the larger hedge fund managers in equity markets.
have registered with SEC as registered investment Hedge funds were able to preserve and grow cap-
advisers, this does not however change the fact ital during 2001 and 2002 because many hedge
that hedge funds continue to be managed in a funds, as the term implies, "hedge their bets”. They
largely regulatory free environment. This lack of reg- may sell shares short to cover themselves against a
ulation gives hedge funds defensive (as well as drop in stock prices. They may buy put options,
opportunistic) flexibility that mutual funds, which which give them the right to sell a stock at a speci-
are subject to strict regulatory control and disclo- fied future price, in order to lock in a sell price in
sure requirements, generally don’t enjoy. Despite the event of a severe market drop. They may buy
the fact that there is no formal regulation stipulat- interest-paying bonds or trade claims of companies
ing what hedge funds can and cannot invest in, undergoing reorganization, bankruptcy, or some

16 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007


HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 17

Hedge Fund Services Market Guide

other corporate restructuring, counting on events returns and who do not have the time, expertise or
in a company, rather than more random macro resources to analyze, identify and monitor the hedge
trends, to affect their investment. funds most suitable for their portfolio.
By the same token, these defensive strategies tend If you prefer to select individual hedge funds your-
to cause hedge funds to under-perform unit trusts self, as opposed to investing in a fund of hedge
and mutual funds in bull markets. However, with funds, the following are some important tips:
the bear market of 2001 and 2002 still fresh in First, always understand what it is the fund manag-
investors minds, many investors have turned to er is doing. If the fund manager is not willing to pro-
hedge funds to help preserve their wealth, and per- vide the level of transparency that allows you to
understand their strategy, and if the fund manager
The broad range of hedge refuses when asked to disclose the fund’s largest
fund strategies can confuse holdings and exposure, do not invest.
You can also help avoid fraud by performing exten-
the average investor sive due diligence on a manager. A prudent investor
can perform background checks on the manager
haps you should too. before investing in a fund. Contact any universities
There are a variety of strategies for investors to the fund manager claims to have attended. If he or
consider. The more conservative of these strategies she lies about a degree, would you trust this manag-
are generally not correlated to equity markets, and er with your savings?
deliver steady profits with low volatility. A visit to a fund manager’s office can also be ben-
More aggressive hedge funds that seek high eficial. Is the back office in good order? Are there
returns, albeit with higher volatility, are also avail- checks and balances in place that make fraud less
able. These strategies generally have a directional likely? A first-hand look may detect signs that
bias to the market, either long or short (long/short either confirm or raise concerns about your choice
equity), or seek to speculate on future market of hedge fund manager.
moves in equity markets, currency markets and Verify all statements made by the fund manager,
bind markets (global currency funds). Aggressive especially those made in the offering document to
funds have the potential to enjoy large gains, but lure investors. Contact the administrator, prime
unless the fund manager is perceptive enough to broker, auditor and custodian to ensure that they
identify market turns in advance, the fund may be have, in fact, been employed by the fund.
susceptible to volatile returns. When looking at past performance numbers,
The broad range of hedge fund strategies and the verify if they are audited.
many complex styles available can confuse the Diversify, across both the number of hedge fund
average investor. Unless you have a real under- managers and style and strategies employed by the
standing of the characteristics and risks associated various hedge funds.
with the different hedge fund strategies, the best The recent $5 bn loss suffered by Amaranth should
approach for investing in hedge funds is to use a not scare you away from investing in hedge funds –
consultant well versed in hedge fund strategies or it should however stress the importance of having an
to invest in an established fund of hedge funds. adequate understanding of what the fund strategy is,
A fund of hedge funds is a diversified portfolio of what some of the major risks are, and the need to be
hedge funds that allows investors to access a vari- adequately diversified. If this sounds like too much
ety of hedge funds with a relatively small invest- work to perform prior to investing in a hedge fund,
ment. Typically, the minimum investment in a use a consultant to assist you in your choice or
hedge fund ranges anywhere from $250,000 to $5 invest in a fund of hedge funds. Well-established
million, whereas the average minimum investment funds of hedge funds and competent consultants
into a fund of hedge funds ranges from $50,000 to can provide these services for you. They dedicate
$250,000. Further, by investing in a fund of hedge themselves to understanding the vast array of hedge
funds, investors are able to access a wide range of fund strategies, identifying the leading managers
different hedge fund strategies, providing wide implementing these strategies, and performing
diversification often with exposure to a variety of extensive due diligence.
markets, with one easy to administer investment. So, next time you hear that hedge funds are
As a result of this added diversification, funds of unregulated pools of capital that are only available
hedge funds are often able to provide more consis- to those who have the stomach to withstand high
tent returns than individual hedge funds. volatility and who can afford to lose the entire
Consequently, funds of hedge funds are ideal invest- investment, you’ll know better. You may even know
ment vehicles for investors who are seeking stable enough to invest in one. HFSMG

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 17


HFSMG 2006 pp1-17 ML 2/11/06 11:43 Page 15

which was the only Hedge Fund Administrator in the world to have had been awarded a

Moody’s Management Quality Rating


is the creator of

“The Custom House Fund Formation Service“

Custom House Administration & Corporate Services Limited (“Custom House”) provides advice and
assistance in the design, incorporation and establishment of offshore funds, as a turn-key package.
Custom House prides itself on its personal service and will create a tailor-made specialist fund, designed
to suit a client’s particular situation and specific objective, taking care of all the documentation, as well as
all legal and statutory matters. Custom House will also liase with the payment and custodian banks, brokers
and other service providers, including the auditor, to ensure that the creation and ongoing operation of the
fund is carried out smoothly and efficiently. If required Custom House will also arrange for the shares
of the fund to be listed on an appropriate stock exchange.

and the

“The Custom House Fund Administration Service“

Once the fund has been organised, Custom House will then provide a full administration service to the fund
and oversee all aspects of the day-to-day operations, except for the actual investment of the fund’s assets.
Custom House will maintain all of the fund’s books and records, carry out the valuations, calculate the NAV
and handle all subscriptions and redemptions, as well as overseeing payment of the fund’s expenses. Custom
House will also be responsible for all investor (and potential investor) communications and for the publication
of the fund’s share price and performance data to investors, as well as the media services directly, or on the Web,
through the CHARIOT secure web reporting platform for managers and investors, as required.
Custom House’s main office is situated in Dublin. However, our long-term plan is to provide a 24/7 service
and, as a first step, opened its office in Chicago in June 2005. Custom House anticipates opening a South-East
Asian office before the end of the second quarter of 2007.

If you would like further detailed information on Custom House, please contact:
Dermot Butler or David Blair
dermot.butler@customhousegroup.com / david.blair@customhousegroup.com

Custom House Administration & Corporate Services Limited


25 Eden Quay, Dublin 1, Ireland
Tel: (353) 1 878 0807 / Fax: (353) 1 878 0827

For further detailed information on Custom House and CHARIOT, please visit our Website:

www.customhousegroup.com

Custom House Administration & Corporate Services Limited is authorised by


the Irish Financial Regulator under the Investment Intermediaries Act, 1995
HFSMG 2006 pp18-35 ML 1/11/06 14:40 Page 18

PANEL DEBATE Alternatives?

Rober Chin Ryan Kennelly Stephen Swindon Don McClean

THE HEDGE FUND SERVICES


PANEL DEBATE
Alternatives. Are hedge funds still alternative?
What are the industry’s alternatives?
Our panel explores the issues..
Robert N. Chin, General Manager, ATC Fund financial technology industry. Mr Swindon
Services. Mr Chin started ATC Fund Services joined Rule Financial in 1998, as managing
Curaçao in March 2003. Prior to joining the ATC consultant, and has been responsible for the
group he was the managing director of Fortis Fund successful delivery of a number of high profile
Services in Curaçao. Mr Chin’s professional experi- client assignments.
ences include a seven-year tenure as CFO of Dutch Prior to joining Rule Financial, Mr Swindon was
brokerage firm where he was a member of the a consultant for Cap Gemini and Deloitte &
European Option Exchange and the Amsterdam Touche. He has also held roles in the technology
Stock Exchange. He spent the first 8 years of his departments of Lehman Brothers and Abbey
career with Ernst & Young in Amsterdam. National Treasury Services and was associate
director with NatWest Markets.
Ryan Kennelly, Senior Investment Analyst,
London and Capital's hedge fund team. Mr Don McClean, Head of Fund Services, Ireland,
Kennelly joined the company from Everest UBS Global Asset Management. Mr McClean is
Capital Ltd in Australia. There he worked on responsible for the development and manage-
hedge fund of fund portfolios contributing to ment of the Fund Services business in Ireland
portfolio/risk management, structuring funds and is a member of the Fund Services
and due diligence on managers. Prior to that he Management Board.
worked at Macquarie Bank Ltd and Zurich Prior to joining UBS in May 2006, he spent nine
Capital Markets, where he structured hedge years at Fortis Prime Fund Solutions Ireland.
fund of fund portfolios. Mr Kennelly is a CFA During his time with Fortis, he was appointed to
and CAIA charter holder. roles with increasing responsibility culminating in
the role of Director of Operations Europe. In this
Stephen Swindon, Head of Hedge Fund position he had responsibility for fund adminis-
Practice, at London-based business IT consul- tration, custody and back office banking opera-
tancy Rule Financial. Mr Swindon has more tions in Ireland. He was also responsible for co-
than 20 years’ experience of business analysis, ordinating operations of Fortis Prime Fund
project and program management within the Solutions in other European jurisdictions.

18 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007


HFSMG 2006 pp18-35 ML 1/11/06 14:40 Page 19

Hedge Fund Services Market Guide

To what extent do you feel hedge funds are Although hedge funds are still alternative
still alternative? investments, going forward they look set to
move more into the mainstream.
Chin: Although hedge funds are definitively
becoming more mainstream I believe they are McClean: There has been a convergence
still alternative. I would argue that as long as it between the market exposure of hedge funds
is unclear how regulators in advanced and mutual funds in recent times as illustrated
economies in Europe, the US and the Far East most recently by the under performance of
will regulate the industry and whether or not hedge funds during the May/June market cor-
“smaller” investors are allowed to invest in this rection. Where previously there existed a gap
asset class, hedge funds are still alternative. between hedge funds and mutual funds -
today there is a grey area where the two over-
“Regulatory scrutiny of hedge lap. Hedge fund structures investing in exotic
funds has also increased.” instruments remain at one end of the continu-
um and mutual funds at the other.
Swindon: As the demand for alternative invest- Therefore, although there has been a conver-
ments have grown and more ex-investment gence of certain hedge fund and mutual fund
bankers take the plunge into the hedge fund exposures in the centre of the spectrum, in
space, some of the larger hedge funds have large, hedge funds are still alternative (some
started to resemble their institutional cousins. more alternative than others) offering an alter-
Indeed, some of the institutions have started native risk profile, alternative targeted returns
hedge funds themselves and it is not uncom- and alternative investment strategies.
mon to see investment houses with a range of
long only funds and hedge funds in addition to Where will the next stage of growth in the
offering funds of funds to a broader range of hedge funds industry come from?
investors. Inevitably, this has moved hedge
funds more into the mainstream from the point McClean: It is difficult to predict within the
of view of the management of their underlying hedge fund business from where the next alter-
processes and transparency of controls. native strategy will emerge. We have seen large
Regulatory scrutiny of hedge funds has also sums of capital moving into emerging markets
increased and it is inevitable that hedge funds in the last couple of years and are seeing an
will have to adopt some of the responsibilities increased focus on private equity and venture
of the institutions such as assuring themselves capital at the moment.
of investor competence, particularly with the It could be, however, that growth of the indus-
advent of MiFID (Markets in Financial try is driven through increased distribution to
Instruments Directive). However, events such new markets and more institutional investors
as the recent large loss at Amaranth (around rather than through the offering of new and
$6bn) has reminded everyone that hedge more diversified investment strategies.
funds are not for the uninitiated and remain at These opportunities present challenges. As
the racier end of the investment spectrum. an illustration, the tax reporting considerations
in Germany will have to be addressed before
Kennelly: Hedge funds are becoming increas- wide-scale distribution into that market can be
ingly part of the mainstream. Recent efforts in attained. These challenges are constantly
the US to regulate hedge funds, the rating of being tackled and the market is beginning to
hedge funds by established fund rating agen- open up.
cies and the generally lower average risk in the
industry is bringing hedge funds increasingly Kennelly: Although it is expected that retail
into the mainstream. There tend to be major clients will significantly increase their alloca-
differences across nations with regards to reg- tion to hedge funds on a relative basis over the
ulations and access that retail investors have next 5 years, the most significant growth in
to hedge funds. However, as regulatory bodies AUM in the hedge fund industry will come
become more comfortable with the asset class from Pension Funds.
in general, access to the wider investing public Pension funds are rethinking how they man-
will open up. age assets. Old investment paradigms like
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PANEL DEBATE Alternatives?

Liability Driven Investment have become to convince institutional investors (e.g. pen-
increasingly popular. This has led to increased sion funds) to allocate more assets to hedge
interest in suitable long term assets such as funds. Another driver for growth might be
UK 30 Yr Gilts, real estate and infrastructure. coming from the Far East, especially China.
Furthermore, there is now increased accessibil-
ity to low cost beta, through for example ETFs How does UK hedge fund exposure compare
and Futures, which has led to increased inter- to that in other advanced economies?
est in alpha generating strategies, such as
hedge funds. McClean: Some of the biggest and best per-
forming hedge fund managers in Europe exist
“The days of phone trading, in the UK and these managers have proven
manual blotters, hand written track records.
We exist in a global market and in the UK we
trade tickets and manual see the same spectrum of risk and exposure to
reconciliations are numbered.” hedge funds as there is elsewhere. The suc-
cess of hedge fund managers in the UK is
Currently most of the larger pension funds apparent when you look at the returns they
have an allocation to hedge funds. These allo- have generated in recent years.
cations are expected to increase as they
become more comfortable with the asset class. Swindon: The UK has traditionally been the
The smaller pension fund managers are largest centre for hedge funds outside of the
expected to follow. Pension fund allocations to US. This is as a result of the regulatory regime,
alternative investments, including hedge the infrastructure and access to investors (par-
funds, is likely to increase dramatically over ticularly the increase in institutional investors
the next 5 years. in hedge funds). There are no signs of this
diminishing in the future and, if anything, the
Swindon: From an IT standpoint, as more UK’s hedge fund exposure will more than likely
long-only institutions start up hedge funds, increase depending on how the FSA intends to
there is increased demand for trade order regulate hedge funds going forward.
management platforms which can support
hedge and long-only funds as well as a drive Kennelly: The UK is the dominant investment
towards Straight-Through Processing (STP) management location for Europe. More than
through increased use of electronic trading, 75 per cent of European investment managers
automatic trade matching and reconciliation. are located in London. New York and London
Recent developments such as algorithmic trad- are now increasingly seen as the hedge fund
ing are also driving the need for a more centres of the World.
sophisticated operations and technology infra- However the UK pension fund industry has
structure. The days of phone trading, manual lagged behind the rest of Europe and the US
blotters, hand written trade tickets and manual when it comes to investing in hedge funds.
reconciliations are numbered. Hedge funds This is expected to change over the coming
want to be able to scale up their operations years as institutions become more comfortable
without a big increase in their operational with the asset class.
staff. This has required hedge funds to review Furthermore, this year there have been sev-
and, often, re-design their business processes eral high profile listings of FoHFs on the AIM
to enable them to benefit from increased stock exchange, enabling retail investors to
automation and resultant scalability. This gain hedge fund exposure through the pur-
increased reliance on technology has brought chase of these listed securities.
with it a need to hire technology professionals
to ensure issues such as BCP are properly With the number of hedge funds continually
addressed. growing, the hedge fund administration busi-
ness is becoming increasingly competitive.
Chin: It depends on what form the regulatory What strategies will hedge fund administrators
oversight will be imposed on the industry. use to keep their competitive edge?
Sufficient regulation and supervision is likely

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Hedge Fund Services Market Guide

Chin: Competition among administrators is bringing together the suite of services avail-
increasing due to new service providers enter- able through a global financial institution by
ing the industry. At the same time more due servicing all the financial needs of a hedge
diligence is done on administrators by institu- fund rather than just providing administration.
tional investors. The big administrators are Furthermore, it is increasingly important for
focussing on the larger funds (USD 500MM service providers to offer clients multiple serv-
plus) by demanding higher minimum fees that ices within a ‘single point of contact’ client
focussed model. Sounds easy! However, bring-
“Introduction of regulations ing together the many and varied parts of mul-
have led to newer hedge tiple services required for hedge funds and
fund of hedge funds requires experienced and
fund servicing centres qualified client facing people in a controlled
being created.” and well managed environment.

smaller hedge funds are likely not willing to What affect has the emergence of newer hedge
pay. As a niche player ATC Fund Services can fund servicing centres (Guernsey, Jersey, Malta
offer its clients a flexible, service-oriented etc) had on the more ‘traditional’ servicing
approach that is often lacking with providing locations?
its clients the smaller funds.
Chin: If we are talking about the domicile of
Swindon: Added value services such as auto- the fund I believe that some of these jurisdic-
mated reconciliations; outsourcing of middle tions will be able to attract business from
office operations and links into specialist pric- managers located in the European time zone
ing services to provide better price accuracy. that otherwise would have gone to the more
traditional jurisdictions. Whether these juris-
Kennelly: There has already been consolidation dictions will be able to attract the fund admin-
in the administration industry and we can istration business is still to be seen as they will
expect more of this to continue. Larger admin- face competition from the traditional offshore
istrators are offering the full range of services servicing centres as well as the onshore servic-
to mainstream hedge fund strategies. ing centers.
Competition is putting pressure on administra-
tors to offer connectivity, service, speed of valu- Kennelly: Recent changes or introduction of
ation and support. An administrator also has regulations have led to newer hedge fund serv-
certain fiduciary responsibilities to investors to icing centres being created. These are quickly
oversee and verify valuations. As such, for becoming a viable alternative to the traditional
niche strategies smaller administrators will sur- servicing locations.
vive offering better service, a local presence, The local regulatory environments in these
and or niche experience and valuations skills. regions are pro-actively seeking to increase the
assets under administration/custody in their
McClean: Hedge fund administration becomes respective region. This combined with a rise in
more competitive as the number of adminis- the number of hedge funds in existence and
trators increase and we have seen a growing the increasing allocation to hedge funds
number of administrators in the Irish market should see these regions continue to grow.
place, particularly over the last two years. For European hedge fund managers the newer
Quality is the differentiating factor between centres mentioned also have the advantage of
administrators. Service quality covers a num- being in the European time zone. However, it
ber of issues including timeliness and accuracy would be difficult to conceive that in the near
of service delivery, ability to process NAVs on a future they will challenge the Caribbean/tradi-
more frequent basis, independent pricing, tional servicing locations.
catering for complex instruments and struc-
tures, and being able to constantly stay at the McClean: Hedge fund administration becomes
cutting edge of the IT infrastructure that is more competitive as the number of adminis-
necessary to deliver these top class services to trators increase and we have seen a growing
clients. Of growing value is the capability of number of administrators in the Irish market
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PANEL DEBATE Alternatives?

place, particularly over the last two years. trade lifecycle as possible with the ultimate
Quality is the differentiating factor between aim of achieving STP. As well as increased
administrators. Service quality covers a num- scalability and control, this provides increased
ber of issues including timeliness and accuracy ability to focus on the management of risk and
of service delivery, ability to process NAVs on a tighter cost controls rather than simply ensur-
more frequent basis, independent pricing, ing the day to day operation does not break.
catering for complex instruments and struc-
tures, and being able to constantly stay at the McClean: IT processing of data is extremely
cutting edge of the IT infrastructure that is important to the hedge fund administration
necessary to deliver these top class services to industry. Being able to take information in an
clients. Of growing value is the capability of electronic format, automatically upload it into
bringing together the suite of services avail- the administrator’s accounting records,
able through a global financial institution by pricing portfolios automatically and
servicing all the financial needs of a hedge independently, automatically reconciling cash
and portfolios back to the manager and prime
“Manual processes, often broker or custodian are all essential to
with key steps omitted, being able to offer a robust and efficient
administration service to clients.
are commonplace.” Organizations are utilising earlier time zones
fund rather than just providing administration. and outsourcing internally within their busi-
Furthermore, it is increasingly important for ness in order to standardize these processes
service providers to offer clients multiple serv- and be able to support more frequent valua-
ices within a ‘single point of contact’ client tion cycles.
focussed model. Sounds easy! However, bring- This type of continual IT development
ing together the many and varied parts of mul- requires a significant capital spend and this
tiple services required for hedge funds and has led to a top tier of administrators emerg-
fund of hedge funds requires experienced and ing comprised of global financial institutions
qualified client facing people in a controlled and those able to continually fund the IT devel-
and well managed environment. opment that is required to stay at the forefront
of these IT developments.
Hedge funds are ramping up their use of tech- The efficiency created through these types of
nology. What are the current levels of automa- system capabilities is becoming ever more
tion and STP within the industry? important to the services offered by an admin-
istrator. This type of processing reduces risk,
Swindon: Hedge funds have experienced enor- assists with more frequent and accurate
mous growth over the last few years but, in reporting thereby creating time for the
many cases, their operations and technology administrator to better ‘service’ clients. It is a
infrastructure have not kept pace with this fact that in the hedge fund world it is difficult
growth. Manual processes, often with key to ‘process’ all trades (esoteric instruments)
steps omitted such as reconciliations, are however the challenge to the administrator is
commonplace. In addition, investments in ‘process’ as far as possible in order to offer
technology such as trade processing and posi- enhanced services.
tion management systems are often not fully It is critical when dealing with funds that
leveraged. However, many hedge funds have trade in these esoteric instruments that state-of-
woken up to the fact that their operations the-art IT systems are complemented with expe-
processes are not sustainable in their current rienced, professional staff who are capable of
form. This is due to pressure from investors providing a personalised service to their clients.
who want up to date information on demand,
as well as evidence that the hedge fund has Kennelly: Despite the growth in assets of
the appropriate controls in place. It also due to Hedge Funds they are still in their infancy
regulators who want to assure themselves that technologically. Subscription or redemption of
operational risks are actively managed. an underlying fund still involves faxing forms
A direct result of this is a desire within to the fund's administrators, getting confirma-
hedge funds to automate as much of their tion of receipt both verbal and faxed and

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Hedge Fund Services Market Guide

ensuring that the cash has been sent or is


going to be received on time. The rapid growth in hedge funds has prompt-
Valuations for certain strategies are still not ed many prime brokers to establish, or boost,
received by investors in a timely fashion. As international prime brokerage platforms. As
pension funds increase their allocations the hedge funds become ever more global, how
demand for transparency and timeliness of val- may the role of the prime broker evolve?
uation information will grow.
Kennelly: The prime broking business has
“Many fund managers trade become more and more competitive.
securities based on corporate Prime brokers now aim to offer a full service
solution. Whilst traditionally offering
action information.” custody, clearing and reporting, they are now
Furthermore, three way reconciliation regularly being asked to support complex
between the manager, prime broker and strategies, provide stock loan services,
administrator is becoming more of a leverage, risk management, marketing
requirement. There has been extensive services, technology solutions and tailored
investment by prime brokers and reporting. Going forward, there will be a
administrators to provide automated trading rise in the demands from hedge funds for
systems, web access, connectivity and price prime brokers to meet their needs.
feeds to hedge fund managers, who are
becoming more demanding. Automation and Chin: I believe that the evolution in the prime
Straight through Processing is the cornerstone brokerage industry as far as hedge funds are
of this activity. concerned will be somewhat comparable to
Managers’s technology needs are on the rise what happened with the hedge fund adminis-
as they look to trade either complexity or trators. There will be a few large players capa-
efficiency. To keep up with these ble of servicing global clients while others will
requirements, service providers are investing be focussing on certain strategies and/or
in technology. Investment in technology becoming niche players.
spending, by hedge funds and service
providers is expected to increase by multiples Swindon: Added value services as well as a
in the coming years. desire to lock in their hedge fund clients includ-
ing increased stock lending services; more
How important is corporate action event infor- sophisticated prime brokerage platforms e.g.
mation for the alternative investment/hedge electronic (and algorithmic) trading, better
fund industry? reporting and possibly trade matching services.

Swindon: Corporate action event information is McClean: There are a growing number of
essential for all hedge funds and ranks along- managers who are launching macro or
side daily price information in importance. multi-strategy funds. This means that
prime brokers are having to develop their
Chin: As the timeliness and frequency of infor- cross-asset class offerings. In order for
mation reporting is becoming more important, prime brokers to remain competitive, it is
so is corporate action event information. necessary that they develop a platform that
can offer full reporting, valuations and
Kennelly: Many fund managers trade securities client service across all asset classes
based on corporate action information. For globally - equities, fixed income, derivatives
these managers, for example those in long (listed and OTC) including fixed income
short equity or certain event driven type man- derivatives and credit products.
agers, the information is very important. Implementing the above services means
However, not every strategy focuses on or is that the considerable investment into IT
concerned with corporate actions. and staff-resourcing that has been the trend
For all strategies, if there is any relevant cor- at prime brokers for the last few years will
porate action event, the information needs to continue, if not increase significantly.
be received in an accurate and timely manner. HFSMG

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Hedge Fund Operation - ATC Fund Services

Hedge Funds In The Main


There is no clear definition of
an “Alternative Investment
Fund” but hedge funds are
commonly considered to be
part of this asset class.
Due to the significant inflow
of capital over the past five
years and the publicity that
came along with it, hedge
funds seem to have become
as common as (regulated)
mutual funds.
Does this mean that hedge funds are now
no longer alternative and should be considered
mainstream?

Let’s take a look at various operational aspects


unique to hedge funds.

Regulation
Since the collapse of Long Term Capital
Portfolio in 1998 there have been ongoing dis-
cussions about the need to regulate the hedge
fund industry. Recently fuel was added to this
discussion due to significant losses incurred by
Amaranth Advisors. In the US efforts have been
made to regulate the hedge fund manager (the
requirement for hedge fund managers to regis-
ter with the SEC by February 1, 2006 was

Hedge fund managers are


branching out and investing in
other instruments.
recently overruled by a court in the US).
Although the European Community has imple-
mented UCIT III, individual member states are
still debating if and how to regulate the hedge
fund manager. The most popular jurisdictions
for hedge funds (Cayman Islands, British Virgin
Robert Chin Islands) have rules in place for investment

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Hedge Fund Services Market Guide

funds but exemptions are easily granted if the the administrator of a hedge fund by means of
fund meet certain requirements. Most, if not all a letter. This often causes problems for
hedge funds will meet these requirements and custodians as their systems cannot handle
therefore are not subject to supervision. these investments due to the fact that most
hedge funds do not have international security
Investment strategy identification numbers.
In general investment strategies used by hedge
funds differs significantly from those used by Liquidity
mutual funds. Hedge funds typically have no This is an area where significant differences
investment restrictions, can maintain short between hedge funds and regular funds exists.
positions, make use of derivatives and most Hedge funds typically offer monthly liquidity
will use a certain degree of leverage. Recently (some even quarterly), have a lock-up period (1
some mutual funds managers started to use to 2 years), can have redemption gates (e.g.
only 20 per cent of the fund’s net assets can
The days when hedge be redeemed at any redemption date) and
require advance written notice for redemption
funds posted double digit (30 to 90 days). Mutual funds typically offer
returns seem long gone. greater liquidity, have no lock-up period and do
not use redemption gates.
strategies used by hedge fund managers such
as short positions. Similarly hedge fund Performance
managers are branching out and invest in This is probably one of the few areas where
other instruments such as private equity, there are hardly any differences left between
insurance policies, art etc. mutual funds and hedge funds. The days when
hedge funds posted double digit returns seem
Compensation long gone and performance is now much more
The traditional compensation for a hedge fund in line with those posted by mutual funds.
manager consists of management fees and
incentive/performance fees while a manager of Conclusion
a mutual fund only charge a management fee. In many areas the differences between hedge
However, some mutual fund managers are funds and mutual funds are less than they
considering charging an incentive fee while once were. However, from an
some hedge fund managers have significantly operational/administrative perspective there
reduced or even waived the incentive fee. are still significant differences. This is
In order to charge incentive/performance evidenced by the fact that these funds are
fees in an appropriate manner to the investors, each administered by specialized
hedge funds use one of two methods to administrators. It is fair to say that a
account for this: series of shares or equaliza- traditional mutual fund administrator does
tion of shares. Both methods often cause con- not have the expertise to administer a hedge
fusion to those not familiar with the concept. fund while a specialized hedge fund
administrator is not equipped to deal with the
Offering large number of investors and often huge
Most hedge funds are still being launched as trading volumes typical to mutual funds.
private placements and hence are not available In conclusion I believe that hedge funds
to the general public. Investors in hedge funds should not be considered mainstream. It is
must meet a list of qualifications (eligible more likely that there will be two types of
investor) and submit various documents hedges funds; hedge funds allowing for retail
(subscription agreement, certified copy of legal investors and subject to increased regulatory
documents, bank reference). oversight and therefore more likely to become
mainstream and ii) the more traditional hedge
Settlement of subscriptions/redemptions funds catering toward high net worth
Settlements of subscriptions/redemptions are individuals and institutional investors.
not done through the traditional clearing
systems. These transactions are confirmed by
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Gibraltar - HASSANS

as well as banks to provide custody services.


Sunny Side High regulatory standards combined with the flex-
ibility of a small jurisdiction and the availability of

of the Street a quality infrastructure at low cost is increasingly


making Gibraltar an attractive fund location.
Gibraltar is part of the European Union by virtue
of its relationship with the United Kingdom.
Gibraltar through its introduction
of Experienced Investor Funds Time zone and proximity to
and through the general revision European financial centres
of its fund regime has placed makes Gibraltar an ideal
itself as a serious alternative choice for European based
fund jurisdiction. hedge funds.
The significant and sustained global expansion Gibraltar has transposed all relevant EU Banking,
in funds has put considerable pressure on estab- Insurance and Investment Services Directives so
lished fund centres such as Dublin, Luxembourg, that its financial services sector is firmly within the
the Channel Islands and the Caribbean. These integrated structured financial services system
pressures have given rise to delays in fund estab- contemplated by the EU. ‘Passporting’ of banking
lishment and greater selectivity by fund adminis- and insurance services has been in place in
trators creating a healthy overspill to other juris- Gibraltar for some years and financial services
dictions which had previously been unexploited. passporting was brought in to effect in July 2003.
There are a number of funds currently domi- This allows financial services firms and certain
ciled in Gibraltar and others that are administered funds to offer their services and products through-
from Gibraltar. The recent crackdown by Inland out Europe on the basis of their Gibraltar licence.
Revenue on offshore hedge funds demonstrates
the need to have genuine substance in the juris- The Gibraltar Regulatory Regime
diction of incorporation of a fund. At a distance The Financial Services Ordinance, 1989, the
of 2 hours from London and Paris, Gibraltar is Financial Services Ordinance (Collective
ideally placed as a hedge fund domicile. Investment Schemes) Regulations, 1991, the
Furthermore, the time zone and proximity to the Financial Services (Collective Investment
European financial centres make Gibraltar an Schemes) Ordinance, 2005, the Financial Services
ideal choice for European based hedge funds. (Collective Investment Schemes) Regulations,
Gibraltar has the major names in accounting serv- 2006 and the Financial Services (Experienced
ices to provide audit and other support services Investor Funds) Regulations, 2005 effectively
divide the types of licensing requirements on
funds that may be incorporated in Gibraltar into
four categories: Private Funds, Experienced
Investor Funds, Non-UCITS Retail Funds and
UCITS Funds.

1. Private Schemes
The recently passed Financial Services (Collective
Investment Schemes) Regulations, 2006 codify
what has been industry practice in Gibraltar for
several years. In effect, a fund that is promoted to
a restricted category of persons whose number is
less than 50 is exempt from any licensing require-
ments and may be promoted to that category of
persons in the following conditions:
a. the offer is addressed directly to the identifiable
category of persons by the promoter or his agent.
b. the members of this category of persons are
James Lasry
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Hedge Fund Services Market Guide

the only persons who may accept the offer. Non-UCITS Retail Funds
c. the offerees must have sufficient information The third category is the Non-UCITS compliant
in order to evaluate the offer. public fund. These funds are licensed by the FSC
d. the scheme will remain a private scheme for a as opposed to the “deemed authorisation” in the
year from the date of offer. case of EIFs. The licensing procedure which nor-
In practice, as long as the investors are friends, mally takes between three and six months,
family or close clients of the promoters, or, per- involves the submission of the formation docu-
haps, employees of a firm, a fund can establish ments of the fund and its prospectus to the FSC
itself as Private Scheme. Private funds in Gibraltar along with application forms on the fund, its
generally produce an offering document in order directors and, investment manager, if any. It is
to ensure that the investors have sufficient infor- possible to structure these funds (as well as EIFs)
mation in order to evaluate the offer. Good corpo- as umbrella funds, hedge funds, feeder funds,
rate governance dictates that in addition to the funds of funds and mutual funds.
production of annual audited accounts, private The requirements for licensing under the
schemes engage the services of fund administra- Financial Services Ordinances are basically that
tors and custodians where appropriate although the company must have a paid up share capital of
there is no statutory requirement to do so. at least £50,000 and it must have at least two
Gibraltar resident directors. The directors and
managers must be ‘fit and proper persons’ and
EIFs do not have to go must have adequate investment experience in
through the regular procedure order for the FSC to consent to grant them a
licence. Unlike with EIFs, all of the directors and
for regulation and licensing. managers must be approved by the FSC and not
2. Experienced Investor Funds solely the Gibraltar-resident directors.
Probably the most exciting and competitive There are also various restrictions on the types of
innovation in the Gibraltar fund industry is the investments, however, it is possible (in the case of
possibility to set up funds for experienced non-UCITS funds) to obtain derogations from
investors that are highly versatile and lightly regu- these regulations by making a case before the
lated. Experienced Investor Funds (“EIFs”) under Commissioner of the FSC. The end result is that
the Financial Services (Experienced Investor these funds may, with consent from the FSC,
Funds) Regulations, 2005 (“the EIF Regulations”) invest in almost any type of investment including
are funds designed for professional, high net hedge funds, real property and even private equi-
worth or experienced investors. Investors in these ty. The advent of the Financial Services
funds must have a net worth in excess of (Experienced Investor Funds) Regulations, 2005
¤1,000,000 or invest a minimum of ¤100,000. will probably lessen the use of this category of
An EIF may be set up in a matter of days. For fund, which heretofore was used for both retail
authorisation to trade, it need only notify the and experienced investor funds, as most of the
Financial Services Commission (“FSC”) within 14 uses of this type of fund can be attained through
days of establishment. The notification is made the EIF regime, save for the fact that EIFs are
by the administrator and is accompanied by the restricted to experienced investors.
fund’s offering documents and an opinion from
counsel that the fund complies with the EIF Public Funds (UCITS
Regulations. An EIF must have two Gibraltar-resi- Where the intention of a public fund is to invest
dent directors who are pre-approved by the FSC, a solely in “transferable securities” namely stocks
custodian or broker to hold its assets and a and bonds listed on a recognised European
Gibraltar-based administrator. EIFs that are Community or other recognised stock exchange, a
closed ended or invest in real estate do not fund may be licensed in compliance with the
require a custodian. EIFs must also produce European directives on Undertakings in Collective
annual audited accounts. Investment in Transferable Securities (“UCITS”).
This is a niche area for funds currently in These funds are generally, but not always, meant
Gibraltar. EIFs do not have to go through the reg- for retail investors. Since Gibraltar is in the
ular procedure for regulation and licensing but are European Union by virtue of Article 299(4) of the
structured both to ensure adequate investor pro- Treaty of Rome, it has been given the right to
tection and comfort and to allow for expansion. passport its financial services throughout Europe.
Set-up time and costs are quite competitive. Gibraltar UCITS funds may therefore passport

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Gibraltar - HASSANS

their services within the European Union on the Asset Value (“NAV”) if the fund is to be open-
basis of their Gibraltar license. Unlike EIFs and ended. Typically, an OEIC fund will have ordinary
non-UCITS retail funds, they must comply with shares that carry most voting rights and participa-
the Financial Services Ordinance (Collective tion shares that carry economic rights.
Investment Schemes) Regulations, 2006 with Participation shares are the units purchased by
regard to investment restrictions and structure. investors at the NAV. Although the participation
Such funds must also engage European-licensed shares usually do not have any voting rights, but
custodians and administrators. they may have if desired by the promoters of the
fund. The ordinary shares are normally issued to
Protected Cell Companies the investment manager or to the directors,
Gibraltar’s Protected Cell Company Ordinance, depending on who manages the fund.
2001 allows for the incorporation of protected cell The fund can be managed by its directors or by
companies (“PCCs”). PCCs enable the statutory investment managers. Investment managers that
segregation of assets and liabilities in different manage funds in or from Gibraltar require a
cells. Long used captive cell insurance companies, licence from the FSC in Gibraltar to do so.
the PCC legislation allows a fund to be set up so Directors who manage a fund do not require any
that there is segregation of assets and liabilities in specific licensing, save for the Gibraltar resident
an umbrella structure (i.e. that includes different directors in EIFs who must be approved to act as
sub-funds) where it is essential to ensure that directors of such funds. Most funds have person-
there is no liability contamination between sub- al rather than corporate directors who hold regu-
funds. Instead of the client relying on a purely lar board meetings in order to ensure that man-
contractual arrangement between shareholders, agement and control is fully exercised in Gibraltar.
the legislative regime gives statutory basis for the
segregation of assets that binds third parties as
well. Sub-funds or cells can be used by separate
“Funds in Gibraltar are usually
clients or by one client wishing to promote several structured as open-ended
investment strategies. PCCs may be licensed as
either EIFs for professional investors or as investment companies.”
licensed funds for retail investors. Third party investment managers must be
The establishment of a PCC as an EIF has authorised to provide such services in their juris-
become a popular method of structuring property diction of operation. It is noteworthy that licensed
funds in Gibraltar. Segregated cells are estab- European investment managers or advisers
lished either for specific property investments or whose licences conform with the European
for subscription over a certain time period for Investment Services Directive to passport their
investment in multiple projects. Investment in services into Gibraltar. The anomaly that UK
PCCs is however by no means limited to property. investment firms faced in this regard whereby
A fund manager may establish a PCC as his or her they could not passport into Gibraltar due to the
business vehicle in order to provide a regulatory fact that the UK and Gibraltar are part of the same
framework for investment. Individual cells may Member State albeit separate jurisdictions was
then be established according to investment strat- rectified in July of this year.
egy, geographical emphasis or even for certain Gibraltar funds can be structured as closed
clients such as insurance companies or pension funds as well, thus locking investors in for a deter-
funds that may require asset segregation under mined amount of time, usually subject to one or
the terms of their own mandates. There is no more extensions. These are usually used for pri-
limit to the number of cells a PCC may create. vate equity or property funds where investment is
deal-specific rather than being intended to allow
Legal Structure for constant buying and selling of investments by
Funds in Gibraltar are usually structured as the fund.
open-ended investment companies (“OEICs”) Gibraltar funds may also be listed on a variety of
although it is also possible to structure them as exchanges. A stock exchange is currently being
unit trusts and limited partnerships. established in Gibraltar to allow for fund and
The fund’s constituting documents – the company listing.
Memorandum and Articles, trust or partnership
deed as the case may be - must be drafted to Taxation & Confidentiality
allow redemptions of shares at the prevailing Net Licensed funds in Gibraltar (including EIFs

28 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007


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Hedge Fund Services Market Guide

which are “deemed authorised”) are exempt from Redemptions of shares in such funds are often
income and company tax in Gibraltar upon restricted in time and scope so that the directors
receipt of a certificate from the Commissioner of or managers may have ample opportunity to
Income tax. There are no capital gains, gift or properly dispose of any such assets in order to
wealth taxes in Gibraltar. Stamp duty of £10 is redeem shares.
payable on the increase of authorised capital.
Auditors
“Gibraltar is fast becoming Fund administrators generally provide manage-
a serious alternative ment accounts as part of their package of servic-
es. EIFs and public funds must be audited by an
to the Caribbean.” auditor registered in Gibraltar. Although UK
GAAP is often used as the accounting standard
Gibraltar is committed to preventing money laun- for funds, there is a movement in the industry
dering and it was the first jurisdiction to imple- toward International Financial Reporting
ment an anti money-laundering regime for all Standards (“IFRS”). This will eventually become
crimes. As with any regulated entity, the fund mandatory.
must know the identity of each investor by obtain-
ing a passport copy and utility bills showing his or Conclusion
her residential address along with a supporting ref- Gibraltar is fast becoming a serious alternative to
erence from a lawyer, accountant or banker. This the Caribbean as a fund jurisdiction – and particu-
information is protected by common law confiden- larly so for European based investors and man-
tiality. As regards third parties, it is possible for the agers. The advent of the EIF Regulations has given
shareholder to remain anonymous on the corpo- a tremendous boost to the Gibraltar funds industry
rate register by registering the shares in the name as it is now possible to set up a fund, be it a hedge
of a nominee. The nominee will then hold the fund, a property fund or even a fund of funds, for
shares in trust for and under the direction of any professional or experienced investors quickly and
particular investor and his or her name will not be efficiently. EIFs can be set up as PCCs thus allowing
disclosed in any public register. the simplicity of one vehicle for a variety of segre-
gated investment strategies. The reform in retail
Custodians, Fund Administrators and NAVs fund legislation that implements the UCITS II and
Investments may be made by the fund’s custo- III directives is likely to attract retail funds that can
dian or, in some cases, directly by the fund. EIFs be passported throughout Europe while remaining
that are closed ended do not require custodians. in a fiscally efficient jurisdiction. Gibraltar’s effective
Brokers that are authorised to hold client assets and efficient regulatory regime, its position in the
may act as depositaries of a fund’s assets. European Union and its favourable fiscal treatment
Although several banks in Gibraltar have ample of funds are geared to make it a competitive alter-
experience and capabilities in providing this serv- native fund jurisdiction.
ice, banks and brokers from other jurisdictions James Lasry, partner in the Tax and Overseas
may be used to carry out this function. Property Department, Hassans.
The fund must be administered by a licensed
fund administrator. In the case of an EIF, the Mr Lasry is a highly regarded practitioner who has been
administrator must be Gibraltar-based. instrumental in setting up the majority of Gibraltar’s
Subscriptions and redemptions are typically made funds, including the first Experienced Investor Fund and
directly through the administrator with the con- the first Protected Cell Company Fund. Prior to joining
sent of the directors. Hassans in 1999, Mr Lasry was at the Ministry of
Where the assets of the fund are publicly traded Industry & Trade where he gave legal opinions on inter-
securities, the administrator can usually produce national trade and consumer protection, as well as
the NAV of the fund and distribute it to share- advice on international R&D contracts to the Chief
holders. The NAV will be the figure at which Scientist. He also served as counsel to the Israeli delega-
shares are purchased and redeemed by share- tion in trade accord negotiations with the Czech and
holders. Slovak republics. On joining Hassans, Mr Lasry has
Where the fund holds private equity such as focused his expertise on funds, trusts, corporate law and
shares in private companies, real estate or chat- financial services, advising the Government of Gibraltar
tels, an NAV must be compiled by competent val- on the regulatory and tax treatment of investment
uers such as accountants or valuation firms. funds. James also assisted in drafting the Financial
Services (Experienced Investor Funds) Regulations 2005.
HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 29
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ASK THE EXPERTS

Advent Software
What likely operational challenges will 2007 bring for Hedge Funds?

Secondly, from our vantage point at least, we see


new entrants opening for business with ever high-
er transaction volumes. Their challenge here is not
simply automating to handle execution flow and
eliminate execution errors. That part addresses
barely a handful of the data points that a trade
accumulates from a wide range of input points
before its impact is incorporated in the books and
records. The challenge is in automating to manage
the inherent ‘cancel and correct’ that the entire
cycle brings at whatever level of transaction activi-
Lord Calum Graham ty. Without the help of automation, this becomes a
Advent major cost area for many hedge funds and an
Last year we saw a lot of upgrading in automa- impediment to scaling the business. Managers are
tion and STP in hedge funds in the US in anticipa- facing the decision to upgrade from entry-level sys-
tion of regulation by the SEC. This year that con- tems earlier.
cern faded, although many upgrade plans were Thirdly, the allocations of institutional money
wisely seen through to completion, nonetheless. that the hedge fund industry has invited to its
2007 will be Europe’s turn to goad on the hedge party have brought with them their actuarial math-
fund sector. Brussels looks more set in its ways ematicians, scrutinizing whatever is being passed
with the Markets in Financial Instruments around the revelers. To keep institutional money,
Directive (MiFID) than was its US counterpart last managers must become more answerable, need-
year. There are fewer counter-lobbies at the funda- ing sophisticated systems for risk analysis, per-
mental level than was the case with the SEC’s formance reporting, audit trailing and accounting
intended ruling last February. True, many funds to recognised standards.
might consider themselves exempt from MiFID Fortunately there are now sophisticated core sys-
with offshore domicile, but at the time of writing tems with far greater stability and ease of installa-
the jury is still out on the implications on those tion than were available only ten years ago. High
funds with marketing arms in Europe. demands from users and years of engineering have
Nonetheless, even for those hedge funds that had a similar effect as they did on the car, where
expect not to fall under MiFID’s regulation, there core engineering is hardly an issue any more –
are wider forces pressing them to upgrade to when was the last time you felt the need to check
greater STP, more robust, secure, functionally rich the oil and water in your engine between services?
systems and greater transparency in reporting. Lord Calum Graham, Advent
Firstly, MiFID will force greater efficiency, trans-
parency and ‘best execution’ in relevant markets Lord Calum is a member of the Advisory Board to Advent
for those institutions unquestionably under its Software EMEA, having previously been Regional Director
jurisdiction so connectivity and automation of for The UK and Ireland. Prior to joining Advent he was
these markets will broaden and improve. Even the European MD for Lexit, a Direct Market Access broker sub-
more esoteric OTC derivatives look set to benefit sequently bought by Neonet. In 1999, prior to Lexit, Lord
from new electronic markets. Regardless of juris- Calum co-founded Fleming Lincoln Limited to provide
diction, hedge fund managers will need sound strategic direction and transaction management to small
technology simply to access these markets, let and medium sized enterprises. He graduated with a BSc in
alone compete with their peers. both Computer Science and Zoology at the University of
Cape Town and has a MBA from INSEAD.

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Hedge Fund Services Market Guide

Custom House
How is the World of Hedge Funds changing amid ‘Regulatory Creep’?

fashion, decided that it had extra territorial pow-


ers and could regulate non-US Managers.
So what happened? In the end one stalwart
hedge fund manager in the United States, Phil
Goldstein, sued the SEC, claiming they had no
legal authority to change the law and a year after
everybody who was going to comply had com-
plied and written their cheques to their lawyers,
the appellate court in Washington threw the
SEC’s case out and within a week or two, the SEC
had totally capitulated.
Dermot Butler Again, almost laughable, but my complaint is
Custom House that the SEC’s decision appears to have been
There has been much talk about ‘Regulatory based on evangelistic and political objectives and
Creep’ in the Hedge Fund Industry over the past not on good law. Furthermore, it did not appear
few years and this has become almost a daily that registering hedge fund managers was going
phenomenon. to help any investors and indeed the net result is
Although it would take an anarchist to reject all that investors in Hedge Funds have or will indi-
forms of regulation, there is no doubt that much rectly pay a huge amount of money, because
of the regulation that we have seen has been ill eventually all the costs incurred by the
thought out, is not productive and has proved Administrators, the Managers and the Funds will
very expensive. In this area I would cite particu- pass to the investors.
larly the European Savings Directive (‘ESD’), As I said at the beginning, I have nothing
which caused many administrators to spend against regulation, but let’s hope that in future
huge sums of money in amending their systems the regulators, in particular those in the EU and
in order to meet its requirements, only to be told the SEC can take off their political and evangelis-
that it has proved to be an absolute fiasco, rais- tic blinkers and look at the broader picture,
ing a negligible amount of tax, which was the before they make such rash judgements and take
whole raison d’être of the exercise in the first such draconian steps.
place. It would be quite laughable, if it hadn’t Dermot Butler is Chairman of Custom House
been such a totally unnecessary waste of time Administration & Corporate Services Ltd.
and money.
The other great regulatory debacle of the last Mr Butler has over 35 year’s experience in the financial
few years was the SEC’s decision to require US services industry. He has worked variously as a Stock
and foreign Hedge Fund managers to register Broker and Stock Jobber, before becoming a Commodity
under the Investment Advisor’s Act, if they had 15 Broker and Market Maker in Metal Options on the
or more US clients. London Metal Exchange.
As a result, the industry spent tens if not hun- In 1983 Mr Butler helped set up McDonnell & Co., the
dreds of millions of dollars on compliance with Bermuda fund management company and issuer of the
the new regulations. Some Managers changed McD range funds. He sold his interest in that company
their fund and incorporated private equity so that and moved to Dublin in 1989 when he established
they could justify having a two year lock up, Custom House.He is a director of several fund companies
which made them exempt from registration. listed in the Irish Stock Exchange and is Deputy
Seminars and conferences were held all over the Chairman of the Alternative Investment Management
world because the US Government, in its usual Association (AIMA).

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ASK THE EXPERTS

Miller Insurance
Extradition – how would your directors’ & officers’ policy respond?
The headline news The cover offers to pay bail bond, civil bond and
regarding ‘the NatWest public relations expenses linked to an extradition
Three’ and the legal battle case. However, there is an issue linked to bail
to fight their extradition to bond expenses, as insurers will not provide the
the US, along with the required collateral, only the actual cost of the bail
other more recent stories of bonds. As bail bonds do not exist in the UK, a US
Jeremy Crook and Ian bail bond company would have to be found in
Norris and the internet order to provide a bond for a non-US individual.
gambling case of David This can prove difficult and the individual involved
Carruthers and Peter Dicks, in an extradition case may have to provide the
have focused attention on assets, as in the case of ‘the NatWest Three’.
directors’ and officers’ lia- Brian Horwell AIG has also restricted the standard limit to
Miller Insurance GBP250, 000 under its extradition extension, but
bility insurance (D&O) and
its response to extradition related claims. These, this can be negotiated.
along with other cases where UK directors are fac-
ing possible extradition, have forced D&O insurers Future developments
to review policy wordings, as fighting an extradi- It was announced on the 30th September that the
tion case can incur huge legal costs for the parties US Senate had ratified its side of the revised US-
involved. UK extradition treaty, although, unlike the UK, to
As a result, directors are querying how their extradite an individual, a prima facie case must be
D&O policy will respond if they should be at threat proven in the US. It will be interesting to see how
of extradition to the US, and the extent to which D&O policies in the US are re-written to deal with
their cover will pay for the extradition proceedings. this issue, or, indeed, if any US citizens will be
extradited to the UK under the terms of the treaty.
What can be covered? What is certain, as the risks facing directors on
Since July, when the impact of extradition proceed- both sides of the Atlantic increase, whilst limited in
ings on D&O policies was first raised, many insur- benefit, there is a need to ensure that D&O polices
ers have reacted. Some have issued clarification to protect directors against the financial implications
policyholders that their policy would respond in of potential legal action of this nature.
the event of an extradition case, whilst others have Where differences between the independent
added an extension to their policies to specifically price and the broker price are material the team
deal with extradition claims. In August, AIG, the will attempt to reverse engineer the price differ-
largest provider of D&O cover in the UK, issued a ence to being either model or market data related.
new wording for its D&O insurance to incorporate Under the new approach AFS is able to independ-
cover for extradition costs. As AIG’s wordings tend ently arrive at a valuation for a wide range of deriv-
to be used as the industry benchmark for all D&O atives in a scalable environment. This allows us to
policies, we look at the key aspects of extradition provide much more of an added value service to
costs that it is prepared to cover. our clients. This skill-set and infrastructure married
The extended D&O cover will pay the legal costs together creates the ability to supply a daily robust
of each insured person to obtain the discharge or pricing service for a wide range of OTC positions
revocation of a judicial order that imposes: to meet the growing needs of the funds industry.
- Confiscation, assumption of ownership and Brian Horwell, Director, Professional Risks
control, suspension or freezing of rights of own- Miller Insurance Services Limited
ership of real property or personal assets,
- A charge over real property or personal assets, Mr Horwell entered the insurance market as a professional
- Restriction of liberty to a specified domestic lines broker over 20 years ago. He also worked as a Lloyd’s
residence or and official detention, underwriter for over 15 years before joining the Miller team
- Deportation or extradition. in 2002. Mr Horwell leads activity in the investment arena
and is recognised as one of the market’s leading experts.
32 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007
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Hedge Fund Services Market Guide

Northern Trust
What are the effects of institutional asset flows on the European
hedge fund industry?

improvement in professional standards and


increased regulation will create conditions
for more investors to diversify into alterna-
tive strategies.
2) Asset allocation: portfolio diversification
and non-correlated absolute returns are driv-
ing asset allocation. The portfolio trans-
parency argument has moved on to focus on
operational transparency leading to the
emergence of “supra” alternative asset man-
Marc Russell-Jones agers who offer in-house, multi-strategy,
Northern Trust multi-structure product offerings coupled
with an established compliance and report-
In 2003, one in five institutional investors in ing infrastructure.
Europe invested in hedge funds or fund of 3) Administration and custody: 77% of insti-
hedge funds. By 2005 this had increased to one tutional investors allocate assets to hedge
in three, as a recent Northern Trust survey enti- funds through the fund of hedge fund route
tled “The Forced Institutionalisation of the today, as a result more emphasis is being
Hedge Fund Industry” highlighted. Other recent placed on core administration and custody
industry surveys indicate that industry growth competencies. With over 40 hedge fund
rates have doubled in the first six months of administrators in Dublin alone, consolida-
2006 compared to the same period in 2005. tion is inevitable as we have seen within the
Increased inflows are impacting the hedge traditional custodian banks over the last ten
fund industry right now and will act as a catalyst years who have the infrastructure, scale,
to the emergence of a two tier hedge fund expertise, technology and banking services
industry in Europe, namely: to accommodate the diverse requirements of
1) Boutique managers servicing private clients institutional investors and managers alike.
and high net worth individuals. As a result of the inevitable increase in regula-
2) “Supra” alternative asset managers with the tion, the greater focus on operational trans-
infrastructure to service institutional clients. parency and the demand for institutional type
The Northern Trust study further concluded that fund administration, it is clear that one size
there were three key effects that institutional asset most certainly does not fit all. Ultimately it is
flows would have on the hedge fund industry. the target investor who will dictate the profile of
1) Increased regulatory environment: this will the administrator/custodian and asset manager
have the single biggest influence on the for alternative assets.
future of the hedge fund industry. The focus Marc Russell-Jones, Northern Trust
of the regulator will be on areas such as
asset valuation, risk monitoring and internal Mr Russell-Jones has over 13 years experience in business
operational and management controls. A by- development, sales and product management in
product of institutional flows will be European financial markets. He joined Northern Trust in
increased standardization benefiting both 2005, following the company’s acquisition of Barings
managers and investors in areas such as Fund Services. Mr Russell-Jones, who is based in London,
asset identification, pricing and subscription is vice president of global fund services, responsible for
and redemption documentation. An alternative investment sales for Northern Trust in Europe.
HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 33
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ASK THE EXPERTS

Spectrum Global
Fund Administration requires quality systems, staff and structure.

Compliance concerns, cannot be avoided and having a quality staff


investor communication with rounded experience in financial markets
and data requirements, makes all the difference. These people drive
along with new investment the structure and execution of tasks necessary
strategies involving things to complete the job and also formulate the
like bank debt, OTC deriva- plan to automate for the future. If administra-
tives, private placements, tors do not control and (are willing to) develop
and futures demand more the systems used to do the work, however
from back and middle manual effort becomes the culture and all
office providers. With qual- involved suffer. Understanding the develop-
Robert Goldbaum ity systems in place and
ment cycles of administrators’ systems has
Spectrum highly experienced people thus become a key point when managers
throughout the organiza- choose a provider.
tion, administrators can significantly reduce Administrators are also perfectly situated to
the angst that is so prevalent in the typical provide services beyond accounting and
client-administrator relationship and provide investor servicing. Acting as a true partner of
more services to help managers focus their their fund manager clients, it is important to
resources on portfolio management. offer dedicated services to assist CCO’s and
Fund administrators’ accounting, valuation, CFO’s with compliance oversight as well as
reconciliation and shareholder transaction pro- the preparation of GAAP schedules and hands
cessing efforts are the core of the services they on support to streamline the audit process.
provide and should be centered on significant These complimentary services also provide
automation and process controls to ensure value internally to the administrator by contin-
accuracy, consistency, and data security. Even ually refining internal processes and proce-
for more complex portfolios and seemingly dures along side their clients.
onerous investor reporting requirements, an The fund administration business has grown
administrator should be able to systematize significantly in the last 5 years and firms that
most of the processes involved from securities situate themselves with appropriate systems,
transactions to investor statements to sup- people and complimentary services are poised
porting the audit. Many fund managers never for better relationships with their clients and
ask to see the process, people or systems achieving lasting success in an ever-evolving
involved in their outsourced back office, industry.
assuming that an established administrator Robert Goldbaum,
with a household name can deliver no matter Spectrum Global Fund Administration
what the issue. Faced with novel circum-
Prior to joining Spectrum Global Fund Administration,
stances, however, controls typically break
Mr Goldbaum was VP of SS&C Technologies after
down, the laws of physics take over and things
the acquisition of Financial Interactive Inc.,
move toward chaos. Fund managers do not
(FundRunner) a firm he co-founded. Before
see the results of this chaos until the outputs
FundRunner, he was COO of KSP Capital
(portfolio valuation, investor statements, and
Management, and was the Operations Manager at
audit support) are delayed, inaccurate or sim-
Robertson Stephens Investment Management and
ply cannot be produced.
Secretary of their public investment trust.
There are circumstances where manual work

34 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007


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Hedge Fund Services Market Guide

StateStreet
As hedge fund managers continue to expand into new markets with
new products and strategies, how will administrators ensure the
continued delivery of consistent service quality?

International Fund its global locations, IFS is well positioned to


Services (IFS), State Street’s ensure that a customer investing in Toronto will
hedge fund administration have access to the same high-quality services as
subsidiary, combines a a customer investing in Paris or Tokyo.
proven service model Proprietary systems enable IFS to create
focused on creating “centers flexible; customised solutions on behalf of each
of excellence” with scalable customer. Clients benefit from many unique
technology and decades of product offerings, including market-leading
industry expertise to deliver accounting platform, specialised middle-office
consistently high quality services (with particular expertise in pricing OTC
administration services. derivatives) and front-office services including
Gary Enos two complementary risk management solutions
StateStreet – one to measure market risk and the other to
Centers of Excellence
IFS’s approach to meeting the needs of hedge evaluate portfolio risk via data management,
fund investors focuses on establishing centers of analysis, portfolio construction and reporting
excellence that ensure high and consistent serv- tools. Because the risk management platform is
ice quality among each operation. In the past, linked to our accounting platform, risk manage-
serving our customers in multiple time zones ment customers benefit from unparalleled data
meant simply taking advantage of the time differ- integrity, analytical sophistication, reporting flexi-
ence between Europe and North America. Today, bility and customer support.
as hedge fund servicing demands have Customers also benefit from our continual
increased, it means developing a scalable service investment in technology to augment and refine
model that we can adapt to any of our opera- our servicing platforms. Between 20 and 25 per-
tions, regardless of where hedge funds are dis- cent of IFS and State Street’s annual operating
tributing their products and where their investors budget is allocated to IT development and more
are located. than 15 per cent of IFS employees are dedicated
IFS has built upon this approach in Ireland by to information technology – a clear advantage in
adding operations in Drogheda and Naas in ensuring that our customers stay ahead of the
addition to its Dublin office. This has enabled IFS technology curve.
to leverage geographic proximity – as well as the Gary Enos, executive Vice President and head of
exceptional accounting and risk management Offshore and Alternative Investment Services and
expertise of the local labor markets – to ensure Credit Services, State Street Corporation.
consistency and excellence in all three locations.
We will also look to follow this same model in Enos joined State Street in 1985 from KPMG Peat
North America. Marwick and has held numerous management positions
focused on supporting State Street’s global business
Technology Complements Service growth. In 2001 he was selected to direct State Street’s
Technology is another critical component of IFS’ entry into the alternative investment servicing arena. Enos
hedge fund administration service model. The led the successful effort to purchase International Fund
ability to deliver a consistent level of service in Services (IFS), a leading provider of administrative services
markets around the world depends in large part to the hedge fund community, in July of 2002. He also
on having proprietary systems and a single tech- oversees the company’s risk management and credit servic-
nology platform. es, which focus on risk accountability and liquidity lending
Because the same technology is offered in all of for State Street’s Investor Services business globally.

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 35


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Hedge Fund STATISTICAL ANALYSIS

Developing The hedge fund industry is performing


positively, according to research from
Data Hedge Fund Research Incorporated.
ISJ presents the latest data.

1: July and August Rate of


Returns

Hedge Funds Indices in August


have shown a steady growth in
comparison with July. Graph 1
takes a look at selected indices
from the two months. The overall
trend is that August has shown
steady growth, only losers being
the HFRI Equity Non-Hedge Index,
the HFRI Merger Arbitrage Index,
the HFRI Merger Arbitrage Index
and most noticeably, the HFRI
Short Selling Index.

2: August Index Winners

Percentage wise however, August


seems to be a much better month
for hedge fund growth than is
depicted through rate of return
increase. The percentage shown in
the graph is the percentage of the
year to date up to the month the
figures were compiled. August is
therefore a relatively successful
month, with the HFRI Market
Timing Index having a significant
increase in August with over 17
per cent of the Year to Date. The
HFRI Distressed Securities Index
also enjoyed a significant increase.

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Hedge Fund Services Market Guide

3: Funds of Hedge Funds


Indices

The big winner in August was


the HFRI Fund Strategic
Index with 0.51 rate of return
over July. The Strategic funds
are funds that seek superior
returns by primarily investing
in funds that engage in
opportunistic methods, e.g.
emerging markets, sector
specific, and equity hedge.
The funds are more volatile
yet tend to perform well in up
markets; in juxtaposition with
the short selling index this
highlights the upward trend
in the market.
However the big loser was the Market Defensive Index. This links with the fall shown in the HFRI
Short Selling Index (Graph 1). The market defensive index shows Funds of Funds that generally
engage in short-biased strategies such as short selling and managed futures. As the market is on a
somewhat upward trend, the Market Defensive Index tends to show lower returns.

The Bigger Picture

Looking back at the past few years, the Rate of Return has stayed high, but as mentioned the
HFRI Short Selling Index has shown a loss over three years. The HFRI Equity Non-Hedge
Index has shown one of the highest Rate of Return with 13.39 Trailing Three Years. Non-
hedge funds do not always have a hedge in place and are predominantly long equities. The
highest Rate of Return comes from the Emerging Markets. Investments are primarily long and
include markets in Latin America, Eastern Europe, the former Soviet Union and parts of Asia.
Global funds become like hot money, moving around according to regional market conditions.

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 37


FINACE® is currently the only fully-integrated solution which supports
future business models within the areas of Securities Finance and Collateral
Management. With flexibility at its core, customer-driven modifications and
extensions can readily be implemented. www.finacesolution.com

FINACE® is a product of IFBS AG, Buckhauserstrasse 11, CH-8048


Zurich, Phone +41 (0)44 218 14 14 www.ifbs.com finace@ifbs.com
HFSMG 2006 pp36-50 ML 1/11/06 14:42 Page 40

Company Article IFBS

Super Models
tion it depends on which perspective you look. One can
make a general distinction between the end-user, princi-
pal intermediaries including universal bank, and the
agency custodial lenders.
The End-user
How the future of The end-user such as hedge funds require more trans-
Securities parency regarding market supply and prices and would
like to cut out the intermediary dealing directly with ben-
Lending impacts eficial owners. However, the beneficial owner may not
on technology. have the skills, the processes in place and the risk
appetite to deal with end-users and will therefore still
have to depend on an intermediary. Still the pressure by
the end-user will lead to decreasing spreads for interme-
Felix Oegerli diaries and the requirement to improve the overall serv-
ice level and the need to get more volume to make up for
smaller profit margins.
As a leading vendor of technology solutions we have to
think broadly about the future of the market in which we Investment and Universal Banks
sell software solutions technology. This is important in Investment Bank and Universal banks can also be end-
order to assure that our technology solution meets future users or act as principal intermediaries. One of the key
market requirements and demand. challenges for these institutions is to integrate its securi-
Since the market will continue to evolve over time, we ties finance activities across product boundaries such as
are not going to see dramatic shifts in business models equity finance, fixed income repo and other collateral
and processes overnight. Keeping this in mind when processes. This is to service external clients more effective-
referring to the future, I am addressing the period ly and to streamline its treasury funding and investment
between 2010 and 2015. processes. Collateral is becoming increasingly a “currency”.
Through the effective use of collateral the risk capital of
Market Demand and Pricing the institution is used more efficiently. Furthermore a glob-
Further strong growth of the business in terms of vol- al collateral view will serve to reduce liquidity risk in any
umes, but further market consolidation in terms of active market or financial institution specific crisis.
participants, can be anticipated. The demand and The Custodial Lenders
spreads for dividend enhancement transactions will Over the last few months there was a lot of discussion
decrease and eventually be very minimal over time due to about the role of custodial lenders and the debate as to
cross border double-taxation, harmonisation and anti- whether beneficial owners will increasingly use different
avoidance rules regarding the use of tax credits. Demand distribution channels such as auction platforms and
in other specials will increase further due to increased “exclusives”. I do believe that these alternative distribu-
growth of derivatives and hedge fund investment strate- tion channels may currently make sense for certain very
gies. Furthermore, it is safe to predict a strong growth of large lenders. On the other hand, the custodial lenders
more complex securities lending and funding structures will not lose any significant market share, as long as they
and increased activities in Asia, Eastern Europe and keep on developing products and markets. With decreas-
Central/South America. Collateral trading will become ing spreads the upside for a beneficial owner to go direct
more of a core treasury activity for many financial institu- will narrow going forward. Furthermore, the complexity of
tions acting as principal. Spreads for GC versus GC trad- Securities Lending is increasing. The global custodian,
ing/collateral trading will increase due to the higher cost which is the process owner for position keeping and valu-
of capital implied by Basel II. The GC versus GC curves ation, risk and collateral management, tax reporting etc.,
will become more transparent using the respective repo may seem the better choice from an operational risk
cash benchmark curves. standpoint. What we are also seeing is that the custodial
Business Models and Distribution lenders jointly together with the beneficial owner are
The critical mass to run a highly profitable securities working together with auction platforms, in order get the
finance business has increased over the years. In the optimal deal for all parties involved. it is anticipated that
future you will be required to have a large diversified global custodians being part of a large universal/whole-
lending pool of over hundred billion US Dollars or a large sale bank, will also look at the principal side of the busi-
captive demand. This would be either in-house or from ness. This may include the principal securities lending
hedge funds, through the prime brokerage product. offering to beneficial owners and a closer internal cooper-
Talking about the future business model and distribu- ation with the treasury and clearing function of the bank.

40 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007


HFSMG 2006 pp36-50 ML 1/11/06 14:42 Page 41

Hedge Fund Services Market Guide

Distribution channels changes. Multiple departments have to be coordinated,


Further standardisation and commoditization of the which is also slow and costly.
business will force market participants to manage the busi- Future
ness over processes and IT because volume insensitivity The requirements incumbent on technology to support
and low unit cost is going to be critical in the future. This the future securities finance business model are
is why electronic trading platforms are gaining in impor- substantially higher than traditional product silo or
transaction processing systems. The challenge is to
“The complexity of Securities provide a consolidated view on a broad variety of
Lending is increasing” products and processes while supporting a high volume
of transactions throughout their life-cycle.
tance. I estimate that in 5-10 years well over 50% of the In order to achieve this goal, a system architecture
market value volume will be traded electronically. would ideally be service oriented (SOA). Service-based
Business Concentration architectures will also provide the way to integrate
In the long term future, the securities finance business systems across the company and Internet based network,
will be as commoditised as the foreign exchange mainly by using Web Services. Transaction processing
business is today. This may mean that a few very large services for settlement, audit trail, accounting etc. should
players make up the majority of the business flow. be loosely coupled, using message-oriented middleware
However, concentration in the securities finance and as the separation layer.
collateral market may amplify the dynamics that Most importantly, real-time information has become a
collateral can create or contribute to turbulent markets. A necessity. In cross-product systems, multiple users with
market crisis and a specific crisis at one of the few major
different business intentions may use the same
players might put substantial pressures on the markets
for securities used as collateral. Securities Finance positions. Only real-time updates on positions,
including collateral management is absolutely crucial for preferably on a ‘push’ basis, meaning the user does not
an efficient capital market, but it also will elevate have to actively query the system, will prevent the
systemic risk exposure to the next level. This is why overuse of positions or not actively funding or selling
collateral risk management in stress testing scenarios positions. Counterparty and trading positions must be
will become as important as the asset and liability kept and updated real-time for risk management
management function of a financial institution. purposes. Real-time profit & loss figures will provide the
required information to automatically optimise the book
Processes and technology and close out unprofitable transactions or to replace with
cheaper sources.
Past and current: On a mandatory basis, the data model of such an
In the past, available technology mainly covered standard application must be designed for maximum flexibility
product centric functionality. Today, business vision and from the beginning. All existing, but also new, trade types
strategies are defined and aligned together with an under- must be supported. This includes single security, security
standing of the technology involved. IT follows strategy. vs. cash and even security versus security
However, IT enables new strategy. Depending on the busi- transactions. All future flows of financial instruments
ness model and the size of an organisation, the securities must be presented as cash flows, which will allow for
lending business is more integrated into other business Cash-for-difference and Total-Return-Swap transactions
lines such as repo and OTC-derivatives and collateral man- but also for other future transaction types.
agement. This is either in the form of integrated processes
To conclude, technology has to cover different business
or even combined organisations. One of the key success
factors for a successful integration of the business lines is a models, be flexible to incorporate changes, scalable
horizontal position-focused IT platform. However, typically regarding functional extensions, high-performance and
there is no single IT platform supporting this business last but not least, low cost.
model. A variety of vendor systems are being used, mostly Felix Oegerli, CEO, IFBS
for the books and records. Very often, in-house functional Felix Oegerli was born in Solothurn, Switzerland. He
add-ons or additional data collection are developed to at obtained a post graduate degree as a Swiss Federal
least partly fulfil the business requirements for a consoli- Banking expert. He began his financial services career
dated view on the positions and transactions. with UBS, assuming a variety of roles in Zurich, New
Consequently, a large number of heterogeneous systems York and London, including: Global head of prime bro-
and interfaces must be supported and reconciled, leading kerage and Deputy global head of securities lending and
to enormous maintenance costs and the risk of poor data repo. Oegerli is Founder and CEO of IFBS, a consulting
quality. As the IT structure typically mirrors the business and solutions firm for the financial industry.
structure, there is often no single point of responsibility for
HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 41
HFSMG 2006 pp36-50 ML 1/11/06 14:42 Page 42

Outsourcing - TELEKURS

exchanges do not permit all clients to see their


Administration data without licence fees being levied, so sys-
tems to restrict certain exchange level data
Challenge have been put into place. Restricting whole
tranches of data though would require a new
approach from data vendors as to how client
level information is dealt with. Yet, it is not
impossible to envisage how such an infrastruc-
ture could work. For example, closed user
Outsourcing has been groups could be built, even using distinct net-
likened to “the beginning works. As data vendors look to provide ever
of the Finance Industry’s more value added services, bulk processing of
industrial revolution”. confidential information will allow hedge fund
This refers to the search operators to be able to rely on both the reliabil-
for a reliable partner who ity of the data vendor, through its size, and the
has standardised process- confidential way in which data is handled,
Richard Newbury es which can be applied on because of the vendors’ expertise.
an industrial scale to pro- A further item for consideration: once the
duce similar results for a similar dataset. Fund infrastructure has been built, will a hedge fund
of (investment) Funds administration can be manager or even the hedge fund client be happy
outsourced to a degree. Some data vendors are enough to have their confidential information
now able to offer bespoke data collection and shared with a further third party? Of course
management activities on an outsourced basis. expansion means greater access to data for
How hard can it be to find a similar service for entities that would not normally have access to
Funds of Hedge Funds? There is a one word this data. Off shoring, for example, now has
answer: “Very”. India’s NASSCOM and the UK’s FSA looking
Boutique type companies have been estab- into the illegal sale of client information in
lished which cover part of the market, but it is India. It is clear that to gain the trust of hedge
difficult to gauge the breadth of the data cover- fund operators and clients, numerous failsafe
age of these firms or how industrial their systems would need to be implemented with
processes may be. strict controls over access to data. One of the
To find a more valuable answer requires that ways of assuring confidentiality would be for a
we look at the issues the administrator of a hedge fund administrator to issue only an exter-
fund of hedge funds may face. nal client identifier to the data vendor and for
Firstly, for open ended investment funds, the hedge fund manager to use the same code
investors can buy into the fund at a stated price when communicating externally. The external
at any time, indeed if there are no available units, identifier could then be mapped back to a sin-
the fund promoter can create new units to sell. gle client, or to a group of clients with the same
The price paid by the investor reflects the dilutive terms, without the data vendor ever knowing
effect that their purchase will have on the overall the whole chain.
value of the fund. Buying into a hedge fund, is So, given the will of a data vendor to build the
less simple. Either an institutional investor or a infrastructure and make the requisite invest-
High Net Worth individual investing in a hedge ment and the desire of the fund administrator
fund will typically make a large investment and to outsource this arduous task to someone
may get special terms. This means that any whose core business it is to collect data, why is
administrator can only provide client data if they outsourcing so difficult?
have access to statement information. The first As in many areas of data management, the
issue that outsourcing of client level data raises questions of standards (there are no hedge
is that of confidentiality – both of the fund and fund ISINs for example), the will of issuers (are
of the investor. administration issues even on the hedge fund
How does a data vendor deal with this con- managers’ radar?) and knowledge in the market
cern? Well, a data vendor’s traditional role has place all conspire to slow down the inevitable
been to take in as much data as possible and to trend toward outsourcing.
resell it as many times as possible to interested Another one may be of service expectation.
parties. However, many contributors and High Net Worth individuals rightly require care
42 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007
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Hedge Fund Services Market Guide

and attention to their portfolios. The hedge to allow them to make the required returns and
fund manager might not feel that their admin- to concentrate on their business.
istrator outsourcing their responsibility is the Data vendors are specialists in obtaining data
best way to provide the required level of serv- and tied to the capacity for innovative solutions
ice. Things are changing though. A new report can look forward to working with hedge fund
from Bank of New York et al. claims that there managers and administrators to assist them in
is to be a 60 per cent increase in investment their next phase of growth.
from institutional investors. With margins The hedge fund industry has exploded since
being squeezed, talented administrators who the mid-1990s and is now worth almost ¤1.2
understand hedge funds being hard to find and trillion, with over one third of these funds,
the requirements of auditors and institutional worth ¤400 billion, serviced by fund adminis-
investors for transparency and low cost admin- trators in Ireland. Hedge funds account for
istration, outsourcing activities or parts of more than 2,000 of the 8,500 people who work
administration activities makes perfect sense, in the fund management industry in Ireland.
providing that the client confidentiality issues Data vendors’ own research shows that local
support is vital and numerous vendors have
A large part of any back office offices giving various degrees of support in
Dublin. This is important for the support of the
data vendor’s existing hedge funds business in Ireland as recent sta-
business lies in helping fund tistics show that around:
• 57% of European Hedge Funds are admin-
managers to value their funds istered in Ireland
can be overcome. • 3027 alternative investment entities are
How else can traditional data vendors help domiciled in Ireland
hedge fund managers or investors in this envi- • 62% of which are hedge funds and
ronment? Data Vendors are experienced entities • 31% of which are funds of hedge funds
who are keenly aware of the service levels that The market grew (number of funds) on average
will be demanded by hedge fund managers and by 41 per cent per annum between 20022005
administrators. So data vendors are developing both the techni-
A large part of any back office data vendor’s cal solutions and the physical presence needed
existing business lies in helping fund managers to provide support to new hedge fund clients in
to value their funds. Depending on the breadth Ireland, or wherever they may be based.
and depth of the company’s coverage often Some vendors are also developing tools
existing mechanisms can be used to provide which allow their clients to scour their client
hedge fund managers with the information that database automatically to find Politically
they need to provide the transparency that reg- Exposed Persons and to verify the identity of
ulators are looking to achieve. their clients at the point that the relationship
In response to regulation such as UCITS III starts. This will help hedge funds with ‘Know
and Basel II, data vendors are devising ways in Your Customer’ regulations which are now
which clients can build groups of companies in being imposed on them around the globe.
their own systems to ease credit risk manage- So outsourcing is still in its infancy where
ment. More and more regulation is expected in hedge funds are concerned. Cost, regulation
the hedge fund industry and with potentially and commercial pressure will undoubtedly
more money being invested in funds, greater come to bear over the coming years and will
transparency is another thing that hedge fund bring about many more outsourcing opportuni-
managers can expect to have to provide. Such ties for hedge fund administrators. Data
company hierarchies will become invaluable to vendors are making the required investment
hedge fund managers, in the same way that now and are ready for the challenge.
other risk managers are discovering now. Richard Newbury, Head of Product Services
The need for high quality data to meet the Telekurs (U.K.) Ltd.
regulatory requirements will become important Mr. Newbury joined Telekurs Financial's UK subsidiary as
to hedge funds as it has to more traditional Head of Product Services in June 2004. His primary focus is
fund companies. Innovative solutions – includ- the development of customised solutions for clients as well
ing partial outsourcing - will be needed to help as leading Telekurs Financial’s (UK) involvement in a wide
hedge funds keep costs down whilst continuing range of industry initiatives such as MiFID and EUSD.

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 43


HFSMG 2006 pp36-50 ML 1/11/06 14:42 Page 44

Fund Administration Service - UBS

inherent valuation issues. Where a top tier

One on One administrator is engaged, strong control process-


es are in place that lend comfort to investors that
a third party is reviewing the activities of the fund.
The fund administration industry is also facing a
Hedge funds continue to human capital crisis and staff turnover is a chronic
become more complex, issue for most administrators. UBS's ability to con-
whether through strategy, sistently attract and retain staff is largely a function
investment valuation or legal of the single point of contact service model. By hir-
structure. Under these ing qualified professional accountants and provid-
increasing complexities, it is ing a job environment where they have direct con-
valuable for investors and tact with the fund managers and shareholders,
managers to be able to work and responsibility for the fund relationship in its
with a single contact who entirety, the business model provides professional
knows and understands all challenge and results in retaining staff for years
aspects and features of each beyond that typical in the industry.
Colleen Montain fund. Not only do clients talk directly to a fully
UBS takes a unique approach to providing informed person, they also build a relationship
hedge fund administration services through a with this person over many years which enables
‘single point of contact’ model. service at a level not attainable were the environ-
While some in the industry have shifted to auto- ment is one of constant staff turnover.
mated telephone call centres, touch tone selection Additionally, as the fund grows in complexity, so
menus and general delivery e-mail addresses, does the contact's experience and knowledge of
UBS has remained consistent in providing fund the fund. With a low staff turnover, knowledge is
managers and investors alike with a ‘live’ person built and retained, which is beneficial to the fund
to speak to. This person is a qualified profession- relationship, thus providing investors with greater
al, responsible for all aspects of the fund service confidence.
delivery from shareholder trades, to calculation of As fund products develop, so UBS is keeping up
NAV, banking transactions and investor ‘Know the ability to price new and unusual instruments,
Your Client’. and evolve in line with the complexity that hedge
By being a hands-on, professionally qualified funds offer.
accountant with responsibility for overseeing all Any administrator operating at the top-tier level is
aspects of the fund, this person can immediately required to continuously invest in supporting and
answer questions that a client has, as well as evolving the global business year on year. Tech-nol-
being highly knowledgeable about the instru- ogy needs to be flexible, robust and able to support
ments being traded and the valuation methodolo- the varying needs of clients and UBS is committed
gies used. to making the necessary investment to remain at
The current trend, for many fund administra- the forefront of technological development.
tors, is the offshoring of a variety of components Being organised and able to focus on each
of the administration process. For example, share- client’s needs is fundamental to business success.
holder services are going to the Caribbean, portfo- As the hedge fund industry continues to develop
lio pricing to India, NAV computation is being and grow, opportunities for administrators to sup-
kept onshore, and client relationship officers are port and grow with it will continue apace.
in the local market. Without a single point of con-
tact, it can become a very challenging model for Colleen Montain, CFA
fund managers to navigate, involving the need to Head of Business Development/Client
contact several different offices to obtain answers Relationships, Hedge Funds Executive Director
to all questions.
Hedge funds continue to operate in an environ- Colleen Montain has global responsibility for business
ment of low regulation and managers can be development and client relationships for Hedge Fund
unregulated depending on their jurisdiction. The Services. She is also responsible for the oversight and
fund administrator is in a good position to see a management of shareholder services for Fund Services
high level overview of the fund and have a in the Americas and is a member of the Fund Services
Management Board.
detailed understanding of the portfolio and the
44 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007
HFSMG 2006 pp36-50 ML 1/11/06 14:42 Page 45

Canadian Hedge Funds

Jim McGovern Gordon Cheeseborough David Fawcett Gary Selke Don Short

THE CANADIAN HEDGE FUNDS


PANEL DEBATE
James McGovern, Managing Director & CEO, employee growth. Prior to this he worked as a
Arrow Hedge Partners. Mr McGovern founded research analyst at Deutsche Bank Securities,
Arrow Hedge Partners in 1999 after working for First Marathon and Middlefield Group. Mr
over thirteen years at BPI Financial Corporation, Fawcett holds a Business Economics degree
the company of which he co-founded, and from Wilfred Laurier University in Ontario.
where he ultimately held the positions of
President and Chief Executive Officer. Mr Gary P. Selke, Chief Executive Officer and
McGovern currently serves as the founding President of Front Street Capital. Mr. Selke
Chairman of the Canadian Chapter of the formed Tuscarora Capital Inc. in 1996 with Mr.
Alternative Investment Management Association Lamarche. From 1981 until 1996, Mr. Selke
(AIMA). Mr McGovern graduated from the was employed by RBC Dominion Securities Inc.
University of Toronto with a Bachelor of and its predecessor firms. During that period,
Commerce and Finance degree in 1985. he was employed in the investment banking
department. From 1993 to 1996, Mr. Selke
Gordon Cheeseborugh, Blair Franklin. In 2003, worked in the institutional equity department in
Mr Cheeseborough and Steven Sharpe formed a the sales area where he provided services to all
partnership which became Blair Franklin Capital types of institutional clientele including mutual
Partners. Prior to this, he worked with Altamira funds, pension clientele, life insurance compa-
Investment Services Inc. as President and nies, investment counselors, and high net worth
Chief Executive Officer where he oversaw the money managers. Mr. Selke holds a Bachelor of
restructuring and eventual sale of the company Commerce degree from the University of Toronto
to the National Bank of Canada in 2002. Mr and is a Chartered Accountant.
Cheeseborough is a former director of Orion
Capital (a U.S. based property and Don Short, President of Origin Capital
casualty company which was sold to Royal Sun Management Ltd. Origin’s flagship fund is the
Alliance Insurance). OCM Energy Total Return Fund. Mr. Short’s
experience includes positions as an equity
David Fawcett, Portfolio Manager, Epic Capital research analyst, institutional salesman and
Management. Mr Fawcett joined Epic Capital in commodity analyst, covering the energy indus-
2000 with main responsibilities for buiding the try. Mr. Short holds bachelor degrees in com-
asset management side of the business, co- merce and computer science as well as the
managing the Epic Canadian Long/Short Fund, Chartered Financial Analyst designation.
and marketing, strategic planning and managing

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 45


HFSMG 2006 pp36-50 ML 1/11/06 14:42 Page 46

Canadian Hedge Funds

Canadian hedge funds have significantly outper- Selke: Hedge funds and the markets in which
formed the broader international hedge fund they invest are intuitively correlated and if oil, gas
indices over the past 12 months, why is this? and natural resources continue to thrive, it is to
be expected that hedge funds invested in those
McGovern: Firstly, and most importantly, the sectors and markets will also do well. Having
Canadian equity, debt and currency markets have said that, the converse is also true in that, if the
been in significant bull market mode for a num- markets slow, for whatever reason – for example,
ber of years now – especially relative to the U.S. as a result of a reduction in perceived geopolitical
Secondly, over 60 per cent of the hedge funds in risk, a reduction in market volatility or through
Canada are “opportunistic” or long/short equity economic slowdown and consequence demand
in nature and the bias has been long which has destruction – Canadian markets will tend to
supported returns. Finally, the strong under perform.
resource/commodity performance has led to
plenty of opportunities across all related asset Fawcett: We believe the mining cycle still has con-
classes. siderable legs left to it. For over a decade the
base metals sector was undercapitalized due to
Short: Our economy is dominated by energy and low commodity prices and money flowing into
basic materials, both of which are late-cycle cycli- the technology sector. The GDP growth in China
cal sectors that have faced global under-invest- and India has generated significant new demand
ment for the past 30 years and are now benefit- for the metals. We therefore believe the cycle will
ing from increased demand in newly industrializ- last a few more years. Also we expect a consider-
ing economies. able amount of merger and acquisition activity.
The major mining companies have significant
Cheeseborough: Many Canadian hedge funds are free cash flow, great balance sheets and are short
focused on resource companies, particularly on organic growth opportunities. We believe this
small cap oil & gas companies. Obviously this will be a great source of alpha-investing.
area of the market has seen outstanding per-
formance over the past five years as the price of McGovern: Many market participants are expect-
oil rose from $20 to almost $80 per barrel. ing a slowdown in global economic growth but
Many of these hedge funds have a long bias and export commodities – and in particular energy –
therefore returns have been exceptional in the to continue to perform well given Asian demand.
recent cyclical upswing in natural resource prices. Given this positive commodity back drop,
Canadian long/short managers (and particularly
Fawcett: The bull market in resources in particu- specialist energy funds) will continue to exploit
lar base metals was a major contributor. With the pricing/informational inefficiencies particular-
almost all base metal prices having enjoyed ly in mid and small cap stocks. Canada has the
major moves over the past year, corporations are largest number of listed oil and gas and mining
enjoying material improvements in free cash shares in the world that is also growing rapidly.
flow. 60 per cent of the world’s public mining Merger and acquisition activity has also been
companies are listed on the TSX Group equity extremely robust.
exchanges.
Short: It is interesting the difference a few
Selke: It reflects the nature of the underlying months can make. Many global strategists are
Canadian investment climate. The strength of now calling for under-performance from the ener-
the resource and energy markets is more broadly gy and resources sectors based on the potential
represented within the Canadian stock equity for slowing demand and recent supply side
markets than other global equity markets, hence capacity additions. Our work suggests that while
Canadian-oriented hedge funds’ relative out-per- we are in the middle of some weakness in the
formance. supply/demand balance for energy, it is really just
a pause in a strong, longer term trend. Our belief
In 2007 Canadian hedge funds are forecasted to is that the market overestimates the world’s abili-
continue to offer exceptional growth largely due ty to supply oil and gas to meet incremental
to Canada's thriving oil, gas and resources sec- demand requirements and also overestimates
tors. Please give your views... the length of time required to rebalance supply

46 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007


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Hedge Fund Services Market Guide

and demand. While we may enter 2007 with the Canadian credit and provincial markets and
weaker oil and gas fundamentals we will exit the with very little resource exposure. The Canadian
year in a much stronger fundamental position. fixed income market has experienced significant
growth in issuance over the past couple years
Cheeseborough: As mentioned in the previous due to an increasingly diverse group of issuers in
question, many Canadian hedge funds tend to be Canada, including many foreign “Maple” issuers.
resource-focused, particularly oil and gas- This added diversity and liquidity in the fixed
income market has led to a growing list of arbi-
Many Canadian hedge trage opportunities.
funds are focused on Short: Our firm focuses exclusively on opportuni-
resource companies ties in the energy sector, so commenting on
opportunities in addition to the resource sector is
focused. Many of these funds are long only and outside our area of expertise. There are some
focus on small cap companies. If you believe that very good reasons for investors to look at
the bull market in oil and commodities (especial- Canadian hedge funds as an option for resource
ly the metals) will continue, these hedge funds based investment. For example, we believe that
will continue to out-perform. the concentration of oil and gas companies in
Calgary has resulted in a globally competitive
While many foreign investors regard Canadian energy industry and that being located in Calgary,
Hedge funds as resource centric for their portfo- within blocks of the head offices of these compa-
lios, comment on the Canadian market and nies is a source of competitive advantage for a
opportunities in addition to the resource sector? fund manager based in Canada.

Selke: Clearly the Canadian market is dominated Fawcett: Canada does offer other opportunities
by resource opportunities, however there are a beside the resource sector. Take for instance the
number of special situation opportunities both Income Trust sector. This is a USD250 bn market
long and short, which can provide opportunities capitalization sector. Companies typically do not
to generate alpha for their relevant portfolios. pay income tax and pay monthly cash distribu-
Experienced Canadian managers providing advice tions. The monthly distribution attracts a high
to hedge funds is one way to take advantage of retail component and thus creates a more ineffi-
some of these non-resource opportunities. In cient sector. We believe fundamental research
addition, the Canadian capital markets are under- can generate excess profits in this area. Another
researched relative to larger world markets and theme is growth companies in Canada. Canadian
for those managers and funds that are aware and company’s often grow to be the dominant player
nimble their funds can take advantage of these in Canada and are then consolidated by interna-
market inefficiencies. tional firms. Research in Motion has over a $20
billion market capitalization. It is a Canadian
McGovern: Resources currently make up 40 per company that develops and manufactures a
cent of the market cap of the TSX (Toronto Stock product in Canada that has been able to grow
Exchange) indicating a wide range of other sec- market share against the likes of Motorola, Nokia
tors and sub sectors to potentially exploit. In and Palm.
particular, income trusts where many retail
investors have “stretched” quality for yield The number of hedge funds in Canada contin-
appears poised for consolidation. High yield, ues to grow at a noticeable rate. What strategies
convertible and sub prime mortgage issuance will Canadian hedge funds use to differentiate
has been steadily growing but is not well followed themselves?
or researched allowing for arbitrage opportuni-
ties. Additionally, there are a growing number of Fawcett: We believe fund managers will differenti-
activist funds on offer in Canada. ate with sector specific strategies. Resource and
Energy only funds are likely to gain in popularity.
Cheeseborough: Blair Franklin Capital Partners
runs a hedge fund focused on opportunities in McGovern: The number of funds and size of the
the fixed income market, investing primarily in hedge fund industry continues to grow in
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PANEL Hedge Fund Manager Debate

Canada. Current estimates have the industry at ket has proven beneficial. As well, in many cases,
over USD30 bn in aggregate. The fastest grow- Canadian based hedge funds are in closer con-
ing segment has been in the single manager cat- tact with and have greater exposure to manage-
egory as existing firms have grown rapidly and ment of Canadian companies, particularly micro
new entrants have emerged. Canadian man- and small cap stocks. Additionally, many fixed
agers will differentiate themselves in a number income credits do not issue into foreign markets
of ways relative to their U.S. counterparts. The and the bonds are not available to be purchased
by foreign investors, so opportunities for foreign
Differentiation in the hedge funds to invest in Canadian securities are
limited.
Canadian market requires
niche strategies What are the main challenges faced in starting a
hedge fund in Canada?
relative small number of funds and assets rela-
tive to the size of the Canadian capital markets; Fawcett: Oddly enough one of the main chal-
niche strategies focused on resources, income lenges is that Canadian institutional investors
trusts, high yield, convertibles, risk arbitrage that have not yet widely supported Canadian hedge
do not make it to the radar screens of large U.S. funds. Therefore, it takes more time and money
hedge funds; and finally, there is a tremendous to either attract high net worth clients domesti-
pool of talented managers and traders with avail- cally or offshore investors as a start-up firm.
ability of capacity. These are all differentiating
features in Canada. Short: The biggest challenge to starting a hedge
fund in Canada or any other part of the world is
Selke: Canadian hedge fund managers are chal- gaining the initial critical mass of sponsors and
lenged in terms of their ability to grow their busi- investment capital required to take the first step.
nesses to world scale levels. It is difficult to dif- The other aspects (regulatory, legal, operations,
ferentiate one self in a market that is essentially relationships with service providers) are daunting
dominated by large cap financials, oil and gas when viewed as a whole, but can be accom-
and mining (70%+). Differentiation in the plished with time and persistence.
Canadian market requires niche strategies, which
are often not scalable. Although the number of McGovern: The main challenges in starting a
hedge funds is increasing in Canada, the ability hedge fund in Canada is the initial or seed capi-
to grow will continue to be the most significant tal. The broader institutional marketplace in
challenge for Canadian hedge fund managers. Canada has been slow to embrace hedge funds
and the large plan sponsors, while committed to
Short: Many of the traditional hedge fund strate- hedge funds, have focussed on more globally ori-
gies (event driven, merger arbitrage, convertible ented hedge fund managers. While incubators
arbitrage) can become crowded rather quickly, such as JP Morgan and others have found suc-
particularly in a relatively small market such as cess in Canada, there remains a void in terms of
Canada. As a result I think future growth will start-up funding. The local prime brokers
focus more on the equity long/short and market (Canadian bank subsidiaries) have become much
neutral categories in areas where there are mar- more sophisticated in terms of the package of
ket inefficiencies such as small cap stocks, spe- services they provide, but they have only started
cial situations or private equities. These funds this year to focus on capital introduction globally.
will either need to push further into areas domi- This leaves the high net worth market as the mar-
nated by conventional funds and become more ket that domestic managers initially focus upon.
widely accepted by the investing public or carve
new territory in non-traditional investment areas. Cheeseborough: The Canadian investor is not as
educated about hedge funds as investors are in
Cheeseborough: Our hedge fund (the Blair U.K. or the U.S. Also, administration and regula-
Franklin MultiStrategy Fund) focuses on opportu- tion issues arise as they do elsewhere.
nities in the Canadian fixed income market, an
area we believe is underserved. Significant trad- Selke: There is no shortage in intellectual capital
ing experience in the Canadian fixed income mar- and there is no shortage of investment opportu-

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Hedge Fund Services Market Guide

nity in Canada. There is, however, a shortage of eign competitors. This will surely change as the
indigenous institutional capital to support a hedge fund industry continues to expand in
world scale business. Consequently, in order for Canada.
hedge fund firms to grow they must choose
either a) a Canadian retail-oriented growth strate- Selke: Hedge funds receive high levels of service
gy or b) market themselves outside the country from domestic prime brokers, administrators and
to non-resident institutions. In order to attract the local legal and accounting community in
Canada. There are a number of options for
The difficulty in Canada is prime brokerage, custody, administration,
accounting and legal support in Canada available
that there are proportionally to hedge fund managers. Moreover, these service
few accredited investors providers are well qualified both intellectually and
financially to advise and service Canadian hedge
relative to the United States funds. In addition, there is a high level of skilled
personnel in the financial community capable of
the latter class of clients, one must have a scala- serving domestic as well as non-resident hedge
ble strategy and sufficient infrastructure to sup- funds, should they wish to operate in the
port the high levels of service that non-resident Canadian market.
institutional investors demand and expect. Most
firms are challenged to reach the necessary scale Fawcett: Presently the services provided are fine.
where they can deliver the required level of serv- We would like to see the level of legal support
ice. As a result, the hedge fund environment in improve and more competition evolve although
Canada is characterized by 2 larger single manag- we expect it will.
er funds, 2 mid-size, and a significant number of
small and micro-sized hedge funds. Is the Canadian Hedge Fund industry sufficiently
regulated?
How would you describe the standard of services
available for hedge funds from administrators, Cheeseborough: Yes.
legal support and prime brokers?
McGovern: The Canadian hedge fund industry is
Short: The standard of services available to hedge sufficiently regulated. Canadian hedge fund man-
funds from the service community is very high. agers must be registered with the provincial
This high level of service and support reduces securities commission in which they reside.
many operational and governance related risks Registrants must pass certain proficiency and
and increases the overall quality of the product working capital requirements in order to manage
provided to investors. The availability of quality public money.
third party service providers allows fund man-
agers to concentrate on managing money and Selke: Canadian regulatory rules require high lev-
outsource some non-core activities. els of standards to be met before a fund/manag-
er/advisor can hold themselves out as providing
McGovern: The standard of hedge fund service investment advisory services to the public. Both
providers in Canada is first rate. The firms firms and individuals must be registered with
involved in legal, accounting and tax, shareholder the appropriate provincial security regulators
services and valuation having the necessary local (which registration must be maintained and
and international expertise to facilitate any hedge updated annually in most cases) and, in order to
fund manager requirements. The market for achieve registration in the first instance must
these services, including prime brokerage is very have demonstrated high levels of skill, experi-
competitive. ence and proficiency. In addition, there are sig-
nificant on-going regulatory reporting require-
Cheeseborough: Considering there are signifi- ments at fund, manager and marketing levels to
cantly fewer Canadian hedge funds and that the protect the investor and the reputation of the
industry is less developed than in the UK or the industry generally.
US, it is not surprising that the services available
to hedge funds have also lagged behind their for- Fawcett: We believe the industry is sufficiently
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PANEL Hedge Fund Manager Debate

regulated. All hedge funds must register with have become increasingly sophisticated. The abil-
provincial security regulatory bodies and are sub- ity to quantify risk in multi-manager/multi strategy
ject to periodic reviews. portfolios through such tools as VAR analysis and
scenario testing is very impressive. For our pur-
Short: Yes, our provincial regulators do a good poses the most suitable risk management policies
job of ensuring that fund managers meet the and procedures actually involve going back to the
basic requirements necessary to successfully basics. This involves monitoring the appropriate
use of leverage, establishing position limits and
In the wake of several ensuring reasonable diversification, properly
headline grabbing hedge matching the liquidity requirements of your
investments and investors and ensuring proper
fund blow-ups, investors governance. One approach to risk management
will likely demand rigorous does not apply in all situations and the proper
matching of your risk management policies to
risk management your investment strategy and corporate structure
is an important consideration.
operate a hedge fund. However, regulation is only
one part of the equation. The involvement of Selke: Generally speaking, risk management is
independent service organizations such as fund quite strong within the Canadian environment
administrators, prime brokers and self regulating and it is clear that additional regulatory require-
bodies are at least as important as regulators in ments are being imposed on the investment
reducing the potential risk of investing in the industry ensure that investors continue to be pro-
hedge fund industry. Investor education and the tected. However, despite the regulatory infra-
ability to properly evaluate and understand the structure and trend towards increasing risk man-
risks involved in a potential investment and the agement, breakdowns in the system can happen.
right questions to ask a fund manager is another The recent example of Amaranth is evidence that
important component. when humans intervene to ignore or abdicate
their responsibilities, problems can and will
Investors continue to demand suitable risk man- occur. The issues surrounding Portus and
agement policies and procedures. As scrutiny Northshield were not investment or hedge fund
increases, how will risk management practices issues but rather more fundamental breeches of
continue to evolve? the securities laws, specifically, selling product
without proper disclosure or a mismatch in the
Fawcett: We believe investors will continue to redemption schedule relative to the underlying
request additional details on risk management investment strategy. Accordingly, although there
policies and procedures. At Epic Capital, we see is a regulatory framework requiring risk manage-
this as an opportunity to provide investors with ment practices of fund managers, which frame-
additional details on our risk management prac- work is evolving and expanding daily, there is
tices including highlights on our portfolio con- nothing like a good dose of common sense
struction limits, current positioning and ongoing (including understanding the consequences of
risk control processes. not complying with laws, etc.) to help managers
and investors assess the degree of risk in their
Cheeseborough: Hedge funds will have to strategies.
become more proactive and actively work to dis-
tinguish their risk management practices from McGovern: A competitive market for hedge funds
firms with less extensive practices. In the wake of will demand excellence in risk management. The
several headline grabbing hedge fund blow-ups, level and type of disclosure will be key to allowing
investors will likely demand rigorous risk man- investors to measure and manage risk according
agement, possibly including third party mid and to their requirements. The key metrics in our
back-office services and risk measurement calcu- opinion, are the level of leverage employed (if
lations (such as VAR) performed by independent any) and liquidity of the underlying investments
third parties. compared to capital employed. The reporting
timelines to investors will be clearly very impor-
Short: Risk management systems and practices tant given the aftermath of Amaranth. HFSMG

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Alogorithmic Trading REUTERS

On the other hand, if a hedge fund is seeking


Touching to automate opportunistic alpha generation, then
a standard VWAP algorithm is not the answer.
Technology This will require a proprietary programme trading
system, and as imposing as that might seem,
The phenomenal growth starting out with a checklist can shorten the
of hedge funds over the past process and reduce the IT expenditure required
decade has driven rapid to set up and operate.
developments in trading At a high level such a system needs technology
technology. High volume to serve as the engine, and data to fuel its opera-
strategies pioneered by tion. As a hedge fund, let’s look at the factors you
hedge funds have been need to consider:
instrumental in pushing tech- Low latency streaming market data -
nology vendors to deliver Regardless of the asset class you choose to trade,
high volume, high speed you will need real-time quotes to drive your trade
straight through processing, decisions. If the market is highly liquid or fast,
Kirsti Suutari to the point where those you will need to pay attention to latency measure-
leading the field now meas- ments and the means by which they are meas-
ure latency in microseconds rather than millisec- ured. There is no point in making trade deci-
onds. But whilst some large hedge fund man- sions on opportunities that have already expired
agers have built significant technology and trad- by the time you act on them! If your data service
ing infrastructures over time, what options are is also managed on your behalf, you will have
there for smaller hedge funds that do not have removed a significant IT headache; dealing with
the capacity to employ large IT teams but who all the changes that the source exchanges create
still wish to implement automated trading strate- on a regular basis. If you are trading across mul-
gies to maintain an edge in this highly competi- tiple venues, it would also be helpful to know that
tive market? the data outputs from your streaming data feeds
It’s difficult to pick up a trade publication these are standardised.
days without running into some reference to pro- Tick history - A source of historical tick by tick
gramme or algorithmic trading. One might inter- trading data is essential for a number of purpos-
pret from the buzz that the practice is therefore es: researching your strategies, regression test-
ubiquitous, well understood and broadly applied. ing, and generating predictive analyses to run
There is a plethora of suppliers hawking wares all your models in production. It’s also helpful for
claiming to serve the needs of programme trad- analysing your trading success, and for compli-
ing. Where to start? How to establish the shop- ance purposes. Pay attention to completeness
ping list of component parts to make it all come and accuracy, and of course, you will want to
together? And how to accomplish this without have content for all the asset classes you wish to
the army of technology gurus that their prop trad- trade.
ing broker associates may employ? Corporate actions and reference data - Without
First, it’s worth noting there is more than one corporate actions data it will be difficult to
way to trade programmatically. It simply depends explain certain price fluctuations, or to normalise
on your goals. If all you want is efficient execu- data when required for predictive analyses, e.g.,
tion (best for infrequent trading and reducing the to accommodate the effect of a stock split on the
market impact inherent in moving large posi- price. And certainly you will want your models to
tions), then hedge funds should talk to their bro- be suitably informed as to the status of the issue,
ker about the structured algorithms they make to protect you from perhaps acquiring a futures
available. Certainly the commissions are lower contract at the point of expiry.
than full-touch trading, the results are reasonably Now let’s look at technology:
consistent and established at the outset, and the Rules or events processing engine - The core of
hedge fund benefits from retaining greater the system is the application in which you build,
anonymity and control. It is likely that at least test, and run your strategies. They come in all
one broker on the contact list offers algorithms shapes and sizes, with varying levels of program-
for agency use, and all that will likely be needed ming expertise required to operate them. Most,
to take advantage of their services is a standard however, have user interfaces that are built for
vendor quote terminal. the purpose. Depending on their sophistication,

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Hedge Fund Services Market Guide

they may offer a standard set of models that you ures across elements that need to interact with
are at liberty to modify. They may also take on each other in an efficient fashion. For example,
some of the execution readiness of the trading historical data should fit easily in your data ware-
signals generated by your strategies. Your choice house, and applying corporate actions to the raw
here will have much to do with your preferences data should be uncomplicated. High output from
for their features and functions. one component should not cause queuing in
another. And a change to one component should
There is no point in making have minimal impact on those with which it
trade decisions on interfaces. To the extent that they natively plug
and play together, your implementation, opera-
opportunities that have tion, and performance metrics will benefit. The
already expired by the time ability to link to other services, such as risk man-
agement and post trade processing, will also
you act on them move you a step closer to all the benefits of
Data warehouse - Efficient execution models straight through processing.
will need a local source of historical data to gen- And if all this seems too much, there is also
erate predictive analyses that serve as the basis the final option of speaking to your broker. Some
for their trading decisions. The ease of storage brokers offer white labelled services that permit
and ease and speed of access will be essential in you to create your own models and run them in
choosing your offering. your broker’s infrastructure. The benefits are
Streaming analytics engine - If your strategy obvious; you need only invest in the generation
requires inputs that require a level of calculation of the models themselves and not in the con-
such as greeks, index values, yield curves, mov- struction, operation and maintenance of the
ing averages or volatility measurements, consider infrastructure to run them. You may not have the
a streaming analytics calculator/publisher to do interfaces or features that you prefer, however the
the leg work. Certainly your events processing trade-offs can be worthwhile as you get used to
engine will appreciate the ready-to-use supply of operating in a fast frequency trading environ-
these values, and can concentrate on what it ment.
does best which is to run the strategy. Assuming All of the above ignores the creative brain
these two work well together, your system’s per- power that will use these tools. But if you didn’t
formance will benefit. And if your model also have that already, you wouldn’t be considering
needs analytical calculations on historical values, programme trading in the first place. Guard
then look for an analytics engine that works these resources carefully. An efficient programme
equally well on stored data as it does on stream- trading facility will permit you to make the most
ing values. of all of these resources to the ultimate benefit of
Order execution system - Once the trade sig- your bottom line.
nals have been generated by your model, it’s Armed with this check list, you improve the
time to get the order to market. Ideally this would potential to shorten your implementation cycle
be done using a Direct Market Access (DMA) and reduce your initial and ongoing IT require-
platform with some form of application interface ments. You needn’t be big to be smart; with an
that will receive the trade signal and route it into efficient programme trading system, you can
the market, a number of which are provided by focus on your investments, not on your systems,
brokers. If not provided by your broker, check and still sleep at night.
with your quote terminal vendors, as DMA order Kirsti Suutari, Global Business Manager,
types are increasingly in demand and may be Algorithmic Trading, Reuters
available as part of their offering. Certainly you
can use traditional methodologies to send your Kirsti Suutari has worked in the financial services industry
trade signal to your broker, however time-sensi- for 27 years with extensive experience in trading, equity,
tive opportunities will not be served by this derivatives, and market data.
methodology. Her current role within Reuters is Global Business
Manager for Reuters Algorithmic Trading. Suutari is
Integration - As anyone that has ever put responsible for the development and packaging of Reuters
together flat pack furniture knows, once you have products for use by customers engaging in algorithmic
chosen the component parts the key is putting it trading. Prior to joining Reuters, Suutari held roles in
all together correctly. The performance of any product management with The Financial Post Data Group
given element can very easily be overcome by fail- and in consultancy with Interactive Data Corporation.

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Risk Roles - RISK CONTROL

This makes the risk officer’s job difficult.

Risk Officer Just as you get everything nicely organized, the


front office innovates and creates a new instru-
ment that you do not have a method to con-
Changing Role trol. There are risk managers that view innova-
tion as a problem that must be stopped. This
is the same innovation that drives the profit at
your firm. It cannot be stopped and the rate
of innovation will only increase.

The innovation in financial


products that increases
profit also makes the
carefully constructed
risk rules obsolete
John Lewis Instead of seeing the creative ability as a
means to make rules obsolete, risk managers
With the recent nine sigma events that should look at it as a opportunity to innovate
brought about the demise of several hedge the risk control methods at the same rate.
funds, the importance of risk managers has Risk management must change its view from
received a three sigma event increase. It is that held in the savings and loan days to a
questionable if risk metrics would have made cooperative venture with the developers of
much difference at Amaranth. The concentra- financial products. Risk officers must embrace
tion in one asset was evident without using innovation like the front office has done. If
sophisticated mathematics. However, losses they do not, they will fail their organizations by
of this magnitude drive the selection of any not having an understanding of the instru-
and all techniques that can help prevent any ments and the ability to prevent the risks like
repeat of these results. those that brought down Amaranth (It should
Senior management at our clients are much be stated that several other hedge funds have
more receptive to the comments from their closed in the past few weeks – so enough of
risk managers. They get a fair and complete picking on Amaranth).
review of their points rather than a perfunctory We do see the first evidence that the risk
managed by the trading staff. Not only are groups are embracing innovation. As senior
buy side firms hiring risk management staff – management gives more credence to the opin-
they are listening to them. ions of the risk groups, the front office must
Before we get too carried away with jubila- enter a detailed debate with them. Instead of
tion for the rise of risk control, we should state blanket statements, the front office are provid-
that this is an event triggered behavior pattern. ing detailed papers explaining their position.
The question is whether it will persist past a We have helped several risk groups interpret
few weeks of newspaper headlines. If a pat- those documents and prepare detailed
tern of greater risk management does persist, I responses. The risk groups are being pulled
am betting on the front office staff to figure towards innovation because the trading groups
out a way around the metrics that were created are being pushed to provide positions that can
to prevent another Amaranth wilt. be debated and examined in detail.
The easy way for front office staff to get Much of this debate centers on the fact that
around any set of controls is innovation. The the risk groups want to use the existing frame-
innovation in financial products that increases works that they have created in the past for
profit also makes the carefully constructed risk other exposures. A new structured product
rules obsolete. Human beings are very good often requires a new set of risk models. The
at reverse engineering constraints and finding use of a risk model from another exposure
ways around them. type as an approximate solution either under

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Hedge Fund Services Market Guide

counts or over counts the actual risk. If the the next level of risk control which is examin-
front office does not complain about your ing the strategy and markets.
treatment of the new product you can be sure In the past, risk groups might send out a
that you have under counted. slice of a complex portfolio to be priced by
The risk group must create new models at valuation groups. This just checks the accura-
the same time that the front office and cy and assumptions of the front office
marketers create their new products. It will analytics. It would be better if the risk group
require both groups to work together had the expertise and time to do this work
cooperatively. This will benefit the bank in themselves. It is fine to use an outside source
receiving better returns and better risk control. to check your work, but it would be better to
The front office will have to get used to this have the expertise within the risk group. This
arrangement as the risk group is having more knowledge is required to examine the details
of a say when charging economic capital to a of the portfolio.
trading group. It is much better to work with The risk group needs to look further into the
the risk group before the trade than to argue trading patterns to see if risk reduction trades
over the capital charge after the trade. truly reduce the risk of the portfolio or whether
In the existing climate of high trade velocity, they simply reduce the risk as measured by
there are not many firms that hold their inadequate metrics. As I mentioned before,
structured products to maturity. This is traders and front office personnel are smart.
proved out by the numerous firms that provide They will figure out what you are measuring
netting services. With the close out of trades and how you are measuring it. Then they will
before maturity it seems odd to work on risk give you what your risk metrics want.
statistics using the assumption that all trades The only way that you will be able to protect
will be held until maturity. your institution is to spend time looking at the
We have worked with a number of trading strategies and analytics and understand them
groups that have disagreed with the use, by as well as the trading groups. If this doesn’t
their risk group, of default mode statistics that seem like a fun game to you then hire the new
assumes buy and hold portfolio management. crop of students receiving graduate degrees in
This might have been a prudent strategy when risk management. Use your knowledge of
holding a portfolio of illiquid long term loans financial markets with their knowledge of
before credit derivatives came along. financial engineering. This provides better
Under default mode, only downward transi- coverage for the bank and another career path
tions to default are examined and do not take for the more technical quants.
into account positive credit transitions. Life is The fast pace of the structured products
more complicated than this scenario. In some market and recent market events have
financial firms this is a very important method changed the role of the risk officer. This will
to measure risk. It has some of the hallmarks require a different view towards risk manage-
of an approximation. Default mode is easier ment by the both the front office and the risk
to compute than a more detailed model as group, but after the learning curve, it will
many aspects of the exposure are ignored. provide a more rewarding career.
This method of measuring risk causes a large
amount of friction between the risk and trad- John Lewis Jr,
ing groups. It should be augmented with CEO, Risk Control Ltd
detailed models and demoted to a lower
importance level.
Risk groups have been more interested in
computing metrics and setting limits. John H. Lewis Jr. has worked in the software, analytics
Advanced strategies require a more proactive and fund management industries for 25 years and is a co-
evaluation of the risk characteristics of each founder of Risk Control LTD. John is CEO of Risk Control
instrument type. Risk groups will have to be and was previously CEO of Scrittura, a venture backed
more involved examining the strategies behind enterprise software firm serving the OTC derivatives mar-
the trades and the computed values. As we ket, until its sale. John holds a BA in computer science
further understand the advanced mathematics from the University of Georgia and an MS in financial
of risk measurement, we can concentrate on economics from Boston University.

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GUIDE The Hedge Fund Guide

Hedge
THE ALTERNATIVE INVESTMENT MANAGEMENT and conventional funds being massively invested in the bond
ASSOCIATION / ISJ HEDGE FUND INTRODUCTION... markets, an unexpected 0.25% increase in US interest rates inter-
preted as signalling increasing inflation and therefore interest
This introduction is designed to assist the financial community rates, rumours about the financial stability of a significant bank-
and investors in their understanding of hedge funds. The docu- ing institution (Bankers Trust), a political assassination in Mexico
ment covers: and a liquidity crisis. South African bonds lost 9.1% in 1994, its
- the hedge fund market, second biggest loss in more than 100 years. In the desperate
- hedge fund strategies, search for someone to blame, hedge funds were in the spotlight
- and the risk/return characteristics of hedge funds. and strong calls were made for regulations.

Fund
In 1998, Long Term Capital Management (LTCM), a massive
Given the steady increase in hedge funds offered in the global and very public hedge fund involving Nobel Prize winners and
marketplace, more investors will begin to recognise the benefits respected industry leaders crashed, ultimately losing $4.4 billion.
of including hedge funds in a diversified portfolio. The fund was eventually bailed out by a consortium of major
banks, facilitated by the US Federal Reserve, and finally effectively
1 BACKGROUND liquidated in 2000. By 1999, the year after the LTCM disaster, and
1.1 History of the Hedge Fund Industry possibly as a response to it, the fund of hedge funds concept had
The first hedge fund was started in 1949, a mere 55 years ago, become a generally accepted means of managing the risks of
by an Australian called Alfred Winslow Jones. Jones utilized two investing in a single hedge fund.

Guide
speculative tools – short selling and leverage – to protect his Both the amount invested in hedge funds and the number of
long portfolio of stocks in a falling market, and so preserve capi- funds on offer has increased substantially over the past 14 years.
tal to achieve From approximately $40bn assets under management (AUM)
superior returns over the long-term. This strategy proved suc- spread across 500 funds in 1990, current estimates are of
cessful as Jones outperformed the best equity mutual funds dur- $820bn AUM spread across 8,100 hedge funds around the globe.
ing the 50’s and 60’s, leading to numerous
imitators. 1.2 The Size of the Hedgge Fund Industry
Despite the long history of ‘hedged’ investing for the goal of an Chicago-based Hedge Fund Research reports that the second
absolute return, hedge funds did not reach significant levels of quarter of 2006 saw $42 billion in asset inflows into the hedge
profile or use until Fortune magazine published an article in 1966 fund industry, the largest quarterly amount since they began
on Jones, entitled ‘The Jones that no-one can keep up with.’ tracking the industry in the early ‘90’s. This increase brings their
The first fund of hedge funds appeared in 1969, started by estimate of the hedge fund industries assets to $1.225 trillion.
Georges Karlweis in Geneva, closely followed by the second, On strategies, HFR says equity hedge funds saw the largest
started in the United States by Grosvenor Partners in 1971. quarterly increase at $13 billion, followed by an $8.4 billion
The 1960’s bull market encouraged many hedge fund managers increase by global macro and $4.8 billion by event driven. Fixed
to utilize leverage on their long portfolio, and forego short-selling income arbitrage had the largest outflow at $164 million.
- a development that led to the decimation of the industry during Funds of funds (FoF) saw an inflow of $15.6 billion compared
the bear markets of the early 1970’s. To illustrate, the S&P500 fell with a $6.4 billion increase in the first quarter of 2006.
by 14.5% and a further 1.1% in 1969 and 1970 and a massive 19% In the US, Hedge Fund Intelligence has estimated that the US
and 29% in 1973 and 1974. hedge fund industry grew to $984 billion by mid 2006, a 32%
During 1984, the original hedge fund manager Alfred Winslow jump from the same figure in 2005, as high net worth investors
Jones, re-organised his multi-manager hedge fund into a formal continue to demand hedge fund products.
fund of hedge funds structure. In 1986, Institutional Investor According to the Bank of New York, since 2004 US institutional
published an article on Julian Robertson, manager of the Tiger investment, excluding banks, has more than doubled, from $66
Fund, reporting that during its first six years, Robertson’s fund billion to $136 billion with endowments and foundations taking
had earned 43% per annum. the lions share.
In comparison the S&P 500 had earned 18.7 per annum! A similar picture exists in Europe where the hedge fund indus-
Over the past 50 years, the hedge fund industry has grown and try enjoyed dramatic growth in the first half of 2006, with total
extended from a predominantly US based industry, to European, assets under management growing to over $400 billion, accord-
Asian, and emerging markets funds. ing to a survey of the industry by specialist hedge fund informa-
The growth in the industry was accelerated through the 1990s tion provider EuroHedge, part of the HedgeFund Intelligence
during which time the increase in the number of new financial group.
vehicles and a change in technology facilitated the development The growth in overall industry assets – to $401 billion at the
of sophisticated investment strategies without the need for back- end of June – represents an increase of 23% from $325 billion at
ing by large investment houses1. In addition, the success of high- the beginning of 2006 and of 44% since June 2005, when total
profile managers such as George Soros, Julian Robertson, and assets were just $280 billion.
Michael Steinhardt, performance based incentive fees and low The survey also showed the overwhelming dominance of
barriers to entry for new funds led to highly-skilled entrepreneur- London as the leading centre of the European hedge fund indus-
ial investment professionals leaving large investment houses to try. Almost 80% of the assets managed in the European industry
start up their own hedge funds, some with initial backing from were run by UK-based firms as of June 2006 – up from 76% a
their former employer and many with their own funds. year before.
The global bond crisis in 1994 caused real damage to some In addition to asset growth from performance and from new
high profile hedge funds, including Soros’s Quantum Fund. The investor inflows, the industry’s overall growth continues to be
crisis was the result of multiple causes including hedge funds supported by the record numbers of new hedge funds being

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launched in Europe. The EuroHedge fund survey, July 2006, 2 WHAT ARE HEDGE FUNDS?
showed that over 170 new European hedge funds launched in the 2.1 Hedge Funds Defined
first half of 2006 – raising combined assets of around $11.5 bil- While there is no standard international definition of hedge
lion. funds, these investment structures typically display the following
In the Asia-Pacific region, the hedge fund market posted solid common characteristics:
overall growth in assets of around 12% during the first half of • The funds utilise some form of short asset exposures or
2006, according to the latest mid-year industry assets by short selling to reduce risk or volatility, preserve capital or
AsiaHedge. Overall, Asia-Pacific hedge fund assets grew just over enhance returns.
$13 billion during the first six months of 2006, bringing the total • Derivatives are used, and more diverse risks or complex
to about $128 billion – up from $115 billion at the beginning of underlying products are involved”.
the year. • The funds use some form of leverage, measured by gross
The steady growth over the past six months returns to the indus- exposure of underlying assets exceeding the amount of
try’s more normal pace of expansion after a period of explosively capital in the fund.
fast growth during the second half of 2005. In that period, assets • The managers of the funds charge a fee based
grew by nearly $40 billion over the six months. on the performance of the fund relative to an absolute
return benchmark such as inflation or call interest rates.
1.3 Who Invests in Hedge Funds? • Investors are typically permitted to redeem their
Historically high net worth individual investors, who desired interest only periodically, e.g.quarterly or semi annually.
and absolute return and a reduced level of risk have been the • Often significant ‘own’ funds are invested by the manag-
main investors into hedge funds. The landscape has changed er alongside those of investors. The term “hedge” is gen-
with institutional investors, particularly, pension funds, increas- erally associated with the practice of covering an invest-
ing their allocation to hedge funds, as they seek out investments ment position (long) with an investment that will act as an
that offer low correlation to traditional portfolios of cash, bonds opposite position (short), thereby nullifying any market
and equities. risk imbedded in the original investment decision. The
A survey by Mercers, October 2006, showed that 33% of institu- hedge may be in the form of a similar asset type to hedge
tional investors used FoF, while a further 19% expect to invest in market risk (e.g. equities) or a different security of the
FoF within the next two years. Of those institutional investors cur- same issuer (e.g. equity/ bond). The degree by which a
rently invested in FoHF, they have a 5% median allocation to hedge fund is “hedged” in the traditional sense varies markedly
funds and this is predicted to rise to 7.8% in the next two years. across managers.
Strong demand by investors for hedge funds has also drawn
the attention of regulators world wide. In the US, the SEC are 2.2 Commparing Hedge Fund Managers to Traditional Investment
currently reassessing their regulatory regime after their registra- Managers
tion was struck down by a Washington Court of Appeal decision. Hedge fund managers differ from traditional active managers
In Europe, the FSA continues to develop and effective ‘light managing benchmark relative funds in a number of ways. The
touch’ approach that has resulted in London becoming the lead- two most significant are the approaches to risk and return.
ing fund management centre in outside the US. Meanwhile the a) Risk • Most hedge fund managers define risk in terms of
EC are issuing a White Paper in late 2006, to outline their views potential loss of invested capital (total risk) where
on pan-European investment regulation, including hedge funds. as traditional active managers define risk as the
Regulators are aware that whilst the hedge fund industry requires deviation (tracking error) from a stated benchmark.
regulation to protect investors, the regulation should not be too • The risk associated with hedge funds is therefore
onerous and should encourage both buyers and sellers to benefit. highly dependant on the skills of the individual
manager, both in implementing the chosen strategy
Comparing Traditional Investing to Hedge Fund Investing
successfully and in the running of their business.
Characteristic Traditional Investing Hedge Fund Investing
b) Return
1 Return Objective Relative returns Absolute returns
• Hedge fund managers aim to deliver a total return
2 Benchmark Constrained by benchmark index Unconstrained by benchmark index
unrelated to a benchmark or index that is therefore
Limited investment strategies Take Flexible investment strategies Take
3 Investment Strategies longonly positions Do not use long and short positions May use independent of the general direction of markets. A
leverage leverage
traditional active manager largely aims to deliver
High correlation to traditional Generally, low correlation to
4 Market Correlation
asset classes traditional asset classes relative returns (returns above a related benchmark).
5 Performance Dependent on market direction Often independent of market • This relative return may be negative if the bench
direction
mark return is negative. Therefore, the generation
Tied to assets under management,
6 Fees
not to performance
Tied primarily to performance of returns by hedge funds is reliant on the skill of
Manager may or may not co-invest Manager generally coinvests
the manager, whereas traditional strategies prima
7 Manager’s Investment
alongside investors alongside investors rily reflect the return of the underlying asset class.
8 Liquidity Good liquidity Liquidity restrictions and initial
lock-up periods
International Organization of Securities
Usually large minimum investment
Commissions (IOSCO) Regulatory and Investor
9 Investment Size Small minimum investment size
size Protection Issues Arising from the participation by
10 Structure
Set up as a trust or investment Set up as a private investment, Retail Investors in (Funds-of) Hedge Funds 2003
company limited partnership or a trust
(hereafter IOSCO Report) at 40.
Highly regulated; restricted use of Less regulated; no restrictions on
11 Regulation strategies Less mandated
short selling and leverage
disclosure 2.3 Characteristics of Single Maanager Hedge Funds
Source: AIMA
• Hedge funds are typically organised as limited partner-

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ships, limited liability companies, unit trusts or listed enti- geographical location, industry sectors, or return drivers. To date
ties as investment pools. there is no standard classification system, and there are numer-
• Many are domiciled offshore to neutralise tax effects and ous hedge fund indices developed by financial services compa-
consequently for South African investors Exchange Control nies (e.g. S&P, MSCI, HFR, etc), each with different characteris-
legislation may apply. tics and classification methodologies.
• Performance related compensation is prevalent, typically The most consistent classification is based upon the process or
with a high water mark and hurdle rate to ensure a manag- strategy that a fund employs and the asset class used. This classi-
er will only take incentive fees on profit generated by posi- fication has limitations and
tive investment performance above a certain level. difficulties when comparing across regions or industries, but the
• Typically, a proportion of the partner’s or principal’s returns generated in hedge funds are primarily driven by the
wealth is invested in the funds, hence aligning their inter- skills of the investment managers in the particular strategies or
ests with the performance of the fund. processes employed. Process describes the methodology that
• Limited in size to preserve investment returns. managers follow when creating positions and managing their
• High minimum investment levels. portfolios and investment risk. Generally these strategies can be
• High expected risk-adjusted returns. further divided into directional and non-directional strategies.
• Low correlation with traditional asset classes and other
skill based strategies. 3.1 Relative Value Strategies
Typical Structure of a Hedge Fund Offering Source: AIMA When using relative value or arbitrage strategies, a manager
generally seeks to profit from perceived mispricing in a specific
Investor asset or security. With each position held in the portfolio, the
manager attempts to isolate and capitalise on a feature of an
asset (or combination of assets) that is mispriced relative to a
Fund Administrator
theoretical fair value or equilibrium relationship. The most com-
Hedge Fund Custodian
mon relative value strategies include convertible arbitrage, fixed-
Processes the subscriptions & Holds the fund’s assets. income arbitrage, and equity market neutral. The degree of lever-
redemptions. Calculates the Monitors and controls
value of investors’ holdings thecapital flows to meet age used in arbitrage strategies varies depending on the strategy
(NAV or partnership shares). margin calls. and the portfolio objectives, but is usually between 2x and 10x
the underlying equity value.
Prime Broker Hedge Fund
Manager 3.1.1 Convertible Arbitrage
Executes the transactions Sets and manages the fund’s
ordered by the fund manager. investment strategy. A convertible arbitrage strategy aims to profit from mispricing
opportunities within convertible bonds and other hybrid
2.4 Structure of Hedge Fund debt/equity securities. (Note: A convertible bond is a bond with
The structural make-up of a typical hedge fund is depicted in an embedded call option on the company’s stock). Convertible
the diagram overleaf. This diagram displays the component serv- securities are a combination of various instruments, and the par-
ice providers of hedge funds and their roles and relationships. cel as a whole may have a different price than the sum of the
component parts. If the price is different, there is an opportunity
2.5 Some Practicalities of Investing in Hedge Funds to buy (sell) the parcel and sell (buy) the various component
• Many hedge funds value assets monthly or parts to lock in a profit.
quarterly. Therefore unit prices will only be available when Therefore the generation of “alpha” is independent from the
assets are re-valued. This makes it difficult for investors general direction of markets. A typical investment is to buy the
that require daily unit pricing to include hedge funds on convertible bond and sell the common stock of the same compa-
their menus. ny, to take advantage of the stock’s price volatility. Positions are
• A lock-up period may apply, restricting the designed to generate returns from both the bond and the short
liquidity of investors’ assets. Monthly and quarterly unit sale of stock, while protecting principal from market moves. The
pricing also impacts fund liquidity. Some redemption poli- fund uses the short stock position to protect against declines in
cies may also require a long notice period (e.g. 60 days). the bond’s principal value.
• The investor should be aware of the level of
gearing permitted within a fund. 3.1.2 Fixed-Incomee Arbitrage
• Some hedge funds may distribute income Fixed-income arbitrage managers aim to profit from price
infrequently (annually) or in some cases not at all. anomalies between related interest-rate securities. Most man-
• While many well run hedge funds stay open to new agers trade globally, with a goal of generating steady returns with
investment for many years, some hedge funds may close to low volatility. A fixed-income
new investors although remain available through fund of arbitrage strategy includes interest-rate swap arbitrage, US and
hedge funds operators. non-US government bond arbitrage, forward yield curve arbi-
• Critically, investors should establish the maximum poten- trage, and mortgage-backed securities arbitrage. The mortgage-
tial loss or liability that an investment could result in. backed securities market is complex, and primarily trades over-
the-counter in the US.
3 STRATEGIES AND EXAMPLES Leverage will depend on the types of portfolio positions, which
There are a multitude of strategies used by hedge fund man- include basis trading, inter-market spreads, yield curve trading,
agers, and hedge funds can be classified in a variety of ways; relative-value option strategies and
based on process or strategy, asset class, financing strategies.

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Convertible Bond example: spread is the difference between the current values of the target
Here the manager believes a convertible bond to be undervalued company’s stock and the acquiring company’s stock. The spread
relative to its current market price and at the same time views is captured where the arbitrageur buys the stock of the target
equity of the company to be overvalued, expecting the market company and shorts the stock of the acquiring company.
price of equity to fall. The manager will buy the convertible bond
and short the stock of the same issuer to eliminate the stock Distressed/High Yiield Securities
price risk embedded in the convertible bond. Managers involved in distressed or high-yield
When executing a strategy of long convertible bonds and short securities are active in bond and equity markets, where the
equity, the manager will need to consider the credit risk associat- strategies focus on actual or anticipated events, such as a bank-
ed with the trade. Asset swaps can be used to strip out the credit ruptcy announcement or corporate
risk from convertible bonds. reorganisation as a result of debt default. Distressed or highyield
3.1.3 Equity Market-Neutral securities are generally below investment grade, and require a
An equity market-neutral strategy is designed to high level of due diligence to take advantage of the low prices at
exploit equity market inefficiencies, and usually which they trade. Investors in distressed securities seek capital
involves long and short matched equity portfolios appreciation of the debt rather than an income stream.
of the same size. The manager aims to position the portfolio to Performance depends on how well the managers analyse event-
be cash or beta neutral, or both. specific situations, rather than on the direction of the stock or
Typically the portfolio will exhibit a small or nil net market expo- bond markets. Managers investing in distressed or high-yield
sure. Well-designed equity market-neutral securities will vary in terms of the level of capital structure in
portfolios typically control for industry, sector, style, market capi- which they invest (debt or equity, and ranking of the security), the
talisation, currency and other stage of the restructuring process, and the degree to which they
exposures, which results in a near 50:50 balance of long and become actively involved in negotiating the terms and manage-
short positions. Leverage is often applied to enhance returns. ment of the restructuring.

3.2 Event Driven 3.3 Opportunistic Strategies (Directional)


An event-driven strategy is designed to capture price movements Opportunistic strategies generally include any hedge fund
generated by a significant pending corporate event, such as a where the manager’s investment approach changes over time to
merger, corporate restructuring, take advantage of current market conditions and investment
liquidation, bankruptcy, or reorganisation. Two sub- opportunities. Opportunistic strategies may have higher risk than
categories in event-driven strategies are: merger or risk-arbitrage relative value and event-driven strategies, as they have higher
(non-directional), and distressed/high yield securities (directional). directional exposure.
Managers will base the investment decision on their view of the
3.2.1 Merger Arbitrage (also see table on page 14 below) degree by which individual securities are under or over valued rel-
Merger arbitrage managers exploit merger activity to capture ative to current market prices. These strategies are heavily reliant
the spread between the current market values of securities and on the skill of the manager in discerning the value of a security.
their values in the event of a merger, restructuring, or other cor- The manager may use quantitative tools, however the final
porate transaction. Managers consider a transaction once an investment decision is usually a subjective one.
announcement has been publicly made. Most merger arbitrage Strategies combine long and short positions thereby reducing
managers exploit both cash-only deals and stock deals. or eliminating (in the case of market neutral strategies), direc-
Before entering into a merger arbitrage strategy, the manager tional market risk and generating returns based on the price
will analyse the probability of the deal closing, the bid price, and movements in securities. This may involve borrowing securities
the timeframe to the closing date. The probability of the the manager considers to be overvalued then selling them on the
takeover’s success directly influences the size of positions the market in the expectation that the price will be lower when the
manager will take, as the profitability of the trade depends on the fund has to buy the securities back to be able to return them to
success of the merger. If the deal involves a regulated industry the brokers. These funds take positions along the whole risk-
(such as banking), regulatory risk is factored into the deal. return spectrum and try to distinguish their performance from
Merger Arbitrage example: In mergers where the target compa- that of the asset class as a whole. Returns will therefore deviate
ny’s shareholders are offered stock in the acquiring company, the substantially from the underlying market return. Portfolios will
also tend to be more concentrated than those of traditional long-
only managers.
Equity Market-Neutral example:
An example of a typical equity market-neutral trade 3.3.1 Long/Short Equity
is a pairs trade in two listed companies of similar size and geogra-
phy. This strategy involves buying one
Managers employing this strategy will hold both long and short
company’s stock and selling short the stock of another company in positions with a net long exposure. The objective is not to be
the same sector. market neutral. This means that at all times more than 50% of
Buys shares in one class Company A, Class C, listed in the UK assets should be held as long (buy) positions. This category
Sells shares in another class Company A, Class D, listed in South excludes long only portfolios. To be considered a hedge fund, the
Africa Profit opportunity The manager expects Class C stocks to manager’s strategy must include short positions while maintain-
rise in price and Class D stocks to fall based on some change to ing an absolute return objective. Managers have the ability to
Company A’s capital structure. shift from value to growth and from small to medium to large
There is no market or sector risk as the two stocks are based on capitalisation stocks. Managers may use futures and options to
the same economic entity, but happen to deviate in price. hedge. The focus may be regional, such as long/short US or

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European equity, or sector specific, such as long and short tech- Dedicated Short-Bias example:
nology or healthcare stocks. The following portfolio is an illustration of the characteristics of a
net short hedge fund.
3.3.2 Dedicated Short-Bias The manager has taken a larger bet on the short positions, as indi-
In employing this strategy, a hedge fund manager will maintain cated by both the number of short versus long positions and the total
a net short bias against the market. Managers look for securities portfolio value of short positions versus the value of long positions.
that they perceive to be overvalued and short those stocks or use direction in market prices of currencies, commodities, equities
derivatives to profit from a declining share price. They may and fixed interest and on spot or futures markets across the
achieve better results in bearish markets. globe. The managers are usually referred to as Commodity
3.4 Global Macro Trading Advisors, or CTAs. Trading disciplines are generally sys-
A global macro strategy involves opportunistically allocating tematic or discretionary.
capital among a wide variety of strategies and asset classes. Systematic traders tend to use price and market specific follow
Strategies or themes may be directional or non-directional. trends while discretionary managers use a less quantitative both
Global macro is the most flexible of investment strategies, with fundamental and technical analysis.
the manager often taking a top-down thematic approach and
investing on an opportunistic basis, moving between countries, 3.6.1 Systematic Trading
markets and instruments based on the manager’s forecasts of Proprietary, quantitative models are typically used to identify
changes in factors such as interest rates, exchange rates and liq- establish positions, including the size of positions and the man-
uidity. A variety of trading strategies are used depending on the agers are trend followers. They seek to identify a trend them-
opportunities identified. Most funds invest globally in both devel- selves to stay invested as long as it persists. Systematic arbitrage
oped and emerging markets. in that each position is essentially an independent
Strategies intended to produce a profit, not a relative position.
Low Market Exposure High
Non-directional Directional 3.6.2 Discretionary Trading
A manger will use fundamental analysis or com-
1 Relative Value 2 Event . Driven 3 Opportunities puter systems two to identify profitable trades. In
general, this tends to return strategy within the uni-
verse of hedge funds, with very short periods of
Convertible Merger (Risk) Distressed/High Equity Hedge time. The main difference between trading is that
Arbitrage Arbitrage yield Securities (Long/Short) the investment decision is not automated. The
manager will make the final investment decision.
Fixed-Income Global Macro
Arbitrage
4 HEDGE FUND RISK/RETURN DRIVERS
Equity An important measure for an investor to consider
Managed Futures
Market-neutral is the degree of exposure to the broad movements
of the market and the impact on the fund’s risk and
Emerging Markets return. Fundsare generally constructed with specific
targets and strategies, such that the investor knows
to anticipate a certain risk/return profile. In general,
3.5 Emerging Markets the higher the degree of “directionality”, or investing in market
Broadly defined, an emerging market is a country direction, the higher will be the potential return and volatility.
making an effort to change and improve its economy with the For hedge funds with absolute return objectives, it is more
goal of raising its performance to that of the world’s more meaningful to measure correlations and risk which evaluate both
advanced nations. The World Bank classifies economies with a the upside and downside deviations relative to each fund’s spe-
Gross National Income per capita of $9,266 and above as high- cific objective, than performance relative to an index or peer
income countries. Emerging markets however are not necessarily group. The emerging markets strategy exhibits the greatest nega-
small or poor. China, for example, is considered an emerging tive monthly return throughout the period. Not surprisingly, the
market even though it has vast resources, has launched satellites smallest negative return for a month occurred within the equity
into space and a population of more than a market neutral strategy that nullifies any market risk through
billion people. The emerging markets strategy used by hedge holding a portfolio of overall equal long and short positions.
funds involves equity or fixed income investing in emerging mar- While all strategies and equity market returns have delivered at
kets around the world. Because many emerging markets do not least one negative monthly return during the period, the majority
allow short selling, nor offer viable futures or other derivative of hedge fund strategies have delivered substantially smaller neg-
products with which to hedge, emerging market investing often ative returns than traditional equity markets. It is important to
employs a note here that while an absolute return objective implies a posi-
long-only strategy. As the currency of many emerging tive return over the long term, short-term volatility can result in
markets cannot be hedged through the use of derivatives, an negative monthly returns for hedge fund strategies through the
investment in an emerging market results in exposure to the market cycle.
movements in currency of the underlying country. The risks associated with each strategy will depend on the type
of strategy and the degree to which it is exposed to market fac-
3.6 Managed Futures tors. The most common risks associated with each strategy are
A managed futures strategy is based on speculation of the detailed in the table opposite:
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Other risks of investing in hedge funds are non-quantifiable risks nature of hedge fund strategies and consequently low correlation
specifically including liquidity issues, transparency, key person with each other.
risk, fraud and leverage. These risks are more pronounced in
hedge funds due to the fact that hedge funds are based on the 5.2 Single Strategy Funds and Fund of Hedge Funds
skill of the manager more than the market return of an asset class. An investor has several options for accessing hedge funds. One
is to directly invest in one or several hedge funds. Another is to
5 INVESTING IN HEDGE FUNDS purchase an interest in a fund of hedge funds, also known as a
5.1 Why Invest in Hedge Funds? multi-manager fund. The investment manager of a fund of hedge
As noted in Section 1, the types of investors who are attracted funds selects and invests in multiple hedge funds, numbering
to hedge funds varies from institutional funds to retail investors. anywhere from 5 to over 40, often through an offshore corpora-
Throughout a market cycle, there will be periods during which tion or similar privately placed vehicle. A single strategy manager
equity and bond markets will offer both attractive and unattrac- will focus on a particular asset class or trading strategy to gener-
tive investment opportunities. The difficulty with investing in any ate returns. A fund of hedge funds manager will combine various
market is identifying when these opportunities will rise and posi- strategies and seek out the “best of breed” hedge fund managers
tioning an investor’s portfolio to take advantage of favourable to diversify across strategies and managers.
market conditions. An equity market bull-run can be followed by A fund of hedge funds incorporates single strategies that are
a bear market with lower returns from market based strategies, broadly available. Several long-term investors may gain broad
price/earnings contraction and the delivery of lower returns by exposure through a fund of hedge fund and seek to add single
traditional managers. However it is difficult to predict the dura- hedge funds to their portfolio. Observations indicate that a
tion and extent of a bull or bear market. sophisticated investor may be able to compile their own fund of
Therefore hedge funds present an attractive opportunity for hedge funds
inclusion in an investor’s diversified portfolio due to the possibil- Using a single manager will result in lower fees than a fund of
ity of enhanced risk adjusted returns (as demonstrated in section hedge funds vehicle, where the investment
4 above) and the low correlation in returns that many hedge selection and monitoring fees of the fund of hedge funds
funds have to traditional asset classes. A lower correlation manager are additional to the fees of the underlying hedge fund
between asset classes within an investor’s portfolio, will result in manager. If the investor is successful in selecting a strategy and
reduction in the overall level of risk within the portfolio. manager, the potential return generation can be greater than a
The lowest correlation of returns occurs with dedicated short fund of hedge funds albeit with a more concentrated level of risk
bias and managed futures strategies where these strategies are by only investing in one strategy with one manager. For a fund of
based on taking profit as a result of opposite movements in the hedge funds, the return to the investor is a combination of the
price of securities from that of the broad equity market. Those performance of the underlying funds minus applicable fees.
strategies that are implemented through investment in equities Using advanced financial engineering techniques and optimisa-
demonstrate the highest correlation of returns with equity mar- tion analysis to achieve targeted asset and risk combinations, the
kets, notably event driven (0.66 correlation to S&P 500) and fund of hedge funds manager creates a new product that seeks to
long/short equity (0.68 correlation to S&P 500) strategies. maximise the advantages and minimise the disadvantages of the
However the correlation in returns of these strategies with the underlying holdings. In an analysis of more than 1000 randomly
US market (S&P 500) and the global market (MSCI World $) is generated hedge fund portfolios, Morgan Stanley Dean Witter
significantly lower than the correlations these markets exhibit concluded that portfolios with as few as 20 hedge funds typically
with each other (0.85). Correlations will however change over preserve the desirable properties of the indexes that cover the
time and may rise in certain market conditions. entire hedge fund universe.
The question has emerged as to whether hedge funds should
be treated as a separate asset class, in a similar way to equities 5.3 What portion of an Investor’s Portfolio should be
or bonds. Support for the case that hedge funds belong to a sep- allocated to Hedge Funds?
arate asset class is primarily based upon the non-correlated An investor’s portfolio will exhibit certain return and risk char-
return profile generated by hedge funds when compared to tradi- acteristics based on their investment objective, time horizon and
tional asset classes. To be considered a separate asset class, the overall “comfort” with short-term return volatility. There are
securities within an asset class need to be more highly correlated many questions and debates as to the appropriate amount an
with each other than with assets outside this class, which is not investor should allocate to hedge funds. Even if a fixed allocation
the case for hedge funds. This belief comes from the diverse of say “10%” is used as a starting point, which assets should be
redeemed to accommodate this investment? Hedge funds are
Long Bias example: not necessarily a separate asset class that is as easily definable as
The manager will take both long and short positions, depending equities, fixed interest or cash as the risk/ return profile of a
on their market outlook. Portfolios may shift between, large cap hedge fund will vary according to the strategy used, the assets
and small cap, and across sectors within a particular market. The invested and the geography.
following example However a hedge fund investing in equity markets or fixed
highlights some typical trades that may be present in a portfolio income markets will not necessarily take on the characteristics of
that trades within and across sectors. The portfolio will usually that particular market. As an example, within the equity based
consist of many more trades than displayed here. category of hedge fund strategies a long/short equity portfolio or
The portfolio has a net long position of 60% with 40% held in an equity market neutral portfolio or a short bias portfolio may
short positions.
deliver risk/return characteristics over time that are quite differ-
Note : The percentages used are for illustrative purposes only, where 100% of the ent to those of broader equity markets and therefore cannot
portfolio is invested in stocks. In reality, a long-bias equity hedge fund portfolio is
more diversified, and is not concentrated with such large weightings in each stock. always be considered an appropriate replacement for equities.

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When using portfolio modelling (such as mean-variance opti- sider whether the investor’s aim is to improve the return pro-
misation) to make asset allocation decisions, it is best to use the file or reduce the risk profile of their existing portfolio posi-
expected risk/ return characteristics of different asset classes that tion. As demonstrated above in general terms, where an
are based on market factors and not a particular manager’s abili- investor aims to substantially improve the return profile of
Distressed Debt Example Source: AIMA
their portfolio, an allocation from fixed interest
1 Loan of USD10 million issued.
to a fund of fund hedge fund may be appropri-
Tel Co. uses financing to repay ate. As an improvement to the return expecta-
Tel. Co. (Borrower)
debt and to restructure. Custodian Co. tion implies taking on additional risk, the oppo-
(Lender) site case applies for a reduction in the return
3 Tel Co. defaults on loan expectation.
2 Tel Co. then has financial repayments to Finance Co.
difficulty and files for • Which asset class to allocate funds from, for
bankruptcy. Hedge Fund investment in hedge funds will depend on the
Manager return/risk objective of the hedge fund being
4 & 5 Hedge fund manager considered.
buys core position of debt or • Whether the investor has the time and knowl-
equity in Tel Co.
Passive Investment Active Investment edge to research individual hedge fund man-
agers offering single strategies to bring together
Buy debt or equity at a discount Buy debt or equity at a discount and become
and wait for appreciation. actively involved in restructuring/refinancing their own “fund of hedge funds”.
to influence process to fund’s advantage. • The time frame to invest, considering any lock
up period the hedge fund manager may impose.
Distressed Debt example: • Fund of Hedge Funds offering may be more suited to con-
In a typical situation depicted above: servative investors in improving the return profile at a slightly
a) A financial institution (Finance Co.) makes a loan to a borrower (Tel lower risk.
Co.). Tel Co.uses the funds to restructure the company and/or repay
some debt. • An appropriate allocation to a single manager will depend
b) Tel Co. then finds itself in financial difficulty, resulting in bankruptcy on whether the hedge fund has fixed interest or equity like
or nearbankruptcy. characteristics.
c) Tel Co. defaults on its debt, resulting in a decrease in the value of • An investor’s income and taxation position should be con-
the loan. sidered. Generally income distributions from hedge funds will
d) A Distressed Debt specialist analyses the situation for possible be treated as ordinary income with very little or no capital
investment, either in the debt or equity of the company considering gains or dividend imputation. This is a result of frequent trad-
the following questions:
• Does the business have long-term value?
ing employed by most hedge funds. However, the tax treat-
• Is the company in trouble because of problems, such as over- ment of distributions, gains and deemed gains may vary
leveraging, that can be rectified? depending on the legal structure of the hedge fund and the
• Are the company’s operating metrics declining? nature of the investors’ participation.
• What class of debt will have the most power in the restructuring? • The need for professional guidance in manager/fund
selection and the appropriate allocation within an investor’s
ty to add value over the market. Given manager capability is portfolio.
removed from all other asset class returns (namely equity, prop-
erty, fixed interest and cash) it is not appropriate to use manager
based hedge fund benchmarks as proxies for the return of all APPENDIX:
hedge funds. These benchmarks provide an indication of the REFERENCES, ADDITIONAL READING / WEBSSITES
average manager skill available rather than passive (market References and additional reading
based) returns available from this form of investing. However • BARRA RogersCasey: “An Introduction to Hedge Funds. The first in the
there is no data available to forecast hedge fund returns given BRC Hedge Fund Series”; BARRA RogersCasey; 2001
there is no passive benchmark. There are limitations to portfolio • Fraser E: “Hedge Funds 101: Trustee Education”; January 2004.
• Ineichen AM: “Absolute Returns. The Risk and Opportunities of Hedge
modelling of hedge funds, and this form of analysis should be Fund Investing”; John Wiley and Sons; 2003.
used only as a tool, not a driver of the decision. The question of • Jaeger L: “Managing Risk in Alternative Investment Strategies: Successful
allocating a portion of a client’s portfolio to hedge funds there- Investing in Hedge Funds and Managed Futures”
fore becomes one of a market specialisation within the portfolio. • KPMG Financial Services and Investment Advisory: “Hedge Fund
Market specialisation categories include active versus passive, Investments”; September 2003.
value versus growth, large cap versus small cap and now market • Lowenstein R: “When Genius Failed: The Rise and Fall of Long Term
based versus skill based strategies. One could therefore argue Capital Management”; Fourth Estate; 2002.
• Rahl L: “Hedge Fund Risk Transparency: Unravelling the Complex and
that the choice of investing in hedge funds (skill-based strate- Controversial Debate”
gies) is part of the active versus passive manager selection deci- • Schneeweis T: “Dealing with Myths of Hedge Fund Investment”; The
sion, rather than part of the traditional asset allocation decision. Journal of Alternative Investments, Winter 1998.

5.4 Factors to consider before Investing Websites


The decisions of whether to invest in hedge funds and how much • AIMA http://www.aima.org
of the investor’s portfolio to allocate require consideration of the • Financial Services Board http://www.fsb.co.za
following factors: • HedgeWorld http://www.hedgeworld.com/
• Hedge Fund Research, Inc. http://www.hedgfundresearch.com/
• The investor’s investment objective, incorporating their • InvestHedge http://www.hedgefundintelligence.com/ih/index.htm
return objective and risk tolerance. This will necessarily con- • Van Hedge Fund Advisors http://www.hedgefund.com/

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THE FOLLOWING ARE EXCERPTS FROM MFA'S SOUND and evaluate trading activities by regularly reviewing the
PRACTICES FOR HEDGE FUND MANAGERS RE-PRINTED performance of each Hedge Fund’s portfolio and the associ-
HERE WITH THE KIND PERMISSION OF THE MANAGED ated risk levels. Internal reportingshould provide the Hedge
FUNDS ASSOCIATION. Fund Manager with information regarding the performance
and risk levels of the different investment strategies
Sound Practices employed and should identify deviations from trading
parameters and risk limits.
for Hedge Fund Managers
1.4 A Hedge Fund Manager should determine the
RECOMMENDATIONS allocation of capital among portfolio managers and should
I. MANAGEMENT AND INTERNAL TRADING CONTROLS establish policies for monitoring their performance.
A Hedge Fund Manager should establish for each Hedge All portfolio managers, including external portfolio man-
Fund, the investment objectives and risk parameters agers, should be subject to controls and review processes
applicable to such Hedge Fund and the trading parameters commensurate with the amount of assets managed, form of
and risk limits designed to achieve these objectives. allocation and trading strategy. Where capital is invested
Suitably qualified personnel should be retained and with an external portfolio manager in a managed account,
adequate systems established (either internally or through applicable trading restrictions and limits, reporting require-
outsourcing) to put in place appropriate controls and review ments and termination provisions should be clearly defined
processes that permit the Hedge Fund Manager to monitor in written management agreements. The performance of all
trading activities and operations, as well as risk levels, portfolio managers should be monitored on a periodic basis
effectively. If third-party service providers perform key as appropriate, depending on the form of the allocation
business functions (such as net asset value calculation or (e.g., monthly performance review of a passive investment
risk monitoring), they also should be subject to appropriate in a Hedge Fund versus more frequent review of a signifi-
controls and review processes. cant managed account investment).

1.1 A Hedge Fund Manager should establish management 1.5 A Hedge Fund Manager should carefully select any “mis-
policies and practices commensurate with the size, nature sion-critical”, third-party service providers that
and complexity of the Hedge Fund Manager’s trading perform key business functions for itself or any Hedge Fund
activities and the Hedge Funds it manages. it manages based upon their experience with Hedge Fund
Management policies should be established for trading operations (e.g., those related to prime brokerage, risk mon-
activities, valuation, risk analysis, compliance and other key itoring, valuation or business continuity/disaster recovery
areas as appropriate (see specific recommendations in the functions) and consistently monitor their performance.
sections that follow). A Hedge Fund Manager should adopt The roles, responsibilities and liability of key
an organizational structure that facilitates effective third-party service providers should be clearly defined in
monitoring of compliance with management policies. written service agreements. The performance of missioncrit-
Policies and practices should be reviewed and updated as ical service providers should be periodically
appropriate (e.g., when changes in structure or strategy are evaluated. “Mission-critical service providers” are those
adopted, when extraordinary market events occur or when required by the Hedge Fund Manager to ensure prompt and
new applicable regulations are adopted). accurate processing of transactions and to meet regulatory
reporting requirements.
1.2 A Hedge Fund Manager should determine the
investment, risk and trading policies to be observed with II. RESPONSIBILITIES TO INVESTORS
respect to each Hedge Fund it manages based on the A Hedge Fund Manager should work together with the Hedge
specific investment objectives of the Hedge Fund. Fund so that Hedge Fund investors are provided with infor-
mation regarding the Hedge Fund’s investment objectives
A Hedge Fund Manager should allocate capital and risk and strategies, as well as periodic summary performance
(among, for example, portfolio managers, strategies and/or information, in order to enhance the ability of Hedge Fund
asset classes, as applicable) based on a Hedge Fund’s per- investors to understand and evaluate for themselves an
formance objectives and targeted risk profile. Allocations investment in the Hedge Fund.
should be reexamined periodically and adjusted as
appropriate. In addition, appropriate trading parameters 2.1 A Hedge Fund Manager should create a management
and risk limits should be established environment that recognizes its responsibility to act in the
consistent with these allocations. These principles are interest of the Hedge Fund and its investors as set forth in
developed more fully in Section IV— Risk Monitoring. the investment management agreement and offering docu-
ments.
1.3 A Hedge Fund Manager should impose appropriate con- A Hedge Fund Manager is retained by a Hedge Fund to act
trols over its portfolio management and trading activities to as its investment
ensure that these activities are undertaken on a basis con- manager, and, consequently, a Hedge Fund Manager has a
sistent with allocated investment and trading parameters. responsibility to act in the interest of the Hedge Fund and
A Hedge Fund Manager’s senior management should analyze its investors in accordance with its investment management

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agreement with the Hedge Fund, the offering documents • Risk associated with limited liquidity;
and applicable law. A Hedge Fund Manager should therefore • Risks associated with the use of leverage and margin;
take steps to ensure that it manages the Hedge Fund’s • Risks associated with the loss of key management per-
assets in accordance with its investment management sonnel; and
agreement with the Hedge Fund as well as the offering doc- • Potential conflicts associated with any performance fee or
uments. use of affiliated brokers.

2.2 A Hedge Fund’s prospective and existing investors 2.5 A Hedge Fund Manager should prepare periodically cer-
should be provided with information regarding the Hedge tain base-line performance and other relevant information
Fund’s investment objectives, the strategies to be employed, for distribution to the Hedge Fund based upon relevant
the range of permissible investments and the risk factors characteristics of the Hedge Fund.
that are material to a Hedge Fund’s business in order to Possible disclosures include:
enhance the ability of investors to understand and evaluate • Performance measures, such as quarterly or monthly net
for themselves an investment in the Hedge Fund. asset value calculations and periodic profit and loss
Informative disclosure regarding a Hedge Fund’s investment statements; and
objectives and strategies will enhance the ability of • Capital measures, such as assets under management
investors to form appropriate expectations as to the Hedge in the Hedge Fund in which the Hedge Fund investor is
Fund’s performance and therefore facilitate a good match invested, net changes to capital based on new subscrip-
between investor and investment product. A Hedge Fund tions less redemptions and the effect of profit and loss on
Manager should therefore seek to ensure that appropriate total capital.
disclosures are prepared for dissemination to Hedge Fund 2.6 Appropriate disclosures should be made about any
investors on a timely basis (without compromising propri- agreement between a Hedge Fund and Hedge Fund investors
etary information regarding the Hedge Fund’s positions). that varies the material terms of the arrangements with
Where there are changes in objectives or strategies, a Hedge certain Hedge Fund investors, for example through use of
Fund Manager should evaluate, and consider consulting its “side letters”, unless the ability to vary such terms is dis-
legal counsel, to determine whether given the circum- closed to Hedge Fund investors in connection with their
stances of the change, disclosure is necessary and whether investment in the Hedge Fund.
consent should be obtained from Hedge Fund investors.
Given that there is substantial breadth of objectives or 2.7 Appropriately qualified external auditors should be
strategies employed by and disclosed to investors in con- engaged to audit annual financial statements with respect
nection with a number of Hedge Fund strategies, for exam- to any Hedge Fund with external investors. Annual audited
ple in multi-strategy Hedge Funds, it is possible that many financial statements for the Hedge Fund should be delivered
Hedge Fund Managers may fairly determine, after evaluat- to Hedge Fund investors in a timely manner.
ing the circumstances, that no disclosure is required. See
Recommendation 2.4 below for a further discussion of III. VALUATION POLICIES AND PROCEDURES
material risk factors that a Hedge Fund should consider dis- A Hedge Fund Manager should determine
closing to Hedge Fund investors. policies for the manner and frequency of
computing net asset value, or “NAV”, based upon GAAP (as
2.3 A Hedge Fund Manager should assess whether its opera- defined below) and its management agreement with each
tions or particular circumstances may present potential Hedge Fund and seek to ensure that material aspects of
conflicts of interest and seek to ensure that any conflicts of those policies are appropriately disclosed to Hedge Fund
interest that may be material are appropriately disclosed investors.
and that controls are in place to address them. A Hedge Fund Manager, in consultation with the
Possible conflicts that may need to be disclosed include: governing body of the Hedge Fund it manages, should estab-
• Relationships with brokers or service providers; lish valuation policies and procedures that are fair, consistent
• Conflicts generated by fee structures; and verifiable, recognizing that Hedge Fund investors may
• Use of Soft Dollar Arrangements; and both subscribe to and redeem interests in the Hedge Fund in
• Other conflicts that may arise in the context of “side-by- reliance on the values derived from such policies and proce-
side” management of multiple accounts, such as alloca- dures. A Hedge Fund Manager should also develop policies for
tion of investment opportunities among Hedge Funds or the manner and frequency of computing portfolio valuation
accounts managed by the Hedge Fund Manager. for purposes of internal risk monitoring of the portfolio.

2.4 A Hedge Fund Manager should work with its legal coun- Fair Value
sel to identify risks to be disclosed to make sure these dis- 3.1 A Hedge Fund Manager’s valuation policies and proce-
closures are adequate. dures should incorporate the concept of “fair value”.
Examples of the types of risks that a Hedge Fund Manager For NAV purposes, a Hedge Fund Manager generally should
should consider disclosing are: value investmentsaccording to applicable generally accept-
• Lack of assurance as to performance; ed accounting principles (GAAP),
• Risks specifically associated with a particular strategy or recognizing that Hedge Fund investors will both buy and sell
types of investment instruments; shares of a Hedge Fund on the basis of NAV and that the

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Hedge Fund’s financial statements should reflect NAV. policies would not produce an accurate or fair price for a
Calculation of NAV should take into account not only the given instrument, senior management may use alternative
value of the financial instruments in the portfolio (some- procedures to price an instrument. In addition, these poli-
times referred to as “trading P&L”), but also accruals of cies should be reviewed with the Hedge Fund’s governing
interest, dividends and other receivables and fees, expenses body (if different than senior management) and its inde-
and other payables. pendent or external auditors. Once pricing policies and pro-
For companies such as Hedge Funds, GAAP typically cedures are set (and updated from time to time, as needed),
requires the use of “fairvalue” in determining the value of a Hedge Fund Manager should adhere to them as much as
an investment or instrument. However, if there are circum- practicable.
stances where a Hedge Fund Manager believes that the Hedge Fund Managers should develop practices and/or
application of fair value would not produce an accurate or systems for capturing pricing data for their positions from
fair valuation for a given instrument, it may employ alterna- independent sources on a daily basis where practicable.
tive means to value an instrument as permitted by agree- Procedures for periodically verifying the accuracy of pricing
ment. A Hedge Fund Manager may appropriately develop data should also be adopted, and material discrepancies
policies for making fair-value determinations that take into between price sources should be investigated. Where an
consideration market sector trends and company fundamen- instrument is not traded actively or where obtaining price
tals. information requires significant effort, weekly (or less fre-
quent) pricing may be appropriate depending on the nature
Fair, Consistent and Verifiable and the size of the position. For positions traded over-the-
3.2 A Hedge Fund Manager’s valuation policies and proce- counter or derivative instruments, where the only external
dures should be fair, consistent and verifiable. source of fair value may be quotes from relevant market-
A Hedge Fund Manager should either calculate or verify the makers (the number of which, based on the liquidity of the
accuracy of prices independent of the trading function to the position, may be very limited), the number of quotes sought
extent practicable. To that end, a Hedge Fund Manager by Hedge Fund Manager to gain comfort with the fair value
should seek to rely on price quotes from external sources should also be considered. This may also lead to model pric-
whenever practicable and cost-effective to do so and estab- ing (as discussed below in Recommendation 3.4). Where
lish policies for determining the value of assets for which market prices do not exist or are not indicative of fair value,
appropriate external price quotes are not reasonably avail- a Hedge Fund Manager should clearly establish the valua-
able (as discussed further below under Pricing Sources). In tion methods to be used for NAV purposes. In valuing certain
addition, a Hedge Fund Manager should fully document the instruments, for example, Hedge Fund Managers may appro-
process it uses to determine whether to implement recom- priately seek the input of their portfolio management team
mendations of a pricing service, as well as circumstances in in the valuation process in order to take advantage of the
which it determines to override a pricing service’s recom- portfolio manager’s expertise.
mendation.
The valuation of portfolio positions for NAV purposes may Pricing Sources
be used to determine the prices at which Hedge Fund 3.4 A Hedge Fund Manager should choose reliable and rec-
investors subscribe to or redeem from a Hedge Fund. ognized pricing sources to the extent practicable.
Accordingly, a Hedge Fund Manager should seek to utilize In general, where market prices for an instrument are readi-
valuation practices so that the Hedge Fund is consistent ly available from organized exchanges for markets or recog-
and fair to both subscribing and redeeming Hedge Fund nized data vendors, a Hedge Fund Manager should use such
investors, to the extent practicable, and makes appropriate market prices to compute NAV. In such circumstances, fair
disclosures of circumstances in which practices may neces- value can be based on the official closing price of an
sarily deviate from this standard in a material way. exchange or other relevant market price as published by a
recognized data vendor for that market.
Pricing Policies and Procedures Where market prices for an instrument are not readily
3.3 A Hedge Fund Manager should establish pricing policies available from such sources, a Hedge Fund Manager should
and procedures that assure that NAV is marked at fair determine the methods to be used in obtaining values from
value. alternative sources, with reliability, stability and independ-
The existence of written pricing policies and procedures is ence being among the main criteria. For example, Hedge
a critical element of the control structure surrounding a Fund Managers should seek to obtain reliable quotes, when
Hedge Fund Manager’s pricing of portfolio investment available, for certain over-the-counter derivative instru-
instruments. These policies should be established by senior ments and structured or distressed securities from well-
management, based upon a thorough review and under- established, recognized pricing services, or use appropriate
standing of the totality of the Hedge Fund Manager’s busi- valuation models developed by third-party pricing services
ness structure (e.g., range and complexity of instruments or recognized industry standard models using third-party
traded, stipulations contained in the Hedge Fund’s govern- inputs.
ing or offering documents, liquidity terms offered to Hedge The range of instruments that may require alternate
Fund investors, etc.). The pricing policies and procedures sources include OTC options (particularly exotic options),
should explicitly authorize that, in circumstances where a complex derivatives, mortgage-backed and asset-backed
Hedge Fund Manager believes that the application of such securities, as well as other instruments of a similar

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nature. However, if these are unavailable, either because dealers or other sources. For certain actively traded instru-
the transactions are “one of a kind” or not actively traded, ments, it may be appropriate to establish multiple feeds
the only market for these instruments may be with the from data vendors in order to compare and verify their
counterparty to the transaction itself. Such instruments prices. With respect to less liquid instruments, dealer
could be valued either by obtaining a quote or estimate quotes, prices generated by models or other estimation
from the counterparty or based on a pricing model, or any methods used should be checked periodically against real-
combination thereof. Where a pricing model is used, a ized prices as appropriate to gauge their accuracy. Diligence
Hedge Fund Manager should make sure that it is in a posi- should be performed to determine if the external pricing
tion to explain and support the model parameters used in agent has been consistent in providing quality service to a
determining the valuation. Hedge Fund.

Valuation of Instruments Frequency of NAV Determinations


3.5 A Hedge Fund Manager should establish policies for 3.8 A Hedge Fund Manager should establish policies for the
determining valuations associated with instruments that frequency of determining a Hedge Fund’s NAV.
may have multiple “official” settlement prices. A Hedge Fund’s official NAV, which reflects all fee and
Certain instruments held in Hedge Fund portfolios may expense accruals in addition to trading profit and loss, is
have more than one official price that can be used for valu- typically determined on an established periodic basis and
ation purposes. One example of this is securities traded on may be used for purposes of pricing Hedge Fund investor
multiple exchanges, including dual-listed securities, those subscriptions and redemptions. Separately, a Hedge Fund
that trade across multiple time zones, and certain over-the- Manager may also prepare an estimated or indicative NAV
counter derivatives. In determining which settlement price more frequently, based upon estimates of accrued fees and
to use in these instances, a Hedge Fund Manager should expenses and trading profit and loss that may be used for
seek to use GAAP as a guideline where practicable, bearing internal risk monitoring purposes or for other internal pur-
in mind the primary objective of using the price that best poses. A Hedge Fund Manager should establish policies and
reflects the correct fair market value. Among the alterna- procedures that set forth whether these indicative NAV cal-
tives available are the use of the most recent price or the culations will be used for risk monitoring purposes or other
price that derives from the greatest source of liquidity. internal purposes, and whether they may be disclosed (e.g.,
upon request or through a website posting). See
3.6 A Hedge Fund Manager should evaluate the use Recommendation 4.13 for additional guidance.
of alternative methods for valuing illiquid, or
otherwise hard-to-value, securities or other investment IV. RISK MONITORING
instruments. Current market practice is to focus on three categories of
A Hedge Fund Manager may appropriately use alternative risk that are measurable – “market risk,” “credit risk” and
approaches for valuing illiquid, or otherwise hard-to-value, “liquidity risk” (both funding and asset liquidity risk).
securities or other investment instruments. Among the vari- Market risk relates to losses that could be incurred due to
ous approaches to the valuation of illiquid and hard-to-value changes in market factors (i.e., prices, volatilities, and corre-
investment instruments that may be available to Hedge Fund lations). Credit risk relates to losses that could be incurred
Managers is the use of “side-pockets”, if their use has been due to declines in the creditworthiness of entities in which
disclosed in the Hedge Fund’s offering documents or govern- the Hedge Fund invests or with which the Hedge Fund deals
ing documents. Under side-pocket methodology, investment as a counterparty (including sovereign risk). Funding liquidity
instruments that are removed from the valuation process that risk relates to losses that could be incurred when declines in
applies to the rest of the portfolio—for example, due to illiq- a Hedge Fund’s capital due to redemptions or other sources of
uidity or similar issues—are held either at cost or at fair funding or liquidity reduce the ability of the Hedge Fund to
value (depending on the Hedge Fund Manager’s valuation fund its investments. It differs from asset liquidity risk (a
policies) until either a liquidation or other valuation-generat- form of market risk), which is defined as the potential expo-
ing event occurs (e.g., acquisition of a private company). sure to loss
Under one variation among a number of possible side-pocket associated with the inability to execute transactions – partic-
methodologies, only those investors that hold a position in the ularly on the liquidation side – at prevailing prices. In addi-
Hedge Fund at the time that the transaction designated for tion, a Hedge Fund Manager should seek to assess “opera-
the side-pocket is executed are typically permitted to partici- tional risk” depending on its particular
pate in the subsequent profit and loss when the position is circumstances.
eventually disposed or there is an event that makes it become While current market practice is to treat the risks
a marketable security (e.g., an initial public offering). Hedge separately, it is crucial for Hedge Fund Managers to
Fund Managers should bear in mind that issues associated recognize and evaluate the overlap that exists between and
with management fees and high water marks, among other among market, credit and liquidity risks.
things, may impact valuation and the use of side pockets.
Structure of Risk Monitoring Function
Price Validation 4.1 A Hedge Fund Manager should establish a Risk
3.7 A Hedge Fund Manager should establish practices for Monitoring Function, either internally or in reliance upon
verifying the accuracy of prices obtained from data vendors, external resources. The Risk Monitoring Function should be

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responsible for the review of objective risk data and analy- and holding period(s) deemed appropriate depending on the
sis of a Hedge Fund’s performance, current risk position, markets traded and the risks assumed. The holding period(s)
the sources of its risk and resulting exposures to changes should take into account the time necessary to liquidate
in market conditions. and/or neutralize positions in the portfolio.
The Risk Monitoring Function should report directly to The role of the Risk Monitoring Function is to: (1) identify
senior management and possess sufficient expertise to and quantify the factors affecting the risk and return of the
understand a Hedge Fund’s trading strategies and the Hedge Fund’s investments, both within individual portfolios
nature and risks of its investments. To the extent appropri- and across the entire range of activities of the Hedge Fund
ate, risk analysis with respect to a particular investment Manager, (2) monitor the risk controls established by senior
strategy or portfolio should be performed independently of management, and (3) disseminate the resulting risk infor-
portfolio management personnel responsible for that strat- mation to senior management and portfolio managers, as
egy or portfolio, so that trading activities and operations appropriate. The factors affecting risk (e.g., market rates
may be effectively supervised and compliance with trading and prices, credit spreads, volatilities, correlation) should
parameters and risk limits can be controlled. be incorporated into the risk monitoring process and, where
Alternatively, a Hedge Fund Manager might seek to appropriate, be included in the market risk model.
ensure the objectivity of risk analysis by providing for an Positions managed as separate accounts by external port-
appropriate level of checks and balances with respect to folio managers on behalf of the Hedge Fund Manager should
risk monitoring. To the extent appropriate, the Risk be incorporated in the routine risk assessment of the overall
Monitoring Function should produce regular risk reports portfolio. Passive investments in funds managed by external
that present risk measures and appropriate breakdowns by portfolio managers should be monitored as appropriate.
category of risk for review by appropriate members of sen- Hedge Fund Managers should recognize that market risk
ior management. The Risk Monitoring Function, in consul- measures such as VAR do not give a complete picture of risk
tation with relevant portfolio management personnel, in that they assess the risk of “standard” market movements
should conduct routine backtests of their risk measures to rather than extreme events. Hedge Fund Managers should
ensure that their systems capture all reasonably anticipat- therefore complement risk modeling with relevant stress tests
ed significant exposures and that the output is consistent and backtesting, as discussed below.
with the assumptions of the models.
4.3 A Hedge Fund Manager should perform “stress tests” to
Market Risk determine how potential changes in market conditions could
Encompasses interest rate risk, foreign exchange rate risk, impact the value of a Hedge Fund’s portfolio, as well as to
equity price risk, and commodity price risk, as well as asset consider liquidity analyses based on legal or contractual rela-
liquidity risk. tionships.
A Hedge Fund Manager should perform stress tests to
4.2 A Hedge Fund Manager should evaluate market risk, not assess the impact of large market moves, taking into account
only for each Hedge Fund portfolio in aggregate, but also for relevant non-linearities in the relationship between portfolio
relevant subcomponents of a portfolio ( e.g., by strategy, by value and the size of the market move. In addition, in perform-
asset class, by type of instruments used, by geographic ing stress tests or liquidity analyses, a Hedge Fund Manager
region or by industry sector), as appropriate. In addition, the may consider, for example, contractual rights of counterparties
market risk assumed by each individual portfolio manager to terminate or otherwise unwind trading relationships or
should be determined. A Hedge Fund Manager should increase margin/collateral requirements upon the occurrence
employ a consistent framework for measuring the risk of of certain events (such as declines in NAV).
loss for a portfolio (and relevant subcomponents of the port- A Hedge Fund Manager also should consider conducting
folio), such as a “Value-at-Risk” (or VAR) model. While the “scenario analyses” to benchmark the risk of a Hedge Fund’s
choice of model should be left to each Hedge Fund Manager, current portfolio against various scenarios of market behavior
the Hedge Fund Manager should be aware of the structural (historical or prospective) that are relevant to the Hedge Fund
limitations of the model selected and actively manage these Manager’s trading activities (e.g., the October 1987 stock
limitations, including the impact of any model breakdown. market event, the Asian financial crisis of 1997, the stock
Consistent with disclosure made to Hedge Fund investors, market declines after March 2000 (bursting of the “dot-com”
the Hedge Fund Manager should determine the appropriate bubble)).
overall level of market risk for a particular Hedge Fund or
strategy at time intervals appropriate for the size and com- 4.4 A Hedge Fund Manager should “backtest” its market risk
plexity of such Hedge Fund or strategy. This overall level of models.
market risk should then be appropriately allocated, among, for For internal control purposes, the Risk Monitoring Function
example, individual portfolio managers, investment strategies should perform backtesting of its market risk models (e.g.,
or asset classes. Once the market risk allocation is deter- VAR). It should compare the distribution of observed
mined, portfolio managers should choose the market-specific changes in the value of a Hedge Fund’s
risks to be assumed by the Hedge Fund consistent with the portfolio to the distribution of changes in value
Hedge Fund Manager’s risk allocation and policies and then generated by its market risk model.
develop a process for monitoring the risk. A sound market risk If the frequency of changes in the value of the portfolio
monitoring process should incorporate the confidence level(s) exceeds the frequency generated by the market risk model (a

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GUIDE The Hedge Fund Guide


statistical expectation based on the confidence level of the requirements.
market risk model), such deviation should be scrutinized to Hedge Fund Managers should take into account in their
determine its source. If, after investigation, the Hedge Fund liquidity planning redemption “windows” or other rights of
Manager determines that the market risk model is not produc- Hedge Fund investors to redeem their interests. Hedge Fund
ing accurate information, or is leading its users to draw inap- Managers should also take into account the relationship
propriate inferences, a Hedge Fund Manager should seek to between a Hedge Fund’s performance and redemptions and
modify it. between a Hedge Fund’s performance and the availability of
credit lines.
Funding Liquidity Risk
Funding liquidity is critical to a Hedge Fund Manager’s abil- 4.8 In an effort to enhance the stability of financing and
ity to continue trading in times of stress. Funding liquidity trading relationships, a Hedge Fund Manager should engage
analysis should take into account the in constructive dialogue with a Hedge Fund’s credit
investment strategies employed, the terms governing the providers and counterparties to determine the extent of
rights of Hedge Fund investors to redeem their interests and financial and risk information to be provided.
the liquidity of assets (e.g., all things being equal, the The extent of disclosure to be provided should be mutually
longer the expected period necessary to liquidate assets, the agreed with such parties depending on their requirements
greater the potential funding requirements) and the funding and the extent and nature of the relationship.
arrangements negotiated with counterparties such as prime A counterparty’s credit department should be required to
brokers. Adequate funding liquidity gives a Hedge Fund provide assurances that financial and other confidential
Manager the ability to continue a trading strategy without information furnished by the Hedge Fund Manager will only
being forced to liquidate assets when market losses occur. be used for credit evaluation purposes and will not be made
available to any member of a counterparty’s trading desk or
Cash should be actively managed. department. These assurances could be confirmed by the
4.5 A Hedge Fund Manager should evaluate the effective- counterparty’s credit department in a written confidentiality
ness of the cash management process and establish poli- agreement or by providing a copy of its confidentiality poli-
cies for investing a Hedge Fund’s excess cash, if any, based cies.
on established risk parameters and taking into account the
credit risk presented by the party with whom cash is invest- Counterparty Credit Risk
ed. In establishing cash management policies, a Hedge 4.9 A Hedge Fund Manager should understand and manage
Fund Manager should consider cash flow needs based on a Hedge Fund’s exposure to potential defaults by trading
the risk and funding profile of the portfolio and investor counterparties.
subscription and redemption windows. A Hedge Fund Manager should identify acceptable counter-
parties based on an analysis of creditworthiness and set
4.6 A Hedge Fund Manager should employ appropriate liq- appropriate risk limits. Where a judgment call with respect to
uidity measures in order to gauge, on an ongoing basis, a particular counterparty is necessary, a Hedge Fund
whether a Hedge Fund is maintaining adequate liquidity. Manager’s senior management should determine whether the
Liquidity should be assessed relative to the size of the counterparty’s creditworthiness is acceptable (e.g., based on
Hedge Fund and the risk of its portfolio and investment an analysis of the costs and benefits of dealing with the
strategies. counterparty to the extent practicable).
Once a trading relationship with a counterparty is estab-
4.7 A Hedge Fund Manager should evaluate the stability of lished, a Hedge Fund Manager should ensure that the coun-
sources of liquidity and plan for funding needs accordingly, terparty’s creditworthiness is appropriately monitored. A
including a contingency plan in periods of stress. Hedge Fund Manager should also seek to establish appropri-
Hedge Fund Managers should assess their cash and bor- ate collateral arrangements with the counterparty (see
rowing capacity under the worst historical drawdown and Recommendation 6.4) and establish the ability to make, if
stressed market conditions, taking into account potential possible, and to respond to collateral calls.
investor redemptions and contractual arrangements that
affect a Hedge Fund’s liquidity (e.g., notice periods for Leverage
reduction of credit lines by counterparties). A Hedge Fund Manager should recognize that, although
Hedge Fund Managers should periodically forecast their leverage is not an independent source of risk, leverage is
liquidity requirements and potential changes in liquidity important because of the magnifying effect it can have on
measures. market risk, credit risk and liquidity risk. Recognizing the
Hedge Fund Managers should perform scenario tests to impact that leverage can have on a portfolio’s exposure to
determine the impact of potential changes in market condi- market risk, credit risk, and liquidity risk, a Hedge Fund
tions on a Hedge Fund’s liquidity. Among these scenario Manager should assess the degree to which a Hedge Fund is
tests, Hedge Fund Managers should consider including the able to modify its risk-based leverage in periods of stress or
potential response to a creditor experiencing a liquidity increased market risk.
problem during times of market stress (e.g., reluctance to
release collateral), as well as a unilateral decision on the 4.10 Hedge Fund Managers should pay careful attention to
part of credit providers to increase haircuts and collateral leverage, whether such leverage is measured in terms of

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financial statement-based leverage or risk-based leverage.
The best means of ensuring that utilization of leverage is Financial Statement-Based Leverage
appropriate for each individual Hedge Fund is for its Hedge A Hedge Fund Manager may consider tracking certain tradi-
Fund Manager to manage its own leverage associated with tional financial statement-based measures of leverage as
its strategies, using appropriate risk monitoring measures part of its financial reporting or in connection with the
or implementation of its strategies. Special attention should analysis and interpretation of certain risk-based leverage
be paid to the manner in which leverage impacts the ability measures or funding liquidity. However, a Hedge Fund
of the Hedge Fund Manager to manage the risks to which Manager should recognize that although such measures can
the portfolio is subject. Note that a Hedge Fund’s exposure provide useful information if they are understood fully and
in the event of losses depends not merely on the amount of interpreted correctly, they have a number of weaknesses,
its leverage, but on the contractual and other measures it particularly as stand-alone measures of leverage, as dis-
takes to address the consequences to a Hedge Fund in the cussed in greater detail in Appendix I of the full report.
event of significant losses.
Operational Risk
4.11 A Hedge Fund Manager should develop and monitor 4.12 Hedge Fund Managers should seek to limit a Hedge
several measures of leverage, recognizing that leverage, Fund’s exposure to potential operational risks, including rec-
appropriately defined, can magnify the effect of changes in onciliation errors, data entry errors, fraud, system failures
market, credit or liquidity risk factors on the value of the and errors in valuation or risk measurement models.
portfolio and can adversely impact a Hedge Fund’s liquidity. Hedge Fund Managers should consider the following
A Hedge Fund Manager should recognize that leverage is measures, among others, to limit or mitigate operational
not an independent source of risk; rather, it is a factor that risk, the implementation of which can be performed through
influences the rapidity with which changes in market risk, any number of support areas within a Hedge Fund Manager:
credit risk or liquidity risk factors impact the value of a • Random, periodic spot checks of all relevant activities;
Hedge Fund’s portfolio. A Hedge Fund Manager should seek • Monitoring of risk, either internally with an appropriate
to assess leverage while taking into account the limitations level of checks and balances to ensure objectivity of risk
inherent in different leverage measures, as noted below and analysis, or through reliance on external service providers;
discussed in further detail in Appendix I of the full report. • Maintenance of a single, centralized position data set
(to avoid the errors inherent in maintaining multiple or
Risk-Based Leverage regionalized data sets);
A Hedge Fund Manager should track a Hedge Fund’s lever- • Establishment of adequate internal controls and review,
age using “risk-based leverage” measures reflecting the including appropriate segregation of duties, controls over
relationship between the riskiness of a Hedge Fund’s portfo- incoming and outgoing cash flows and balances with
lio and the capacity of the Hedge Fund to absorb the impact counterparties, daily confirmation of trades and positions,
of that risk. Risk-based leverage measures that could per- etc.; and
form this function are described in Appendix 1 of the full • Reviewing the operational risk – including legal
report. Some of the liquidity measures discussed in compliance, and transactional policies – issues that are
Appendix 1 can also be viewed as risk-based leverage covered in the Recommendations of Sections V and VI.
measures.
The Hedge Fund Manager should be aware of limitations Risk Monitoring Valuation
of the models used and should guard against placing too 4.13 A Hedge Fund Manager should establish policies for
much reliance on mathematical measures of leverage alone. determining when risk monitoring valuation methods may
For example, market risk measures such as VAR are incom- differ from NAV for operational or risk analysis reasons.
plete measures of market risk because they focus on “stan- Portfolio values used to calculate NAV should also be used
dard” market movements rather than extreme events. for risk monitoring valuation unless the Hedge Fund
Consequently, the Hedge Fund Manager should consider Manager has determined that operational or risk analysis
assessing the impact of extreme events by comparing a reasons may justify a different approach. For example, in
market risk measure derived from analysis of extreme event order to examine potential effects on the portfolio of
scenarios (or stress tests) to the Hedge Fund’s capital. In changes in market conditions, the Hedge Fund Manager may
addition, it is essential that the Hedge Fund Manager use permit the Risk Monitoring Function to use alternative val-
judgment based on business experience in calculating and ues or make adjustments to the position values calculated
assessing quantitative measures of leverage. in accordance with GAAP for NAV purposes. Similarly, in
A crucial factor influencing the Hedge Fund’s ability to volatile markets, a Hedge Fund Manager may wish to dis-
absorb the impact of extreme market events is the degree to count prices for risk analysis purposes if the Risk
which the Hedge Fund can modify its risk-based leverage, Monitoring Function does not believe that quoted bids or
especially during periods of market stress. A Hedge Fund offers are prices at which a trade could actually be execut-
Manager should therefore assess its ability to reduce risk- ed. See Recommendation 3.8 for additional guidance.
based leverage by modifying (upward or downward) tradi-
tional leverage or by reducing the level of risk that is being [SECTION V HAS BEEN OMITTED FROM THIS EXTRACT AND IS AVAILABLE IN
accepted (e.g., by changing strategy or the types of assets THE FULL REPORT ONLINE AT WWW.MFAINFO.ORG]
being held in the portfolio).

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VI. TRANSACTIONAL PRACTICES 6.5 A Hedge Fund Manager should have appropriate docu-
A Hedge Fund Manager should pursue a consistent and mentation and approval processes for retaining external
methodical approach to documenting transactions with coun- traders as well as administrators, prime brokers or other
terparties in order to enhance the legal certainty of its posi- third-party service providers.
tions.
In addition, to the extent applicable, a Hedge Fund Manager Best Execution
should seek to obtain best execution and 6.6 In selecting both “clearing” and “executing” brokers on
establish guidelines for using Soft Dollar Arrangements, if behalf of a Hedge Fund, the Hedge Fund Manager should
applicable. consider, among other thing:

Documentation Policies and Controls For clearing brokers:


6.1 A Hedge Fund Manager should establish transaction
execution and documentation management practices that • The operational expertise of the clearing broker in pro-
seek to ensure timely execution of necessary transaction viding clearing and custody services for the products trad-
documents and enforceability of transactions. ed by the Hedge Fund Manager;
• The clearing brokerage fees;
To the extent practicable, a Hedge Fund Manager may wish • The commission rate or spread involved when the clear-
to implement the following practices: ing broker executes transactions;
• Require that all trading counterparties be approved • The clearing broker’s responsiveness to the Hedge Fund
prior to executing any transactions and verify counterparty Manager;
authorizations; • The ability of the clearing broker to maintain the confi-
• Establish documentation requirements for all trading dentiality of all proprietary position information provided;
(including confirmation requirements and documentation • The clearing broker’s financial responsibility; and
of master agreements as appropriate); and • The clearing broker’s credit worthiness.
• Ensure that appropriate security interests are created
and perfected when collateral is received as part of a For executing brokers:
transaction.
• The executing broker’s expertise in providing timely exe-
6.2 A Hedge Fund Manager should track the status of docu- cution services for the products traded by the Hedge Fund
mentation and the negotiation of key provisions and terms Manager;
such as termination events and events of default (including • The ability of the executing broker to execute transac-
use of a database if needed) to seek to ensure consistency tions of size in both liquid and illiquid markets at compet-
and standardization across Hedge Funds and counterparties itive market prices without disrupting the market for the
to the extent appropriate and feasible. security traded;
• The ability of the executing broker to maintain the confi-
6.3 A Hedge Fund Manager should seek consistent bilateral dentiality of all proprietary position information provided;
terms with counterparties to the extent appropriate and fea- • The executing broker’s execution fees;
sible in order to enhance stability during periods of market • The range of services offered by the executing broker,
stress or declining asset levels. including the range of markets and products covered,
For example, a Hedge Fund Manager may seek to negotiate quality of research services provided and recommenda-
standardized events of default and other termination or col- tions made by the executing broker;
lateral events to achieve consistency in documentation with • The quality and timeliness of market information provid-
different counterparties to the extent appropriate and feasi- ed by the executing broker;
ble. A Hedge Fund Manager may also endeavor to avoid • The execution broker’s financial responsibility; and
including provisions that permit counterparties to terminate • The execution broker’s credit worthiness.
or make demands for collateral solely at their discretion or
based upon subjective determinations. Because it is difficult to determine how to make a best execu-
tion determination in the context of various
6.4 A Hedge Fund Manager should seek to negotiate bilater- structured and derivative products, Hedge Fund Managers, in
al collateral agreements that require each party to furnish evaluating counterparties, should consider additional factors
collateral, taking into account the relative creditworthiness that they deem relevant, including, but not limited to:
of the parties.
To the extent feasible, a Hedge Fund Manager should seek • The range of derivative products offered by the
to establish collateral arrangements either internally or counterparty;
through reliance on external resources that permit the • The operational expertise of the counterparty in provid-
Hedge Fund Manager to effectively and regularly make calls ing confirmation, documentation, timely settlement and
for deliveries and returns of collateral from counterparties on-going operational support for the derivative products
when permitted. entered into by the Hedge Fund Manager;
• The terms and appropriate documentation of the deriva-
70 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007
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Hedge Fund Services Market Guide

tive transactions products by the counterparty; 2. The types of products and services that may be received
• The counterparty’s financial responsibility; through Soft Dollar Arrangements in an appropriate level
• The availability of the particular derivative product; and of detail.
• The counterparty’s credit worthiness.
6.10 If a Hedge Fund Manager relies on the safe harbor pro-
6.7 Hedge Fund Managers should periodically examine the vided by Section 28(e), which protects the adviser from even
performance of the brokers executing transactions on behalf a claim of breach of fiduciary duty solely because the advis-
of a Hedge Fund to assess whether it continues to provide er causes an account managed by the Hedge Fund Manager
best execution. Hedge Fund Managers should include in its to pay for Soft Dollar Arrangements, the Hedge Fund
recordkeeping policies documentation of evaluations of the Manager should evaluate with its advisers how to do the
execution quality of the brokers. following:
1. Make a good faith determination that the amount of
Soft Dollar Arrangements commission is reasonable in relation to the value of the
6.8 A Hedge Fund Manager should evaluate the types of brokerage and research services provided by the broker-
products and services that are the subject of Soft Dollar dealer, in light of the terms of the particular transaction
Arrangements, including, as appropriate, the extent to or the Hedge Fund Manager’s overall responsibilities with
which products or services have research functions or are respect to its discretionary accounts;
developed by a third party and provided by a broker and 2. Disclose Hedge Fund Manager’s policies and procedures
should develop policies relating to the use of these arrange- relating to such Soft Dollar Arrangements; and
ments. 3. Determine whether the brokerage and research services
are covered within the safe harbor (as set forth in Section
If applicable to its business model, a Hedge Fund 28(e)(3)). In an interpretive release relating to this prong,
Manager should develop policies related to Soft Dollar the SEC indicated that “the focus should be on whether
Arrangements, including the proper allocation of products or the product or service provides lawful and appropriate
services with mixed uses (i.e., computer hardware that assistance to the money manager in the carrying out of
assists an adviser in research functions and in non- his responsibilities”.
research functions) so that non-research services are paid
for out of the Manager’s own funds and the proper alloca- 6.11 If a Hedge Fund Manager does not rely on the safe har-
tion of “step-out” arrangements. Step-out arrangements bor provided by Section 28(e) in its use of Soft Dollar
can assist a Hedge Fund Manager in obtaining best execu- Arrangements, the Hedge Fund Manager should evaluate
tion by allowing it to use the broker that provides best exe- with its advisors how to do the following:
cution to execute the trade and to pay commissions to other 1. Assuming that the services are not covered within the
brokers from which it receives research or services through Section 28(e) safe harbor, the Hedge Fund Manager
Soft Dollar Arrangements. Policies may vary depending on a should utilize those services that are determined to pro-
Hedge Fund Manager’s customized advisory arrangements. vide lawful and appropriate assistance to the Hedge Fund
Policies should include procedures and documentation Manager in carrying out its responsibilities to Hedge Fund
requirements for thirdparty arrangements. These may investors;
include, depending on the nature of the Hedge Fund 2. Make a good faith determination that the amount of
Manager’s business, policies regarding step-out arrange- commission, under the Soft Dollar Arrangement, is rea-
ments, and proprietary arrangements, addressing, as appro- sonable in relation to the value of the services provided by
priate, approved broker-dealers and products/services, the broker-dealer, in light of the terms of the particular
reliance on the Section 28(e) of the Securities Exchange Act transaction or the Hedge Fund Manager’s overall responsi-
of 1934, as amended, safe harbor (described below) bilities with respect to its Hedge Funds; and
(“Section 28(e)”), personnel authorized to approve the prod- 3. Disclose the Hedge Fund Manager’s policies and proce-
uct/service and agreements or commitments regarding com- dures relating to such Soft Dollar Arrangements.
mission quotas or thresholds. Policies should also address
retention of correspondence, including, if applicable, emails Investor Services Journal thanks the Managed Funds
related to directed brokerage and step-out arrangements Association for their kind permission to reprint this extract
and records of and the value, quantity, purpose and ratios
of each product/service. For a complete copy of the MFA's Sound Practices for
Hedge Fund Managers please visit MFA's Web site at:
6.9 A Hedge Fund Manager should fully disclose that it may www.mfainfo.org.
engage in Soft Dollar Arrangements prior to engaging in
such arrangements and should clearly disclose its policies NB: THE MANAGED FUNDS ASSOCIATION IS
with respect to such arrangements, including: THE SOLE COPYRIGHT OWNER OF THIS
1. Whether it may use the products and services provided CONTENT WHICH IS NOT TO BE
by a broker pursuant to Soft Dollar Arrangements to bene- REPRODUCED IN ANY FORM WITHOUT THE
fit Hedge Funds other than those whose trades generated EXPRESS PERMISSION OF THE MFA.
the relevant brokerage commissions or fees; and
HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 71
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Hedge Funds GLOSSARY


Accredited Investors - Refers to to one another. Variables that rise into (usually opposite transac- parties outside of exchanges
institutional investors or individu- or fall in parallel on average are tions within the same asset class Pairs Trading - Non-directional
als with high net worth or high net positively correlated and those or market) that protect against relative value investment strategy
income, as specified by securities that move in opposite directions adverse price movements and that seeks to identify two compa-
regulators, and therefore not are negatively correlated. limit the exposure to a specific nies with similar characteristics
requiring the protection of a Correlations range from –1 to +1. risk. whose equity securities are cur-
prospectus and registration Credit Risk - The financial risk High Watermark - The assurance rently trading at a price relation-
requirements under securities law. that debt will not be repaid, that a fund only takes fees on ship that is out of their historical
Active Risk (Tracking Error) - resulting in a loss. For example, profits once past losses are recov- trading range.
Refers to the variation between a debt holders face the risk of not ered. Prime Broker - The principal bro-
fund’s returns and a benchmark’s receiving interest and/or principal Hurdle Rate - The minimum kerage firm an investment fund
returns. A large tracking error from the issuer when payments investment return a fund must does business with.
indicates a large variation from are due. Usually, the higher the exceed before a performance allo- Risk - Risk in a portfolio sense
the benchmark, and implies a issuer’s credit rating, the lower cation/incentive fee can be taken. refers to the variation or volatility
high level of manager risk. the default risk, and vice-versa. Leverage - The practice of bor- of returns. It is generally meas-
Alpha - A numerical value indi- Credit Spread - The spread rowing money to add to an invest- ured by the standard deviation of
cating a manager’s risk-adjusted between Treasury securities and ment position when one believes the portfolio returns.
excess rate of return relative to a non-Treasury securities that are that the return from the position Sharpe Ratio - Demonstrates the
benchmark. Measures a manag- identical in all respects except for will exceed the cost of borrowed reward to risk generated by an
er’s “value-added” in selecting quality rating. funds. asset. The difference between the
individual securities, independent Derivatives - Financial instru- Long Position - Holding a positive return on the portfolio and the
of the effect of overall market ments whose value is derived amount of an asset. risk free rate, divided by the stan-
movements. from the value of an underlying Managed Account A trading dard deviation of the portfolio.
Arbitrage - To take advantage of security, asset or variable. account held with a broker and Short Position - Holding a negative

communicate
disparate pricing between two Examples include options, war- owned directly by the investor amount of an asset, whereby assets
similar instruments in the same rants, futures, forwards and (e.g. an individual investor or a are sold without owning them.
or different markets. swaps. FOFs). Market Neutral Strategy - Standard Deviation - Standard
Asset Swap - An interest rate or Diversification - Minimising of Taking long and short positions in deviation is a statistical measure
cross currency swap used to con- non-systematic portfolio risk by related assets (such as spread of the absolute variability of
vert the cash flows from an investing assets in several securi- trades) in order to offset direc- returns. It is the most commonly
underlying security (a bond or ties and investment categories tional market risk. used measure of the volatility of
floating-rate note), from a fixed with low correlation between each Market Risk - Refers to risk fac- returns or investment risk.
coupon to a floating coupon, a other. tors that affect financial market Swap - An agreement between
floating coupon to a fixed coupon, Duration - The duration of a bond returns as a whole. This risk is two parties to exchange cash
or from one currency to another. is a measure of how interest rate present in all financial markets, flows over time according to a
Benchmark - A reference (securi- changes affect a bond’s price. It including the money, bond, stock, predetermined formula.
ty or index) against which a com- is also a measure of how long, on and currency markets. Total Risk - The potential loss of
parison and evaluation of per- present value money-weighted Master-feeder Structure- In this invested capital. The goal of
formance of an investment portfo- basis, the holder of a bond has to structure, one or more investment absolute return managers is to
lio can be made. wait before receiving coupon pay- vehicles (the feeder funds) with manage total risk, which is to
Beta - Measures the sensitivity of ments and final repayment. identical investment objectives, avoid absolute financial losses,
the manager’s returns to the mar- Efficient Frontier - A two-dimen- pool their assets in a common preserve principal and to actively
ket return. It is the extent to sional risk-return chart showing portfolio held by a separate invest- manage volatility.
which the manager’s return has all optimal combinations of a ment vehicle (the master fund). Volatility - The degree of price
varied in line with movements in portfolio’s expected return and Multi Strategy Investment - phi- fluctuation for a given asset, rate,
benchmark returns. expected risk, given a specified losophy allocating investment or index.
Beta Neutral - Describes a fund set of asset classes/ investment capital to a variety of investment Warrant - An option in the form of
with no sensitivity to broad mar- strategies. strategies, although the fund is a security. Banks or companies
ket movements. Therefore, the Forward Contract - Agreement run by one management company. issue warrants and can either be
fund’s beta is close to zero. between two parties to buy or sell Offering Memorandum - A docu- traded on exchanges or OTC. a
CTA Commodity Trading Advisor - an underlying asset at a specified ment provided to a potential proportion of trades executed by
CTA’s generally trade commodity future date for a specified price. hedge fund investor that intermediaries. These transactions
futures, options and foreign Not traded on an exchange, but describes the hedge fund’s busi- artificially inflate the overall value
exchange and most are highly between specific parties. ness and operations. Usually on loan and are, therefore, auto-
leveraged. Fund of Funds - Investment part- offered under a prospectus matically removed prior to publi-
Closed-end Fund- An investment nership that invests in a series of exemption. cation of the data. In brief, the
fund whose securities do not pro- other funds. A portfolio will typi- Options - A financial instrument process to exclude double count-
vide a right of redemption on cally diversify across a variety of that gives the holder the right but ing removes transaction values
demand based on a net asset investment managers, investment not the obligation to buy (call where one participant is seen to
value. The fund’s securities may strategies, and subcategories. option) or sell (put option) the lend and borrow the same security
be listed on an exchange and, as Futures Contract - Standardised, underlying asset up to (American value from two other participants
a result, may trade at a discount exchange traded contract for the option) or on (European option) a on the same day. The originating
(or premium) to the fund’s net future delivery or receipt of a defined expiration date for a lender and end borrower values
asset value. specified amount of an asset at a defined price. are retained to represent the true
Correlation - A measure of how specified price. OTC Over-the-counter trading - level of value on loan.
variables tend to move in relation Hedging - Transactions entered Trading of products between two

72 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007


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HFSMG 2006 pp72-80 ML 1/11/06 14:53 Page 74

Service Provider - PROFILES

Robert Chin

Company Brief: Prior to establishing ATC Fund Services in Curaçao in


ATC Fund Services is a specialized hedge fund March 2003, Mr Chin was the managing director of
administrator who has consistently received Fortis Fund Services (Curaçao) N.V. since August 2002
excellent reviews from its clients. ATC provides where he was responsible for approximately 75 staff
full administration to hedge funds, including members and US$ 22 billion under administration.
daily processing of all funds’ activities, nav calcu- During the last four years of his tenure at Fortis Mr
lation on a daily, weekly or monthly basis and reg- Chin was also a member of the management team of
istrar & transfer agency services. In addition, ATC Fortis Fund Services International. Mr Chins previous
professional experience includes a seven year tenure as
takes a pro active approach in assisting start up
CFO of Dutch brokerage firm where Robert was a
hedge fund managers with the incorporation of member of the European Option Exchange and the
their fund in jurisdictions such as the Cayman Amsterdam Stock Exchange. Furthermore, he spent
Islands, the British Virgin Islands and the the first 8 years of his career with Ernst & Young,
Netherlands Antilles. Amsterdam, The Netherlands.
Robert Chin,
Chief Executive Officer,
ATC Fund Services.

Key Contacts:

Robert N. Chin Kedi J. Chang


General Manager Managing Director
ATC Fund Services ATC Fund Services
Bon Bini Business Center, units 2B2K & 2B2L Bon Bini Business Center, units 2B2K & 2B2L
Schottegatweg Oost 10 Schottegatweg Oost 10
Curaçao, Netherlands Antilles Curaçao, Netherlands Antilles
Telephone: (+) 5999 738 1351 ext 11 Telephone: (+) 5999 738 1351 ext 10
Fax: (+) 5999 738 1311 Fax: (+) 5999 738 1311
E-mail: robert.chin@atcfunds.an E-mail: kedi.chang@atcfunds.an

Website: www.atcgroup.info

74 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2007


HFSMG 2006 pp72-80 ML 1/11/06 14:53 Page 75

Hedge Fund Services Market Guide

Dermot Butler

Company Brief:
Custom House Administration & Corporate Mr Butler has over 35 experiences in the financial serv-
Services Ltd (“Custom House”) is one of the ices industry and worked as a Stock Broker and Stock
world’s leading specialist hedge fund adminis- Jobber (specialising in South African mining stocks),
tration companies. Based in Dublin, it also before becoming a Commodity Broker and Market
operates out of offices in Chicago and has plans Maker in Metal Options on the London Metal
to open offices in South East Asia. In addition Exchange.
to providing a full administration service, In 1983 Mr Butler helped set up McDonnell & Co.,
Custom House also assists emerging hedge the Bermuda fund management company and issuer
of the McD range funds. He sold his interest in that
fund managers in establishing their fund, help- company and moved to Dublin in 1989 when he
ing produce the Offering Memorandum and all established Custom House. Mr Butler is a director of
relevant documentation in cooperation with several fund companies listed in the Irish Stock
attorneys in the selected jurisdiction. Custom Exchange and is Deputy Chairman of the Alternative
House currently acts for approximately 250 Investment Management Association (AIMA).
funds for some 100 clients, with total assets
under administration in excess of $20 billion.
Custom House, which is authorised and regu- Key Services:
lated by the Irish Financial Regulator under
Section 10 of the Investment Intermediaries Act Fund Administration
of 1995, is the only administrator in the world to Shareholder Services/Transfer Agent
have been awarded a Moodys Management Fund Formation
Quality Rating. Advice on Stock Exchange listing
Corporate Secretarial Services
Dermot Butler, Chairman, Custom House Irish Paying Agent
Administration & Corporate Services Ltd.

Key Locations: Key Contacts:

Dermot S. L. Butler, Chairman


Dublin, Chicago, Singapore dermot.butler@customhousegroup.com
T: +353 1 878 0807 F: +353 1 878 0827
Web: www.customhousegroup.com David P. M. Blair, Managing Director
david.blair@customhousegroup.com

T: +353 1 878 0807

SECURITIES LENDING MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 75


HFSMG 2006 pp72-80 ML 1/11/06 14:53 Page 76

Service Provider - PROFILES

James Lasry

Company Brief: stantial trust in a case involving litigation in Paris, New


Hassans International Law Firm, with over 55 York and Buenos Aires that also featured in reports in
lawyers is by far the largest law firm in Gibraltar. the New Yorker magazine, the New York Law Journal
Hassans was established in the 1930s , and has and on CBS News.
earned a reputation for high-standards, integrity Key Services:
and client service. Renowned for excellence as Property
lawyers dealing with tax advice, litigation, off- Corporate and Commercial:
shore finance and corporate practices including Gaming
financial transactions, banking, insurance, prop- Private Client and Tax residence advice
erty and conveyance advice, offshore trusts and Trust advice
company formations. Joint Venture
James Lasry, partner in the Tax and Overseas Mergers and Acquisitions.
Property Department, Hassans. Capital Duty Restructuring
Litigation
Mr Lasry is a highly regarded practitioner who has been Commercial
instrumental in setting up the majority of Gibraltar’s Trust and asset tracing
funds, including the first Experienced Investor Fund and Dispute Resolution
the first Protected Cell Company Fund. Criminal
Prior to joining Hassans in 1999, Mr Lasry was at the Matrimonial
Ministry of Industry & Trade where he gave legal opin- Admiralty and Shipping
ions on international trade and consumer protection, as Judicial Review
well as advice on international R&D contracts to the Banking
Chief Scientist. He also served as counsel to the Israeli Insurance
delegation in trade accord negotiations with the Czech Investment Services, Funds
and Slovak republics. Securitisation
On joining Hassans, Mr Lasry has focused his expertise Structured Finance
on funds, trusts, corporate law and financial services, Private Equity
advising the Government of Gibraltar on the regulatory E – Money Institutions, Derivatives
and tax treatment of investment funds. He also assist- Tax and Overseas Property
ed in drafting the Financial Services (Experienced Telecom & Deregulating Industries
Investor Funds) Regulations 2005. A member of the Drafting of Legislation
Society of Trust Practitioners, Mr Lasry advised a sub- Maritime and Transport
Key Locations: If you are considering structuring an the ideal location for setting up a European holding
investment in Europe, Gibraltar is the ideal location company or possibly even setting up a company to do
through which to do so. It is a recognised international business elsewhere in Europe.
finance centre with an attractive tax regime, yet it is a part 57/63 Line Wall Road
of the European Union having acceded with the United PO Box 199
Kingdom. It therefore enjoys the stability and support of GIBRALTAR
being within the EU whilst still retaining the advantages Tel (350) 79000 Fax (350) 71966
of being an international finance centre. This makes it e-mail: info@hassans.gi www.gibraltarlaw.com

76 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2007


HFSMG 2006 pp72-80 ML 1/11/06 14:53 Page 77

Hedge Fund Services Market Guide

Felix Oegerli

Company Brief: expert, and is a frequent conference speaker and


IFBS offers the financial industry a wide industry expert on Securities Lending, Repo and
range of consulting services, individual Collateral Trading and Management.
software development and standard
software solutions. IFBS has offices
in Zurich and New York. Key Services & Products:
Consulting for financial institutions focused on
Felix Oegerli, CEO, IFBS the “securities value chain” including securities
lending, repo and collateral management
Individual software development based on the
Oegerli is Chief Executive Officer and founder of IFBS Java framework
IFBS AG, an IT- application solutions and consult-
ing firm specializing in Securities Lending, Repo On the product side IFBS offers FINACE®,
and Collateral Management, with offices in Zurich a modular and fully integrated solution in the
and New York. Prior to launching IFBS in 1999, he area of securities lending, repo and collateral
held a number of business leadership roles at UBS management.
in Zurich, New York, and London for over 20 years
in different functions. Between 1990 and 1999 he
was responsible for the creation and expansion of
the Securities Lending, Repo and Prime Brokerage
business at UBS Zurich, was deputy global head of
Securities Lending and Repo, global head of Prime
Brokerage and head of global product manage-
ment Collateral Trading and Management. Oegerli
holds a degree as Swiss federal certified banking

Key Locations: Key Contacts:

IFBS AG Felix Oegerli, CEO, IFBS


45 Rockefeller Plaza T: +41 (0)44 218 14 14
20th floor F +41 44 218 14 18
New York, NY 10111 USA
Tom Ricciardi, Managing Director Americas
IFBS AG, Buckhauserstrasse 11, T: +1 212 332 7144
CH-8048 Zurich, Switzerland F: +1 212 332 7145
T: +41 (0)44 218 14 14
F: +41 (0)44 218 14 18 www.ifbs.com / info@ifbs.com
info@ifbs.com

SECURITIES LENDING MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 77


HFSMG 2006 pp72-80 ML 1/11/06 14:53 Page 78

Service Provider - PROFILES

Lionel deMercado

Company Brief: Group offers a full range of financial products


TD Securities Prime Brokerage Services is one and services to more than 14 million customers
of Canada’s leading service providers to the worldwide. As of July 31, 2006, TD Bank
alternative investment industry. Our clients Financial Group had CDN $385.8 billion in
include a large number of Canadian-based assets. TD Bank Financial Group ranks as one
Hedge Fund managers with a Canadian focus. of the top on-line financial services providers in
Strategies include Long/short, Energy focused, the world with more than 4.5 million on-line
Convertible Arbitrage, Risk Arbitrage and Fixed customers.
Income. Lionel deMercado,
Our Prime Brokerage professionals are able to Managing Director and Global Head Equity
offer customized hands-on support and guid- Finance, TD Securities.
ance in the areas of trade execution, margin
financing, securities lending, settlement and Mr deMercado joined the company in June 2001 with a
clearance, custody and technology . We can mandate to expand its Equity Finance operations and
also provide introductions and work with other develop the Prime Brokerage business. Mr deMercado
worked for a large Canadian financial institution where
areas of the firm such as trading, structured he held several senior positions including Managing
products, FX, tax structuring and investment Director Equity Finance and Vice President Operations.
banking.
Our large internal holdings as well as the Key Services:
strong relationships we maintain with an exten- - Trade Execution
sive network of securities lenders can guarantee - Margin Financing
both low borrowing costs and excellent access - Securities Lending
to difficult-to-borrow securities. - Settlement and Clearance
The Toronto-Dominion Bank and its sub- - Custody
sidiaries are collectively known as TD Bank - Technology
Financial Group (TDBFG). TD Bank Financial

Key Locations: Key Contacts:


Lionel deMercado, Managing Director
Ernst and Young Tower (1) 416 308 7321
222 Bay Street, 7th Floor lionel.demercado@tdsecurities.com
Toronto, Ontario
M5K 1A2 Vicki Juretic, VP, Sr. Relationship Manager
(1) 416 308 1560
www.tdsecurities.com vicki.juretic@tdsecurities.com
Peter Boffo, Marketing Manager
(1) 416 983 1356
Peter.boffo@tdsecurities.com

78 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2007


HFSMG 2006 pp72-80 ML 1/11/06 14:53 Page 79

Hedge Fund Services Market Guide

Telekurs Financial provides a wide range of dis-


play and feed products for different purposes.
They are accompanied by several local products
and services.
Richard Newbury
Key Services:
Telekurs iD: new Web-based (Java applet) display product
generation giving users access to Telekurs Financial's entire
range of data and functions. A number of packages geared
to the needs of different banking departments are offered.
Valordata Browser, a user-friendly search engine providing
Company Brief: access to descriptive data, corporate actions and valuation
Telekurs Financial is a company in the Telekurs prices, is integrated into this product.
Group, which operates in the fields of financial Telekurs iD html: The HTML version can be used by com-
information, payment transactions and IT servic- panies who have limited bandwidth for transmitting finan-
es. As a leader in its field, Telekurs Financial spe- cial information or whose corporate policy does not permit
cializes in the procurement, processing and distri- the use of the Java applet.
bution of international financial information for Telekurs iD mobile: Telekurs iD mobile offers easy access
investment advisory services, portfolio manage- to current prices for all securities in the Telekurs Financial
ment, financial analysis and securities administra- database for mobile devices (currently BlackBerry). The
tion. A global network of local financial market mobile version works together with Telekurs iD in the
specialists procures real-time stock exchange client’s office. Personal user lists can be maintained on the
information at source from the leading financial move.
centres. Containing over 2.7 million financial Valordata Browser: As a convenient search engine, the
instruments, the database of structured, encoded Valordata Browser rapidly and easily finds the instruments
that meet a special combination of search criteria, even with
securities information maintained by Telekurs complex questioning, and in just a few seconds.
Financial and its ten representative offices abroad Intraday Pricing Service: Snapshot service which enables
is unparalleled throughout the world in terms of the valuation of portfolios several times daily. The timing of
both depth and data coverage. snapshots is tailored to each client’s requirements. It is flexi-
As the official numbering agency for Switzerland ble and can be easily changed. The requirements for timing
and the Principality of Liechtenstein, Telekurs of snaps may vary significantly: intraday snaps, market close
Financial is responsible for allocating Swiss secu- times or traditional EOD after the integration of all market
rity (Valor) numbers. It is a founding member of corrections.
the Association of National Numbering Agencies Valordata Feed (VDF): structured and encoded descriptive
(ANNA) and leads the way in introducing stan- and corporate events data; ratings and reference data for
dards aimed at simplifying trading and securities instruments and institutions, corporate actions, cash flows,
administration. valuation prices; the data feeds are supplied several
times a day.

Key Locations:

Telekurs (UK) Ltd


15 Appold Street
London
EC2A 2NE
Tel: +44 (0) 20 7550 5000
Fax: +44 (0) 20 7550 5001
Email: info@telekurs.co.uk
Contact us at: www.telekurs.co.uk

SECURITIES LENDING MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 79


HFSMG 2006 pp72-80 ML 1/11/06 14:53 Page 80

Service Provider - PROFILES

Don McClean

Company Brief: Key Services & Products:


Fund Services, based in the Cayman Islands, With specialist expertise in both single manager
Ireland and Canada holds a leading position in and fund of hedge fund administration, services
the area of hedge fund administration, offering can be provided for both onshore and offshore
a complete range of services including funds.
accounting, NAV computation, share holder
services, banking and credit facilities. With the Capabilities also extend to services for invest-
dedication and experience of a professional ment funds through our teams in Luxembourg,
team of over 150 and state-of-the-art web Switzerland and the UK.
reporting, accounting and shareholder sys-
tems, UBS is well positioned to provide clients
with a first class service.
Don McClean,
Head of Fund Services, Ireland,
UBS.

Mr McClean has specific responsibility for the develop-


ment and management of the business and is a
member of the Fund Services Management Board.
He has 17 years of investment industry experience, is a
graduate of the University College Dublin and a
Fellow of the ACCA. Prior to joining UBS he spent
nine years at Fortis, culminating in the role of
Director of Operations Europe and has previously
worked at Rudolf Wolf Fund Management Ireland,
Strachans Management Services and Coopers and
Lybrand Jersey.

Key Locations / Contacts: Website:

Cayman Islands: www.ubs.com/fundservices


Darren Stainrod, tel. +1-345-914 1076

Ireland:
Don McClean, tel. +353-1-436 3636

Canada:
Pearse Griffith, tel. +1-416-971 4702

80 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2007


Successful Hedge
Fund Administration?
It’s a question of
partnership.

When it comes to hedge fund administration, you need to know you are working
with a provider you can rely on. At UBS, our years of experience in administering
hedge fund assets now totaling over $120 billion, allow us to offer the solution you
need. One that is flexible, bespoke, draws on a breadth of services and accesses state
of the art technology. But more importantly, it’s delivered through a professional
single point of contact, based from our offices in the Cayman Islands, Ireland or
Canada. That’s because we believe successful hedge fund administration is all about
the relationship we build together, which can give you confidence to focus on your
core business. It’s what we call ‘You & Us’.

www.ubs.com/fundservices

You & Us
© UBS 2006. All rights reserved.

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