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Foreword AIMA
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.
INTRODUCTION
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
Contents - Section 1
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?
Section Two
36 Statistics HFRI Stats and Analysis
Special Feature
46 Discussion The Canadian Hedge Fund Managers Panel Debate
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.
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
ibtco.com
HFSMG 2006 pp1-17 ML 1/11/06 12:37 Page 8
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-
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
REVIEW / EMEA
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
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.
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
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
which was the only Hedge Fund Administrator in the world to have had been awarded a
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
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
For further detailed information on Custom House and CHARIOT, please visit our Website:
www.customhousegroup.com
REVIEW / HFA
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
which was the only Hedge Fund Administrator in the world to have had been awarded a
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
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
For further detailed information on Custom House and CHARIOT, please visit our Website:
www.customhousegroup.com
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
HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 19
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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
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
HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 21
HFSMG 2006 pp18-35 ML 1/11/06 14:40 Page 22
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
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
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
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
HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 25
HFSMG 2006 pp18-35 ML 1/11/06 14:40 Page 26
Gibraltar - HASSANS
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
26 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007
HFSMG 2006 pp18-35 ML 1/11/06 14:40 Page 27
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
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
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
HFSMG 2006 pp18-35 ML 1/11/06 14:40 Page 30
Advent Software
What likely operational challenges will 2007 bring for Hedge Funds?
Custom House
How is the World of Hedge Funds changing amid ‘Regulatory Creep’?
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
HFSMG 2006 pp18-35 ML 1/11/06 14:40 Page 33
Northern Trust
What are the effects of institutional asset flows on the European
hedge fund industry?
Spectrum Global
Fund Administration requires quality systems, staff and structure.
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?
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.
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.
Outsourcing - TELEKURS
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.
Jim McGovern Gordon Cheeseborough David Fawcett Gary Selke Don Short
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
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
HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 47
HFSMG 2006 pp36-50 ML 1/11/06 14:42 Page 48
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-
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
HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 49
HFSMG 2006 pp36-50 ML 1/11/06 14:42 Page 50
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
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.
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.
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
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
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
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:
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
HFSMG 2006 pp72-80 ML 1/11/06 14:53 Page 72
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
GLOBAL CORPORATE
ACTIONS, PRICING,
CROSS-REFERENCE AND
DESCRIPTIVE DATA.
Robert Chin
Key Contacts:
Website: www.atcgroup.info
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.
James Lasry
Felix Oegerli
Lionel deMercado
Key Locations:
Don McClean
Ireland:
Don McClean, tel. +353-1-436 3636
Canada:
Pearse Griffith, tel. +1-416-971 4702
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.
INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007 WWW.ISJFORUM.COM