HFSMG 2007 Cover 29/10/07 2:27 pm Page 1

£10 - UK, ROW

HEDGE FUND SERVICES $20 - Americas
€15 - EMEA

MARKET GUIDE

BEYOND THE SPIN

2008
INVESTOR
S ERVICES
JOURNAL
WWW.ISJNEWS.COM
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HFSMG 2007 pp1-16 ML 26/10/07 2:33 pm
HEDGE FUND SERVICES
MARKET GUIDE
Risky business
Hedge funds have had a
hard time of it this summer,
but are things are looking up?
Welcome to the 2008 edition of ISJ’s annual
Hedge Fund Services Market Guide.The quest
for a more transparent market has been the
defining theme of the hedge fund sector over
the last year. Rarely a day has gone by
without some media attention focused on the
risks posed by the hedge fund community to
the wider financial market and the credit
market crisis of the latter half of the year
drew yet more attention to the subject.
As an industry that has been largely
ignored by the press, it has been a shock to
many hedge fund managers to find them-
selves made scapegoats for the financial
crisis. The secrecy that surrounds the funds
and the reluctance of managers to discuss
their positions has made them seem even
more suspicious. Will this crisis therefore
increase the push for transparency in the
market? Our main feature examines the
developments in the market over the last 12
months and the likely impact of the credit
crunch on the future of the hedge funds sector.
Investors have also become more demanding
masters and the process of due diligence has
become even more onerous for hedge fund
Page 1
INTRODUCTION
2008
managers. There are though a lot of hedge
funds that have taken great care to ensure that
they are well equipped to deal with heavy
investor scrutiny, but this has been taking
money away from their traditional investments
in leading edge front office technology. We look
at what is happening in the front office in our
feature on algorithmic trading.
The issue of hedge fund replication has
also become a hot topic in the industry and it
is difficult to gauge exactly what impact it will
have on the market in the long term. We took
the time to talk to Professor Harry Kat, one of
the key proponents of hedge fund replication,
to find out his views on the future.
While prime brokers were long a key and
often only resource for hedge funds, they are
now joined by a proliferation of service
providers and must work harder to keep their
competitive edge. Mayiz Habbal, managing
director of the Securities and Investments
Group at analyst firm Celent, provides his
views on the developments within the
hedge fund administration market over the
last 12 months.
We have also gathered together a number of
leading providers in the hedge funds space to
debate the issues in our
future of the market panel
discussion and provide you
with key insights into the
landscape of the sector
today and tomorrow.
Virginie O’Shea
Group Editor
HFSMG 2007 pp1-16 ML 26/10/07 2:33 pm Page 2

Foreword Hedge Fund Association

Swings and roundabouts

David Friedland of the Hedge Fund
Association (HFA) reflects on the
past 12 months

The hedge fund industry over the past four and a
half years has enjoyed robust performance and a
largely favourable investment environment. As a
result, assets in the hedge fund industry have
swelled. Today, assets in hedge funds are
approaching USD1.5 trillion, with an estimated
10,000 plus hedge funds managing those assets.
Attempts at formal regulation of the industry in
the US have come and gone, but may certainly
reappear at some point in the future.
However, events of this summer have resulted in
many hedge funds facing their most challenging
environment since 1998. The sub-prime mort-
gage debacle and ensuing credit crisis resulted in
losses for many hedge funds. As banks became
nervous, margin calls were made to hedge funds,
resulting in forced selling, which wreaked havoc
for many statistical arbitrage hedge funds.
Large losses mounted for several large hedge
funds in July and August, most notably funds man-
aged by Bear Stearns and Goldman Sachs. Investor
nervousness is now the prevailing theme, and the
question is how long until the environment
improves. Remember, although 1998 proved to be
a black eye for the hedge fund industry, many
hedge funds were able to profit enormously in the
aftermath in 1999, as spreads narrowed and equi-
ty markets recovered. Will we see a similar occur-
rence for hedge funds in the fourth quarter of
2007 and into 2008, or will these problems have
a more lasting impact? The answer to that question
will play itself out over the next months and years,
and should provide for very interesting times for
hedge funds and hedge fund investors.
The global reach of hedge funds, the depth of
product available and the size of the industry cer-
tainly make for an exciting and challenging indus-
try. The Hedge Fund Services Market Guide covers
many of the cutting edge issues facing hedge fund
managers, investors and service providers – it is a
must read for anyone interested in keeping on top
of developing and changing trends in the industry.
2 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
The guide takes a close look at the recent credit
crisis, and evaluates what happened, and what
the likely outcome is going to be. It takes a look at
the latest in hedge fund technology - who is using
it and how they are using it. How will recent
events in the industry impact on risk averse money
managers, particularly with regards to secretive
practices that are still somewhat prevalent in the
industry? Will we see a reduction in secretive
black box algorithm trading strategies?
Discussions about hedge fund regulation, despite
being put on the back burner temporarily in the
US, are likely to resurface shortly. Industry propo-
nents have always advocated the theory that the
hedge fund industry should be self-regulated due
to the sophistication of hedge fund investors. The
SEC however, remains adamant about cracking
down on hedge funds.
The range and depth of topics in this handbook,
which extend beyond what I have discussed here-
in, are certain to be of interest to you. If you want
to gain insights from many of the most experi-
enced practitioners in the hedge fund industry,
the Hedge Fund Services Market Guide is a must
read for you, whether you are a hedge fund man-
ager, hedge fund investor, or service provider to
the industry. In an evolving and fast growing
industry where new issues, concerns and trends
constantly arise, where can an investor turn to in
order to keep up to date? Associations like the
Hedge Fund Association and others are certainly
useful in providing guidance and education, but in
terms of a single resource to provide answers to
many of your questions, this guide is as good a
starting point as any.
David Friedland, president, Hedge Fund Association
and president of Magnum US Investments. The Hedge
Fund Association www.thehfa.org is an international
not-for-profit association of hedge fund managers, serv-
ice providers and investors formed to unite the industry,
and increase education and the awareness of the oppor-
tunities and advantages of hedge funds
HFSMG 2007 pp1-16 ML 26/10/07 2:33 pm Page 3

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Foreword Chartered Alternative Investment Analyst Association

Rollercoaster ride
It has been a hectic few months in the
market, says Craig Asche of the
Chartered Alternative Investment Analyst
(CAIA) Association

After years of unprecedented liquidity and
tightening spreads, US credit markets first
blinked, then buckled as falling real estate
prices and rising short term rates fed their way
through the system to negatively impact the
ability of the weakest of borrowers to meet
their mortgage obligations. As default rates
began to rise at lending institutions specialis-
ing in these sub-prime mortgages, broader
questions emerged regarding the creditworthi-
ness of much of the outstanding paper backed
by these same mortgages.
globe – the world really is becoming smaller
and smaller.
But perhaps most important of all is that
change happens and that markets, especially
adolescent ones such as the hedge fund
industry, are rapidly and continuously evolv-
ing. Recognising that education is not a static
process but a lifelong challenge, the onus is
squarely on all of us to keep apprised of these
changes.
The Hedge Fund Services Market Guide is an
excellent starting point to help novices and

One valuable reminder made abundantly clear by the market’s reaction is

that liquidity is a variable, not a constant, and that it should never be
taken for granted, no matter how long it persists in ample supply
This, in turn, has led to a market wide professionals, investors and service providers
reappraisal of the broader CMO market. Many alike stay on top of developments within the
of these securities have found their way into a alternative space. The various sections found
significant number of hedge fund (as well as within this annual publication cover not only
institutional) portfolios around the globe. What current market developments (such as those
came as a surprise was not that these securi- found within the sub-prime mortgage market),
ties were marked down in price, but the speed but also geographic, operational, and
and extent of the markdowns, as well as the regulatory trends affecting the industry
spill over effect it had on other markets globally. Contributions come from a variety of
including asset backed commercial paper and experienced professionals representing a cross
Treasury bills. section of industry participants, ensuring the
What lessons can one take away from this reader of a balanced, diverse perspective. I
experience? Certainly, one valuable reminder encourage all of you to make full use of this
made abundantly clear by the market’s reac- comprehensive industry resource.
tion is that liquidity is a variable, not a con-
stant, and that it should never be taken for Craig Asche, executive director of the Chartered
granted, no matter how long it persists in Alternative Investment Analyst (CAIA) Association.
ample supply. Borrowers and lenders should CAIA is an independent, not for profit global organi-
be grateful when it’s plentiful but prepared to sation committed to education and professionalism
in the field of alternative investments. Founded in
cope when it’s not. A second reminder is of the 2002, the association is the sponsoring body for the
interconnectedness of markets around the CAIA designation
4 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
HFSMG 2007 pp1-16 ML 26/10/07 2:33 pm Page 5

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HFSMG 2007 pp1-16 ML 26/10/07 2:33 pm Page 6

Contents

1 Introduction Hedge Fund Services Market Guide 2008

2 HFA Foreword Swings and roundabouts

4 CAIA Foreword Rollercoaster ride

8 Year in review A review of the last 12 months
12 Fair play Hedge fund replication

14 Electric avenue Algorithmic trading and hedge funds

18 Celent report Following the flow
20 Panel debate Industry experts discuss the issues
28 Statistics Numbers from Hedge Fund Research
30 Ask the experts Practitioner perspectives
36 UBS Back to the future
38 ATC Fund Services Are hedge funds still alternative?

40 Custom House Resilient returns

42 Dillon Eustace The coming storm

44 Advent Hedge fund compliance and its silver lining

46 Fintuition Trends in hedge funds

50 Guide Sound practices for hedge fund managers

60 Profiles Details of hedge fund services providers

6 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008

HFSMG 2007 pp1-16 ML 26/10/07 2:34 pm Page 7

Innovation Expertise Resources

Dillon Eustace focuses on providing advice and innovation For more information, contact:
Donnacha O’Connor, David Dillon,
in alternative investment products such as single and Andrew Bates, Etain De Valera or
Peter Stapleton. at:
multi-strategy hedge and private equity vehicles.
33 Sir John Rogerson’s Quay, Dublin 2, Ireland.
Tel:+353 1 667 0022, Fax:+353 1 667 0042,
e-mail: info@dilloneustace.ie, www.dilloneustace.ie
With one of the largest alternative investment teams
or Brian Dillon or Gregory Noone at:
in Ireland,with in-depth experience from all sectors Dillon Eustace, Tokyo.
Tel: +813 5219 2042
of the industry,Dillon Eustace advises on all aspects
Fax: +813 5219 2021
of alternative investments including product design, e-mail: brian.dillon@dilloneustace.ie
gregory.noone@dilloneustace.ie
launch, listing, tax and compliance for international
or Andrew Lawless at:
and domestic managers, prime brokers and other Dillon Eustace, Boston.
Tel: +1 617 217 2866
service providers.
Fax: +1 617 217 2566
e-mail: andrew.lawless @dilloneustace.ie

DUBLIN CORK BOSTON TOKYO

33 Sir John Rogerson’s Quay, Dublin 2, Ireland.
Tel:+353 1 667 0022, Fax:+353 1 667 0042,
e-mail: info@dilloneustace.ie, www.dilloneustace.ie
In alliance with Arendt & Medernach
HFSMG 2007 pp1-16 ML 26/10/07 2:34 pm Page 8

YEAR IN REVIEW

Beyond the spin

It has been a year of significant

highs and lows for the hedge fund
community. Virginie O’Shea reflects on
the past 12 months in the market

There can be no doubt that hedge funds have had a
hard time of it in the international press over the last
half of 2007. The US sub-prime mortgage mess and
its impact on the global economy has meant that a
number of funds faced significant losses and some
were even driven out of business completely. Of
course, the trade press has also had a field day
reporting on the carnage, but when it actually comes
down to it, how much of an impact has the crisis
actually had on the future of the hedge fund indus-
try?
The coverage has centred on a number of high pro-
file hedge fund failures such as the USD1.5 billion
failure of Bear Stearns’s two sub-prime funds, which
were put into provisional liquidation in the Cayman
Islands in August. Moreover, BlueCrest Capital
Management, which had around USD12 billion of
assets under management at the end of June, closed
one of its equity funds at the start of September due
to a period of what it termed as “unacceptable per-
formance”.
At that same point in time, Goldman Sachs’ North
America fund, which follows a statistical arbitrage
strategy and was hit hard in the second week of
August, finished the month down 16.7%. Goldman
was also forced into injecting USD3 billion into the
firm’s quantitative hedge fund, the Global Equity
Opportunities Fund, which lost about 30% of its
value in a week.
Hedge funds investing in the credit markets were the
worst hit and quantitative strategies funds were lam-
basted by the media for poor performance.
Deleveraging by funds of hedge funds as they faced
redemptions from investors rushing to recover their
assets may have also contributed significantly to the
stock market turmoil in the summer, according to
research by BarclayHedge and TrimTabs. The
research indicates that investors in funds of hedge
funds may have redeemed as much as USD 55
billion in July, largely due to concerns about risk
exposure within credit derivatives. The risk of
redemptions is higher for hedge funds compared to
private equity funds, because the period during
which investors cannot access their investments is
shorter at 90 days or less.
However, hedge funds are renowned for bouncing
back quicker than equity markets from turmoil in the
wider financial marketplace. Just look at the data
provided in Credit Suisse Index’s report on hedge
funds in financial crises (Analysing Past Market
Turmoil and Outcome for Hedge Funds), which was
released in October, for proof positive of this fact.
The research, which looks at five separate incidents
including the dotcom bubble burst and the World
Trade Centre attacks, highlights how hedge funds
have proved resilient despite unfavourable market
conditions, due in a large part to the use of diversifi-
cation strategies.
“Hedge funds, as represented by the Credit
Suisse/Tremont Hedge Fund Index, have tended to

8 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008

HFSMG 2007 pp1-16 ML 26/10/07 2:34 pm Page 9
remain less volatile and have retained some positive
performance throughout most market crises,” the
report states. “Given the current sub-prime market
fallout, we believe that hedge funds are well posi-
tioned to be successful once again. Hedge funds are
able to take advantage of new opportunities, such as
those created in the past few months.”
The Lipper TASS Asset Flows Report on hedge funds
for the second quarter of 2007 seems to tally with this
view. From the results of the report it is possible to
see that despite the sub-prime situation, most hedge
funds displayed a strong performance over the quar-
ter. The aforementioned Credit Suisse/Tremont
Hedge Fund Index returned 5.19% during the second
quarter, according to Lipper. And if such reports are
to be believed, the average fund only lost 1.31% as a
result of the sub-prime crisis, according to figures
released by Hedge Fund Research.
Figures for September from Hedge Fund Research
indicate that the market has rallied yet further still.
The industry generated a positive return for investors
of 0.85% net of fees for the month to 26 September,
according to the firm’s investable hedge fund index.
The index indicates that, of the eight hedge fund
strategies it details, six made a profit in September.
It also seems that hedge funds will not experience a
long term crisis of confidence from the industry.
During the last few weeks of July and the first week of
August at the peak of the market turmoil, Citi sur-
veyed almost 50 pension managers from Europe and
the US that collectively manage over USD1 trillion in
assets and the results highlight that the hedge fund
industry has little to fear in the future. Respondents
indicated that they would, on average, raise their allo-
cation in alternative investments to nearly 20% by
2010 from 14% today, effectively adding another
USD1.2 trillion into alternatives over the next two
years. A large proportion of this investment will be via
hedge fund investments.
The slowdown in the hedge fund market over the late
summer period will not put these pension funds off,
says Kenneth Heinz, president of Hedge Fund
Research: “Investors are continuing to focus on the
longer term merits of the industry. They are not
impacted by one bad month.”
The convergence that is occurring between mutual
funds and hedge funds is also set to continue. David
Smithers, head of IT for Hedge Funds in Fund
Services, UBS, explains: “There is no question that
convergence is underway and will continue, and we
are already seeing some traditional mutual funds
investing in ‘alternative’ asset classes. The largest
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 9
area of impact is increased asset flows from pension
funds into hedge funds and in particular fund of
hedge funds, which are seen as less risky, highly
diversified investment vehicles.”
The short term impact of the crisis has been a trend
towards consolidation in the sector. For example,
London-based Integrated Asset Management bought
a majority stake in fellow fund of hedge funds group
Altigefi in mid-October. Chicago-based hedge fund
Citadel Investments decided in July to take over the
credit portfolio of Sowood Capital, a smaller fund that
ran up heavy losses in the credit markets. This M&A
activity seems set to continue, as the casualties of the
sub-prime losses are swallowed by the larger and
more resilient hedge fund players.
Bob Guilbert, managing director, Eze Castle
Integration, elaborates: “As the hedge fund market
continues maturing, there will most likely be more
consolidation and more publicly traded firms.
Industry analyst reports and public surveys from
organisations like CPA firm Rothstein Kass say that
consolidation is likely within the next three years, as
larger firms target more institutional money and
competition increases among smaller firms.”
But it is not just the hedge funds that are buying each
other; big brokerages and banks have also been busy
snapping up hedge funds over the last year. These
major deals include: Citigroup’s purchase of Old
Lane Partners in April; Merrill Lynch’s purchase of
stakes in GSO Capital Partners and Sterling Stamos
Capital Management in May; and Lehman Brothers’
purchase of DE Shaw in March.
The negative press surrounding hedge funds has also
had a significant impact in the area of regulation.
Calls for tighter regulation of hedge funds are nothing
new; the Securities and Exchange Commission (SEC)
has been debating the extend to which the sector
should be regulated for some time. However, tighter
regulation of hedge funds would essentially hamper
the sector’s ability to achieve significant returns.
Concerns over this outcome have caused a rift to
appear in the US between the SEC and the Federal
courts over the scope of the SEC’s ability to regulate
hedge funds.
The Goldberg decision last year, which struck down
the SEC’s authority to require hedge funds to register
as investment advisers, meant the SEC had to come
up with new proposed procedures to regulate the
market. To this end, on 10 September, the SEC adopt-
ed a new rule clarifying hedge fund fraud. The regula-
tion prohibits advisers to investors in hedge funds
and pooled investor vehicles from making false or
HFSMG 2007 pp1-16 ML 26/10/07 2:34 pm
YEAR IN REVIEW
misleading statements to investors or defrauding
investors and prospective investors. The SEC justified
the introduction of the rules by citing the rapid growth
of hedge funds in recent years combined with the ris-
ing interest of retail investors and a growing number
of fraud cases in the industry. The Investment Adviser
Act Rule 206(4)-8 therefore represents a substantial
shift in the SEC’s regulatory priorities, as it is the first
time it is seeking to extend its regulatory authority to
all private funds in this manner.
“As the hedge fund industry matures and increases
its coverage with the mutual fund industry, it may go
through similar cycles that affected mutual funds.
There may be a blurring as mainstream regulation
becomes looser for mutual funds and tighter for
hedge funds,” explains Bhagesh Malde, head of
JPMorgan Hedge Fund Services in EMEA and Asia
Pacific.
However, this regulatory intervention could be a
potential threat to the future profitability of hedge
funds, says Fabian Vandenreydt, head of Broker-
Dealer Services at Swift. “Tighter regulation inhibits
their ability to take risks and provide higher returns.
We suggest that more transparency and participation
in regulatory efforts is the best way to mitigate
this factor. You have to work with the regulators,”
he adds.
In the spirit of collaboration, the US Treasury
Department has announced the formation of two
advisory groups under the direction of the
President’s Working Group on Financial Markets to
develop recommendations for best practices in the
operation of hedge funds. One advisory group will
comprise investors in hedge funds and be chaired by
Russell Read, chief investment officer for the
California Public Employees’ Retirement System and
the other will be composed of asset managers and
chaired by Eric Mindich, the chief executive of Eton
Park Capital Management. The groups will make
their suggestions available for public comment
before they become finalised and Read has already
indicated that some recommendations will be ready
before the end of 2007.
In a similar move and as a bid to fend off regulatory
intervention in the UK, the Hedge Fund Working
Group (HFWG), which represents 14 leading hedge
fund managers based mainly in the UK, has pub-
lished a consultation document on best practice
standards for the hedge funds industry. The pro-
posed best practices focus particularly on the areas
of valuation, risk management, disclosure and fund
governance. The working group has also recom-
10 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 10
mended that hedge fund managers improve their
transparency by disclosing more information to
potential investors and the public. Following a period
of public consultation, the HFWG intends to publish
its final report in January 2008.
The consultation document has already been well
received by a number of key figures in the industry.
Germany’s Finance Minister Peer Steinbruck has
publicly supported the idea of a voluntary code of
conduct for the hedge fund industry and believes it
would solve many of the problems being experienced
in the hedge fund market today. The Alternative
Investment Management Association (AIMA) has
also welcomed the consultation paper.
Eze Castle’s Guilbert highlights the change he sees
coming in the market: “Hedge funds have had a rep-
utation for being cloaked in secrecy and resistant to
disclosing information for fear trade secrets or strate-
gies would be exposed. We are seeing this change
and demands from investors is one of the primary
drivers. Regulatory compliance has also played a role
in removing the veil of secrecy and driving funds to
be more transparent in their dealings with investors
and the market.”
Rory Gage, management consultant at Morse, adds:
“Looking forward, hedge fund managers are going to
be forced to build far more robust compliance frame-
works around their businesses if they are to attract
further inflows of new investors in the future and to
meet with regulators’ requirements. Our clients are
telling us that they are seeing an ever increasing
number of due diligence questionnaires. These ques-
tionnaires have also grown in length and are now
beginning to probe almost every area of a fund man-
ager’s operations, from their structure to who their
third party service providers are and how they price
individual instruments.”
It seems that the issue of transparency is key to the
future of the hedge fund market, but exactly how
much transparency will be required is likely to be a
bone of contention for some time to come. It is also
probable that the characteristics that distinguish a
hedge fund from other funds will break down yet fur-
ther still. For instance, short selling, leverage and an
alpha strategy no longer define a hedge fund, you
only need to look at the 130/30 funds to realise that.
As Mark Brady, partner at Eversheds, explains, it’s
now becoming a question of degree. “Registered
funds that use leverage and short selling are limited
in the strategies they can pursue. Most hedge funds
aren’t,” he says. How long this distinction will last,
only time will tell. ■
HFSMG 2007 pp1-16 ML 26/10/07 2:34 pm Page 11
HFSMG 2007 pp1-16 ML 26/10/07 2:34 pm Page 12
HEDGE FUND REPLICATION
Fair
play
Giles Turner
explores the
impact of hedge
fund replication
on the market
It is difficult to gauge the effect hedge fund repli-
cation will have on hedge funds themselves. It is
certain that their existence won’t be threatened,
for to have replication you need the original ele-
ment, and for replication to be a success, hedge
funds have to keep generating positive returns.
Yet it is the cost of these returns that have been
one of the catalysts behind the creation of hedge
fund replication.
Professor Harry Kat of the Cass Business School,
states: “Anybody who is well calibrated to the real-
ities of the global capital markets knows how dif-
ficult it is to systematically do better than the mar-
ket and will find it hard to believe that there are
not just one or two, but thousands of managers
out there that have no difficulty systematically
outperforming the market to such an extent that
their services are truly worth 2 plus 20.”
Hedge fund fees are often in the newspapers
because they are an easy target with which to
bash the corporate fat cats. Since 2000, the
12 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
hedge fund world has doubled in size. Now with
over 9,000 funds and combined assets of around
USD1.9 trillion, the quest for alpha has turned
into a crusade. If these hedge funds are not mak-
ing the mythical alpha, perhaps people are justi-
fied in questioning the 2 plus 20 fees these man-
agers charge. Do people need to be educated in
order to demystify hedge funds’ ability to gener-
ate alpha?
According to Kat, the public needs to be educated
a lot: “People are extremely eager to believe there
is something out there that is going to make
them a lot of money. In addition, the marketing
machine surrounding hedge funds is extremely
powerful and aggressive as there is a lot of money
to be made by selling hedge funds. In a way there-
fore, we are not just fighting a simple lack of
understanding, but one of the most basic human
emotions: greed.”
Kat has published two papers questioning the 2
plus 20 (or 3 plus 30 in the case of some fund of
HFSMG 2007 pp1-16 ML 26/10/07 2:34 pm Page 13
funds) fee structure. The first, published in 2003
in the Journal of Financial and Quantitative
Analysis, highlighted the failure of funds to out-
perform the market benchmark. Looking at the
fee adjusted returns of 77 funds between 1990 and
2000, in relation to similar risk profiles that gen-
erated the market benchmark, Kat discovered that
only five out of the 77 outperformed the bench-
mark. The next article, released in 2006, analysed
a considerably larger field of 1,900 funds and
came to a similar conclusion. This time, only 18%
of the funds beat the benchmark and even the
The mere threat of passive indexation and replication in the
hedge fund world will help focus the minds of managers and
investors. No hedge fund manager likes to be compared to a
commodity product
most successful funds couldn’t keep up their high
returns over a longer time frame.
Northwater Capital Management, a Toronto-
based fund of funds manager, has come to the
rescue of the hedge fund industry, providing
quantitative research defending hedge fund fees.
According to Northwater, the underlying
approaches to hedge fund replication are “limited
in their ability to access the performance of hedge
funds”. This suggests that Kat’s method is just
plain vanilla variance rather than a method of tap-
ping alpha generated by hedge funds. Another
problem is that Kat’s method relies on historical
covariance, which is unstable in the financial mar-
ket, as recent events have highlighted. A simple
response on Kat’s behalf would be that ‘They
would say that’. Northwater is a fund of fund after
all.
It is important to note at this point that hedge
fund replication does not attempt to replicate
hedge fund returns in their entirety. Short of risk-
ing ‘Hedgegate’ by planting microphones
throughout Mayfair or Greenwich, this would be
unfeasible. William Fung and David Hsieh, the
two original ‘replicators’, coined the term ‘alterna-
tive beta’. They aim for an average rather than
alpha, and their benefits go beyond returns. Giles
Drury, senior manager with KPMG, explains: “As
well as lower fees, hedge fund replicators also
appear to offer a number of other potential bene-
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 13
fits to their clients. According to promoters, they
are often rules-based – so performance can be
easily understood and explained, appear more
transparent, make liquid investments and can be
executed at a lower cost than a typical hedge fund
strategy. There are also potential benefits for the
wider industry: if alternative beta does exist and
can be truly replicated, this will encourage hedge
fund managers to concentrate on skill-based per-
formance rather than deriving performance from
market risks. It should encourage funds to charge
fees for delivering real alpha, and help investors
to better understand where returns come from.
Also, some replication products could offer the
ability to short alternative beta, enabling hedge
fund investors to capture the pure alpha element
of their portfolios.”
Drury also points out some underlying problems
with hedge fund replication. According to Edhec,
the French business school, replication products
have been launched too soon, without sufficient
academic research. Then again, the only way you
can test a theory is apply it to the real world.
Whether Edhec’s postulation is merely rivalry
between business schools or a well thought out
observation, only time will tell. But one factor that
Drury hits on the head is that, regardless of whether
or not hedge fund replication is a worthwhile prod-
uct regarding returns, it will definitely have an affect
on the mentality of hedge fund managers.
“The mere threat of passive indexation and repli-
cation in the hedge fund world will help focus the
minds of managers and investors, and help to
ensure that the industry remains focussed on the
delivery of uncorrelated absolute returns. No
hedge fund manager likes to be compared to a
commodity product. As the industry moves for-
wards, and becomes more mainstream and more
institutional, financial innovation will continue to
push the boundaries further and prevent the tal-
ented from sitting comfortably on their laurels for
too long,” concludes Drury. ■
HFSMG 2007 pp1-16 ML 26/10/07 2:34 pm Page 14
ALGORITHMIC TRADING
Electric avenue
Hedge funds are passing on their algorithmic needs to brokers as
they search for more customised systems, Jamie Darlow reports
Buy side firms are using algorithms like never
before and the most rapacious of users, the hedge
funds, are at the vanguard of adoption as they
seek fragmented liquidity in complex
marketplaces. But concerns have been voiced that
recent market volatility could halt the investment
from pension funds that has been fuelling hedge
fund growth, and bring to an end the algorithmic
explosion.
However, not all hedge funds are using algo-
rithms for front office trading. While researching
for this feature, it became apparent there are many
funds unwilling to talk to the press, for fear their
clients would surmise they had started using this
kind of technology. Clearly, algorithms are not for
all – those operating strategies that require only
minimal trading on long term stocks, perhaps as
few as a handful of trades a day, are not in need of
algorithms that scour every market for hidden liq-
uidity or the best prices.
Front office trading algos are also bound to be
less useful to those buy side funds trading outside
the traditional FX and equities markets. Chip
Lowry, senior managing director and head of
Global Link EMEA at State Street, explains some
of the largest growth in the foreign exchange
industry has come from hedge funds. “But once
you leave the equity and FX space, the assets
classes which you can trade electronically drops
dramatically,” he says. “I think hedge funds will
use new asset classes for their strategies; they just
won’t be traded electronically. For example, some
hedge funds have looked at property and fine art
as investments – you can’t really trade those elec-
tronically.”
But there is a growing army of hedge funds that
14 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
needs the best prices and operates in the equities,
FX and, to a growing extent, fixed income markets.
“Whether funds are using algorithms comes down
to the specific investment profile of the fund rather
than whether they are a hedge fund or institution,”
explains Chris Jackson, director of execution sales
at Merrill Lynch. “Stat arb, day trading funds and
low cost, high volume traders, like index funds, are
natural users of automated trading.”
These natural users want several things from
their algorithmic fixes. First, hedge funds like the
anonymity algorithms afford them, explains
Richard Balarkas, head of Advanced Execution
Services (AES, Credit Suisse’s algorithmic trading
platform) sales at Credit Suisse. Trading through
AES minimises signalling risk to the market, he
says.
Second, algorithms are extremely efficient at find-
ing dark liquidity, which is not displayed on
exchanges, and aggressively trading it with the
minimum market impact, says Balarkas. “Third,
liquidity fragmentation. The only way to operate is
via smart order routing. For example, in the US,
there are dozens of venues. You need ultra fast
technology constantly monitoring and probing in
order to know which venue to use. Changes in
market microstructure are leading to an explosion
in data volumes. In the US, it is estimated the
number of trading related data points in equities
will rise from roughly 250,000 per second to
550,000 by the end of the year. You execute in this
environment without first class algo, crossing and
smart routing technology.”
Recent research suggests hedge funds will
increase their technology spend over the coming
months and years. Jackson says hedge funds are
HFSMG 2007 pp1-16 ML 26/10/07 2:34 pm Page 15
going to increase spending on technology expo-
nentially over the next six to 12 months. They are
often starting from a low infrastructure base – per-
haps relying on technology from a prime broker –
yet their trading requirements are at least as
sophisticated as institutional managers, he says.
A recent poll by Ernst & Young of over 100 global
hedge funds and fund of funds managers, collec-
tively managing around USD900 billion in assets,
showed that three quarters of respondents identi-
fied technology as the biggest spending area in the
next two years. The survey found 58% of respon-
dents said expenditure on risk management tech-
nology was expected to take up the biggest pro-
portion of overall spending.
The larger hedge funds are also now finding they
must spend money on technology for the back
office. As the more established funds begin to
mature, they are starting to need the enhanced lev-
els of process and control that have traditionally
only been seen in the institutional space, explains
Jackson. “For example, a pension fund investing in
a hedge fund may have strict maximum holding
limits, a bespoke restricted list and limits on the
amount of cash that can be held. Modelling these
kind of requirements across multiple accounts
requires significant technology.”
Increasingly, hedge funds have seen investment
from more traditional fund sectors, like pension
funds. “The overall trend amongst all money man-
agers is towards absolute returns,” comments
Balarkas. “Even pension funds have to look at allo-
cating some portion of their funds into diverse or
alternative strategies in order to improve perform-
ance.”
While these funds may still be investing only a
fraction of their total assets – typically less than
10% of their capital – this represents an increas-
ingly important revenue stream for hedge funds.
But the recent market turbulence seen over the
summer months has caused some to worry about
the continuation of this investment, and thereby
the increasing investment in algorithmic trading
strategies. Lowry suggests the unfavourable mar-
ket conditions will cause some investors to revisit
their policies. “Some investors have already stated
there must be transparency in the hedge fund’s
investment process in order to invest,” he
explains. Some hedge funds have made it clear,
however, that transparency could potentially come
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 15
at a performance cost.”
Those responsibilities involve making returns on
investments, but it is the nature of hedge fund risk
that some funds will fail. In essence, nothing has
changed since the high profile failures at Bear
Stearns over the summer. “If there has been signif-
icant growth in investment in hedge funds, that
still represents a relatively small percentage of
total assets invested,” comments Jackson. “There
is still huge growth potential in the hedge fund
space as investors seek to increase returns and
diversify risk.”
KPMG’s advice is for pension funds to invest in
hedge funds via fund of funds, which invest across
a range of investment strategies, and thus reduce
fund specific risk. “The recent spate of hedge fund
failures highlights the importance of this approach
as investors have much lower exposure to single
manager or single strategy risk,” explains Daniel
Broad, executive consultant, Investment Advisory,
Pensions, Tax and People Services at KPMG. “For
example, during August 2007 when many algorith-
mic trading funds had significant draw downs,
many multi-strategy fund of hedge funds experi-
enced a relatively small loss in the range of 2%-
3%. Therefore, we believe that recent events will
not slow down the investment in fund of hedge
funds by pension schemes in the near future.”
To maintain this investment in hedge funds and to
continue to increase returns in spite of possible
regulatory scrutiny, hedge funds must continue to
upgrade their algorithms. VWAP or participation
algorithms are no longer good enough for best
execution.
Hedge funds rely on being more nimble in their
approach than the sell side – they can be more
innovative and target specific areas more quickly
than large banks can and, while they sometimes
pay a price, they often gain the edge. Robert
Boardman, head of Algorithmic Sales at ITG in
Europe, says that while hedge funds don’t neces-
sarily have technologically superior algorithms,
they are less rigid in their approach. “They are less
resistance to change and, therefore, are usually
early adopters of the latest technology,” he
explains. Hedge funds are therefore searching for
the latest and greatest and, at the moment, this
means more flexibility. The industry is
steadily moving towards the adoption of
customised algorithms, supplied by the banks,
HFSMG 2007 pp1-16 ML 26/10/07 2:34 pm
ALGORITHMIC TRADING
and away from proprietary systems built in-house
by funds themselves.
The latest research note from Tabb Group sug-
gests that before the end of 2008, at least 30% of
all algorithmic flow will be sent through cus-
tomised strategies, up from 18% today, as brokers
look to offer customisation to a broader set of
clients. The report’s author, Tabb senior research
analyst Adam Sussman, says that for algorithmic
providers, customisation re-engages buy side
clients on a personal level and differentiates
brands in a market with much choice. “In the end,
this is a buy side issue because what traders real-
ly want is a tool that allows them to control an
order using a wide range of variables,” he explains.
Credit Suisse is alive to this buy side need, accord-
ing to Balarkas, and the bank may even be ahead
of the game. More than 60% of algorithmic usage
by Credit Suisse clients involves tactics that have
been adjusted or customised in some way to meet
an individual client’s needs, he explains.
“Customisation is sometimes regarded as a new
phenomenon but we invested in rebuilding the
whole of AES in a modular fashion about three
years back. Compound strategies are very easy to
put together. For example, we can build a complex
strategy that includes the DNA from several other
strategies, or a strategy that will flip between strate-
gies based on triggers defined by the client.”
He continues: “Markets are getting more complex.
Trading is turning into a technological arms race
and its getting hard for trading desks to simply
maintain existing products, never mind build new
functionality to exploit new opportunities. This is
why our mantra on the AES desk is innovation.”
Similarly, for Merrill’s Jackson, customisation is
key. “We’ve never marketed our algorithms as
black boxes,” he says. “The first thing that
struck us coming to the market, was the huge void
between the understanding of what is going on
inside the box and the desire of the street to
show them. Lifting the lid on the process is
important to us.”
ITG’s Boardman concurs, some hedge funds are
building algorithms in-house, he says, but most
are buying them in or working with external parties
to develop products specifically tailored for them.
“Having a bespoke or highly customised algo-
rithm is important to hedge funds as its one of the
things that sets them apart from each other and
16 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 16
also from the more traditional funds,” he explains.
Hedge funds are choosing broker provided algo-
rithms because the technology on the marketplace
is now more client specific. Two years ago there
was little choice for funds but to build their own
systems, as those provided by brokers were not
tailored to clients’ needs. Hedge funds would
rather buy in technology and leave the design
process to others, instead concentrating on what
they do best – maximising profits, and today there
is great potential to do this. The arguments do not
stand up for building algorithms in-house because
a hedge fund can be at the market with a broker
provided, custom designed algorithm within
months at a fraction of the cost and years before
an in-house design, says Boardman.
The Tabb report found two major trends within
electronic trading. The first is for greater choice
within strategies: a greater amount of market data
that drives the decision making, more choices on
how to interact with the marketplace and more
execution venues to execute with. This frustrates
the buy side in the short term, Sussman says, but
a period of rapid growth is followed by rationalisa-
tion and consolidation. The end result is not more
or less strategies but different strategies that more
accurately reflect the way the buy side trader wants
to execute, he explains.
The second trend Sussman found was that
various technology components such as ticker
plants, FIX engines, event processors, and market
simulators are available off the shelf. This means
there are enough specialist products and
choices available that the buy versus build
dichotomy has been replaced with: where is your
competitive advantage?
Algorithms are often the key differentiating factor
for hedge funds to gain that all important compet-
itive advantage. The successful hedge funds are
those that can exert significant control over the
investment process. These sophisticated funds
that can properly manage and spread risk have
done well over the turbulent summer, while those
with less sophisticated management strategies
have struggled. These strategies do not necessari-
ly require algorithms, but for a growing number of
funds, they are indispensable. Hedge funds’
spend on algorithms looks set to increase at least
into 2009, as firms struggle in what Balarkas
termed the ‘technological arms race’. ■
HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm Page 17
HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm
CELENT REPORT
Following
the flow
A major transition is
occurring in the hedge fund
administration market, says
Mayiz Habbal
Technology that serves the global hedge fund
market, which is approximately USD1.3 trillion in
assets and is expected to reach USD2.38 trillion by
2009, is moving from mere administration to full
business process outsourcing. Hedge fund
administrators (HFAs) are providing a variety of
services classified as mid to back office opera-
tions. Still, other firms offer a full front to back
operational platform that includes trade capture
and allocation. The HFA market is diverse, with
some firms exclusive to hedge funds and some
market neutral, serving hedge funds, mutual
funds, wealth managers, and institutional asset
managers.
The hedge fund administrator group consists of
long term providers, as well as relatively recent
entrants from the global custodian market. Large
global custodians and HFAs have spurred on
industry consolidation, and the acquisitions and
mergers will continue. Globally, there are about 70
hedge fund administrators, as well as a few small
firms in local markets. Among these hedge funds,
Citco, HSBC Alternative Fund Services, and Fortis
Fund Services are the top three hedge fund admin-
istrators, as measured by total assets under
administration.
Hedge fund administration used to be a lonely
business. Twenty years ago, just a handful of firms
were catering to this niche market. Large mutual
fund administrators, arguably in a parallel busi-
ness, had no interest in hedge fund administra-
tion. The booming mutual fund business did keep
administrators quite busy, but hedge funds were
not on the radar. Times have certainly changed.
The niche administrators have grown larger, and
several global custodians and administrators have
made acquisitions into the hedge fund side of the
business. A variety of other firms are also entering
the market, from startups to management con-
18 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 18
sultants with BPO units.
The hedge fund industry relies on multiple coun-
terparties and service providers. Prime brokers are
engaged for trade execution, security structuring,
financing, securities lending, and, often in the US,
custody. In Europe, regulation generally requires a
separate custodian for safekeeping of the assets.
HFAs have traditionally provided fund administra-
tion services and are now rapidly expanding BPO
for core operations.
Technology vendors are gaining traction in the
hedge fund market as well, providing point or full
front to back solutions typically supported by port-
folio management and accounting solutions to
support core operations. Technology vendors
have targeted hedge funds with application serv-
ice provider (ASP) deployments that offer lower
upfront costs and eliminate the client’s ongoing
system maintenance involvement. Building core
infrastructure internally has kept many large
hedge fund technology teams busy.
And finally, hedge funds serve both institutional
and high net worth clients, each with unique
demands. Institutions require evidence of internal
controls and typically request ad hoc reports. High
net worth individuals require client relationship
tools and benefit from web-based reporting.
Outside the US, where retail investment restric-
tions are less onerous and income restrictions do
not often exist, hedge funds are gaining (and will
continue to gain) traction with the mass affluent
investor, which will put further pressures on client
servicing tools and automation.
Business process outsourcers targeting hedge
funds are establishing or enhancing their plat-
forms to support investment operations and
multi-asset class funds. Hedge fund administra-
tors in particular are capitalising on their industry
involvement by adding offerings, primarily in mid-
dle and back office operations.
Longtime providers are finding the space a little
snug and are intent on keeping their market posi-
tion through technology and service enhance-
ments. Product positioning frequently promotes
domain knowledge and staff retention.
In addition to the expanding variety of provider
types, consolidation activity is creating a new set
of factors to consider in provider selection. The
hedge fund market is orienting itself to the caliber
of these new organisations, increasing service
quality, range of product offerings, staff expertise,
and pricing. Hedge funds have a diverse selection
of providers to choose from, and this does not
make the task any easier.
HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm
The USD1.3 trillion hedge fund industry has chal-
lenged the investment business to rethink its
strategies. Dozens of businesses have come into
existence or seen sales take off. While prime bro-
kers were long a key and often only resource for
hedge funds, they are now joined by a proliferation
of service providers.
There is no shortage of service providers offering
business process outsourcing. Some focus on the
traditional fund administration services, and oth-
ers add investment operations support to the mix.
Still others provide what one might call ‘point
BPO’, outsourcing select processes that are a pain
point in the organisation, such as reconciliation,
security master maintenance, or performance
measurement. Examples of BPO service providers
serving the hedge fund market include traditional
mutual fund administrators and custodians,
prime broker affiliated HFAs, management con-
sultants, offshore firms, and technology providers.
Traditional fund administration services include
fund accounting, general ledger, NAV, shareholder
accounting, and payments transfer. However,
these services are widely expanding.
HFAs today are a mixture of automation and
manual processes. There is definitely progress
being made toward a new vision, but HFAs are
equally encumbered by the challenges facing the
industry. Several issues are from the external envi-
ronment such as prime brokerage silos that send
separate client data files by asset class or that pro-
vide files without complete data sets that would
better facilitate HFAs’ workflow. There are also
issues from the settlement processes – the com-
plex tracking of OTC documents and novation,
where there is substitution of a new contract for an
old one; or the substitution of one party in a con-
tract with another party. The hedge fund adminis-
tration business is caught in the automation whirl-
wind occurring throughout the financial services
industry: on demand access and automation are
the key ingredients in the new environment.
The global hedge fund community is entering the
next phase. Over the past few years, discussion
has focused on the tremendous explosion of
assets, market impact, investment capacity, hedge
fund scandals, and the surge of high profile man-
ager startups opening their doors with USD2 bil-
lion to USD3 billion in assets.
The next few years will turn greater attention to
cross border distribution, finding the appropriate
balance in regulation and free markets, the middle
ground for fund disclosure that protects invest-
ment decisioning, while assuring investors can
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 19
Page 19
monitor their advisers, securities valuation, retail
investor access to hedge funds, long only manag-
er mandates with widening use of derivatives, and
the continued hedge fund firm infrastructure.
On this last point, access to technology pur-
chased or outsourced, is the key. Hedge funds
accustomed to operating in lean environments
will find the long term competitive road tough to
travel without automation. Given hedge fund
firms’ aggressive stance and openness to change,
they are likely to be at the forefront of positive
change in the financial markets.
Hedge fund administrators have an advantage in
service provider selection. These firms may
already be providing fund administration services,
and there are generally pricing benefits to working
with the same vendor. They are generally
independent providers in the hedge fund support
framework. Aggregating fund transactions and
details with an HFA is not as threatening to the
hedge fund manager as disclosure is to a prime
broker.
HFAs have significant domain knowledge in the
alternatives industry and can be an asset to the
firm, which might otherwise go it alone.
Furthermore, HFAs are investing in technology
enhancements that will offer improved platform
and servicing features.
Hedge fund firms tend to have an open mind and
are not encumbered with traditional market prac-
tices. If a business case can be made where the
service is priced appropriately and genuinely
removes pain points from operations, the pre-
ferred focus is on investments. However, as the
hedge fund business continues to ‘mainstream’,
and, in particular, very large funds diversify their
product lines, there may well be something
inevitable about running operations in-house.
Perhaps it is empire building or simply the need
for greater control.
Outsourcing is not for everyone, but the outsourc-
ing market is quite fragmented and may serve a
variety of firms. There will be small firms that ben-
efit from outsourcing, as well as mid-size and large
firms that face internal chal-
lenges in staffing or cost struc-
tures that benefit from out-
sourcing all operations or
select processes.
Mayiz Habbal is managing
director of the Securities and
Investments Group at Celent
HFSMG 2007 pp17-33 ML 26/10/07 5:05 pm Page 20

Hedge Fund Services PANEL DEBATE

THE HEDGE FUND SERVICES

PANEL DEBATE
Donard McClean is head of Fund Services Ireland at UBS Global Asset
Management, with specific responsibility for the development and
management of the business. He is a member of the Fund Services
Management Board and is responsible for hedge fund operations within Fund
Services globally. McClean has 18 years of investment industry experience.

Ras Sipko graduated from Rutgers University with a BA in Applied

Mathematics. He has been involved with Koger for the past 10 years, and is
currently working in the capacity of chief operating officer.

Dermot Butler, who is chairman of Custom House Administration and Corporate

Services Limited, the Dublin-based alternative investment and hedge fund
administrator, has over 35 experiences in the financial services industry. He is a
director of several international financial services and fund companies and is
deputy chairman of the Alternative Investment Management Association (AIMA).

Robert Chin, general manager at ATC Fund Services, started ATC Fund
Services Curaçao in March 2003. Prior to joining the ATC group, he was the
managing director of Fortis Fund Services in Curaçao. Chin’s professional
experiences include a seven year tenure as chief financial officer of Dutch
brokerage firm where he was a member of the European Option Exchange and
the Amsterdam Stock Exchange.

Chris Cattermole is the European sales manager of Advent’s Global Account

business. In this role he has responsibility for European strategy, product mar-
keting and sales of Advent’s Geneva solution to the Alternative Investment
Management market. Prior to joining Advent in 2005, Cattermole held
positions in the financial services industry at Fidelity Brokerage Services,
SS&C and Linedata Services.

James Lasry is a partner of Hassans International Law Firm in Gibraltar.

He specialises in corporate and fund work and he advised the government
of Gibraltar on the regulatory and tax treatment of investment funds. Lasry
serves on the boards of various private investment companies and funds in
Gibraltar and abroad.

20 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008

HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm
It has been a hard few months for the hedge
fund market – how will it bounce back and
tackle the issue of risk?
McClean: Although it has been a difficult time for
financial markets, many hedge funds, as one
would expect, have fared well in the volatile mar-
kets. Recent market events have caused many
institutions and hedge funds to push risk assess-
ment and its management further up the agenda.
Sipko: Hedge funds are known to do well in the
downturn of the market as well as in the upside of
the market. Therefore, since the markets are cycli-
cal, we feel that hedge funds will recover, particu-
larly with the amount of assets that they attract for
new investments and opportunities.
Butler: From what I have read in the press, pub-
lished as far afield as The Irish Times and the
Sydney Morning Herald, the hedge fund market
has already ‘bounced back’, having, apparently
recouped in September, most, if not all, of the
Hedge fund managers increasingly are tackling risk by improving their
risk management technology capabilities
losses of August.
What I suspect had happened is that tabloid and,
inevitably, some of the broadsheet press jumped
on those funds that were directly affected by the
sub-prime debacle and subsequent credit crisis
and succeeded in writing their copy in such a way
so as to persuade the world, not only that all
hedge funds had collapsed, but also were respon-
sible for the sub-prime problem and the subse-
quent credit crisis, using an unrepresentative
small sample as a basis for the allegations. Of
course, as we all know, truth and accuracy must
never stand in the way of a juicy headline.
What has been demonstrated by the whole affair
is that there were good grounds for the regulators
and the industry to be concerned some time
before this summer about pricing – but it should
also be recognised that, if liquidity dries up in any
market, pricing will become an art, rather than a
science. The only price that is valid is the price at
which a deal is struck between a willing buyer and
a willing seller.
We have also seen, in the last few days, the pub-
lication of the UK Hedge Fund Working Group’s
(HFWG) consultation paper, which makes 15 rec-
ommendations for sound or best practices that
hedge fund managers should follow and risk man-
HEDGE FUND SERVICES GUIDE 2008 INVESTOR SERVICES JOURNAL 21
Page 21
agement is one area covered in that paper.
Chin: Managing risk has always been an issue in
the industry. With new financial instruments con-
tinuing to be developed, it will take severe market
conditions to stress test new instruments. We
have seen this in 1994, when the mortgage backed
security funds collapsed, in 1998, with the global
financial crisis and, recently, with the sub-prime
mortgages. I consider these developments as part
of a maturing industry.
Cattermole: While some strategies may have been
hit in the recent market turmoil, others have prof-
ited too. Likewise, some funds that took losses in
July and August have recouped them in the subse-
quent rebound, with September proving to be a
banner month for hedge fund performance. And
that is the nature of the hedge fund industry.
Volatility creates investment opportunities. As for
those that survived the summer’s tribulations,
they will take note of what happened, learn les-
sons and move forward with new trading models
and strategies.
In addition, hedge fund managers increasingly
are tackling risk by improving their risk manage-
ment technology capabilities. For example, a new
survey of more than 100 hedge fund and fund of
hedge fund managers by Ernst & Young,
Navigating New Complexities, found that technol-
ogy will be the biggest spending area in the next
two years for three quarters of respondents, and
that for 58%, funds’ investment in risk
management systems will be the largest piece of
that technology expenditure.
Lasry: In fact, it was not so bad. September was,
according to CSFB/Tremont, a successful month
for hedge funds. This does not mean that in the
hedge fund universe, which is composed of many
different strategies, there were some that did not
perform very well.
There are now a lot of industry initiatives in place,
which deal with risk in the hedge fund world, such
as the UK Hedge Fund Working Group (HFWG)
that just sent out a consultation paper and the
Alternative Investment Management Association
(AIMA), which published several sound practice
guides. Also in the US, there is a presidential work-
ing group. All these initiatives will lead eventually
to an industry standard that will allow for better
HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm
Hedge Fund Services PANEL DEBATE
risk management and more transparency.
What impact would greater regulation on the
hedge fund market have?
McClean: Regulators ultimately decide on the level
of regulation they determine appropriate for their
jurisdiction. It is a balancing act for regulators to
be able to provide meaningful regulation at the
same time as maintaining the attractiveness of
their own domicile to asset managers and
investors alike, allowing business to flourish in a
well regulated environment.
Fair Value Measurement (FAS 157) – designed in
response to investors’ requests for more informa-
tion on how hedge fund managers are measuring
investments at fair value – will continue to be a key
regulatory issue.
Recently, it has been reported that a number of
major players in the hedge industry in London
have collaborated to propose self regulation in an
attempt to avoid unwanted over regulation. While
managers vigorously pursue investment opportu-
nities with as few barriers to investment as possi-
ble and keep their investment strategies confiden-
tial, regulators seek transparency. However, to
facilitate increased distribution through a broader
investor base, managers need regulation and the
increased oversight this can bring.
Sipko: There are two kinds of opinions on this sub-
ject, one for and one against, however we feel that
imposing greater regulations on the hedge fund
market would limit the creativity of hedge fund
managers, thus restricting the opportunities that
hedge funds take advantage of.
Butler: At the risk of sounding glib, it depends on
what form the ‘greater regulation’ takes and
where the regulation comes from. Many fear that
the SEC could impose quite draconian regula-
tions on hedge funds, if for no other reason than
to get their own back for being made to look not
a little foolish by Mr Goldstein. Of course, from a
European point of view, I think it is not the fund,
but the manager that should be better regulated
in the United States, given that, in fact, they are
not regulated at all at the moment. In Europe, we
have strong and, in my opinion, very adequate
regulations governing hedge fund managers,
both in the United Kingdom and Ireland and I do
not see the need for any more regulation. Having
said that, a tweak here and a tweak there can
always be justified.
What I think is recognised by some regulators, in
22 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 22
Europe, certainly, is that the hedge fund industry is
a responsible industry and this is largely because
of the Alternative Investment Management
Association’s (AIMA’s) prodigious efforts. This is
in the context of introducing the Sound Practices
Guidelines for Managers, Administrators and
Directors of offshore funds, their research papers
on the pricing of hard to value assets, backed up
by the six Due Diligence Questionnaires. All of
these documents have been, or are in the process
of being, updated since they were first introduced
and I think it is fair to say that they have gone a
long way to set standards in the industry.
It is to be hoped and, I think, it is not too opti-
mistic to hope, that the HFWG’s efforts will go
even further to show that in the UK and Europe, at
least, the industry is being proactive in keeping its
house in order and following practical self regula-
tion in the context of sound or best practices.
Chin: It will depend on the form of regulation to
decide what the impact would be. The recent ini-
tiative by a group of London-based hedge fund
managers appears to be a good starting point for
regulation that is acceptable to all parties involved.
Cattermole: It depends on where it is implement-
ed and what it entails. Reactionary and restrictive
measures implemented unilaterally – for example
in the US – run the risk of forcing managers to
relocate to more benign jurisdictions. That seems
unlikely to happen in any of the countries with a
meaningful industry presence though.
However, some form of voluntary code of prac-
tice aimed at raising the bar of internal risk con-
trols and providing greater transparency to
investors is looking more likely in the wake of Sir
Andrew Large’s recent report. If widely embraced
and adopted by managers, such measures could
work to their advantage, by nipping the threat of
more onerous imposed regulation in the bud, and
by sending a positive message to the more cau-
tious and risk averse institutional investors.
Lasry: It is very important to state that the hedge
fund market is not unregulated at all. All the man-
agers in the UK and account for about 20% of the
world’s hedge fund assets are regulated under the
Financial Services Authority. In the US, managers
take advantage of safe harbours in order not to be
regulated, but these safe harbours were set up in
order to protect retail investors, so the safe har-
bours themselves have a lot of restrictions.
Nevertheless, it is also true that hedge funds use
HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm Page 23

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Exchange (BSX) is today
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HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm
Hedge Fund Services PANEL DEBATE
offshore regulations, which do not prevent the
funds of investing in certain asset classes or
strategies. The industry sees its responsibility and
this why it started all the initiatives mentioned
above. I think these sound practices and industry
standards are more than sufficient and show how
mature the industry is.
In terms of technological developments – what
has had the greatest impact on the hedge fund
community?
McClean: One of the key issues for hedge funds is
the standardisation of communication and mes-
saging. A platform similar to the Swift platform for
mutual funds, available for all types of instru-
ments including OTCs and funds of funds, would
improve efficiencies and avoid bottlenecks. A stan-
dard messaging platform is the ultimate solution
to straight through processing and would allow
greater frequency of net asset value (NAV) produc-
tion, therefore greater liquidity for hedge funds
and fund of hedge funds, which in turn would lead
to greater investor participation in the industry.
Until such time as a global platform is in place,
trade and information files will continue to be
developed, enhanced, sent, received and mapped
Historically, hedge funds have had more association with and relied more
heavily on their prime brokers than on an independent administrator
between investment managers, prime brokers and
administrators.
The introduction of specialist pricing vendors
facilitates a more automated approach allowing a
manual exercise to be replaced with an automated
process. Again, a more automated approach leads
to greater frequency of NAVs and greater participa-
tion in the industry. Specialist pricing vendors also
create independence in valuation of a fund’s port-
folio, which, as we see through due diligence ques-
tionnaires, is a high priority for investors.
Sipko: As a technology firm, we feel that the great-
est impact on the hedge fund industry is yet to
come, particularly with the products that would
create information flow down to the investors.
Butler: Although this affects all ‘communities’ and
not just hedge funds, in my opinion, it must be the
amazing growth of the internet and the web and
the huge advances in communication overall,
24 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 24
which has resulted in automated STP, not only in
the context of trading, but also in administration
and reporting. And that refers to the technological
advances described at their simplest, compared to
the extraordinary developments in analytical
processes and trading algorithms that some man-
agers have introduced. This obviously explains
why economics seems to be a secondary qualifica-
tion for hedge fund managers, after PhDs in neu-
ral networking and nanoscience!
Cattermole: Electronic trading capabilities, in the
shape of black boxes and direct market access
platforms, have radically altered the trading oppor-
tunities open to hedge funds, with a growing share
of their order flow routed via no touch and low
touch channels. And going forwards, as market
globalisation and cross asset strategies prolifer-
ate, we can expect to see a growing sophistication
in multi-asset class algorithms.
Lasry: The upcoming of automatic trading, the
development of sophisticated trading algorithms
and the increased interconnectivity crystallised in
the so-called ‘quant funds’ who are machine only
funds and free of emotions. Some of the world’s
most powerful computers are owned by hedge
funds in order to trade securities within millisec-
onds. These funds are exploiting mis-pricings in
different markets or securities and are helping the
markets to become ever more efficient.
In the triangular relationship between hedge
fund managers, prime brokers and administra-
tors, where does the weakest link lie? How can
communication between these parties be
improved?
McClean: The relationship between the three par-
ties relies on the strength and effectiveness of the
communication between them, as well as the
method of communication. In the absence of an
industry-wide communication standard, particu-
larly for hedge funds trading instruments, includ-
ing OTCs such as derivatives and other illiquid
instruments, any corner of the triangle could be
the weakest link.
Establishing an industry-wide communication
standard would require collaboration of industry
HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm
participants including investment managers,
prime brokers and administrators. The degree to
which these methods can be standardised has a
direct impact on the strength of this three-way
relationship.
Sipko: We feel that communication is weak in gen-
eral, and the weakest link lies in the technology
that could be used by each of the three groups to
communicate more effectively.
Butler: It is not possible to give a standard answer
to this question. The weakest link will depend
upon the relative quality and ability of the manag-
er, the prime broker and the administrator
involved and, in particular, the relative quality of
their systems and how they communicate with
each other.
Of course there are other considerations, such as
the complexity of the investment strategy of the
fund, the volume of trading, the difficulty of valu-
ing the portfolio or certain instruments in it, and
the required liquidity (daily/weekly/monthly) of
the fund. But, all other things being equal, the
weakest link will be the party that has the most dif-
ficulty in delivering the information needed to
enable the other parties to do their job properly. It
is, of course, communication again and this
applies not only to the single strategy funds with
difficult portfolios, but also to funds of funds
where the weakest link may be the ability to obtain
prices from uncooperative administrators and/or
custodians of the underlying funds.
Many of these problems can be, at least, mitigat-
ed and, at most, eliminated, with improved auto-
mated data delivery systems. For example, with
automated communication, which avoids and
reduces the human element.
Finally, having raised the subject of the ‘human
element’, often the weakest link in a relationship
between service providers is personality clashes
between individuals in the various organisations
and it is a given that this is something that needs
to be carefully managed by each company.
Chin: There is some room for improvement in the
relationship between the prime broker and admin-
istrator. Since the administrator is not being con-
sidered a client, the prime broker is not always
interested in reconciling differences reported by
the administrator.
Cattermole: Historically, hedge funds have had
more association with and relied more heavily on
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 25
Page 25
their prime brokers than on an independent
administrator – with many domestic US funds still
handling administration in-house. However, the
perceived and potential conflict of interest
between fund managers and their primes, many of
whom run sizable prop trading desks that effec-
tively compete with hedge funds, continues to be
a source of tension and mistrust. How thin the
Chinese walls are between the banks’ prime bro-
kerage units and the rest of their organisations is
not always easy to tell. In many cases fears of
information leakage may be unfounded. But nev-
ertheless, perception is what matters. To this end,
hedge funds are embracing the independence and
anonymity that electronic trading advances are
bringing. In this environment, actions speak loud-
er than words, so it is up to the primes to prove
their impartiality.
Lasry: The communications in this ‘triangle’ are
normally very good and of mutual benefit.
Administrators are the ones that provide an inde-
pendent third party valuation for the fund’s assets,
the prime broker helps to execute the trades and
gives the fund the necessary facilities for imple-
menting the respective strategy and provides addi-
tional services.
Given the growth in the size of hedge funds, will
back office outsourcing become a thing of the
past? How will the role of prime brokers and
administrators change over time?
McClean: In the mutual funds world, it is widely
accepted that the investment management, mid-
dle office functions and administration can all
take place in-house. This is also largely the case
for US-based hedge funds. In Europe, back office
outsourcing for hedge funds is a more common
practice.
As the alternative funds industry grows ever
larger, this could develop two ways. It could follow
the pattern set by the mutual fund world by per-
forming the administration in-house. Alternatively,
the benefits of employing the services of an inde-
pendent administrator could be further recog-
nised, thus further allowing managers to focus on
investment and adding value to the fund. If inde-
pendence is deemed the priority, the latter will pre-
vail with independent service providers, prime
brokers and administrators, allowing an open
architecture arrangement.
Sipko: It is very likely that with the improvements
HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm
Hedge Fund Services PANEL DEBATE
in technology and with automation it will take
fewer resources to perform tasks of the brokers
and administrators.
Butler: I believe that the larger hedge funds will get
larger and this will be because of the growth in
direct institutional investment and, indeed, indi-
rect institutional investment, via increasingly large
funds of hedge funds. The question is whether
these large hedge funds will be administered by
third party administrators or whether the man-
agers will keep the administration in-house. We
know that several of the larger US managers do
their own administration and, presumably, this is
acceptable to their investors. This is because the
vast majority of US hedge funds are self-adminis-
tered, which is a legacy matter from the way in
which the US hedge fund industry has grown over
the years.
I think it is also true that, with the exception of the
very large players I have just described, most pro-
fessional and institutional investors prefer to invest
in funds that have independent administrators.
As the industry grows, so will the requirements for new funds,
notwithstanding the media concentration on the huge funds
It should also be remembered that between 60%
and 70% of all the hedge funds have less than
USD100 million or, perhaps USD200 million and
many of these, including most, if not, all offshore
funds, will be administered by independent
administrators. So, for the vast majority of hedge
funds and their prime brokers and administrators,
business will continue as usual. For the larger
hedge funds, the prime brokers and/or the admin-
istrators will have to continually upgrade their
service and technology, as new complex deriva-
tives and pricing problems are introduced. It is
worth remembering that in AIMA’s first pricing
research paper, it was noted that what was hard to
value two or three years prior to the paper being
produced, had become a commonplace and
straightforward pricing procedure by the time the
paper was published. So the whole area is one of
continual evolution and development.
Also, it is possible and perhaps probable that
when we know what the HFWG and the
PWG finally decide in terms of the best or sound
practices, it will be the administrators who will
have to confirm that the funds comply with
those practices. This will, no doubt, require
revised and upgraded systems and more
detailed reports from the administrators.
26 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 26
Chin: To the contrary, back office outsourcing will
become more important. As most of the new
assets invested in hedge funds are from institu-
tional investors, the need for greater transparency
and independent pricing will grow. The large funds
are likely to appoint global service providers
(administrators and prime brokers), however, the
vast majority of the funds have assets less than
USD1 billion and these funds will probably appoint
smaller administrators who are typically more cost
effective.
Cattermole: No. Hedge funds will, for the most
part, continue to outsource to specialist servicing
providers, particularly given that between 60%
and 70% of all hedge funds have less than
USD100 million in assets under management and
are keen to focus on their core competencies.
Meanwhile, those that do take on the back office
function internally will be lumbered with a hefty
cost base that is only likely to become greater as
instruments and trading strategies become ever
more complex. One way to offset that is to hive off
the functionality and sell it as a service to third par-
ties, à la correspondent clearing. Convincing the
notoriously suspicious hedge fund community
that the Chinese walls at these firms are sufficient-
ly robust to avert any information leakage would
be no easy sell though.
As for the roles of prime brokers and administra-
tors, we are seeing a blurring of the lines. Some
primes, such as Morgan Stanley and Goldman
Sachs, have already set up administration units,
while the administrators are always looking at
ways to move up the value chain with their suite of
services, potentially into areas traditionally
occupied by the prime brokers.
Nevertheless, the growing demand for
independent instrument pricing and fund
valuations means administrators continue to
have a central role, while prime brokers remain
unchallenged (for the moment) in their core offer-
ings, for example for financing and start up assis-
tance. Whether the big custodian banks, such as
State Street and the Bank of New York Mellon,
which have piled into the administration space in
recent years, will ultimately use their banking
muscle to challenge that role remains to be seen.
Lasry: Outsourcing will be ever increasing, since
HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm
the growth of the industry is exponential and man-
agers should concentrate on their strategies.
Prime brokers eventually will, as regulated entities,
assume more responsibility for risk controlling in
the funds and administrators will be strengthened
in their role as an independent valuation party.
How are the new entrants into the hedge fund
domicile race standing up to the traditional
jurisdictions?
McClean: New centres such as Singapore, Malta
and Dubai all have their role to play and will find
their niche in an expanding global alternative
investment industry. The more traditional jurisdic-
tions of the Cayman Islands, Luxembourg and
Ireland continue to grow and develop and are like-
ly to do so in the future. Asia and Europe will con-
tinue to be growth opportunities for hedge fund
managers. Many large fund of hedge fund and sin-
gle managers opening local offices, especially in
Asia, illustrate this. In addition, domiciles such as
Luxembourg and Ireland are approving new and
improving existing fund structures, in order to
allow more alternative products to be distributed
across Europe and Asia.
Sipko: We believe that most new entrants are very
well positioned to compete with traditional juris-
dictions, since in order to attract hedge funds they
will have to provide an environment that the tradi-
tional jurisdictions may not at the moment.
Butler: I think that Luxembourg, the Channel
Islands and Malta are doing well and I would sus-
pect that, over time, they will become well estab-
lished hedge fund domiciles. On the other hand, I
do not think that, at this time, the Cayman Islands
or Dublin should worry, but nor should they
become complacent. The Bahamas, the BVI and
Bermuda will retain their ‘faithful’ supporters for
some years to come, but I fear that, certainly in the
case of the BVI and the Bahamas, their market
may fade away. While Bermuda may maintain its
respectable and respected status, it is unlikely to
pose a huge threat to the European centres.
The point is that, as the industry grows, so will
the requirements for new funds, notwithstanding
the media concentration on the huge funds. As I
have said, the majority of funds still are relatively
small and there will always be such ‘smaller
funds’. The one point that could change the
‘weighting’ of the relative importance of domiciles
could be any legislation that the EU may bring in
that requires funds sold in the EU to be domiciled
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 27
Page 27
in the EU, or affiliated domiciles such as the
Channel Islands. Watch this space.
Chin: If one takes a look at the most recent data
published by jurisdictions such as Jersey and
Guernsey it appears that they are gaining
market share. These jurisdictions seem to be
especially of interest to European based
managers. In addition, these jurisdictions are
planning to launch products (lightly regulated
structures) to compete with the traditional
Caribbean based domiciles. In the Asia time zone,
Hong Kong and Singapore are also reporting
growth in locally domiciled funds. It is obvious
that this is happening at the expense of the
traditional jurisdictions, although these domiciles
will continue to incorporate new funds due to the
growth of the industry as a whole.
Cattermole: While European nations such as
Spain, Italy and Germany have all introduced
legislation in recent years aimed at fostering their
hedge fund industries, the effect to date has been
muted. Rather, the traditional jurisdictions
continue to hold sway. For the management
companies, New York City and its environs and
London remain the locations of choice.
Meanwhile, the Cayman Islands followed by the
British Virgin Islands dominate as offshore funds
jurisdictions, with Bermuda and the
Channel Islands well behind. And while Malta, for
example, has experienced some success as an
onshore EU jurisdiction, such territories remain
niche players.
Other offshore domiciles, particularly Channel
Islands and the Isle of Man, also offer consider-
able taxation advantages and assistance with start
up infrastructure that could be an interesting
option for some funds.
Lasry: I think that the distinction between
traditional hedge fund domiciles and ‘new’ domi-
ciles is vanishing. Hedge funds look for a conven-
ient jurisdiction, which allows them for flexibility, a
good legal infrastructure, other benefits such as
same time zone and the necessary service
providers. One key point is, in my opinion, to
avoid any reputational risks, which only can be
guaranteed by a well regulated jurisdiction,
though not sacrificing a hands on approach by a
regulator. Gibraltar is a very good example for
such a high standard, but it is a flexible
jurisdiction, as the latest report by the
International Monetary Fund shows. ■
HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm
Statistics
Statistically
savvy
Hedge Fund Research provides a perfomance data download
According to Chicago-based hedge fund tracker
service Hedge Fund Research, its index of
1,600 funds gained 5.6% in the third quarter,
most of the 7.3% it estimates hedge funds
have returned this year through September.
The average fund only lost 1.31% as a result
of the sub-prime crisis. Moreover, figures for
September indicate that the market has rallied
yet further still. The industry generated a posi-
tive return for investors of 0.85% net of fees
for the month to 26 September, according to
the firm’s investable hedge fund index. The
index indicates that, of the eight hedge fund
strategies it details, six made a profit in
September.
Pension funds, endowments and wealthy pri-
vate investors added a net USD45.2 billion to
hedge funds in July, August and September,
bringing the total assets under management in
28 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 28
the loosely regulated
industry to USD1.8 trillion.
The net inflow was down from USD58.6 bil-
lion in the second quarter and USD60.2 billion
in the first quarter. But analysts said the inflow
was still sizable, suggesting the hedge fund
industry remains popular with many investors.
During the third quarter, the average hedge
fund posted a return of only 1.36%, down from
5.04% in the second quarter.
Funds that rely on computer models to make
trading decisions suffered heavy losses in July
and August and saw net outflows of USD278
million. Short seller funds, which profit when
stocks fall and are considered very volatile,
delivered the best returns in the quarter but
attracted only USD1 million.
Funds that invest in other hedge funds attract-
ed the most assets during the quarter, pulling
HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm Page 29

in USD22.5 billion. Fig 1: Comparison of September’s rally against

Hedge Fund Research, which has been the year to date (incl Sept) benchmarks.
tracking hedge funds for 14 years, said Fig 2: Fund of fund indices underline the rally.
more than 7,000 funds report results to Fig 3: Emerging markets index performs best.
its database. ■

HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 29

HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm
Ask the EXPERTS
Lipper
How has the sub-prime syndrome impacted hedge funds?
In a two week period starting mid-July, the S&P
500 Index fell initially 6.4% and the MSCI World
Index lost just over 7%. The speed and manner in
which this happened sent shockwaves throughout
the investment community. Correlations across dif-
ferent asset classes, liquidity constraints and a
rush to de-lever, plus risk aversion by lenders,
became the order of the day. In some cases, even
the accessibility of overnight funding in the com-
mercial paper market became dysfunctional, hin-
dering some quality corporates from accessing
normal avenues of financing. This is when the cen-
tral banks intervened.
When credit agencies started to downgrade a
number of complex structures that had sub-prime
assets as a component of their underlying, it set
off a chain of events. As prices fell, those investors
using leverage saw losses amplified. This triggered
margin calls and redemptions. With many
ABS/CDO tranches illiquid, it forced the selling of
unrelated liquid holdings like stocks. Bonds and
currency position selling was set in motion too.
The market turmoil has produced a higher degree
of volatility and performance dispersion across var-
ious asset classes and among hedge funds too.
And while there may be short term negative effects
on consumer sentiment, economic growth led by
buoyant exports and business spending and corpo-
rate profitability still remain firmly intact.
A record USD41.1 billion funds flowed into the
USD1.67 trillion hedge fund industry in the second
quarter of 2007. This was the second highest level
of inflows since data was recorded back in 1994.
While one might logically expect a slower rate in
the third and fourth quarter of 2007, talk of mas-
sive redemptions simply does not make sense.
In fact, out of approximately 100 of the largest
hedge funds with an average of USD2.75 billion in
assets, only 27% have notice dates of 45 days that
would in theory be an initial indicator of institu-
tional investor redemptions by the end of
September 2007. And certainly not all of those
managers suffered losses in the recent period. In
terms of actual dollar outflows, this might only
amount to USD3-4 billion from hedge funds –
hardly the tsunami that the popular media would
have us all believe.
30 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 30
This should be a good time for long/short equity
managers that have demonstrated the ability to
hedge or pick short candidates, as well as long
stock candidates. This is particularly the case, as
the global consumer theme remains intact. This
latter builds upon a popular investment story: we
are in the midst of this phenomenal wave of con-
sumerism with burgeoning middle classes in
China, Hungary, Argentina, Nigeria, Ghana, India,
Egypt, Russia and Brazil.
Distressed security investing may also benefit
some hedge funds, as the roster of corporate win-
ners and losers thins out not only in the US, but in
Europe and Asia as well. Believe it or not, man-
agers that have deep experience in credit will also
come out of the current turmoil with decent
returns too.
Moreover, as currencies, energy, equities and
interest rates undergo potentially significant
change, global macro and managed futures man-
agers focusing on short term quantitative models
are likely to do well. Indeed, since the dislocations
of July, many quant-based models have bounced
back somewhat in early August.
The discerning investor will realise that the
hedge fund sky is not falling. Indeed, there may be
more opportunities now that ever before, which is
why one might expect institutional investors to
step up allocations to hedge fund strategies,
including fund of hedge funds over the longer
term. Hedge funds will survive the sub-prime syn-
drome and grow.
Ferenc Sanderson is a senior
research analyst with Lipper
in New York.
Lipper supplies mutual fund
information, analytical tools,
and commentary to asset
managers, fund companies
and financial intermediaries.
Owned by Reuters
HFSMG 2007 pp17-33 ML 26/10/07 4:09 pm
Hedge Fund Association
What are the key issues surrounding sound valuation?
As trading positions must be frequently and accu-
rately valued, the first step is to consider which
exposures can be marked to market (MTM) daily by
accessing a liquid two way market. Trading firms
and funds should establish and maintain adequate
systems and controls to ensure that valuation esti-
mates are prudent and reliable. Where possible, val-
uations should be MTM daily at conservative close
out prices and market bids should be verified
through several reputable brokers; screen or
exchange prices should also be used as an addition-
al cross reference. For this to be meaningful, an
independent person working outside the front office
must make this assessment. These valuation esti-
mates must be integrated with other risk manage-
ment systems.
In addition, there should be documented policies
and procedures concerning the valuation process,
for example sources of market information, the fre-
quency of independent valuation, the timing of clos-
ing prices, procedures for adjusting valuations and
so forth. Documentation must also clarify where
responsibilities lie for gathering and analysing infor-
mation related to such valuations.
Valuations should also take into account: costs
associated with close out prices for concentrated or
stale positions; the amount of time required to
hedge a position and risks associated with a posi-
tion; the average volatility of bid/offer spreads; the
number and availability of independent market
quotes and average trading volumes, as well as
associated volatility.
Marking to model is defined as any valuation that
has to be benchmarked, extrapolated or otherwise
calculated from a market input. When marking to
model, more caution is required. For illiquid assets
that are marked to model, one must identify and
hedge material risks using hedging instruments
with an active two way market.
Model inputs should be sourced for independence
and accuracy and, where possible, several pricing
sources should be taken. Pricing sources should be
reviewed regularly to ensure these sources remain
appropriate. In addition, any valuations based on
mark to model should use generally accepted valua-
tion methodologies and if the model was developed
in-house, it should have been developed, tested and
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 31
Page 31
approved, independently of front office.
Positions must be actively monitored for any
adverse changes in market conditions. Other factors
to consider during these assessments would be: the
quality and availability of market inputs, required for
the valuation process; the level of market turnover;
and position sizes.
There should be documentation covering pricing
sources, the model’s key assumptions and how it
derives key model parameters. Documentation
should also cover trading strategies at the instru-
ment, position and portfolio level, as well as expect-
ed holding periods and this should be approved by
senior management. Firms should also implement
clearly defined policies and procedures with respect
to: which dealers have the right to enter into and
manage positions and limits per strategy; how posi-
tions are actively managed; how position limits are
set; whether these limits are appropriate for the risk
undertaken; and they should monitor any diver-
gence of positions from stated trading strategies,
turnover, as well as stale positions.
Reports sent to senior management should explain
that valuations have been marked to model. The
reports should detail the methodology, pricing
sources, assumptions on which the model is based,
as well as flaws in the model, to help senior man-
agement deal with model risk and determine the
materiality of any risks, as well as adjustments
required. Formal change control procedures are
required to ensure any changes to the model are
carefully implemented and the change control
process should be reviewed regularly. The model
should also be reviewed frequently to determine the
accuracy of its assumptions and close out prices
versus model prices.
Sara Statman is founder and
CEO of Statman Consulting, a
financial training and risk
management consultancy. She
is also vice president of the
Hedge Fund Association
HFSMG 2007 pp17-33 ML 26/10/07 5:00 pm
Ask the EXPERTS
KPMG
There has been significant M&A activity in the hedge fund administra-
tion sector. What is the structure of the market likely to be in the future?
There has been a considerable amount of transac-
tion activity over the last couple of years and the
sector will continue to consolidate and reshape.
The deals have included JPMorgan’s lift out of
Paloma Partners, BNY’s merger with Mellon, State
Street’s acquisition of IFS, Citigroup’s purchase of
Bisys and Caceis’s acquisition of Olympia Capital.
Other investments have included 3i’s stake in
Fulcrum and Credit Suisse’s in Viteos.
Working on transactions, I am privileged to see
patterns among those buying, selling or develop-
ing their business models. There are currently
more than 60 hedge fund administrators with
USD1 billion or more of assets under administra-
tion. The largest players, however, are set to take
an even greater share of the market as institutional
money goes to the largest funds, which tend to be
clients of the largest administrators.
As a result, a ‘barbell’ structure is emerging. There
will be a small handful of major players, perhaps
between five and seven, which will enjoy an
increase in combined market share from the cur-
rent level of approximately 50% to potentially 65-
70%. The largest providers, with one or two excep-
tions, will be administrators within financial
groups that also offer prime brokerage or custody,
or both. These organisations have four compelling
reasons to win market share: revenue maximisa-
tion, relationship development, convergence and
control.
The first reason, revenue maximisation, rests on
the fact that as assets under management contin-
ue to burgeon, administration revenues are
increasing too. The revenues that can be earned
from the provision of core and value added servic-
es become even more attractive once the hedge
fund market growth projections are layered into
the forecasts.
The second reason, stronger relationships, is the
recognition by the financial groups that alongside
prime brokerage and custody, administration is a
‘sticky’ service that enables them to build deeper
and broader relationships with major fee paying
clients.
The third reason, convergence, refers to the trend
that is occurring on three separate fronts. First,
32 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 32
hedge funds, private equity, real estate and
infrastructure fund managers are becoming
broader alternative investment (AI) providers.
These larger AI managers are lucrative clients.
Second, long only clients and alternative
investment managers are moving into each other’s
spaces and both are turning to the banks for
administration. Third, the banks, in particular, are
bringing their administration, prime brokerage and
custody servicing businesses closer together in an
attempt to move from a product push business
model to an increasingly client centric alternative.
The fourth and final reason is the desire to exert
greater control over operational performance and
client service. The majority of administrators are
struggling to deliver high quality service under the
dual pressures of product complexity and the rapid
pace of growth. Although we are yet to see this
emerge, I believe we will witness several of the
administrators within banking groups start to
mirror the strategic footprint of the in-house prime
brokers. They will build a business that specialises
in the same clients, strategies and markets.
At the other end of the ‘barbell’, the choice is a
relatively stark one: specialise or exit. The number
one key purchase criteria among clients remains
service quality, but with much of the industry
struggling to be profitable, smaller players will
need to focus on servicing specific fund strategies
and achieving economies of scale through
customised IT led solutions.
Nicholas Griffin is a partner
and the head of KPMG
Europe’s Transaction Services
strategy practice. He specialis-
es in the asset servicing sector,
working with investors and top
management teams before,
during and after transactions
on strategy, due diligence and
integration
HFSMG 2007 pp17-33 ML 26/10/07 4:41 pm Page 33
HFSMG 2007 pp34-49 ML 26/10/07 6:33 pm
Ask the EXPERTS
Lionhart
Mass panic followed the Northern Rock affair, raising the question:
how would retail investors react to a negative hedge fund event?
Northern Rock has not had the best of times of
late. The crisis sparked by its loan from The Bank
of England has transformed it from a solid,
dependable institution into a company on the
brink. Since 13 September, GBP11 billion has
been pumped into the lender and this precipitat-
ed a run on the bank. Pictures of people queuing
to withdraw their savings led to mass panic, as
both the Bank of England and Northern Rock
sought to assure customers that all was well.
Eventually, the Bank of England guaranteed any
savings held with Northern Rock and this seems
to have halted the run. Northern Rock has been
left battered and bruised and speculation is rife
surrounding its future.
It could be argued that Northern Rock may well
have weathered the storm better had its cus-
tomers not withdrawn their savings. Their under-
standable concerns certainly intensified the pres-
sure the lender was under. The pictures of round
the block queues, reminiscent to most of us from
our history books of the period of the Great
Depression, portrayed the image of a company
trying to keep the wolves from the door. Had
their customers had faith and left their money in,
Northern Rock would probably have weathered
the storm more effectively than it transpired.
In recent months, there has been increased
interest in opening up hedge funds to retail
investors. It seems that not a week goes by with-
out an announcement of a new ‘absolute return’
product being marketed to retail investors in the
Far East – HSBC most recently – and with the
roll out of UCITS III earlier this year, it is only a
matter of time before we see retail investors in
this country.
Hedge funds, as any investment might, can
have months with negative returns. They are
structured with terms for investment, including
redemption notice periods and lock ups, that
investors are required to understand, sign and
agree to in advance. Would retail investors be
comfortable with this when their investments are
‘in trouble’? Would hedge funds be allowed to
stick with the same standard lock up conditions
that institutional investors are used to?
34 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 34
Hedge funds need to approach the market for
retail investors with caution, foresight and
understanding. Terms must be clear and even
longer lock ups may be necessary to ensure only
‘serious’, true investors are likely to sign up. The
introduction of retail investors could, if terms are
not well thought out, ultimately compromise the
stability of a hedge fund. If hedge funds move to
adopt strategies to attract less sophisticated
retail investors, they should do so responsibly for
the current and future investors. The investor’s
interest and capacity for risk needs to be at the
forefront of thinking in this area. Hedge funds
might end up setting up structures for certain
clients that move toward the institutional
investor model if they want to tap into the retail
market.
Retail investors do represent a new market, and
one that is, relatively speaking, of a considerable
size. The compromises that funds might make to
engage this market should be taken seriously
and carefully scrutinised. Compromises general-
ly are not a good approach and could lead to
uncomfortable outcomes for funds and
investors. A positivist approach that takes into
consideration the investor needs first and allows
for hedge funds to do what they do best will be a
winning combination.
Many managers have listed a part of their fund,
allowing access to retail investors without being
beholden to them. This approach is understand-
able to the market, encourages transparency and
affords increased liquidity. Others have launched
segregated, retail specific funds. It will be an
interesting space to watch. The funds with the
most creative approach, providing safeguards,
ease of use, quality informa-
tion, in addition to a solid
investment vehicle, will be
the funds that succeed.
Greg Froese, head of Investor
Relations, Lionhart
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm
Eversheds
What next for the UK hedge fund market?
The UK hedge fund market falls into three sub-
categories: traditional houses that have moved
into hedge funds; the established start-ups that
have maintained their independence and built
the necessary infrastructure; and the less estab-
lished start-ups that are still concerned with
gathering sufficient assets to make a viable busi-
ness. It has rarely been easy for this latter group,
but it is getting harder and some of them are
struggling.
One consequence is likely to be a growth in
M&A activity in the hedge funds space. This in
turn will increase scrutiny on hedge funds and, in
particular, on some of the idiosyncrasies that
characterise hedge funds – the stickiness or oth-
The well established hedge fund houses will grow by acquisition
and by widening their product ranges and, no doubt, some will
move towards managing more traditional assets too
erwise of money, the degree of board oversight,
the tax affairs of hedge funds, the relationships
between hedge fund managers and brokers, side
by side management issues – and that will
encourage greater corporate governance all
round.
The well established hedge fund houses will
grow by acquisition and by widening their prod-
uct ranges and, no doubt, some will move
towards managing more traditional assets too.
They and the traditional houses that have moved
into hedge funds have every reason to feel opti-
mistic and will dominate the hedge fund market,
with the very occasional and exceptional start-up
breaking into their ranks.
The level of assets going into hedge funds is
continuing to grow, but is now likely to be direct-
ed towards those with at least USD1 billion under
management, for whom gathering assets may
well prove no more difficult than before. In doing
so, though, they are likely to find that investors
have tightened their due diligence processes and
so asset gathering might mean more effort than
pre-credit crunch.
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 35
Page 35
Regulators will continue to look for a way of
bringing hedge funds onshore into a regulated
environment and will need to find a solution to
the question of how such funds would be taxed
onshore. In the UK, there are signs that the
Financial Services Authority (FSA) and the Inland
Revenue are inching towards a plan with the
Funds of Alternative Investment Funds (FAIFs)
product, but it is looking like the product that is
most likely to encourage a wider participation in
hedge funds long term is the 130/30 fund. A lot
of people are putting a lot of effort into making
those work. I would expect to see some hedge
fund managers launching 130/30 products,
although they seem ideally suited to the more
traditional institutions looking to gain some
exposure to alternative strategies.
In the US, the SEC seems to have gone quiet on
its attempts to force hedge fund managers to
register, but the political will to force this through
seems to still be there, so we’ll need to watch
that closely. European politicians meanwhile,
continue to berate hedge funds and to press for
direct regulation. As long as it proves so difficult
for individuals or smaller investors to invest in
hedge funds, thereby forcing hedge funds to deal
with only sophisticated or larger investors, they
are unlikely to succeed.
Mark Brady,
partner at Eversheds
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm
UBS PAST AND PRESENT
Back to
the future
Guy Martell talks about
the hedge fund administration
business past, present
and future
Established for more than 50 years, UBS Global
Asset Management’s Fund Services business
has evolved in step with the evolution of the
alternative and mutual fund business and today
services offshore and onshore funds, single
manager hedge funds and funds of hedge funds.
Operating out of the Cayman Islands, Ireland,
Canada, Luxembourg, Switzerland and the UK,
A fund administration business’s ability to recruit and retain
adequately qualified and professional staff is inextricably linked
with the service model operated in terms of the job satisfaction
afforded by staff
its specialist hedge fund team draws on the
expertise and resources of all UBS businesses.
With its fast paced rate of evolution, the hedge
fund industry demands the speed of response
and type of service from administrators that
can only be achieved by those with a technolog-
ically advanced global platform and the know
how that comes with first hand experience of
the financial instruments that are critical to suc-
cess. These capabilities, combined with a client
centric business model, are the characteristics
that distinguish Fund Services and make it the
successful business it is today.
UBS started servicing hedge funds from the
Cayman Islands during the early 1990s, adopt-
ing the private banking client focused model
that remains today. The last five years in partic-
ular have seen substantial growth in the busi-
ness, in line with the hedge fund industry glob-
ally. Through purely organic growth, Fund
Services is the largest hedge fund administrator
in the Cayman Islands, ranks as one of the
36 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 36
world’s largest and has close to USD200 billion
of hedge fund assets under administration
globally.
As hedge funds have become an accepted
asset class, this has resulted in a number of tan-
gible changes to both the profile of funds and
the ways in which they are serviced. One of the
biggest changes has been the shifting demand
from private to institutional investors, which
requires a highly sophisticated administration
infrastructure and is one reason why global tech-
nological capabilities are so important.
Another key challenge for administrators is
keeping pace with the use of complex instru-
ments in hedge funds. In their efforts to gener-
ate higher rates of return in an increasingly
competitive marketplace, fund managers are
using a number of strategies and techniques.
Valuation and product structuring issues lie at
the centre of the hedge fund administration
business. There are two factors to consider: val-
uation, and how to structure the vehicle so val-
uation issues can be minimised.
We are seeing more hybrid structures holding
both liquid and illiquid instruments, which
would be valued by experts in their respective
areas on a periodic basis, be it biochemical or
real estate, or esoteric derivative instruments
that may require a complex model to support
the valuation. Finding a structure that works
efficiently and where the valuation issues can
be dealt with in a hybrid product is a key chal-
lenge the industry is working with right now.
Being part of a large global financial institu-
tion clearly supports the activity of the fund
services business, where foreign exchange
hedging, distribution capabilities and prime
brokerage services are well established and
made available as required. Being able to bring
more to clients has been a core differentiating
factor in the development and growth of Fund
Services.
What differentiates UBS is our ability to offer
an integrated, comprehensive service that
extends beyond fund administration – seam-
lessly – with fund administration just one
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm Page 37

aspect of the value chain of services. Some
clients want different counterparties for every
service contracted by their fund. Others are con-
fident that global financial institutions have in
place the necessary Chinese walls and inde-
pendent checks, and want to engage the full
suite of services. In addition to our global plat-
these types of organisations perform due dili-
gence on all counterparties in the business
model of the hedge fund, including administra-
tors, as well as there being a move towards
increased independence.
We are seeing a push for the administrator to
be a value added counterparty in the hedge

We are seeing more hybrid structures holding both liquid and illiq-
uid instruments, which would be valued by experts in their respec-
tive areas on a periodic basis, be it biochemical or real estate, or
esoteric derivative instruments that may require a complex model
to support the valuation
form, advanced infrastructure and ability to pro- fund equation. Managers are starting to look for
vide additional, complementary services, having more from their administrator than they may
a client centric business model is fundamental previously have requested. The technology has
– a key driver behind the success of the busi- to be there to support this and needs to be con-
ness to date. sistent across all service centres. There is defi-
A particular service model exists within UBS. nitely a move for more timely and meaningful
We have professionals who oversee the entire information as the administrator is increasingly
NAV computation process and retain a big pic- seen as a hedge fund partner. As a global insti-
ture overview of our clients’ operations. In addi- tution, we are able to offer all elements of this
tion, we have been able to retain highly qualified service to a client.
and experienced staff to perform our fund
administration services. Seeing the whole fund Fund Services
administration ‘picture’ makes it a challenging Fund Services is a dedicated fund administrator
job, offers plenty of job satisfaction and pro- providing services for hedge funds as well as for
vides an environment in which our people want traditional investment funds. Capabilities
to stay for many years. This approach also rep- include accounting, NAV computation, share-
resents a value added proposition to our clients holder services, banking and credit facilities,
– they benefit from top quality administration with services for investment funds including
services and a consistent relationship with the fund design, set up, international distribution
same account officer. The account officer can support, reporting and private labelling.
develop a body of knowledge about the client’s Administration centres are located in Cayman,
fund, and the client has that one point of con- Ireland, Canada, Luxembourg, Switzerland and
tact that can bring together all the elements of the UK. At 30 September 2007, the business
Fund Services and provide access to the full administered fund assets of over USD560 bil-
range of services offered through UBS. lion in more than 1,825 funds. Specialist hedge
A fund administration business’s ability to fund administration service centres adminis-
recruit and retain adequately qualified and pro- tered more than 1,000 funds with assets of
fessional staff is inextricably linked with the close to USD200 billion.
service model operated in terms of the job sat-
isfaction afforded by staff. Nonetheless, the dif- Guy Martell, head of
ficulty in recruiting good quality people has Business Development &
increased in recent years and there is an Client Relationships, Fund
acknowledged global shortage of accountants. Services UK and Ireland,
The increase in the number of institutional UBS Global Asset
investors – pension plans, endowments, foun- Management
dations – has caused a shift in how administra-
tors operate. Teams of experts working within
HEDGE FUND SERVICES GUIDE 2008 INVESTOR SERVICES JOURNAL 37
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm
ATC Fund Services NATURE OF HEDGE FUNDS
Are they still
alternative?
Have hedge funds become
mainstream? asks Robert Chin
There is no clear definition of an ‘alternative
investment fund’, but hedge funds are
commonly considered to be part of this asset
class. Due to the significant inflow of capital
over the past five years and the publicity that
came along with it, hedge funds seem to have
become as common as (regulated) mutual
funds. Does this mean that hedge funds are
now no longer alternative and should be con-
sidered mainstream?
Let us take a look at various operational aspects
unique to hedge funds.
Some mutual fund managers are considering charging an
incentive fee, while some hedge fund managers have significantly
reduced or even waived the incentive fee
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
register with the SEC by 1 February 2006 was
recently overruled by a court in the US).
Although the European community has imple-
mented UCITS III, individual member states are
still debating if and how to regulate the hedge
fund managers. The most popular jurisdictions
for hedge funds (Cayman Islands, British Virgin
Islands) have rules in place for investment
funds, but exemptions are easily granted if the
fund meets certain requirements. Most, if not
all hedge funds will meet these requirements
and therefore are not subject to supervision.
38 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 38
Investment strategy
In general, investment strategies used by hedge
funds differ significantly from those used by
mutual funds. Hedge funds typically have no
investment restrictions, can maintain short
positions, make use of derivatives and most will
use a certain degree of leverage. Recently, some
mutual funds managers started to use strate-
gies used by hedge fund managers such as
short positions. Similarly, hedge fund managers
are branching out and investing in other
instruments such as private equity, insurance
policies and art.
Compensation
The traditional compensation for a hedge fund
manager consists of management fees and
incentive or performance fees, while a manager
of a mutual fund only charges a management
fee. However, some mutual fund managers are
considering charging an incentive fee, while
some hedge fund managers have significantly
reduced or even waived the incentive fee.
In order to charge incentive or performance
fees in an appropriate manner to the investors,
hedge funds use one of two methods to
account for this: series of shares or equalisation
of shares. Both methods often cause confusion
to those not familiar with the concept.
Offering
Most hedge funds are still being launched as
private placements and hence are not available
to the general public. Investors in hedge funds
must meet a list of qualifications (eligible
investor) and submit various documents (sub-
scription agreement, certified copy of legal doc-
uments and bank reference).
Settlement of subscriptions or redemptions
Settlements of subscriptions or redemptions
are not done through the traditional clearing
systems. These transactions are confirmed by
the administrator of a hedge fund by means of
a letter. This often causes problems for
custodians, as their systems cannot handle
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm
these investments due to the fact that most
hedge funds do not have international security
identification numbers.
Liquidity
This is an area where significant differences
between hedge funds and regular funds exist.
Hedge funds typically offer monthly liquidity
(some even quarterly), have a lock up period
(one to two years), can have redemption gates
(for example, only 20% of the fund’s net assets
can be redeemed at any redemption date) and
require advance written notice for redemption
(30 to 90 days). Mutual funds typically offer
greater liquidity, have no lock up period and do
not use redemption gates.
Performance
This is probably one of the few areas where
there are hardly any differences left between
mutual funds and hedge funds. The days when
hedge funds posted double digit returns seem
long gone and performance is now much more
in line with those posted by mutual funds.
In many areas the differences between hedge
funds and mutual funds are less than they once
were. However, from an operational or adminis-
trative perspective, there are still significant dif-
ferences. This is evidenced by the fact that these
funds are each administered by specialised
administrators. It is fair to say that a traditional
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 39
Page 39
mutual fund administrator does not have the
expertise to administer a hedge fund, while a
specialised hedge fund administrator is not
equipped to deal with the large number of
investors and often huge trading volumes typi-
cal to mutual funds.
In conclusion, I believe that hedge funds should
not be considered mainstream. It is more likely
that there will be two types of hedges funds:
hedge funds allowing for retail investors and
subject to increased regulatory oversight and
therefore more likely to become mainstream;
and the more traditional hedge funds catering
toward high net worth individuals and institu-
tional investors.
Robert Chin, general manager at ATC Fund Services,
started ATC Fund Services Curaçao in March 2003.
Prior to joining the ATC group, he was the managing
director of Fortis Fund Services in Curaçao. Chin’s
professional experiences
include a seven year tenure as
chief financial officer of Dutch
brokerage firm where he was
a member of the European
Option Exchange and the
Amsterdam Stock Exchange.
He spent the first eight years
of his career with Ernst &
Young in Amsterdam
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm
Custom House CURRENT MARKET
Resilient
returns
Hedge funds will thrive despite
the sub-prime debacle, says
Dermot Butler
I suppose it was inevitable that the predictable
representatives of the fourth estate (the press)
would somehow manage to imply that the whole
sub-prime debacle and the ensuing credit
crunch was the fault of the evil ‘hedge fund’.
And the public lapped it up.
I am no economist or econometricist, but I
smugly believe I can claim a reasonable allocation
of common sense and, as an administrator of
hedge funds, I have yet to meet a hedge fund
manager that had made a dollar or euro, or any-
thing else for that matter, by miss-selling mort-
gages to unwary immigrants in the United States.
I am told – and before I am shot, I accept this is
only hearsay – but, I repeat, I have heard from a
reliable and knowledgeable source that had
analysed the marketing strategy of one supplier of
prime mortgages, and his analysis went some-
thing like this: “The sub-prime mortgages were
sold with a two or three year low fixed interest
rate, largely to customers who could not speak
English well, if at all – so forget the small print.
The important point of his analysis is that, despite
the supposedly low interest rate charged on these
mortgages, the repayments, nevertheless, repre-
sented an average of 45% of the earnings of the
customer. And what happened a couple of years
later when the mortgage was reset? The cost to
the customer rose to an average of 65% of their
salaries – or, rather, wages. It is, therefore, no sur-
prise that there were massive defaults.”
That was stage one. Stage two was that the
financial institutions and banks who had lent the
money to the issuers of the mortgages to enable
them to sell their mortgages, wanted to free up
their balance sheet so that they could lend even
more money to these mortgage companies, so
that they, in turn, could sell even more of this,
40 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 40
frankly, awful product. To do this, the big name
banks and financial institutions who lent the
money to the mortgage issuers packaged the
mortgages into the, now infamous, structured
products and arranged for them to receive a very
high rating – often ‘A’ or higher – from the rating
agencies. I presume they were, in fact, rating the
financial institution and not the actual instru-
ment or its underlying investment portfolio.
These structured instruments were then sold
on to unwitting or, perhaps we could say, care-
less investors, who do not appear to have carried
out even minimal due diligence, but relied on the
‘A’ or higher rating and assumed that the instru-
ment was near to risk free. In order to sell these
instruments, I understand the yield was set at an
attractive, relatively high, rate. As a result, many
investors leveraged their positions with money
borrowed – maybe even from the same financial
institutions – at a cost that was lower than the
yield on the structured instruments.
Everything went well until one morning, the
investors woke up to find that this programme
had, in fact, all gone to hell in the proverbial
hand basket.
Some of these investors were hedge funds –
maybe they could and, indeed, will be accused
of bad management, failure to manage their risk
or even carrying out proper due diligence in
managing their portfolios, but I fail to see why
they were deemed responsible for the whole
debacle. Those hedge funds that did invest were
hurt and, indeed, have now introduced gates or
closed, but I still think it is unreasonable to put
the blame onto them.
It is a sad fact that, in many areas of the press
and media, truth and accuracy in reporting will
never be allowed to stand in the way of a juicy
headline and it is not just the tabloids. I recently
attended a conference in the Far East, which had
a media panel consisting of three representa-
tives of the Financial Times, Bloomberg TV and,
I think, CBS Business News. They started their
panel by saying that they were somewhat skepti-
cal about the use of the name ‘hedge fund’
because they were not convinced that everyone,
or anyone, for that matter, knew what a hedge
fund was and they didn’t believe that many
hedge funds actually hedged anything.
Someone in the audience introduced a story
from a recent edition of the Wall Street Journal
about a hedge fund manager. The headline was
something like: “XYZ Hedge Fund Manager
Achieves 22% Return In The Year To Date But…”
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm
The story under this headline went on to explain
that this particular manager had made a profit
for the year by being short of various sectors of
the fixed income market. It then went on to
specifically refer to a long investment in a sub-
prime or similar structured product, which had
resulted in the portfolio suffering a loss in that
investment of 2.4%.
The media representatives commented on this,
but didn’t seem to pick up the obvious point to
me and so I asked them whether I was missing
something, or was this not a perfect example of
a hedge fund operating in just that way that they
had, only a few minutes earlier, claimed hedge
funds no longer behaved. I went on to ask
whether it was not obvious to everyone that, if
you have a hedged portfolio, then one of either
the long position or the short position will result
in a loss. That is what hedging is all about,
whether you’re a hedge fund manager trying to
exploit inefficiencies in the market, or a choco-
late producer trying to buy cocoa beans at a rea-
sonable price.
So having got that off my chest, one next won-
ders what the medium and long term effect of
the sub-prime and credit crunch affair is going
to have on hedge funds in general. It appears,
from figures released, particularly by Hedge
Fund Research in the United States, that many
of the hedge funds that suffered during August
recouped much of their losses during
September. Whether that was because they were
too closely correlated with the stock market,
rather than other strategic investments is not yet
clear. What is also not yet clear is how many
investors have actually given notice to redeem
out of the funds. It must be remembered that
many US funds have annual lock ups and
redemptions can only be exercised at the end of
each year. Therefore, the full knock on effect of
crises such as the one we saw this summer, may
not actually become apparent until January.
At risk of sticking my neck out too far and with
the caveat that I am an administrator and not a
trader, therefore, my timing is inevitably going to
be wrong. I believe that, in fact, hedge funds will,
once again, ride the storm and probably end up
stronger for it. Certain strategies will be either
decimated or put on the shelf until the next
cycle, but the overall hedge fund market is going
to continue to grow and institutions are going to
continue to increase their participation.
Many observers have questioned whether the
increased participation from institutions, which
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 41
Page 41
has resulted in an increased number of very
large funds and, particularly, very large funds of
funds, will in fact lead to the demise of the
smaller funds. Sticking my neck out again, I do
not believe so. It is still a fact that between 60%
and 70% of all hedge funds are below USD200
million and the majority of those will be below
USD100 million in size. Some of those will fall
by the wayside, but then they always have, and it
won’t necessarily be because they don’t know
how to manage the market. Many start up hedge
funds go out of business, not because of trading
problems, but because their excellent traders
have no idea how to run a business and it is that
aspect that crucifies them. I have often said that
I doubt whether the ratio of start up hedge funds
that fail is any greater than the ratio of start up
restaurants that fail.
What we have seen at Custom House over the
past couple of years is a substantial increase in
the demand for new funds, as well as the greater
liquidity in funds and that has become apparent
by the increased number of daily dealing funds
that we administer. This also reflects the particu-
lar strategy that we have been able to implement
for one customer, which enabled us to take a
multi-manager managed account platform off
their prop desk and move it into a master feeder
structure, which was established in Malta.
The master fund has 36 or more sub-funds that
are structured as segregated portfolios or cells.
Each managed account was moved off the prop
desk into its own individual cell or sub-fund in
the master fund. The manager of the portfolio
has the same liquidity, flexibility and transparen-
cy as he had with the direct managed account,
because we are able to provide daily valuations.
This has been possible because of our
technology and the fact that we can now operate
on a 24 hour basis, from midnight on Sunday,
when our Singapore facility opens, until some-
time after midnight on Friday, when our Chicago
facility closes.
It is my belief that the daily dealing hedge fund
will become relatively com-
monplace within the next
three to five years.
Dermot Butler, chairman of
Custom House Administration
& Corporate Services,
the Dublin based alternative
investment and hedge fund
administrator
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm
Hassans GIBRALTAR DOMICILE
Going to
Gibraltar
Is Gibraltar the key to
European private equity funds?
James Lasry asks
Recent reforms in Gibraltar’s tax and fund legis-
lation have granted investors and their advisers a
simple and effective way to structure funds and
enabled Gibraltarian companies and funds to
access the benefits of the European Parent
Subsidiary Directive. This includes the phasing
out of the tax exempt company regime as a result
of pressure from the European Commission and
the introduction of the Experienced Investor Fund
regime. These changes have turned Gibraltar into
the jurisdiction of choice for European private
equity and property funds.
The classical private equity tax dilemma is how
does a fund (or any investment structure for that
matter) extract dividends from its investee com-
panies without being subject to the double taxa-
tion of withholding tax at the investee company
level and corporate tax at the fund (or holding)
company level? While any tax liability can often be
minimised through the use of tax treaties and,
with respect to European investee companies, the
Parent Subsidiary Directive, it is difficult to find a
solution where the profits from the investment
will not be taxed at the holding company level.
Jurisdictions such as Luxembourg, the
Netherlands and Cyprus have been used with
some success, but there are certain inherent diffi-
culties in each solution.
The solution is to establish the fund or invest-
ment vehicle in Gibraltar. This opens up substan-
tial opportunities for private equity or property
funds. If the fund is incorporated in Gibraltar, and
it incorporates a wholly owned subsidiary in
Luxembourg, the fund will effectively have the
benefits of Luxembourg’s tax treaties, as well as
access to the Parent Subsidiary Directive. As a
result, dividend distributions by a Luxembourg
companies to its Gibraltar parent will not suffer
withholding tax.
For example, if the fund invests in a German
42 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 42
company (as a wholly owned subsidiary or at least
with a relevant participation as per the Parent
Subsidiary Directive) then the German company
can pay its dividends to its Luxembourg parent
without paying any German withholding tax. This
is only after paying any German taxes on its
income – whether it be rental income on a com-
mercial property or commercial income from a
business. Once the dividends reach the
Luxembourg company, those profits can be sent
as dividends to the Luxembourg company’s
Gibraltar parent without suffering any
Luxembourg withholding tax.
In Gibraltar, the dividends will not be taxed as
they are generated from the proceeds of a
European parent subsidiary relationship. There is
no capital gains tax, wealth tax or estate duty in
Gibraltar. Furthermore, there is no Gibraltar with-
holding tax on dividends paid to non-Gibraltarian
resident shareholders of a Gibraltar company. The
profits, therefore, of the German investment will
have been effectively repatriated to the investors
in the fund without any tax leakage (other than
German internal tax on the company’s earnings).
Cyprus’ position is similar to that of Gibraltar,
however many clients seem to opt for the
Gibraltar option due to the effective fund regime
and Gibraltar’s reputation as a well regulated
finance centre. Indeed, in May 2007, the
International Monetary Fund praised Gibraltar as
a well regulated jurisdiction that is superior to
many of its larger competitors.
Part of the quid pro quo with the European
Commission for the phasing out of Gibraltar’s tax
exempt company regime was that the European
Commission communicated to the member
states that the Parent Subsidiary Directive should
be applied to Gibraltar tax resident companies in
the way that it would be applied to companies that
are tax resident in any other member state.
Gibraltar is, of course, within the European Union
by virtue of Article 299(4) of the Treaty of Nice.
Up until recently, many jurisdictions took the
view that since Gibraltar is not an actual member
state, they would not apply the directive to
Gibraltar companies, even though European
directives apply to Gibraltar and must be trans-
posed into internal legislation. At present, some
jurisdictions are either unaware of this develop-
ment, or some have even decided not to apply the
directive to Gibraltar companies in contradiction
to the Commission’s notice.
Certain jurisdictions, including Luxembourg,
have taken a view that if the Gibraltar company is
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm Page 43
properly tax resident in Gibraltar and if it has a
relevant participation in a Luxembourg company,
the Luxembourg authorities will not tax divi-
dends paid from a Luxembourg company to its
Gibraltar parent.
Gibraltar’s Experienced Investor Fund (EIF)
regime under the Financial Services (Experienced
Investor Funds) Regulations 2005 (the EIF
Regulations) is a very quick and efficient way to
structure a fund, whether a hedge fund or a private
equity/real estate fund, where the intention is to
market such a fund to experienced high net worth
investors. Experienced investors are defined in
Gibraltar as investors who are generally demon-
strably experienced in making investments or
those who have a net worth in excess of
EUR1,000,000 besides their principal place of res-
idence or those who have invested EUR100,000 or
equivalent in the fund.
The EIF’s board must include two Gibraltar-
based resident directors who are authorised by
Gibraltar’s regulator, the Financial Services
Commission (FSC), to act as directors of such
funds. In practice, having experienced independ-
ent directors on the board, who are answerable to
both investors and the regulator for the decisions
they take, helps to ensure there is ‘substance’ to
the fund’s board, which is important both from a
fiscal and a regulatory perspective. As individuals
who have been approved by the FSC are on the
board of the EIF, it allows the FSC to operate a
‘light touch’ approach to regulation, as the
Commission can rely on the directors to notify
them of any breaches of the EIF Regulations.
An EIF must have an authorised Gibraltar-based
administrator and it must be audited annually by a
Gibraltar registered auditor. Custody of the assets
is not restricted to Gibraltarian service providers
and the fund’s assets may be kept with any autho-
rised depository or broker that is deemed accept-
able to the FSC. In certain cases, there are distinct
legal advantages to using a Gibraltar-based custo-
dian, particularly with funds structured as protect-
ed cell companies. A closed ended private equity
or real estate fund will generally hold is own assets
other than the fund’s cash.
An EIF must produce a prospectus that complies
with the EIF Regulations. One of the unique
advantages of the EIF is that the fund can begin
trading on the basis of the approval and issue of
the prospectus by the board of the fund. This is
provided that within 14 days of launch, the fund’s
prospectus, memorandum and articles of associa-
tion and certain other documents are lodged with
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 43
the FSC, along with a legal opinion from a
Gibraltar lawyer of at least five years’ standing that
certifies that the fund complies with the EIF
regulations. These documents are presented to
the FSC by the administrator, along with a basic
informational form and an application fee of
GBP2,500. The FSC may request further
documentation or even on occasion, amend-
ments to the prospectus.
The huge significance of this is that there is no
regulatory down time to the authorisation of a
fund. If necessary, a fund can be set up in a matter
of days as many of the service providers can offer
turnkey solutions.
Funds in Gibraltar are usually structured as closed
or open ended investment companies and as
either ‘simple’ companies or protected cell
companies. It is also possible to structure them as
unit trusts and limited partnerships.
Gibraltar funds may also be listed on a variety of
exchanges. A stock exchange is currently being
established in Gibraltar to allow for fund and com-
pany listing.
A further attraction of Gibraltar for private equity
and property funds is the availability of protected
cell companies (PCCs). PCCs, established under
the Gibraltar Protected Cell Company Act of 2001,
enable the statutory segregation of assets and
liabilities in different cells. The PCC legislation
allows a fund to be set up so that there is
segregation of assets and liabilities in an umbrella
structure (that includes different sub-funds) where
it is essential to ensure that there is no liability
contamination between sub-funds.
The establishment of a PCC as an EIF has
become a popular method of structuring property
funds and private equity funds in Gibraltar.
Segregated cells are established either for specific
investments or for subscription over a certain time
period for investment in multiple projects.
The combination of Gibraltar’s effective EIF
regime and the ability of Gibraltar funds to make
use of the Parent Subsidiary Directive provides a
strong solution to private equity and real estate
funds that plan to invest in
Europe or indeed in coun-
tries within Luxembourg’s
formidable treaty network.
James Lasry,
partner, Hassans
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm
Dillon Eustace REGULATION
The coming
storm
Can hedge funds police
themselves before external
regulators do it for them?
Donnacha O’Connor
investigates
Against a backdrop of growing political
pressure, 14 large hedge funds, 12 of which are
UK-based, have come out of the shadows to con-
tribute to the drafting of a voluntary code of con-
duct. The draft code, published earlier in
October by Sir Andrew Large under the auspices
of the UK Hedge Fund Working Group (HFWG),
is self-described as a preliminary step towards
establishing standards of best practice for hedge
fund managers in some of the critical areas of
their business, including governance, disclosure,
risk management, activism and valuation. The
report is essentially a roadmap for hedge fund
managers to comply with the UK Financial
Services Authority’s (FSA) “11 Principles of
Business”, which are general statements of the
main regulatory obligations that apply to all FSA
authorised firms. The working group is hopeful
that the ideas could be picked up by similar
working groups in the US and elsewhere, and
eventually form the basis of global guidelines.
The report is currently out to consultation until
mid-December 2007.
Hedge funds have never really been off the
financial market regulatory agenda in Europe for
the past number of years. Investor protection,
market integrity, shareholder activism, systemic
stability, market fragmentation and latterly, the
USD6.5 billion loss of Amaranth Advisors and
the sub-prime crisis, have all contributed to the
debate in recent times. Hedge funds have
become a political hot potato and calls for regu-
latory intervention have been many and varied.
European hedge funds’ foray into US style
shareholder activism against European blue
chips, for example, has led to calls for greater
transparency in hedge funds’ often complex
holdings, capping of their ownership in individ-
44 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 44
ual companies, more responsible shareholder
voting requirements and the like. High profile
instances of hedge funds’ activities in this area
have included the thwarting of Deutsche Börse’s
attempted takeover of the London Stock
Exchange in 2005 and the forced resignation of
its chief executive, Werner Seifert, which was
attributed to Chris Hohn and the Children’s
Investment Fund (TCI). And, more recently, TCI,
again flexed its muscles, publicly applying pres-
sure on ABN AMRO, to either spin off, de-merge
or sell off its assets. The call for regulatory inter-
vention has not, however, been a position sup-
ported by all, notably the UK and the US, which
are home to the vast majority of the world’s
hedge fund managers.
The political machinery in Brussels had been
examining hedge funds for some time, but really
only as part of a wider process of assessing the
integration of financial services as envisaged by
the 1999 Financial Services Action Plan (FSAP)
and as part of an impact assessment on existing
EU investment funds legislation. In May 2004, a
group of experts mandated by the European
Commission to report on the progress of inte-
grating the FSAP in the asset management area
stated in their report to the Commission that a
flexible, principles-based regulatory approach
would be most suited to achieving an EU-level
framework for alternative investment funds.
In Autumn 2005, the Commission opened up a
debate in its green paper on the enhancement of
the EU framework for investment funds and long
term savings vehicles. This included a series of
questions on the hedge fund market including:
whether access to hedge funds was sufficiently
hampered by market fragmentation to justify a
common EU approach; whether a harmonised
private placement regime might be warranted;
and whether there were any specific risks relating
to investor protection or market stability that
required examination.
By the time the Commission’s November 2006
white paper on investment funds came around,
the EU regulatory focus was now fixed on meas-
ures to facilitate a common approach EU-wide to
the sale of hedge funds. The previous focus on
additional regulation to control the activities of
hedge funds appeared to be firmly off the regula-
tory agenda.
By May of this year, significant support had
developed for a voluntary code of conduct for
hedge funds in order to encourage greater trans-
parency and better governance. Little support
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm Page 45
had come from the UK and the US for Germany’s
calls for direct regulation and German
Chancellor, Angela Merkel, conceded that self-
regulation was a possible solution.
Commissioner McCreevy subsequently said he
would back plans for a voluntary code of conduct
to increase transparency. In May, the EU’s
finance ministers recommended the “indirect
supervision” approach favoured by the US, and
supported a voluntary commitment from the
industry regarding risk management,
transparency and good corporate governance.
This indirect approach had found favour earlier
this year. The US President's Working Group on
Financial Markets in its paper, “Principles and
Guidelines regarding Private Pools of Capital”,
concluded that market discipline in risk taking is
the rule and regulatory intervention the excep-
tion. The responsibility for market discipline falls
on fund managers, investors, creditors, trading
partners and market regulators should create
policies that support them.
In its first guidance to the industry since 1999,
the working group, which includes representa-
tives from the Department of the Treasury, the
Federal Reserve and the Securities and Exchange
Commission, issued a six page report setting out
a series of non-binding principles and guidelines
that places the onus largely on investors and
creditors of the hedge fund industry to monitor
and manage market risks themselves. The group
took the position that the best way to protect
capital markets from systemic risks posed by the
failure of large hedge funds is for the biggest par-
ticipants, including major institutional investors
and investment banks, to impose discipline. The
report also recommends that accurate informa-
tion be made available to investors, creditors and
counterparties.
The Commission’s work on the cross border
sale of hedge funds within the EU now appears
to be gaining some traction. In September, the
Commission published a summary of the feed-
back that it received on its call for evidence in
relation to the cross border sale of hedge funds
within Europe. The Commission’s formal posi-
tion is expected to be published in the spring
2008 and while it augurs well, any harmonisation
of national private placement rules will no doubt
take time to introduce.
While all of this has been going on, there
appears to have been a significant evolution in
the approach among some European regulators
to the issue of the cross border sale of hedge
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 45
funds and hedge fund strategies. Ireland, France
and Luxembourg, among others, now have regu-
lation in place to allow hedge funds to be autho-
rised by the local regulator on a self-certification,
filing only basis.
Recently, European regulators have given signs
of softening their approach to the approval of
foreign hedge fund offerings. Anyone who has
tried to privately place a hedge fund in Europe
will tell you that though it is not an impossible
task, there is a high degree of legal uncertainty
involved. This is particularly the case in some
markets, where the notion of private investment
funds placement, as opposed to an offering
approved by the local regulator, does not exist.
Also, the offering is almost always done on the
basis of country specific legal advice and that
this takes time to collate and can be costly. The
Dutch financial regulator, the Autoriteit
Financiële Markten, for example, has recently
recognised Ireland as an equivalent jurisdiction
under its domestic investment fund rules, which
will make it easier to sell Irish non-UCITS funds
privately in Holland without further authorisa-
tion. I was recently involved in the first registra-
tion of a non-Italian hedge fund offering with the
Bank of Italy.
While the debate on hedge funds goes on,
UCITS are now developing new ways to adopt
certain hedge fund-like strategies, such as the
ability to go short, the ability to leverage and to
use a wide range of derivatives for hedging or
speculation. Ireland’s regulator, the Irish
Financial Services Regulatory Authority, issued a
policy paper in October in which it stated that it
would permit UCITS to physically short sell, pro-
vided that the stock was borrowed in advance,
collateral provided to the lender was maintained
within the UCITS’ custody network, and the
usual counterparty and global exposure limits
were adhered to. This represents further integra-
tion of hedge funds and hedge fund strategies
into the mainstream.
Donnacha O’Connor is a
financial services partner
with Dillon Eustace and
advises primarily in the area
of financial services, and in
particular, asset
management
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm
Advent COMPLIANCE
A silver
lining?
Despite a successful rearguard
action fought thus far, the
spectre of greater regulation
still looms over the hedge fund
industry, says Chris Cattermole
In the US, last year’s ruling by the US Court of
Appeals for the District of Columbia Circuit may
have kyboshed the Securities and Exchange
Commission’s (SEC’s) original hedge fund
registration plans, but moves on Capitol Hill
keep the issue alive. Leading the charge is
Senator Charles Grassley, the senior Republican
on the Senate Finance Committee. In the wake of
the Amaranth Advisors debacle, he called for
more regulation of hedge funds and better trans-
parency in the way they operate, citing fears that
‘normal’ investors could be hit if their pension
plans have exposure to hedge funds. As a result,
in March he introduced legislation aimed at once
again forcing hedge funds to register with the
SEC.
The SEC, for its part, has taken a different tack.
Last December, it proposed a new rule to raise
the financial bar for individuals who would be
allowed to invest in hedge funds, changing the
requirement from USD1 million total net worth
(including house value), to USD2.5 million in
investment assets. The effect, if finally agreed,
would be to dramatically curtail the number of
people eligible to invest in the sector.
Then in February, the President’s Working
Group (PWG) on Financial Markets, which fea-
tures the Treasury Secretary and chairs of the
Federal Reserve Board, SEC, and Commodity
Futures Trading Commission, issued guidelines
aimed at enhancing vigilance and market disci-
pline, thus strengthening investor protection
and countering the threat of systemic risk. For
hedge funds, that means improving valuations
and risk management systems, and providing
market participants with better, more and faster
46 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 46
information. The PWG also kept its options open
for further action with the catch all phrase that it
will continue to monitor developments as the
market evolves.
Transparency is also at the heart of the ongo-
ing campaign being waged by the German gov-
ernment. On the domestic front, in August, the
German cabinet approved new rules that would
force private equity and hedge funds to disclose
how they finance company bids, to more fully
disclose their intentions when buying more than
10% of a company, and limit hedge funds’ influ-
ence at shareholder meetings.
As this year’s president of the Group of Eight
(G8) nations, Germany’s Chancellor, Angela
Merkel, and Peer Steinbrück, her finance minis-
ter, have continued to press hedge funds to pro-
vide more disclosure to investors and creditors
in the shape of a voluntary code of conduct.
Jean-Claude Trichet, head of the European
Central Bank, indicated his support for a code of
conduct back in May. However, the US and UK
governments, while affirming the need for vigi-
lance, have been sceptical of the German pro-
posals, with the UK emphasising the effective
regulatory framework already put in place by the
Financial Services Authority (FSA).
Nevertheless, Germany’s message will again
be raised at the G8 Finance Ministers meeting in
Washington DC at the end of October, with
Steinbrück believing the recent market turmoil
has added ammunition to his cause.
What the brouhaha underscores is the level of
anxiety that hedge funds engender for many in
the wider world. While fraud and fund blow ups
may in fact be rarities, they make news, reinforc-
ing the perception that industry participants can
be trusted as far as Jack Nicholson in front of a
free bar at your daughter’s graduation.
Regardless of the rights or wrongs of this per-
spective, as the number of funds and their assets
under management expand, and investor expo-
sure broadens, potential systemic risks are
increasingly a cause of concern.
To this end, in May, the Financial Stability
Forum (FSF), which brings representatives of
national financial authorities together with
international regulatory and supervisory group-
ings, central bank experts and international
financial institutions, released a series of recom-
mendations to address the issue. In particular, it
focused on the need for core intermediaries,
notably investment banks that provide prime
brokerage services and act as counterparties, to
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm
strengthen market discipline by improving their
risk management practices. In addition, it calls
for hedge fund managers to review and enhance
their sound practice benchmarks, while stress-
ing the importance of rigorous market surveil-
lance by the relevant authorities.
And members of the hedge fund community
are taking the broad thrust of these arguments
to heart, as evidenced by the conclusions of Sir
Andrew Large’s recently published consultation
document. The Hedge Fund Working Group
(HFWG) report, written in collaboration with 14
hedge fund managers and the Alternative
Investment Management Association (AIMA),
and with input from the US Managed Funds
Association, proposes a series of best practices,
including greater disclosure of information to
investors and counterparties, improvements to
the valuation process, and more focus on
portfolio, operational and outsourcing
risk management.
Indeed, whether or not regulation or height-
ened scrutiny eventually comes to pass, what the
tone of the debate underlines is the considerable
mileage hedge funds can achieve by voluntarily
implementing their own ‘culture of compliance’.
For one, it can be a key tool in terms of client
acquisition and retention, particularly when
soliciting institutional investors. While this seg-
ment’s exposure to the alternatives space is lim-
ited at present, the potential flows are enor-
mous, and are expected to fuel much of the
industry’s growth in the coming years.
But such funds seek transparency and account-
ability from the managers with which they invest,
and will perform due diligence on them to check
credentials such as their policies and proce-
dures, their trading and performance history,
and any litigation woes. Those managers
that pass muster are the ones best placed to
reap the capital flows. Those that can’t will be
passed over.
So what does this compliance culture entail?
First, written policies, procedures and practices
that provide guidance on employees’ behaviour
and thus prevent legal or ethical infractions.
More than merely satisfying legal requirements,
the mantra should be one of ‘putting clients
first’, codified in concrete steps to protect client
interests. As such, it should address issues such
as personal trading, access to insider informa-
tion, and managing errors and complaints.
Next, and allied to the first, is a written code of
ethics. When properly observed, this helps foster
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 47
Page 47
in the organisational culture a spirit of above
board conduct, and sets out for employees an
understanding of their responsibility to
investors.
And third are systems to ensure the mainte-
nance of accurate and complete records, includ-
ing archiving and retrieval of email (written poli-
cies on email and instant message use are also
recommended). A central component of this will
be a robust disaster recovery capability. For one,
it proves to investors that their data, privacy and
money are being protected. In addition,
MiFID stipulates that firms have disaster recov-
ery and business continuity policies in place, so
any hedge fund that falls under its remit will
have to comply.
But making this culture truly meaningful, and
contributory – however indirectly – to the
bottom line, means more than just writing a
manual. Like everywhere else in financial servic-
es today, it is dependent on having a compre-
hensive technology framework.
In particular, that requires an advanced trade
order management system that offers efficiency
of execution, flawless data access from the back
through to front office, coupled with a dynamic
portfolio management system with the capacity
to price and value holdings accurately. In
addition having a proven books and records
system – able to automate GAV and NAV
computations and automatically cut P&L at
multi-tiered, multi-currency fund structures,
while maintaining accurate and accessible audit
trails – underscores a firm’s commitment to
data accuracy and integrity.
In this age of heightened supervisory scrutiny
and fierce competition for capital inflows,
having a technology infrastructure that enhances
the transparency of a hedge fund’s operations
and makes its data more reliable will be a power-
ful investment for the future, not
only as insurance against changes in the
regulatory environment, but as a source of
competitive advantage. Of course, performance
will ultimately remain king,
but compliance makes an
attractive bride.
Chris Cattermole, European
sales manager, Advent
Software EMEA
HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm Page 48

FinTuition EDUCATION

Trends in hedge funds

Education is key to
understanding the hedge fund
market, says FinTuition
Investors have always been thrilled by hedge
funds’ returns and, to a certain extent, by the
regulators’ inability to implement a framework
for this market segment. Since institutional
investors and hedge funds of funds have
become major liquidity suppliers, funds and
service providers now require formal procedures
and supervision put in place. In addition, the
recent liquidity drain as a consequence of the
sub-prime mortgage disaster will force
counterparties to rethink procedures in hedge
fund related services (collateral management,
securities financing, Basel II compliant
operations, prime brokerage, leveraged
financing). Therefore, it is a must to know the
market’s mechanics.
The market today
In the bear market between 2001-2003, most of
the media coverage on hedge funds was posi-
tive. After the internet bubble burst, the per-
formance of hedge funds was impressive. Their
ability to generate stable returns in a highly
volatile market environment suggested that their
earnings were uncorrelated to equity markets.
This unexpected performance led to a significant
number of new entrants into the market, using a
wide range of strategies from risk arbitrage and
distressed debt to global macro.
Today, experts believe the growth in innovative
hedge funds is ongoing. Nonetheless, the num-
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of smaller unsuccessful market participants and
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unfavourable in their risk/return profile.
In accordance with our training philosophy,
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today’s hedge fund industry worth knowing:
• the foundation of hedge funds and their
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• the techniques hedge funds use to generate
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• the leveraged financing of their strategies;
• the regulatory framework to which hedge
funds are subjected; and
• the measuring of hedge funds’ performances.
The importance of training
To sustain success in this competitive market,
you have to follow the manifold legal and
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48 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008

HFSMG 2007 pp34-49 ML 26/10/07 6:02 pm Page 49

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HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm
Hedge Fund Market GUIDE
Hedge Fund Market GUIDE
A guide to the machinery of the hedge fund market by the Managed
Funds Association
Management and internal trading controls
A hedge fund manager should establish for each
hedge fund, the investment objectives and risk
parameters applicable to such a hedge fund and the
trading parameters and risk limits designed to
achieve these objectives.
Suitably qualified personnel should be retained and
adequate systems established (either internally or
through outsourcing) to put in place appropriate
controls and review processes that permit the hedge
fund manager to monitor trading activities and oper-
ations, as well as risk levels, effectively. If third party
service providers perform key business functions
(such as net asset value calculation or risk monitor-
ing), they also should be subject to appropriate con-
trols and review processes.
A hedge fund manager should establish manage-
ment policies and practices commensurate with the
size, nature and complexity of the hedge fund man-
ager’s trading activities and the hedge funds it man-
ages.
Management policies should be established for
trading activities, valuation, risk analysis, compli-
ance and other key areas as appropriate. A hedge
fund manager should adopt an organisational struc-
ture that facilitates effective monitoring of compli-
ance with management policies. Policies and prac-
tices should be reviewed and updated as appropriate
(for example, when changes in structure or strategy
are adopted, when extraordinary market events
occur or when new applicable regulations are adopt-
ed).
A hedge fund manager should determine the
investment, risk and trading policies to be observed
with respect to each hedge fund it manages based
on the specific investment objectives of the hedge
fund.
A hedge fund manager should allocate capital and
risk (among, for example, portfolio managers,
strategies and/or asset classes, as applicable) based
on a hedge fund’s performance objectives and tar-
geted risk profile. Allocations should be re-examined
periodically and adjusted as
appropriate. In addition, appropriate trading param-
eters and risk limits should be established
consistent with these allocations.
A hedge fund manager should impose appropriate
controls over its portfolio management and trading
activities to ensure that these activities are undertak-
en on a basis consistent with allocated investment
50 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 50
and trading parameters.
A hedge fund manager’s senior management
should analyse and evaluate trading activities by reg-
ularly reviewing the performance of each hedge
fund’s portfolio and the associated risk levels.
Internal reporting should provide the hedge fund
manager with information regarding the perform-
ance and risk levels of the different investment
strategies employed and should identify deviations
from trading parameters and risk limits.
A hedge fund manager should determine the
allocation of capital among portfolio managers and
should establish policies for monitoring their per-
formance.
All portfolio managers, including external portfolio
managers, should be subject to controls and review
processes commensurate with the amount of assets
managed, form of allocation and trading strategy.
Where capital is invested with an external portfolio
manager in a managed account, applicable trading
restrictions and limits, reporting requirements and
termination provisions should be clearly defined in
written management agreements. The performance
of all portfolio managers should be monitored on a
periodic basis as appropriate, depending on the
form of the allocation (for example, monthly per-
formance review of a passive investment in a hedge
fund versus more frequent review of a significant
managed account investment).
A hedge fund manager should carefully select any
“mission critical”, third party service providers that
perform key business functions for itself or any
hedge fund it manages based upon their experience
with hedge fund operations (for example, those
related to prime brokerage, risk monitoring, valua-
tion or business continuity/disaster recovery func-
tions) and consistently monitor their performance.
The roles, responsibilities and liability of key
third party service providers should be clearly
defined in written service agreements. The perform-
ance of missioncritical service providers should be
periodically evaluated. “Mission critical service
providers” are those required by the hedge fund
manager to ensure prompt and accurate processing
of transactions and to meet regulatory reporting
requirements.
Responsibilities to investors
A hedge fund manager should work together with
the hedge fund so that investors are provided with
HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm
information regarding the hedge fund’s investment
objectives and strategies, as well as periodic sum-
mary performance information, in order to enhance
the ability of hedge fund investors to understand
and evaluate for themselves an investment in the
hedge fund.
A hedge fund manager should create a manage-
ment environment that recognises its responsibility
to act in the interest of the hedge fund and its
investors as set forth in the investment manage-
ment agreement and offering documents.
A hedge fund manager is retained by a hedge fund
to act as its investment manager, and, consequently,
a hedge fund manager has a responsibility to act in
the interest of the hedge fund and its investors in
accordance with its investment management agree-
ment with the hedge fund, the offering documents
and applicable law. A hedge fund manager should
therefore take steps to ensure that it manages the
hedge fund’s assets in accordance with its invest-
ment management agreement with the hedge fund
as well as the offering documents.
A hedge fund’s prospective and existing investors
should be provided with information regarding the
fund’s investment objectives, the strategies to be
employed, the range of permissible investments and
the risk factors that are material to a hedge fund’s
business in order to enhance the ability of investors
to understand and evaluate for themselves an
investment in the hedge fund.
Informative disclosure regarding a hedge fund’s
investment objectives and strategies will enhance
the ability of investors to form appropriate expecta-
tions as to the hedge fund’s performance and there-
fore facilitate a good match between investor and
investment product. A hedge fund manager should
therefore seek to ensure that appropriate disclosures
are prepared for dissemination to hedge fund
investors on a timely basis (without compromising
proprietary information regarding the hedge fund’s
positions). Where there are changes in objectives or
strategies, a hedge fund manager should evaluate,
and consider consulting its legal counsel, to deter-
mine whether given the circumstances of the
change, disclosure is necessary and whether con-
sent should be obtained from hedge fund investors.
Given that there is substantial breadth of objectives
or strategies employed by and disclosed to investors
in connection with a number of hedge fund strate-
gies, for example in multi-strategy hedge funds, it is
possible that many hedge fund managers may fairly
determine, after evaluating the circumstances, that
no disclosure is required.
A hedge fund manager should assess whether its
operations or particular circumstances may present
potential conflicts of interest and seek to ensure that
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 51
Page 51
any conflicts of interest that may be material are
appropriately disclosed and that controls are in
place to address them.
Possible conflicts that may need to be disclosed
include:
• relationships with brokers or service providers;
• conflicts generated by fee structures;
• use of soft dollar arrangements; and
• other conflicts that may arise in the context of
“side by side” management of multiple accounts,
such as allocation of investment opportunities
among hedge funds or accounts managed by the
hedge fund manager.
A hedge fund manager should work with its legal
counsel to identify risks to be disclosed to make sure
these disclosures are adequate.
Examples of the types of risks that a hedge fund
manager should consider disclosing are:
• lack of assurance as to performance;
• risks specifically associated with a particular strat-
egy or types of investment instruments;
• risk associated with limited liquidity;
• risks associated with the use of leverage and mar-
gin;
• risks associated with the loss of key management
personnel; and
• potential conflicts associated with any perform-
ance fee or use of affiliated brokers.
A hedge fund manager should prepare periodically
certain baseline performance and other relevant
information for distribution to the hedge fund based
upon relevant characteristics of the hedge fund.
Possible disclosures include:
• performance measures, such as quarterly or
monthly net asset value calculations and periodic
profit and loss statements; and
• capital measures, such as assets under manage-
ment in the hedge fund in which the hedge fund
investor is invested, net changes to capital based
on new subscriptions less redemptions and the
effect of profit and loss on total capital.
Appropriate disclosures should be made about any
agreement between a hedge fund and hedge fund
investors that varies the material terms of the
arrangements with certain hedge fund investors, for
example through use of “side letters”, unless the
ability to vary such terms is disclosed to hedge fund
investors in connection with their investment in the
hedge fund.
Appropriately qualified external auditors should be
engaged to audit annual financial statements with
respect to any hedge fund with external investors.
Annual audited financial statements for the hedge
fund should be delivered to fund investors in a
timely manner.
HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm
Hedge Fund Market GUIDE
Valuation policies and procedures
A hedge fund manager should determine policies for
the manner and frequency of computing net asset
value, or NAV, based upon GAAP and its manage-
ment agreement with each hedge fund and seek to
ensure that material aspects of those policies are
appropriately disclosed to hedge fund investors.
A hedge fund manager, in consultation with the
governing body of the hedge fund it manages,
should establish valuation policies and procedures
that are fair, consistent and verifiable, recognising
that hedge fund investors may both subscribe to and
redeem interests in the hedge fund in reliance on the
values derived from such policies and procedures. A
hedge fund manager should also develop policies
for the manner and frequency of computing portfo-
lio valuation for purposes of internal risk monitoring
of the portfolio.
Fair value
A hedge fund manager’s valuation policies and pro-
cedures should incorporate the concept of “fair
value”. For NAV purposes, a hedge fund manager
generally should value investmentsaccording to
applicable generally accepted accounting principles
(GAAP), recognising that hedge fund investors will
both buy and sell shares of a hedge fund on the basis
of NAV and that the hedge fund’s financial state-
ments should reflect NAV. Calculation of NAV
should take into account not only the value of the
financial instruments in the portfolio (sometimes
referred to as “trading P&L”), but also accruals of
interest, dividends and other receivables and fees,
expenses and other payables.
For companies such as hedge funds, GAAP typical-
ly requires the use of “fair value” in determining the
value of an investment or instrument. However, if
there are circumstances where a hedge fund manag-
er believes that the application of fair value would
not produce an accurate or fair valuation for a given
instrument, it may employ alternative means to
value an instrument as permitted by agreement. A
hedge fund manager may appropriately develop poli-
cies for making fair value determinations that take
into consideration market sector trends and compa-
ny fundamentals.
Fair, consistent and verifiable
A hedge fund manager’s valuation policies and pro-
cedures should be fair, consistent and verifiable. A
hedge fund manager should either calculate or veri-
fy the accuracy of prices independent of the trading
function to the extent practicable. To that end, a
hedge fund manager should seek to rely on price
quotes from external sources whenever practicable
and cost effective to do so and establish policies for
determining the value of assets for which appropri-
52 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 52
ate external price quotes are not reasonably avail-
able. In addition, a hedge fund manager should fully
document the process it uses to determine whether
to implement recommendations of a pricing service,
as well as circumstances in which it determines to
override a pricing service’s recommendation.
The valuation of portfolio positions for NAV pur-
poses may be used to determine the prices at which
hedge fund investors subscribe to or redeem from a
hedge fund. Accordingly, a hedge fund manager
should seek to utilise valuation practices so that the
hedge fund is consistent and fair to both subscribing
and redeeming hedge fund investors, to the extent
practicable, and makes appropriate disclosures of
circumstances in which practices may necessarily
deviate from this standard in a material way.
Pricing policies and procedures
A hedge fund manager should establish pricing poli-
cies and procedures that assure that NAV is marked
at fair value. The existence of written pricing policies
and procedures is a critical element of the control
structure surrounding a hedge fund manager’s pric-
ing of portfolio investment instruments. These poli-
cies should be established by senior management,
based upon a thorough review and understanding of
the totality of the hedge fund manager’s business
structure (for example, range and complexity of
instruments traded, stipulations contained in the
hedge fund’s governing or offering documents, liq-
uidity terms offered to investors). The pricing poli-
cies and procedures should explicitly authorise that,
in circumstances where a hedge fund manager
believes that the application of such policies would
not produce an accurate or fair price for a given
instrument, senior management may use alternative
procedures to price an instrument. In addition,
these policies should be reviewed with the hedge
fund’s governing body (if different than senior man-
agement) and its independent or external auditors.
Once pricing policies and procedures are set (and
updated from time to time, as needed), a hedge fund
manager should adhere to them as much as practi-
cable.
Hedge fund managers should develop practices
and/or systems for capturing pricing data for their
positions from independent sources on a daily basis
where practicable. Procedures for periodically verify-
ing the accuracy of pricing data should also be
adopted, and material discrepancies between price
sources should be investigated. Where an instru-
ment is not traded actively or where obtaining price
information requires significant effort, weekly (or
less frequent) pricing may be appropriate depending
on the nature and the size of the position. For posi-
tions traded over the counter or derivative instru-
ments, where the only external source of fair value
HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm
may be quotes from relevant market-makers (the
number of which, based on the liquidity of the posi-
tion, may be very limited), the number of quotes
sought by a hedge fund manager to gain comfort
with the fair value should also be considered. This
may also lead to model pricing. Where market prices
do not exist or are not indicative of fair value, a
hedge fund manager should clearly establish the val-
uation methods to be used for NAV purposes. In
valuing certain instruments, for example, hedge
fund managers may appropriately seek the input of
their portfolio management team in the valuation
process in order to take advantage of the portfolio
manager’s expertise.
Pricing sources
A hedge fund manager should choose reliable and
recognised pricing sources to the extent practicable.
In general, where market prices for an instrument
are readily available from organised exchanges for
markets or recognised data vendors, a hedge fund
manager should use such market prices to compute
NAV. In such circumstances, fair value can be based
on the official closing price of an exchange or other
relevant market price as published by a recognised
data vendor for that market.
Where market prices for an instrument are not
readily available from such sources, a hedge fund
manager should determine the methods to be used
in obtaining values from alternative sources, with
reliability, stability and independence being among
the main criteria. For example, hedge fund managers
should seek to obtain reliable quotes, when avail-
able, for certain over the counter derivative instru-
ments and structured or distressed securities from
well established, recognised pricing services, or use
appropriate valuation models developed by third
party pricing services or recognised industry stan-
dard models using third party inputs.
The range of instruments that may require alternate
sources include OTC options (particularly exotic
options), complex derivatives, mortgage-backed and
asset-backed securities, as well as other instruments
of a similar nature. However, if these are unavailable,
either because the transactions are “one of a kind”
or not actively traded, the only market for these
instruments may be with the counterparty to the
transaction itself. Such instruments could be valued
either by obtaining a quote or estimate from the
counterparty or based on a pricing model, or any
combination thereof. Where a pricing model is used,
a hedge fund manager should make sure that it is in
a position to explain and support the model param-
eters used in determining the valuation.
Valuation of instruments
A hedge fund manager should establish policies for
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 53
Page 53
determining valuations associated with instruments
that may have multiple “official” settlement prices.
Certain instruments held in hedge fund portfolios
may have more than one official price that can be
used for valuation purposes. One example of this is
securities traded on multiple exchanges, including
dual listed securities, those that trade across multi-
ple time zones, and certain over the counter deriva-
tives. In determining which settlement price to use
in these instances, a hedge fund manager should
seek to use GAAP as a guideline where practicable,
bearing in mind the primary objective of using the
price that best reflects the correct fair market value.
Among the alternatives available are the use of the
most recent price or the price that derives from the
greatest source of liquidity.
A hedge fund manager should evaluate the use
of alternative methods for valuing illiquid, or
otherwise hard to value, securities or other invest-
ment instruments.
A hedge fund manager may appropriately use alter-
native approaches for valuing illiquid, or otherwise
hard to value, securities or other investment instru-
ments. Among the various approaches to the valua-
tion of illiquid and hard to value investment instru-
ments that may be available to hedge fund man-
agers is the use of “side pockets”, if their use has
been disclosed in the hedge fund’s offering docu-
ments or governing documents. Under side pocket
methodology, investment instruments that are
removed from the valuation process that applies to
the rest of the portfolio — for example, due to illiq-
uidity or similar issues — are held either at cost or
at fair value (depending on the hedge fund manag-
er’s valuation policies) until either a liquidation or
other valuation generating event occurs (for exam-
ple, acquisition of a private company). Under one
variation among a number of possible side pocket
methodologies, only those investors that hold a
position in the hedge fund at the time that the trans-
action designated for the side pocket is executed are
typically permitted to participate in the subsequent
profit and loss when the position is eventually dis-
posed or there is an event that makes it become a
marketable security (for example, an initial public
offering). Hedge fund managers should bear in
mind that issues associated with management fees
and high water marks, among other things, may
impact valuation and the use of side pockets.
Price validation
A hedge fund manager should establish practices for
verifying the accuracy of prices obtained from data
vendors, dealers or other sources. For certain
actively traded instruments, it may be appropriate to
establish multiple feeds from data vendors in order
to compare and verify their prices. With respect to
HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm
Hedge Fund Market GUIDE
less liquid instruments, dealer quotes, prices gener-
ated by models or other estimation methods used
should be checked periodically against realised
prices as appropriate to gauge their accuracy.
Diligence should be performed to determine if the
external pricing agent has been consistent in provid-
ing quality service to a hedge fund.
Frequency of NAV determinations
A hedge fund manager should establish policies for
the frequency of determining a hedge fund’s NAV. A
hedge fund’s official NAV, which reflects all fee and
expense accruals in addition to trading profit and
loss, is typically determined on an established peri-
odic basis and may be used for purposes of pricing
hedge fund investor subscriptions and redemptions.
Separately, a hedge fund manager may also prepare
an estimated or indicative NAV more frequently,
based upon estimates of accrued fees and expenses
and trading profit and loss that may be used for
internal risk monitoring purposes or for other inter-
nal purposes. A hedge fund manager should estab-
lish policies and procedures that set forth whether
these indicative NAV calculations will be used for
risk monitoring purposes or other internal purposes,
and whether they may be disclosed (for example,
upon request or through a website posting).
Risk monitoring
Current market practice is to focus on three cate-
gories of risk that are measurable – “market risk,”
“credit risk” and “liquidity risk” (both funding and
asset liquidity risk). Market risk relates to losses that
could be incurred due to changes in market factors
(prices, volatilities, and correlations). Credit risk
relates to losses that could be incurred due to
declines in the creditworthiness of entities in which
the hedge fund invests or with which the hedge fund
deals as a counterparty (including sovereign risk).
Funding liquidity risk relates to losses that could be
incurred when declines in a hedge fund’s capital due
to redemptions or other sources of funding or liquid-
ity reduce the ability of the hedge fund to fund its
investments. It differs from asset liquidity risk (a
form of market risk), which is defined as the poten-
tial exposure to loss associated with the inability to
execute transactions – particularly on the liquidation
side – at prevailing prices. In addition, a hedge fund
manager should seek to assess “operational risk”
depending on its particular circumstances.
While current market practice is to treat the risks
separately, it is crucial for hedge fund managers to
recognise and evaluate the overlap that exists
between and among market, credit and liquidity risks.
Structure of risk monitoring function
A hedge fund manager should establish a risk moni-
54 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 54
toring function, either internally or in reliance upon
external resources. The risk monitoring function
should be responsible for the review of objective risk
data and analysis of a hedge fund’s performance, cur-
rent risk position, the sources of its risk and resulting
exposures to changes in market conditions.
The risk monitoring function should report directly
to senior management and possess sufficient
expertise to understand a hedge fund’s trading
strategies and the nature and risks of its invest-
ments. To the extent appropriate, risk analysis with
respect to a particular investment strategy or portfo-
lio should be performed independently of portfolio
management personnel responsible for that strategy
or portfolio, so that trading activities and operations
may be effectively supervised and compliance with
trading parameters and risk limits can be controlled.
Alternatively, a hedge fund manager might seek to
ensure the objectivity of risk analysis by providing for
an appropriate level of checks and balances with
respect to risk monitoring. To the extent appropriate,
the risk monitoring function should produce regular
risk reports that present risk measures and appropri-
ate breakdowns by category of risk for review by
appropriate members of senior management. The
risk monitoring function, in consultation with rele-
vant portfolio management personnel, should con-
duct routine backtests of their risk measures to
ensure that their systems capture all reasonably
anticipated significant exposures and that the output
is consistent with the assumptions of the models.
Market risk
This encompasses interest rate risk, foreign
exchange rate risk, equity price risk, and commodity
price risk, as well as asset liquidity risk. A hedge fund
manager should evaluate market risk, not only for
each hedge fund portfolio in aggregate, but also for
relevant subcomponents of a portfolio (for example,
by strategy, by asset class, by type of instruments
used, by geographic region or by industry sector), as
appropriate. In addition, the market risk assumed by
each individual portfolio manager should be deter-
mined. A hedge fund manager should employ a con-
sistent framework for measuring the risk of loss for
a portfolio (and relevant subcomponents of the port-
folio), such as a ‘value at risk’ (VAR) model. While
the choice of model should be left to each hedge
fund manager, the hedge fund manager should be
aware of the structural limitations of the model
selected and actively manage these limitations,
including the impact of any model breakdown.
Consistent with disclosure made to hedge fund
investors, the hedge fund manager should deter-
mine the appropriate overall level of market risk for
a particular hedge fund or strategy at time intervals
appropriate for the size and complexity of such
HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm
hedge fund or strategy. This overall level of market
risk should then be appropriately allocated, among,
for example, individual portfolio managers, invest-
ment strategies or asset classes. Once the market
risk allocation is determined, portfolio managers
should choose the market specific risks to be
assumed by the hedge fund consistent with the
hedge fund manager’s risk allocation and policies
and then develop a process for monitoring the risk.
A sound market risk monitoring process should
incorporate the confidence level(s) and holding peri-
od(s) deemed appropriate depending on the mar-
kets traded and the risks assumed. The holding peri-
od(s) should take into account the time necessary to
liquidate and/or neutralise positions in the portfolio.
The role of the risk monitoring function is to: (1)
identify and quantify the factors affecting the risk
and return of the hedge fund’s investments, both
within individual portfolios and across the entire
range of activities of the hedge fund manager, (2)
monitor the risk controls established by senior man-
agement, and (3) disseminate the resulting risk
information to senior management and portfolio
managers, as appropriate. The factors affecting risk
(for example, market rates and prices, credit
spreads, volatilities, correlation) should be incorpo-
rated into the risk monitoring process and, where
appropriate, be included in the market risk model.
Positions managed as separate accounts by exter-
nal portfolio managers on behalf of the hedge fund
manager should be incorporated in the routine risk
assessment of the overall portfolio. Passive invest-
ments in funds managed by external portfolio man-
agers should be monitored as appropriate.
Hedge fund managers should recognise that mar-
ket risk measures such as VAR do not give a com-
plete picture of risk in that they assess the risk of
“standard” market movements rather than extreme
events. Hedge fund managers should therefore
complement risk modeling with relevant stress tests
and backtesting, as discussed below.
A hedge fund manager should perform “stress
tests” to determine how potential changes in market
conditions could impact the value of a hedge fund’s
portfolio, as well as to consider liquidity analyses
based on legal or contractual relationships.
A hedge fund manager should perform stress tests
to assess the impact of large market moves, taking
into account relevant non-linearities in the relation-
ship between portfolio value and the size of the mar-
ket move. In addition, in performing stress tests or
liquidity analyses, a hedge fund manager may con-
sider, for example, contractual rights of counterpar-
ties to terminate or otherwise unwind trading rela-
tionships or increase margin/collateral require-
ments upon the occurrence of certain events (such
as declines in NAV).
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 55
Page 55
A hedge fund manager also should consider con-
ducting “scenario analyses” to benchmark the risk of
a hedge fund’s current portfolio against various sce-
narios of market behavior (historical or prospective)
that are relevant to the hedge fund manager’s trad-
ing activities (for example, the October 1987 stock
market event, the Asian financial crisis of 1997, the
stock market declines after March 2000 (bursting of
the “dot-com” bubble)).
A hedge fund manager should “back test” its mar-
ket risk models. For internal control purposes, the
risk monitoring function should perform backtesting
of its market risk models. It should compare the dis-
tribution of observed changes in the value of a hedge
fund’s portfolio to the distribution of changes in
value generated by its market risk model.
If the frequency of changes in the value of the port-
folio exceeds the frequency generated by the market
risk model (a statistical expectation based on the
confidence level of the market risk model), such
deviation should be scrutinised to determine its
source. If, after investigation, the hedge fund man-
ager determines that the market risk model is not
producing accurate information, or is leading its
users to draw inappropriate inferences, a hedge fund
manager should seek to modify it.
Funding liquidity risk
Funding liquidity is critical to a hedge fund manag-
er’s ability to continue trading in times of stress.
Funding liquidity analysis should take into account
the investment strategies employed, the terms gov-
erning the rights of hedge fund investors to redeem
their interests and the liquidity of assets (for exam-
ple, all things being equal, the longer the expected
period necessary to liquidate assets, the greater the
potential funding requirements) and the funding
arrangements negotiated with counterparties such
as prime brokers. Adequate funding liquidity gives a
hedge fund manager the ability to continue a trading
strategy without being forced to liquidate assets
when market losses occur.
Cash should be actively managed
A hedge fund manager should evaluate the effective-
ness of the cash management process and establish
policies for investing a hedge fund’s excess cash, if
any, based on established risk parameters and taking
into account the credit risk presented by the party
with whom cash is invested. In establishing cash
management policies, a hedge fund manager should
consider cash flow needs based on the risk and fund-
ing profile of the portfolio and investor subscription
and redemption windows.
A hedge fund manager should employ appropriate
liquidity measures in order to gauge, on an ongoing
HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm
Hedge Fund Market GUIDE
basis, whether a hedge fund is maintaining adequate
liquidity. Liquidity should be assessed relative to the
size of the hedge fund and the risk of its portfolio
and investment strategies.
A hedge fund manager should evaluate the stabili-
ty of sources of liquidity and plan for funding needs
accordingly, including a contingency plan in periods
of stress.
Hedge fund managers should assess their cash and
borrowing capacity under the worst historical draw-
down and stressed market conditions, taking into
account potential investor redemptions and contrac-
tual arrangements that affect a hedge fund’s liquidi-
ty (for example, notice periods for reduction of cred-
it lines by counterparties). Hedge fund managers
should periodically forecast their liquidity require-
ments and potential changes in liquidity measures.
Hedge fund managers should perform scenario
tests to determine the impact of potential changes in
market conditions on a hedge fund’s liquidity.
Among these scenario tests, hedge fund managers
should consider including the potential response to
a creditor experiencing a liquidity problem during
times of market stress (for example, reluctance to
release collateral), as well as a unilateral decision on
the part of credit providers to increase haircuts and
collateral requirements.
Hedge fund managers should take into account in
their liquidity planning redemption “windows” or
other rights of hedge fund investors to redeem their
interests. Hedge fund managers should also take
into account the relationship between a
hedge fund’s performance and redemptions and
between a fund’s performance and the availability of
credit lines.
In an effort to enhance the stability of financing and
trading relationships, a hedge fund manager should
engage in constructive dialogue with a hedge fund’s
credit providers and counterparties to determine the
extent of financial and risk information to be provid-
ed. The extent of disclosure to be provided should be
mutually agreed with such parties depending on
their requirements and the extent and nature of the
relationship.
A counterparty’s credit department should be
required to provide assurances that financial and
other confidential information furnished by the
hedge fund manager will only be used for credit eval-
uation purposes and will not be made available to
any member of a counterparty’s trading desk or
department. These assurances could be confirmed
by the counterparty’s credit department in a written
confidentiality agreement or by providing a copy of
its confidentiality policies.
Counterparty credit risk
A hedge fund manager should understand and man-
56 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 56
age a hedge fund’s exposure to potential defaults by
trading counterparties. A hedge fund manager
should identify acceptable counterparties based on
an analysis of creditworthiness and set appropriate
risk limits. Where a judgment call with respect to a
particular counterparty is necessary, a hedge fund
manager’s senior management should determine
whether the counterparty’s creditworthiness is
acceptable (for example, based on an analysis of the
costs and benefits of dealing with the counterparty
to the extent practicable).
Once a trading relationship with a counterparty is
established, a hedge fund manager should ensure
that the counterparty’s creditworthiness is appropri-
ately monitored. A hedge fund manager should also
seek to establish appropriate collateral arrange-
ments with the counterparty and establish the
ability to make, if possible, and to respond to
collateral calls.
Leverage
A hedge fund manager should recognise that,
although leverage is not an independent source of
risk, leverage is important because of the magnifying
effect it can have on market risk, credit risk and liq-
uidity risk. Recognising the impact that leverage can
have on a portfolio’s exposure to market risk, credit
risk, and liquidity risk, a hedge fund manager should
assess the degree to which a hedge fund is able to
modify its risk-based leverage in periods of stress or
increased market risk.
Hedge fund managers should pay careful attention
to leverage, whether such leverage is measured in
terms of financial statement-based leverage or risk-
based leverage.
The best means of ensuring that utilisation of lever-
age is appropriate for each individual hedge fund is
for its hedge fund manager to manage its own lever-
age associated with its strategies, using appropriate
risk monitoring measures or implementation of its
strategies. Special attention should be paid to the
manner in which leverage impacts the ability of the
hedge fund manager to manage the risks to which
the portfolio is subject. Note that a hedge fund’s
exposure in the event of losses depends not merely
on the amount of its leverage, but on the contractu-
al and other measures it takes to address the conse-
quences to a hedge fund in the event of significant
losses.
A hedge fund manager should develop and moni-
tor several measures of leverage, recognising that
leverage, appropriately defined, can magnify the
effect of changes in market, credit or liquidity risk
factors on the value of the portfolio and can
adversely impact a hedge fund’s liquidity.
A hedge fund manager should recognise that lever-
age is not an independent source of risk; rather, it is
HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm
a factor that influences the rapidity with which
changes in market risk, credit risk or liquidity risk
factors impact the value of a hedge fund’s portfolio.
A hedge fund manager should seek to assess lever-
age while taking into account the limitations inher-
ent in different leverage measures.
Risk-based leverage
A hedge fund manager should track a hedge fund’s
leverage using “risk-based leverage” measures
reflecting the relationship between the riskiness of a
hedge fund’s portfolio and the capacity of the hedge
fund to absorb the impact of that risk.
The hedge fund manager should be aware of limi-
tations of the models used and should guard against
placing too much reliance on mathematical meas-
ures of leverage alone. For example, market risk
measures such as VAR are incomplete measures of
market risk because they focus on “standard” mar-
ket movements rather than extreme events.
Consequently, the hedge fund manager should con-
sider assessing the impact of extreme events by
comparing a market risk measure derived from
analysis of extreme event scenarios (or stress tests)
to the hedge fund’s capital. In addition, it is essen-
tial that the hedge fund manager use judgment
based on business experience in calculating and
assessing quantitative measures of leverage.
A crucial factor influencing the hedge fund’s ability
to absorb the impact of extreme market events is the
degree to which the hedge fund can modify its risk-
based leverage, especially during periods of market
stress. A hedge fund manager should therefore
assess its ability to reduce risk-based leverage by
modifying (upward or downward) traditional lever-
age or by reducing the level of risk that is being
accepted (for example, by changing strategy or the
types of assets being held in the portfolio).
Financial statement-based leverage
A hedge fund manager may consider tracking certain
traditional financial statement-based measures of
leverage as part of its financial reporting or in con-
nection with the analysis and interpretation of cer-
tain risk-based leverage measures or funding liquid-
ity. However, a hedge fund manager should recog-
nise that although such measures can provide use-
ful information if they are understood fully and inter-
preted correctly, they have a number of weaknesses,
particularly as stand alone measures of leverage.
Operational risk
Hedge fund managers should seek to limit a hedge
fund’s exposure to potential operational risks,
including reconciliation errors, data entry errors,
fraud, system failures and errors in valuation or risk
measurement models. They should consider the fol-
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 57
Page 57
lowing measures, among others, to limit or mitigate
operational risk, the implementation of which can be
performed through any number of support areas
within a hedge fund manager:
• random, periodic spot checks of all relevant activ-
ities;
• monitoring of risk, either internally with an appro-
priate level of checks and balances to ensure objec-
tivity of risk analysis, or through reliance on exter-
nal service providers;
• maintenance of a single, centralised position data
set (to avoid the errors inherent in maintaining
multiple or regionalised data sets);
• establishment of adequate internal controls and
review, including appropriate segregation of
duties, controls over incoming and outgoing cash
flows and balances with counterparties, daily con-
firmation of trades and positions; and
• reviewing the operational risk – including legal
compliance, and transactional policies.
Risk monitoring valuation
A hedge fund manager should establish policies for
determining when risk monitoring valuation meth-
ods may differ from NAV for operational or risk
analysis reasons. Portfolio values used to calculate
NAV should also be used for risk monitoring valua-
tion unless the hedge fund manager has determined
that operational or risk analysis reasons may justify
a different approach. For example, in order to exam-
ine potential effects on the portfolio of changes in
market conditions, the hedge fund manager may
permit the risk monitoring function to use alterna-
tive values or make adjustments to the position val-
ues calculated in accordance with GAAP for NAV
purposes. Similarly, in volatile markets, a hedge fund
manager may wish to discount prices for risk analy-
sis purposes if the risk monitoring function does not
believe that quoted bids or offers are prices at which
a trade could actually be executed.
Transactional practices
A hedge fund manager should pursue a consistent
and methodical approach to documenting transac-
tions with counterparties in order to enhance the
legal certainty of its positions. In addition, to the
extent applicable, a hedge fund manager should seek
to obtain best execution and establish guidelines for
using soft dollar arrangements, if applicable.
Documentation policies and controls
A hedge fund manager should establish transaction
execution and documentation management practices
that seek to ensure timely execution of necessary
transaction documents and enforceability of transac-
tions. To the extent practicable, a hedge fund manag-
er may wish to implement the following practices:
HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm
Hedge Fund Market GUIDE
• require that all trading counterparties be
approved prior to executing any transactions and
verify counterparty authorisations;
• establish documentation requirements for all
trading (including confirmation requirements and
documentation of master agreements as appropri-
ate); and
• ensure that appropriate security interests are cre-
ated and perfected when collateral is received as
part of a transaction.
A hedge fund manager should track the status of
documentation and the negotiation of key provi-
sions and terms such as termination events and
events of default (including use of a database if
needed) to seek to ensure consistency and stan-
dardisation across hedge funds and counterparties
to the extent appropriate and feasible.
A hedge fund manager should seek consistent
bilateral terms with counterparties to the extent
appropriate and feasible in order to enhance stabil-
ity during periods of market stress or declining
asset levels.
For example, a hedge fund manager may seek to
negotiate standardised events of default and other
termination or collateral events to achieve consis-
tency in documentation with different counterpar-
ties to the extent appropriate and feasible. A hedge
fund manager may also endeavor to avoid including
provisions that permit counterparties to terminate
or make demands for collateral solely at their dis-
cretion or based upon subjective determinations.
A hedge fund manager should seek to negotiate
bilateral collateral agreements that require each
party to furnish collateral, taking into account the
relative creditworthiness of the parties.
To the extent feasible, a hedge fund manager
should seek to establish collateral arrangements
either internally or through reliance on external
resources that permit the manager to effectively and
regularly make calls for deliveries and returns of col-
lateral from counterparties when permitted.
A hedge fund manager should have appropriate
documentation and approval processes for retain-
ing external traders as well as administrators, prime
brokers or other third party service providers.
Best execution
In selecting both “clearing” and “executing” brokers
on behalf of a hedge fund, the hedge fund manager
should consider, among other thing:
For clearing brokers:
• The operational expertise of the clearing broker
in providing clearing and custody services for the
products traded by the hedge fund manager;
• The clearing brokerage fees;
• The commission rate or spread involved when
58 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 58
the clearing broker executes transactions;
• The clearing broker’s responsiveness to the
hedge fund manager;
• The ability of the clearing broker to maintain the
confidentiality of all proprietary position informa-
tion provided;
• The clearing broker’s financial responsibility; and
• The clearing broker’s creditworthiness.
For executing brokers:
• The executing broker’s expertise in providing
timely execution services for the products traded
by the hedge fund manager;
• The ability of the executing broker to execute
transactions of size in both liquid and illiquid mar-
kets at competitive market prices without disrupt-
ing the market for the security traded;
• The ability of the executing broker to maintain
the confidentiality of all proprietary position infor-
mation provided;
• The executing broker’s execution fees;
• The range of services offered by the executing
broker, including the range of markets and prod-
ucts covered, quality of research services provided
and recommendations made by the executing bro-
ker;
• The quality and timeliness of market information
provided by the executing broker;
• The execution broker’s financial responsibility;
and
• The execution broker’s credit worthiness.
Because it is difficult to determine how to make a
best execution determination in the context of vari-
ous structured and derivative products, hedge fund
managers, in evaluating counterparties, should con-
sider additional factors that they deem relevant,
including, but not limited to:
• The range of derivative products offered by the
counterparty;
• The operational expertise of the counterparty in
providing confirmation, documentation, timely
settlement and ongoing operational support for
the derivative products entered into by the hedge
fund manager;
• The terms and appropriate documentation of the
derivative transactions products by the counter-
party;
• The counterparty’s financial responsibility;
• The availability of the particular derivative prod-
uct; and
• The counterparty’s creditworthiness.
Hedge fund managers should periodically examine
the performance of the brokers executing transac-
tions on behalf of a hedge fund to assess whether it
continues to provide best execution. Hedge fund
managers should include in its recordkeeping poli-
HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm
cies documentation of evaluations of the execution
quality of the brokers.
Soft dollar arrangements
A hedge fund manager should evaluate the types of
products and services that are the subject of soft
dollar arrangements, including, as appropriate, the
extent to which products or services have research
functions or are developed by a third party and pro-
vided by a broker and should develop policies relat-
ing to the use of these arrangements.
If applicable to its business model, a hedge fund
manager should develop policies related to soft dol-
lar arrangements, including the proper allocation of
products or services with mixed uses (computer
hardware that assists an adviser in research func-
tions and in non-research functions) so that non-
research services are paid for out of the manager’s
own funds and the proper allocation of “step out”
arrangements. Step out arrangements can assist a
hedge fund manager in obtaining best execution by
allowing it to use the broker that provides best exe-
cution to execute the trade and to pay commissions
to other brokers from which it receives research or
services through soft dollar arrangements. Policies
may vary depending on a hedge fund manager’s
customised advisory arrangements.
Policies should include procedures and documen-
tation requirements for thirdparty arrangements.
These may include, depending on the nature of the
hedge fund manager’s business, policies regarding
step-out arrangements, and proprietary arrange-
ments, addressing, as appropriate, approved bro-
ker-dealers and products/services, reliance on the
Section 28(e) of the Securities Exchange Act of
1934, as amended, safe harbor (Section 28(e)), per-
sonnel authorised to approve the product/service
and agreements or commitments regarding com-
mission quotas or thresholds. Policies should also
address retention of correspondence, including, if
applicable, emails related to directed brokerage and
step out arrangements and records of and the
value, quantity, purpose and ratios of each prod-
uct/service.
A hedge fund manager should fully disclose that it
may engage in soft dollar arrangements prior to
engaging in such arrangements and should clearly
disclose its policies with respect to such arrange-
ments, including:
1. Whether it may use the products and services
provided by a broker pursuant to soft dollar
arrangements to benefit hedge funds other than
those whose trades generated the relevant broker-
age commissions or fees; and
2. The types of products and services that may be
received through soft dollar arrangements in an
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 59
Page 59
appropriate level of detail.
If a hedge fund manager relies on the safe harbor
provided by Section 28(e), which protects the advis-
er from even a claim of breach of fiduciary duty sole-
ly because the adviser causes an account managed
by the hedge fund manager to pay for soft dollar
arrangements, the hedge fund manager should
evaluate with its advisers how to do the following:
1. Make a good faith determination that the
amount of commission is reasonable in relation
to the value of the brokerage and research servic-
es provided by the broker-dealer, in light of the
terms of the particular transaction or the hedge
fund manager’s overall responsibilities with
respect to its discretionary accounts;
2. Disclose the hedge fund manager’s policies and
procedures relating to such soft dollar arrange-
ments; and
3. Determine whether the brokerage and research
services are covered within the safe harbor (as set
forth in Section 28(e)(3)). In an interpretive
release relating to this prong, the SEC indicated
that “the focus should be on whether the product
or service provides lawful and appropriate assis-
tance to the money manager in the carrying out of
his responsibilities”.
If a hedge fund manager does not rely on the safe
harbor provided by Section 28(e) in its use of soft
dollar arrangements, the hedge fund manager
should evaluate with its advisors how to do the fol-
lowing:
1. Assuming that the services are not covered
within the Section 28(e) safe harbor, the hedge
fund manager should utilise those services that
are determined to provide lawful and appropriate
assistance to the hedge fund manager in carrying
out its responsibilities to hedge fund investors;
2. Make a good faith determination that the
amount of commission, under the soft dollar
arrangement, is reasonable in relation to the value
of the services provided by the broker-dealer, in
light of the terms of the particular transaction or
the hedge fund manager’s overall responsibilities
with respect to its hedge funds; and
3. Disclose the hedge fund manager’s policies
and procedures relating to such soft dollar
arrangements.
For a complete copy of the Managed Funds
Association's Sound Practices for Hedge Fund
Managers please visit MFA's website at:
www.mfainfo.org.
The MFA is the sole copyright owner of this content which is
not to be reproduced in any form without the express permis-
sion of the MFA
HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm Page 60

Service Provider PROFILES

Chris Cattermole

Company Brief: ket. Prior to joining Advent in 2005, Cattermole

Advent Software, formed in 1983, has over
4,500 clients managing in excess of USD14 tril-
lion. Clients include hedge fund managers,
prime brokers and fund administrators private
banks, wealth managers, asset managers and
family offices. Advent’s solutions cover the full
range of investment operations from front
through to the back office. The solutions
include Geneva, the premier real-time global
portfolio management and accounting, Advent
Portfolio Exchange; the industry’s only fully inte-
grated portfolio and client management system,
and Moxy, the industry’s most widely used trade
order management system.
Advent EMEA, formed in 1998, now has over
175 clients spread across the region with offices
in London, Zurich, Stockholm, Copenhagen,
Oslo, Amsterdam, Dubai and Athens.
held positions in the financial services industry at
Fidelity Brokerage Services, SS&C & Linedata
Services. After his European Baccalaureate in
Luxembourg, Cattermole earned his BA hons in
European Business Studies at the Hertford
Business School, University of Hertfordshire.
Key Services:
Advent’s solutions cover the full range of invest-
ment operations from front through to the back
office. The solutions include Geneva, the pre-
mier real-time global portfolio management and
accounting, Advent Portfolio Exchange; the
industry’s only fully integrated portfolio and
client management system; and Moxy, the
industry’s most widely used trade order man-
agement system.

Chris Cattermole is the European sales manager of

Advent’s Global Account business. In this role he
has responsibility for European strategy, product
marketing and sales of Advent’s Geneva solution
to the Alternative Investment Management mar-

Key Locations: Key Contacts:

Advent Software T: +44 20 7631 9240
One Bedford Avenue E: emea@advent.com
London WC1B 3AU
England
T: +44 20 7631 9240
E: emea@advent.com
W: www.advent.com

60 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008

HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm Page 61

Robert Chin

Company Brief: includes a seven year tenure as CFO of Dutch bro-

ATC Fund Services is a specialised hedge fund
administrator who has consistently received
excellent reviews from its clients. ATC provides
full administration to hedge funds, including
daily processing of all funds’ activities, NAV cal-
culation on a daily, weekly or monthly basis and
registrar and transfer agency services. In addi-
tion, ATC takes a proactive approach in assist-
ing start up hedge fund managers with the
incorporation of their fund in jurisdictions such
as the Cayman Islands, the British Virgin
Islands and the Netherlands Antilles.
kerage firm where he was a member of the
European Option Exchange and the Amsterdam
Stock Exchange. Furthermore, Chin spent the first
eight years of his career with Ernst & Young,
Amsterdam, The Netherlands.
Key Services:
ATC provides full administration to hedge
funds, including daily processing of all funds’
activities, NAV calculation on a daily, weekly or
monthly basis and registrar and transfer agency
services.

Robert Chin, chief executive officer, ATC Fund

Services.
Prior to establishing ATC Fund Services in Curaçao
in March 2003, Robert Chin was the managing
director of Fortis Fund Services (Curaçao) since
August 2002 where he was responsible for approxi-
mately 75 staff members and USD22 billion under
administration. During the last four years of his
tenure at Fortis, Chin was also a member of the
management team of Fortis Fund Services
International. His previous professional experience

Key Locations: Bon Bini Business Center, units 2B2K & 2B2L
Robert Chin Schottegatweg Oost 10
Chief executive officer Curaçao, Netherlands Antilles
ATC Fund Services T: (+) 5999 738 1351 ext 10
Bon Bini Business Center, units 2B2K & 2B2L F: (+) 5999 738 1311
Schottegatweg Oost 10 E: kedi.chang@atcfunds.an
Curaçao, Netherlands Antilles W: www.atcgroup.info
T: (+) 5999 738 1351 ext 11
F: (+) 5999 738 1311
E: robert.chin@atcfunds.an Key Contacts:
Robert Chin
Kedi Chang Chief executive officer
Managing director E: robert.chin@atcfunds.an
ATC Fund Services T: (+) 5999 738 1351 ext 11

HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 61

HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm
Service Provider PROFILES
Dermot Butler
Company Brief:
Custom House offers a full ‘round the world’
and ‘round the clock’ service out of its office in
Dublin and representative offices in Chicago
and Singapore. Services cover all aspects of day
to day operations, including maintaining the
fund’s books and records, carrying out the valu-
ations, calculating the NAV and handling all
subscriptions and redemptions, as well as over-
seeing payment of the fund’s expenses.
Reporting can be effected through CHARIOT,
Custom House’s secure web reporting platform
for managers and investors. Custom House is
the only hedge fund administrator in the world
to have been awarded a Moody’s Management
Quality Rating.
Custom House is authorised and regulated by
the Irish Financial Regulator under Section 10 of
the Investment Intermediaries Act of 1995
(which authorisation does not extend to the
Chicago and Singapore representative offices).
Dermot Butler, who is chairman of Custom House
Administration & Corporate Services Limited
(Custom House), the Dublin based alternative
Key Locations:
Dublin
T: +353 1 878 0807
Chicago
T: +1 312 280 0330
Singapore
T: +65 6303 8393
W: www.customhousegroup.com
62 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008
Page 62
investment and hedge fund administrator and has
over 35 years of experiences in the financial services
industry. Butler has worked variously as a stock
broker and stock jobber (specialising in South
African mining stocks), before becoming a com-
modity broker and market maker in metal options
on the London Metal Exchange (LME). Butler was
a member of the Options Sub Committees of the
LME, liaising with the Bank of England, the UK
Department of Trade and the US Commodity
Futures Trading Commission (CFTC) on option
regulation.
Key Services:
Turn-Key Package incorporating alternative
investment and hedge fund set-up and full fund
administration service, to include:
- fund administration services
- shareholder services
- corporate secretarial services
- fund formation services
- assistance on obtaining a stock exchange list-
ing
Key Contacts:
Dermot Butler, chairman
dermot.butler@customhousegroup.com
David Blair, managing director
david.blair@customhousegroup.com
HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm
James Levy
Company Brief:
Hassans was founded in 1939, and is the largest
law firm in Gibraltar. It was the first to structure
itself as a modern international law practice,
with separate departments for different fields of
specialisation. Its aim is to give high quality,
personal and effective service to its clients of
what ever size or nature. The firm has an inter-
national clientele, which it continues to develop.
It has global links with major international law
firms and a presence in Spain.
The majority of the firm’s work is related to
international clients. Many of them use
Gibraltar companies and trusts to structure
their fiscal, fiduciary or investment require-
ments and, over the years, strong links have
been forged with major multinationals, financial
institutions, banks, law and accountancy firms
worldwide.
Gibraltar’s status as part of the EU is a signifi-
cant factor in attracting such institutions and
businesses. The firm’s international clients
come mainly from the US, the UK, Israel and
Europe (in particular Luxembourg, the
Netherlands, Spain and Portugal).
Key Locations:
57/63Line Wall Road,
PO Box 199,
Gibraltar
T: +350 79000
F: +350 71966
E: info@hassans.gi
W: www.gibraltarlaw.com
HEDGE FUND SERVICES MARKET GUIDE 2008 INVESTOR SERVICES JOURNAL 63
Page 63
Languages spoken: English, Spanish, French,
Hebrew, Portuguese, German and Chinese
(Cantonese and Mandarin).
James Levy advises large public companies on
mergers and acquisitions and property companies
on acquisitions throughout Europe. He assisted the
government of Gibraltar on its development of the
jurisdiction as a finance centre. This has included
advice on anti-money laundering, banking, insur-
ance, financial services and trust legislation.
Key Services:
The majority of the firm’s work is related to
international clients. Many of them use
Gibraltar companies and trusts to structure
their fiscal, fiduciary or investment require-
ments and, over the years, strong links have
been forged with major multinationals, financial
institutions, banks, law and accountancy firms
worldwide.
Key Contacts:
Senior partner: James Levy QC.
Number of lawyers: 60
Centro Sotomarket oficina 8
Urb Sotogrande
11310 San Roque
Spain
E: info@hassans.gi
W: www.gibraltarlaw.com
HFSMG 2007 pp50-64 ML 26/10/07 6:22 pm Page 64

Service Provider PROFILES

Donard McClean

Company Brief: Key Services:

Fund Services, based in the Cayman Islands, With specialist expertise in both single manager
Ireland and Canada, holds a leading position in and fund of hedge fund administration, services
the area of hedge fund administration, offering can be provided for both onshore and offshore
a complete range of services including funds. Capabilities also extend to services for
accounting, NAV computation, shareholder investment funds through our teams in
services, banking and credit facilities. With the Luxembourg, Switzerland and the UK.
dedication and experience of a professional
team of 280 and state of the art web reporting,
accounting and shareholder systems, UBS is
well positioned to provide clients with a first
class service.

Donard McClean is head of Fund Services Ireland,

at UBS Global Asset Management, with specific
responsibility for the development and manage-
ment of the business. He is a member of the Fund
Services Management Board and is responsible for
hedge fund operations within Fund Services
globally. McClean has 18 years of investment
industry experience, is a graduate of the University
College Dublin and a fellow of the ACCA. Prior to
joining UBS in 2006, he spent nine years at Fortis,
and before that was with Rudolf Wolf Fund
Management Ireland, Strachans Management
Services and Coopers and Lybrand Jersey.

Key Locations: Key Contacts:

Canada Canada: Pearse Griffith
T: +1-416-971 4700 T: +1-416-971 4702
Cayman Islands Cayman Islands: Darren Stainrod
T: +1-345-914 1000 T: +1-345-914 1076
Ireland Ireland: Don McClean
T: +353-1-436 3600 T: +353-1-436 3636
Luxembourg Luxembourg: Jean-Paul Gemari
T: +352-44-1010 1 T: +352-44-1010 6503
Switzerland Switzerland: Markus Steiner
T: +41-61-288 4910 T: +41-61-289 0492
UK UK: Mark Porter
T: +44-20-7901 5000 T: +44-20-7901 5371
W: www.ubs.com/fundservices

64 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2008

HFSMG 2007 Cover 29/10/07 2:28 pm Page 3
 Successful Hedge
Fund Administration?
It’s a question of
partnership.
Page 4

Find out more by visiting www.ubs.com/fundservices

2:28 pm

or e-mail us at fundservices@ubs.com
29/10/07
HFSMG 2007 Cover

Global Asset
Management You & Us
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