INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006

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2006
INVESTOR
SERVICES
JOURNAL
HEDGE FUND SERVICES
MARKET GUIDE
£10 - UK, ROW
$20 - Americas
€ 15 - Europe, Mid-East, Africa
investor
intelligence WWW.ISJFORUM.COM
Dresdner K|e|nwort Wasserste|n (DrKW} |s the |nvestment bank of Dresdner Bank AG and a member of A|||anz. Dresdner Bank AG |ondon Branoh, 2 Swan |ane, |ondon, EO4R 3Ü×. Author|sed by
the German Federa| F|nano|a| Superv|sory Author|ty and by the F|nano|a| Serv|oes Author|ty, regu|ated by the F|nano|a| Serv|oes Author|ty for the oonduot of des|gnated |nvestment bus|ness |n the ÜK
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Hedge Fund Services Market Guide
Anyone involved in the financial
markets will remember always the
“perfect storm” that occurred in
August 1998. The virtual meltdown
of the Russian economy combined
with continued economic problems
in Japan, poor performance in
emerging markets debt securities,
dramatic declines in the stock
prices of global banking institu-
tions, and a severe widening of risk
premiums between U.S. Gover-
nment debt and other debt instru-
ments which led to now legendary market turmoil and a
Category 5 storm that wreaked havoc for months. The loss-
es globally amounted to hundreds of billions of US dollars.
Hedge fund performance suffered severely and catapulted
the industry into a household word due to the near collapse
and famous “bail-out” of Long-Term Capital Management
(LTCM). In the wake of the LTCM debacle, hedge funds,
their lenders, and their trading counter-parties faced
intense scrutiny from government legislators and regula-
tors, particularly in the U.S.
And, as with every storm, a silver lining eventually emerged.
In April 1999, The President’s Working Group on
Financial Markets (PWG) published a study recommending
that hedge funds establish a set of sound practices for their
risk management and internal controls. In response to the
PWG recommendation, the original Sound Practices for
Hedge Fund Managers was published in 2000. This
document, a set of guidelines, focused largely on the
internal risk monitoring functions of large hedge fund
managers and also addressed management and internal
controls, valuation policies and procedures, and regulatory
and documentation controls.
Sound Practices for Hedge Fund Managers is a dynamic
document for a rapidly evolving and highly entrepreneurial
industry, and is widely embraced by hedge fund profession-
als. Just like the industry it represents, it is a living manu-
script that requires an occasional check-up and, from time
to time, an update or alteration. Thereby, the guidance was
revised in 2003, and again this year.
On August 3, 2005, Managed Funds Association (MFA),
the leading Association of the hedge fund industry, pub-
lished its third iteration of guidance – MFA’s 2005 Sound
Practices for Hedge Fund Managers (MFA’s 2005 Sound
Practices) -- for the benefit of its members and the hedge
fund industry as a whole. MFA believes that the
recommendations provided in the 2005 Sound Practices
will enhance the ability of hedge fund managers to manage
operations, comply with applicable regulations, address
unexpected market events. and help to satisfy their
responsibilities to investors.
MFA’s 2005 Sound Practices is written by the industry, for
the industry, from a “peer to peer” perspective and focuses
on practices that are primarily relevant to the single
manager hedge fund operation. From its inception through
the current version, industry sound practices are premised
on the belief that the most effective form of industry over-
sight is “self-evaluation combined with the development of
strong practices and internal controls.”
Perhaps most importantly, MFA’s 2005 Sound Practices
recognizes that “one size does not fit all” among hedge
fund managers or their funds. The strategies, investment
approaches, organizational structures, and amount of
assets managed by individual hedge fund managers vary
greatly. For this reason, MFA’s 2005 Sound Practices offers
enough specificity to provide meaningful guidance, but rec-
ognizes that it is impossible to address all of the considera-
tions that should be taken into account in determining
whether and how to apply the recommendations.
In ISJ’s Hedge Fund Services Market Guide you will find
an Executive Summary of MFA’s 2005 Sound Practices and
certain excerpts from the document to give readers a sense
of what the document offers. MFA’s 2005 Sound Practices
is the latest addition to a long history of achievement on
many educational and policymaking initiatives on behalf of
a burgeoning industry. MFA is confident that the sound
practices set industry standards of excellence that help both
hedge fund managers and their investors understand the
scope of sound business practices that should be adhered
to by the industry. The document is widely respected and
has been well received by a wide audience. It is a center-
piece for educating policymakers, on a global basis, as
hedge fund regulatory issues continue to be vigorously
debated in the public discourse.
John G. Gaine, President, Managed Funds Association
The Dynamic
of Sound
Practices
John Gaine of the MFA on the need for
strong hedge fund industry practices
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 1
John Gaine MFA
Hedge funds have been on the receiving end
of good and bad press since their introduction
to financial markets. Certain media have sought
to portray them as risky undertakings, with nega-
tive impacts on the systemic risk of financial
markets. Other media have glorified hedge
funds for their ability to generate handsome
returns for pensions funds and other institution-
al investors, particularly in the face of more
mediocre returns provided by traditional invest-
ment instruments.
Fact Finding
Whatever the perception about these funds,
hundreds of questions have yet to be answered.
What, exactly, is a hedge fund? What investment
strategies do they employ? What systemic risks
do they present to worldwide financial markets?
How skilled are the people who manage them
and, more importantly, how can hedge fund
service providers ensure these funds are compli-
ant with best practice? It has been argued that
part of the lure of hedge funds is their apparent
lack of transparency.
In our first Hedge Fund Services Market
Guide, Investor Services Journal seeks to uncov-
er some of the ‘mysteries’ behind hedge funds,
their different strategies, their impact on the
wider financial market place and how relation-
ships between hedge funds and their service
providers, the administrator and the custodian
can ensure regulatory compliance and longevity.
From forestry to art trading, hedge funds are
inevitably involved in some way, shape or form,
thereby intensifying their role in systemic risk.
Long Term Capital Management, for example,
took a bet on low value stocks and leveraged its
position by purchasing good stocks. The pur-
chasing power granted to the hedge fund by
banks and broker dealers had a profound impact
on these lending institutions, and hence the
wider financial market place when LTCM was
declared over-borrowed.
Regulation
The amount of money hedge funds can make
in a short space of time, and the sheer size of
some of these funds has caught the attention of
financial regulators worldwide.
In the US for example, the Securities &
Exchange Commission intends to make it an
obligation for all hedge fund managers with US
investors to register with the Commission by
January 2006. This will result in an onus on the
hedge fund manager to produce a fair amount of
paper work in order to satisfy regulatory con-
cerns about hedge funds. In the UK, the Bank of
England has sought to uncover the systemic risk
behind hedge funds via its Financial Stability
Review. As hedge funds enter the domain of the
retail investor, further regulation is inevitable.
Regulation provides an added layer of comfort to
institutional and retail investors and further reg-
ulation is likely until all investors’ interests are
protected. While regulation may often appear
quite burdensome for some hedge fund man-
agers, help is only a step away. Fund administra-
tors offer a variety of solutions that enable hedge
fund managers to comply with regulation while
they focus on managing money. Law firms can
also advise on the most appropriate domicile for
a particular fund.
Technology
Technology and automation will also have wide
ranging impacts on the future of the hedge funds
industry. Even the top hedge fund managers,
comprising roughly 40 members of staff, are still
reliant on the fax machine when processing their
orders. The rise of algorithmic trading in the
hedge funds industry serves to provide a black
box approach to hedge fund trades, whereby
traders can predict, via algorithmic trading tech-
nology, the likely outcome of a hedge fund trade.
The automation of hedge fund trades has indi-
rectly contributed to an era of best execution,
where investors can be sure they are getting the
best price from their broker.
Technology also enables hedge fund managers
to produce monthly and daily NAVs. This tech-
nology is either white labelled or externally sup-
plied by third party technology vendors and fund
administrators.
The tools to ensure further transparency and a
greater lifespan of the hedge funds industry are
there. ISJ and industry service providers present
an insight into how they can be obtained.
Janet Du Chenne - ISJ
2 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
Into the Light
Welcome to the second in our
series of Market Guides, following
our Securities Lending Market
Guide. Here we address the
market of services to Hedge
Funds at a time when these funds
are attracting investors and
controversy in equal measure
This document has been prepared solely for information purposes by TD Securities. It is not an offer, recommendation or
solicitation to buy or sell, nor is it an official confirmation of terms. Any transaction entered into is in reliance only upon
your judgement as to financial suitability and risk criteria. TD Securities does not hold itself out to be an advisor in these
circumstances, nor does any of its staff have the authority to do so. The information in this document is subject to change
without notice. Not intended for US distribution at this time. Approved in the UK and Europe by TD Securities Limited for
issuance to persons falling within Articles 19 and 49 of the Financial Services & Markets Act 2000 (Financial Promotion)
Order 2001. TD Securities Limited is authorised and regulated by the Financial Services Authority. TD Securities is a trade-
mark of The Toronto-Dominion Bank and represents TD Global Finance, TD Securities Inc., TD Securities (USA) LLC,
TD Securities Ltd and certain investment and corporate banking activities of The Toronto-Dominion Bank.
Are you an asset allocator seeking information on
the Canadian market or on Canadian Alternative
Investment Managers?
Talk to us.
TD Securities Prime Brokerage is one of Canada’s leading service
providers to the Alternative Investment industry. The Canadian
landscape includes a large number of Hedge Fund Managers focused
on the domestic market across a wide range of strategies.
We can help you get to know them.
Contact Vicki Juretic: 1 416 308 1560 / [email protected]
Let’s talk about
Canada.
Contents
AN INTRODUCTION BY THE ALTERNATIVE INVESTMENT MANAGEMENT ASSOCIATION
6 PART 1 BACKGROUND
8 PART 2 WHAT ARE HEDGE FUNDS?
10 PART 3 STRATEGIES AND EXAMPLES
14 PART 4 HEDGE FUND RISK/RETURN DRIVERS
14 PART 5 INVESTING IN HEDGE FUNDS
THE MFA’S SOUND PRACTICES FOR HEDGE FUND MANAGERS
18 PART I MANAGEMENT AND INTERNAL TRADING CONTROLS
20 PART II RESPONSIBILITIES TO INVESTORS
21 PART III VALUATION POLICIES AND PROCEDURES
23 PART IV RISK MONITORING
27 PART VI TRANSACTIONAL PRACTICES
29 APPENDIX III: MFA PRELIMINARY GUIDANCE ON DEVELOPING
ANTI-MONEY LAUNDERING PROGRAMS
AN ANALYSIS OF THE EVOLUTION OF THE HEDGE FUNDS INDUSTRY
WHY HAVE THE NUMBER OF HEDGE FUND ASSETS INCREASED IN THREE YEARS?
SEAN FLYNN OF UBS ON THE GROWTH IN HEDGE FUND SERVICES & NEW CHALLENGES
ROBERT CHIN OF ATC FUND SERVICES LOOKS AT DEVELOPING REGULATION
JAMES LASRY OF HASSANS ON WHY GIBRALTAR IS AN IDEAL DOMICILE
LIONEL DEMERCADO OF TD SECURITIES PRESENTS THE LATEST HUB FOR HEDGE FUNDS
THE DUBAI INTERNATIONAL FINANCIAL CENTRE
GOAL’S STEPHEN EVERARD ON THE IMPOR TANCE OF TAX RECLAMATION TO INVESTORS
OUR PANEL OF HEDGE FUND EXPERTS DEBATE THE CHALLENGES AND OPPORTUNITIES
INDUSTRY EXPERTS ANSWER A RANGE OF QUESTIONS FROM CLIENTS
PROFILES OF MOVERS & SHAKERS IN THE HEDGE FUND SERVICES INDUSTRY
DEFINITIONS OF VARIOUS HEDGE FUND SERVICES INDUSTRY TERMS AND PHRASES
8
18
37
39
41
43
45
48
52
54
56
63
72
80
INTRODUCTION
HEDGE FUNDS &
SERVICES
HOW TO...
SOUND PRACTICES
HISTORY & GROWTH
HEDGE HISTORY
RISE OF THE FUNDS
WORDS OF WISDOM
CHANGING LANDSCAPE
LOCATION, LOCATION
THE CUT OF YOUR GIB...
CANADA CALLING
DUBAI
SERVICES
ARE INVESTORS
LOSING OUT ?
PANEL DEBATE
ASK THE EXPERTS
COMPANY PROFILES
GLOSSARY
Hedge Fund Services Market Guide
4 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
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THE FOLLOWING IS AN EXTRACT FROM ‘THE HEDGE FUND BOOKLET’
BY THE ALTERNATIVE INVESTMENT MANAGEMENT ASSOCIATION.
This introduction is designed to assist the financial
community and investors in their understanding of
hedge funds. The document covers:
- the hedge fund market,
- hedge fund strategies,
- and the risk/return characteristics of hedge funds.
Given the steady increase in hedge funds offered in the
global marketplace, more investors will begin to
recognise the benefits of including hedge funds in a
diversified portfolio.
1 BACKGROUND
1.1 History of the Hedge Fund Industry
The first hedge fund was started in 1949, a mere 55
years ago, by an Australian called Alfred Winslow Jones.
Jones utilized two speculative tools – short selling and
leverage – to protect his long portfolio of stocks in a
falling market, and so preserve capital to achieve
superior returns over the long-term. This strategy proved
successful as Jones outperformed the best equity mutual
funds during the 50’s and 60’s, leading to numerous
imitators.
Despite the long history of ‘hedged’ investing for the
goal of an absolute return, hedge funds did not reach sig-
nificant levels of profile or use until Fortune magazine
published an article in 1966 on Jones, entitled ‘The Jones
that no-one can keep up with.’
The first fund of hedge funds appeared in 1969, started
by Georges Karlweis in Geneva, closely followed by the
second, started in the United States by Grosvenor
Partners in 1971.
The 1960’s bull market encouraged many hedge fund
managers to utilize leverage on their long portfolio, and
forego short-selling - a development that led to the deci-
mation of the industry during the bear markets of the
early 1970’s. To illustrate, the S&P500 fell by 14.5% and a
further 1.1% in 1969 and 1970 and a massive 19% and
29% in 1973 and 1974.
During 1984, the original hedge fund manager Alfred
Winslow Jones, re-organised his multi-manager hedge
fund into a formal fund of hedge funds structure. In
1986, Institutional Investor published an article on Julian
Robertson, manager of the Tiger Fund, reporting that
during its first six years, Robertson’s fund had earned
43% per annum.
In comparison the S&P 500 had earned 18.7 per annum!
Over the past 50 years, the hedge fund industry has
grown and extended from a predominantly US based
industry, to European, Asian, and emerging markets
funds.
The growth in the industry was accelerated through the
1990s during which time the increase in the number of
new financial vehicles and a change in technology facili-
tated the development of sophisticated investment
strategies without the need for backing by large invest-
ment houses1. In addition, the success of high-profile
managers such as George Soros, Julian Robertson, and
Michael Steinhardt, performance based incentive fees
and low barriers to entry for new funds led to highly-
skilled entrepreneurial investment professionals leaving
large investment houses to start up their own hedge
funds, some with initial backing from their former
employer and many with their own funds.
The global bond crisis in 1994 caused real damage to
some high profile hedge funds, including Soros’s
Quantum Fund. The crisis was the result of multiple
causes including hedge funds and conventional funds
being massively invested in the bond markets, an unex-
pected 0.25% increase in US interest rates interpreted as
signalling increasing inflation and therefore interest
rates, rumours about the financial stability of a signifi-
cant banking institution (Bankers Trust), a political assas-
sination in Mexico and a liquidity crisis. South African
bonds lost 9.1% in 1994, its second biggest loss in more
than 100 years. In the desperate search for someone to
blame, hedge funds were in the spotlight and strong calls
were made for regulations.
In 1998, Long Term Capital Management (LTCM), a
massive and very public hedge fund involving Nobel
Prize winners and respected industry leaders crashed,
ultimately losing $4.4 billion. The fund was eventually
bailed out by a consortium of major banks, facilitated by
the US Federal Reserve, and finally effectively liquidated
in 2000. By 1999, the year after the LTCM disaster, and
possibly as a response to it, the fund of hedge funds con-
cept had become a generally accepted means of manag-
ing the risks of investing in a single hedge fund.
Both the amount invested in hedge funds and the num-
ber of funds on offer has increased substantially over the
past 14 years. From approximately $40bn assets under
management (AUM) spread across 500 funds in 1990,
current estimates are of $820bn AUM spread across
8,100 hedge funds around the globe.
1.2 The Size of the Hedge Fund Industry
Estimates on the size of the hedge fund industry vary, as
many successful and closed funds are not included in the
various hedge fund indices and surveys, approximately
1/3 of funds overlap across the leading surveys, and there
is a measure of double-counting between single strategy
funds and fund of funds. To illustrate, Hedge Fund
Research Inc estimated the growth in hedge funds from
1990 to December 2003 as $38.9bn across 530 funds in
6 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
Introducing...
Hedge Funds
1990 to over $800bn across 4,742 funds by end 2003,
while Van Hedge Fund Advisors 2Hedge Funds: Number
of Funds & Dollars Under Management 1999-2003, Van
Hedge Fund Advisors International, LLC, 2004.
Very different growth rates for the industry have been
cited, but most commentators agree that 2001 was the
pivotal year for the hedge fund industry, as according to
Hennessee Group LLC the hedge fund industry grew by
38% in 2001 to a total estimated size of US$563 billion
from US$408 billion in 2000 and “it was the first time a
bear market has been met by a mature hedge fund indus-
try ... reflects investor recognition of hedge funds as a
realistic alternative investment for the purpose of diversi-
fying portfolios, capital, appreciation, and managing
downside risk”.
1.3 Who Invests in Hedge Funds?
Historically, high net worth individual investors, who
desired an absolute return and a reduced level of risk,
have been the main investors into hedge funds. The land-
scape is now changing with institutional investors
increasing their allocation to hedge funds, as they seek
out alternative investments that offer low correlations to
traditional portfolios of cash, bonds and equities. Strong
demand has also seen the SEC and other regulators turn
their attention to facilitating access to retail investors
through a move from a loosely regulated environment to
jurisdiction specific guidelines, e.g. Hong Kong,
Singapore, Germany, Italy, Ireland, and soon South Africa.
In their 2003 “Hedge Fund Investor Survey”, the
Hennesee Group reported that the largest investors in
hedge funds in the US continue to be individuals and
family offices, representing 47% of capital in the industry.
Portfolio allocations to hedge funds were surveyed at
28%, with 55% of respondents seeking to increase
exposure that year.
Significantly, research by Morgan Stanley has
highlighted the spectacular growth in the market share of
hedge fund of funds, which now represent 35% of hedge
fund investments, and have grown at 40% for the last 3
years. This represents double the growth rate of the
hedge fund industry itself over the period!
2 WHAT ARE HEDGE FUNDS?
2.1 Hedge Funds Defined
While there is no standard international definition of
hedge funds, these investment structures typically dis-
play the following common characteristics:
• The funds utilise some form of short asset expo-
sures or short selling to reduce risk or volatility,
preserve capital or enhance returns.
• Derivatives are used, and more diverse risks or
complex underlying products are involved”.
• The funds use some form of leverage, measured
by gross exposure of underlying assets exceeding
the amount of capital in the fund.
• The managers of the funds charge a fee based
on the performance of the fund relative to an
absolute return benchmark such as inflation or call
interest rates.
• Investors are typically permitted to redeem their
interest only periodically, e.g.quarterly or semi annually.
• Often significant ‘own’ funds are invested by the
manager alongside those of investors.
The term “hedge” is generally associ-
ated with the practice of covering an
investment position (long) with an
investment that will act as an opposite
position (short), thereby nullifying any
market risk imbedded in the original
investment decision. The hedge may
be in the form of a similar asset type
to hedge market risk (e.g. equities) or
a different security of the same issuer
(e.g. equity/ bond). The degree by
which a fund is “hedged” in the tradi-
tional sense varies markedly across
managers.
2.2 Comparing Hedge Fund
Managers to Traditional Investment
Managers
Hedge fund managers differ from
traditional active managers manag-
ing benchmark relative funds in a
number of ways. The two most sig-
nificant are the approaches to risk
and return.
8 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
Relative returns
Constrained by benchmark index
Limited investment strategies Take
longonly positions Do not use
leverage
High correlation to traditional
asset classes
Dependent on market direction
Tied to assets under management,
not to performance
Manager may or may not co-invest
alongside investors
Good liquidity
Small minimum investment size
Set up as a trust or investment
company
Highly regulated; restricted use of
short selling and leverage
Absolute returns
Unconstrained by benchmark index
Flexible investment strategies Take
long and short positions May use
leverage
Generally, low correlation to
traditional asset classes
Often independent of market
direction
Tied primarily to performance
Manager generally coinvests
alongside investors
Liquidity restrictions and initial
lock-up periods
Usually large minimum investment
size
Set up as a private investment,
limited partnership or a trust
Less regulated; no restrictions on
strategies Less mandated
disclosure
1 Return Objective
2 Benchmark
3 Investment Strategies
4 Market Correlation
5 Performance
6 Fees
7 Manager’s Investment
8 Liquidity
9 Investment Size
10 Structure
11 Regulation
Traditional Investing Hedge Fund Investing Characteristic
Source: AIMA
Comparing Traditional Investing to Hedge Fund Investing
Introducing Hedge Funds & Services
a) Risk
• Most hedge fund managers define risk in terms of
potential loss of invested capital (total risk) where
as traditional active managers define risk as the
deviation (tracking error) from a stated benchmark.
• The risk associated with hedge funds is therefore
highly dependant on the skills of the individual
manager, both in implementing the chosen strategy
successfully and in the running of their business.
b) Return
• Hedge fund managers aim to deliver a total return
unrelated to a benchmark or index that is therefore
independent of the general direction of markets. A
traditional active manager largely aims to deliver
relative returns (returns above a related benchmark).
• This relative return may be negative if the bench
mark return is negative. Therefore, the generation
of returns by hedge funds is reliant on the skill of
the manager, whereas traditional strategies prima
rily reflect the return of the underlying asset class.
International Organization of Securities
Commissions (IOSCO) Regulatory and Investor
Protection Issues Arising from the participation by
Retail Investors in (Funds-of ) Hedge Funds 2003
(hereafter IOSCO Report) at 40.
2.3 Characteristics of Single Manager Hedge Funds
• Hedge funds are typically organised as limited
partnerships, limited liability companies, unit
trusts or listed entities as investment pools.
• Many are domiciled offshore to neutralise tax
effects and consequently for South African
investors Exchange Control legislation may apply.
• Performance related compensation is prevalent,
typically with a high water mark and hurdle rate to
ensure a manager will only take incentive fees on
profit generated by positive investment perform-
ance above a certain level.
• Typically, a proportion of the partner’s or princi-
pal’s wealth is invested in the funds, hence aligning
their interests with the performance of the fund.
• Limited in size to preserve investment returns.
• High minimum investment levels.
• High expected risk-adjusted returns.
• Low correlation with traditional asset classes and
other skill based strategies.
2.4 Structure of Hedge Fund
The structural make-up of a typical hedge fund is
depicted in the diagram overleaf. This diagram displays
the component service providers of hedge funds and
their roles and relationships.
2.5 Some Practicalities of Investing in Hedge Funds
• Many hedge funds value assets monthly or
quarterly. Therefore unit prices will only be available
when assets are re-valued. This makes it difficult for
investors that require daily unit pricing to include
hedge funds on their menus.
• A lock-up period may apply, restricting the
liquidity of investors’ assets. Monthly and quarterly
unit pricing also impacts fund liquidity. Some
redemption policies may also require a long notice
period (e.g. 60 days notice).
• The investor should be aware of the level of
gearing permitted within a fund.
• Some hedge funds may distribute income
infrequently (annually) or in some cases not at all.
• While many well run hedge funds stay open to
new investment for many years, some hedge
funds may close to new investors although
remain available through fund of hedge funds
operators.
• Critically, investors should establish the maximum
potential loss or liability that an investment could
result in.
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 9
Investor
Processes the subscriptions &
redemptions. Calculates the
value of investors’ holdings
(NAV or partnership shares).
Executes the transactions
ordered by the fund manager.
Sets and manages the fund’s
investment strategy.
Holds the fund’s assets.
Monitors and controls
thecapital flows to meet
margin calls.
Source: AIMA
Typical Structure of a Hedge Fund Offering
Fund Administrator
Hedge Fund
Custodian
Prime Broker
Hedge Fund
Manager
3 STRATEGIES AND EXAMPLES
There are a multitude of strategies used by hedge fund
managers, and hedge funds can be classified in a variety
of ways; based on process or strategy, asset class,
geographical location, industry sectors, or return driv-
ers. To date there is no standard classification system,
and there are numerous hedge fund indices developed
by financial services companies (e.g. S&P, MSCI, HFR,
etc), each with different characteristics and classification
methodologies.
The most consistent classification is based upon the
process or strategy that a fund employs and the asset
class used. This classification has limitations and
difficulties when comparing across regions or industries,
but the returns generated in hedge funds are primarily
driven by the skills of the investment managers in the
particular strategies or processes employed. Process
describes the methodology that managers follow when
creating positions and managing their portfolios and
investment risk. Generally these strategies can be further
divided into directional and non-directional strategies.
3.1 Relative Value Strategies
When using relative value or arbitrage strategies, a
manager generally seeks to profit from perceived mis-
pricing in a specific asset or security. With each position
held in the portfolio, the manager attempts to isolate
and capitalise on a feature of an asset (or combination of
assets) that is mispriced relative to a theoretical fair
value or equilibrium relationship. The most common rel-
ative value strategies include convertible arbitrage, fixed-
income arbitrage, and equity market neutral. The degree
of leverage used in arbitrage strategies varies depending
on the strategy and the portfolio objectives, but is usually
between 2x and 10x the underlying equity value.
3.1.1 Convertible Arbitrage
A convertible arbitrage strategy aims to profit from
mispricing opportunities within convertible bonds and
other hybrid debt/equity securities. (Note: A convertible
bond is a bond with an embedded call option on the
company’s stock). Convertible securities are a combina-
tion of various instruments, and the parcel as a whole
may have a different price than the sum of the compo-
nent parts. If the price is different, there is an opportuni-
ty to buy (sell) the parcel and sell (buy) the various com-
ponent parts to lock in a profit.
Therefore the generation of “alpha” is independent
from the general direction of markets. A typical invest-
ment is to buy the convertible bond and sell the common
stock of the same company, to take advantage of the
stock’s price volatility. Positions are designed to generate
returns from both the bond and the short sale of stock,
while protecting principal from market moves. The fund
uses the short stock position to protect against declines
in the bond’s principal value.
3.1.2 Fixed-Income Arbitrage
Fixed-income arbitrage managers aim to profit from
price anomalies between related interest-rate securities.
Most managers trade globally, with a goal of generating
steady returns with low volatility. A fixed-income
arbitrage strategy includes interest-rate swap arbitrage, US
and non-US government bond arbitrage, forward yield
curve arbitrage, and mortgage-backed securities arbitrage.
The mortgage-backed securities market is complex, and
primarily trades over-the-counter in the US.
Leverage will depend on the types of portfolio positions,
which include basis trading, inter-market spreads, yield
curve trading, relative-value option strategies and
financing strategies.
3.1.3 Equity Market-Neutral
An equity market-neutral strategy is designed to
exploit equity market inefficiencies, and usually
involves long and short matched equity portfolios
of the same size. The manager aims to position the
portfolio to be cash or beta neutral, or both.
Typically the portfolio will exhibit a small or nil net
market exposure. Well-designed equity market-neutral
portfolios typically control for industry, sector, style,
market capitalisation, currency and other
exposures, which results in a near 50:50 balance of
long and short positions. Leverage is often applied to
enhance returns.
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Fixed-Income Arbitrage example:
A simple example of a fixed-income arbitrage strategy
is a basis trade. This trade involves the purchase or
sale of an interest-rate futures contract and a concur-
rent offsetting sale or purchase of a fixed-income secu-
rity that is deliverable into the futures contract. This
can be illustrated with the following transaction:
Purchase a government bond Simultaneously
Sell a futures contract on that bond.
Profit Opportunities Uncertainty in the composition
of bonds required in the delivery option of the bond
futures Shift in the supply and demand for the
underlying bonds.
Convertible Bond example:
Here the manager believes a convertible bond to be
undervalued relative to its current market price and
at the same time views equity of the company to be
overvalued, expecting the market price of equity to
fall. The manager will buy the convertible bond and
short the stock of the same issuer to eliminate the
stock price risk embedded in the convertible bond.
When executing a strategy of long convertible
bonds and short equity, the manager will need to
consider the credit risk associated with the trade.
Asset swaps can be used to strip out the credit risk
from convertible bonds.
Introducing Hedge Funds & Services
3.2 Event Driven
An event-driven strategy is designed to capture price
movements generated by a significant pending corporate
event, such as a merger, corporate restructuring,
liquidation, bankruptcy, or reorganisation. Two sub-
categories in event-driven strategies are: merger or risk-
arbitrage (non-directional), and distressed/high yield
securities (directional).
3.2.1 Merger Arbitrage (also see table on page 14 below)
Merger arbitrage managers exploit merger activity to
capture the spread between the current market values of
securities and their values in the event of a merger,
restructuring, or other corporate transaction. Managers
consider a transaction once an announcement has been
publicly made. Most merger arbitrage managers exploit
both cash-only deals and stock deals.
Before entering into a merger arbitrage strategy, the
manager will analyse the probability of the deal closing,
the bid price, and the timeframe to the closing date. The
probability of the takeover’s success directly influences
the size of positions the manager will take, as the prof-
itability of the trade depends on the success of the
merger. If the deal involves a regulated industry (such as
banking), regulatory risk is factored into the deal.
Merger Arbitrage example: In mergers where the
target company’s shareholders are offered stock in the
acquiring company, the spread is the difference between
the current values of the target company’s stock and the
acquiring company’s stock. The spread is captured
where the arbitrageur buys the stock of the target
company and shorts the stock of the acquiring company.
Distressed/High Yield Securities
Managers involved in distressed or high-yield
securities are active in bond and equity markets, where
the strategies focus on actual or anticipated events,
such as a bankruptcy announcement or corporate
reorganisation as a result of debt default. Distressed or
highyield securities are generally below investment
grade, and require a high level of due diligence to take
advantage of the low prices at which they trade.
Most merger arbitrage managers
exploit both cash-only deals
and stock deals
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 11
Equity Market-Neutral example:
An example of a typical equity market-neutral trade
is a pairs trade in two listed companies of similar size
and geography. This strategy involves buying one
company’s stock and selling short the stock of another
company in the same sector.
Buys shares in one class Company A, Class C, listed
in the UK Sells shares in another class Company A,
Class D, listed in South Africa Profit opportunity The
manager expects Class C stocks to rise in price and
Class D stocks to fall based on some change to
Company A’s capital structure.
There is no market or sector risk as the two stocks are
based on the same economic entity, but happen to
deviate in price.
Strategies
1 Relative Value
Equity
Market-neutral
Convertible
Arbitrage
Fixed-Income
Arbitrage
2 Event .
Merger (Risk)
Arbitrage
Driven
Distressed/High
yield Securities
3 Opportunities
Equity Hedge
(Long/Short)
Global Macro
Managed Futures
Emerging Markets
Low Market Exposure High
Non-directional Directional
1 Loan of USD10 million issued.
Tel Co. uses financing to repay
debt and to restructure.
Investors in distressed securities seek capital apprecia-
tion of the debt rather than an income stream.
Performance depends on how well the managers
analyse event-specific situations, rather than on the
direction of the stock or bond markets. Managers
investing in distressed or high-yield securities will vary
in terms of the level of capital structure in which they
invest (debt or equity, and ranking of the security), the
stage of the restructuring process, and the degree to
which they become actively involved in negotiating the
terms and management of the restructuring.
3.3 Opportunistic Strategies (Directional)
Opportunistic strategies generally include any hedge
fund where the manager’s investment approach changes
over time to take advantage of current market conditions
and investment opportunities. Opportunistic strategies
may have higher risk than relative value and event-driven
strategies, as they have higher directional exposure.
Managers will base the investment decision on their
view of the degree by which individual securities are
under or over valued relative to current market prices.
These strategies are heavily reliant on the skill of the
manager in discerning the value of a security. The man-
ager may use quantitative tools, however the final invest-
ment decision is usually a subjective one.
Strategies combine long and short positions thereby
reducing or eliminating (in the case of market neutral
strategies), directional market risk and generating returns
based on the price movements in securities. This may
involve borrowing securities the manager considers to be
overvalued then selling them on the market in the expec-
tation that the price will be lower when the fund has to
buy the securities back to be able to return them to the
brokers. These funds take positions along the whole risk-
return spectrum and try to distinguish their performance
from that of the asset class as a whole. Returns will there-
fore deviate substantially from the underlying market
return. Portfolios will also tend to be more concentrated
than those of traditional long-only managers.
3.3.1 Long/Short Equity
Managers employing this strategy will hold both long
and short positions with a net long exposure. The objective
is not to be market neutral. This means that at all times
more than 50% of assets should be held as long (buy)
positions. This category excludes long only portfolios. To
be considered a hedge fund, the manager’s strategy must
include short positions while maintaining an absolute
return objective. Managers have the ability to shift from
value to growth and from small to medium to large
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To be considered a hedge fund,
the manager’s strategy
must include short positions
while maintaining an
absolute return objective
Buy debt or equity at a discount
and wait for appreciation.
Buy debt or equity at a discount and become
actively involved in restructuring/refinancing
to influence process to fund’s advantage.
2 Tel Co. then has financial
difficulty and files for
bankruptcy.
Source: AIMA
Distressed Debt Example
Tel. Co. (Borrower)
Custodian Co.
(Lender)
Passive Investment
Active Investment
3 Tel Co. defaults on loan
repayments to Finance Co.
4 & 5 Hedge fund manager
buys core position of debt or
equity in Tel Co.
Hedge Fund
Manager
Distressed Debt example:
In a typical situation depicted above:
a) A financial institution (Finance Co.) makes a loan
to a borrower (Tel Co.). Tel Co.uses the funds to
restructure the company and/or repay some debt.
b) Tel Co. then finds itself in financial difficulty,
resulting in bankruptcy or nearbankruptcy.
c) Tel Co. defaults on its debt, resulting in a decrease
in the value of the loan.
d) A Distressed Debt specialist analyses the situation
for possible investment, either in the debt or equity
of the company considering the following questions:
• Does the business have long-term value?
• Is the company in trouble because of problems,
such as over-leveraging, that can be rectified?
• Are the company’s operating metrics declining?
• What class of debt will have the most power in
the restructuring?
Introducing Hedge Funds & Services
capitalisation stocks. Managers may use futures and
options to hedge. The focus may be regional, such as
long/short US or European equity, or sector specific, such
as long and short technology or healthcare stocks.
3.3.2 Dedicated Short-Bias
In employing this strategy, a hedge fund manager will
maintain a net short bias against the market. Managers
look for securities that they perceive to be overvalued
and short those stocks or use derivatives to profit from a
declining share price. They may achieve better results in
bearish markets.
3.4 Global Macro
A global macro strategy involves opportunistically allo-
cating capital among a wide variety of strategies and
asset classes. Strategies or themes may be directional or
non-directional.
Global macro is the most flexible of investment strate-
gies, with the manager often taking a top-down thematic
approach and investing on an opportunistic basis, mov-
ing between countries, markets and instruments based
on the manager’s forecasts of changes in factors such as
interest rates, exchange rates and liquidity. A variety of
trading strategies are used depending on the opportuni-
ties identified. Most funds invest globally in both devel-
oped and emerging markets.
3.5 Emerging Markets
Broadly defined, an emerging market is a country
making an effort to change and improve its economy
with the goal of raising its performance to that of the
world’s more advanced nations. The World Bank classi-
fies economies with a Gross National Income per capita
of $9,266 and above as high-income countries.
Emerging markets however are not necessarily small or
poor. China, for example, is considered an emerging
market even though it has vast resources, has launched
satellites into space and a population of more than a
billion people. The emerging markets strategy used by
hedge funds involves equity or fixed income investing in
emerging markets around the world. Because many
emerging markets do not allow short selling, nor offer
viable futures or other derivative products with which to
hedge, emerging market investing often employs a
long-only strategy. As the currency of many emerging
markets cannot be hedged through the use of derivatives,
an investment in an emerging market results in exposure
to the movements in currency of the underlying country.
3.6 Managed Futures
A managed futures strategy is based on speculation of
the direction in market prices of currencies, commodi-
ties, equities and fixed interest and on spot or futures
markets across the globe. The managers are usually
referred to as Commodity Trading Advisors, or CTAs.
Trading disciplines are generally systematic or discre-
tionary.
Systematic traders tend to use price and market specif-
ic follow trends while discretionary managers use a less
quantitative both fundamental and technical analysis.
3.6.1 Systematic Trading
Proprietary, quantitative models are typically used to
identify establish positions, including the size of posi-
tions and the managers are trend followers. They seek to
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 13
An emerging market is a
country making an effort to
change and improve its economy
with the goal of raising its
performance to that of the
world’s more advanced nations
Long Bias example:
The manager will take both long and short positions,
depending on their market outlook. Portfolios may shift
between, large cap and small cap, and across sectors
within a particular market. The following example
highlights some typical trades that may be present in a
portfolio that trades within and across sectors. The
portfolio will usually consist of many more trades than
displayed here.
The portfolio has a net long position of 60% with
40% held in short positions.
Note : The percentages used are for illustrative purposes only,
where 100% of the portfolio is invested in stocks. In reality, a
long-bias equity hedge fund portfolio is more diversified, and
is not concentrated with such large weightings in each stock.
Dedicated Short-Bias example:
The following portfolio is an illustration of the
characteristics of a net short hedge fund.
The manager has taken a larger bet on the short
positions, as indicated by both the number of short
versus long positions and the total portfolio value of
short positions versus the value of long positions.
Global Macro example:
A manager will attempt to exploit global trends and
market movements by entering into leveraged, direc-
tional positions. If for example a manager expects
interest rate spreads between South Africa and the USA
to widen as a result of interest rates rising in South
Africa, positions may be taken in interest rates or cur-
rencies of the two countries. The fund manager takes a
position to buy the South African Rand (ZAR) and sell
the US Dollar (USD), with the expectation that the
Rand will rise against the USD following an increase in
South African interest rates. The risk in this strategy is
that the ZAR may depreciate against the USD.
identify a trend themselves to stay invested as long as it
persists. Systematic arbitrage in that each position is
essentially an independent intended to produce a profit,
not a relative position.
3.6.2 Discretionary Trading
A manger will use fundamental analysis or computer
systems two to identify profitable trades. In general, this
tends to return strategy within the universe of hedge
funds, with very short periods of time. The main differ-
ence between trading is that the investment decision is
not automated. The manager will make the final invest-
ment decision.
4 HEDGE FUND RISK/RETURN DRIVERS
An important measure for an investor to consider is the
degree of exposure to the broad movements of the mar-
ket and the impact on the fund’s risk and return.
Fundsare generally constructed with specific targets and
strategies, such that the investor knows to anticipate a
certain risk/return profile. In general, the higher the
degree of “directionality”, or investing in market direc-
tion, the higher will be the potential return and volatility.
For hedge funds with absolute return objectives, it is
more meaningful to measure correlations and risk which
evaluate both the upside and downside deviations rela-
tive to each fund’s specific objective, than performance
relative to an index or peer group. The emerging markets
strategy exhibits the greatest negative monthly return
throughout the period. Not surprisingly, the smallest
negative return for a month occurred within the equity
market neutral strategy that nullifies any market risk
through holding a portfolio of overall equal long and
short positions.
While all strategies and equity market returns have
delivered at least one negative monthly return during the
period, the majority of hedge fund strategies have deliv-
ered substantially smaller negative returns than tradition-
al equity markets. It is important to note here that while
an absolute return objective implies a positive return
over the long term, short-term volatility can result in neg-
ative monthly returns for hedge fund strategies through
the market cycle.
The risks associated with each strategy will depend on
the type of strategy and the degree to which it is exposed
to market factors. The most common risks associated
with each strategy are detailed in the table below:
Other risks of investing in hedge funds are non-quantifi-
able risks specifically including liquidity issues, trans-
parency, key person risk, fraud and leverage. These risks
are more pronounced in hedge funds due to the fact that
hedge funds are based on the skill of the manager more
than the market return of an asset class.
5 INVESTING IN HEDGE FUNDS
5.1 Why Invest in Hedge Funds?
As noted in Section 1, the types of investors who are
attracted to hedge funds varies from institutional funds
to retail investors. Throughout a market cycle, there will
be periods during which equity and bond markets will
offer both attractive and unattractive investment oppor-
tunities. The difficulty with investing in any market is
identifying when these opportunities will rise and posi-
tioning an investor’s portfolio to take advantage of
favourable market conditions. An equity market bull-run
can be followed by a bear market with lower returns from
market based strategies, price/earnings contraction and
the delivery of lower returns by traditional managers.
However it is difficult to predict the duration and extent
of a bull or bear market.
Therefore hedge funds present an attractive opportuni-
ty for inclusion in an investor’s diversified portfolio due
to the possibility of enhanced risk adjusted returns (as
demonstrated in section 4 above) and the low correlation
in returns that many hedge funds have to traditional
asset classes. A lower correlation between asset classes
within an investor’s portfolio, will result in reduction in
the overall level of risk within the portfolio.
The lowest correlation of returns occurs with dedicat-
ed short bias and managed futures strategies where
these strategies are based on taking profit as a result of
opposite movements in the price of securities from that
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Company A is the acquirer
Company A makes an offer
to acquire Company B
Company A typically
declines or remains flat
Company A’s stock price
will decline or remain flat
Manager sells short
Company A’s stock
Takeover completed
/stock prices converge-
Company A’s stock price
declines and/or Company
B’s stock price rises.
Another suitor, Company
E (the new acquirer)
makes a bid for Company
B (the target) for a higher
price than offered by
Company A.
Company B is the target
The offer is at a 20%
premium of Company B’s
current market price
Company B’s stock price
appreciates by 10%
Company B’s stock price
will rise
Manager buys Company
B’s stock
1 Takeover
2 Offer
3 Market’s Reaction
4 Manager’s Expectation
5 Manager’s Response
6 Position will profit if
OR Position will profit if
A (Acquirer) Company B (Target) Action Company
Source: AIMA
An Example of Merger Arbitrage
Typical Trades of Managed Futures strategies include:
• Trend following using technical analysis with stop-
losses in place. Instruments used include currency
futures, forwards, exchange traded and over-the-
counter options and warrants.
• Long-term directional trading based on market
fundamentals.
• Short-term spot trading based on flow information.
Introducing Hedge Funds & Services
of the broad equity market. Those strategies that are
implemented through investment in equities demon-
strate the highest correlation of returns with equity
markets, notably event driven (0.66 correlation to S&P
500) and long/short equity (0.68 correlation to S&P
500) strategies. However the correlation in returns of
these strategies with the US market (S&P 500) and the
global market (MSCI World $) is significantly lower
than the correlations these markets exhibit with each
other (0.85). Correlations will however change over
time and may rise in certain market conditions.
The question has emerged as to whether hedge funds
should be treated as a separate asset class, in a similar
way to equities or bonds. Support for the case that hedge
funds belong to a separate asset class is primarily based
upon the non-correlated return profile generated by
hedge funds when compared to traditional asset classes.
To be considered a separate asset class, the securities
within an asset class need to be more highly correlated
with each other than with assets outside this class, which
is not the case for hedge funds. This belief comes from
the diverse nature of hedge fund strategies and conse-
quently low correlation with each other.
5.2 Single Strategy Funds and Fund of Hedge Funds
An investor has several options for accessing hedge
funds. One is to directly invest in one or several hedge
funds. Another is to purchase an interest in a fund of
hedge funds, also known as a multi-manager fund. The
investment manager of a fund of hedge funds selects and
invests in multiple hedge funds, numbering anywhere
from 5 to over 40, often through an offshore corporation
or similar privately placed vehicle. A single strategy man-
ager will focus on a particular asset class or trading strat-
egy to generate returns. A fund of hedge funds manager
will combine various strategies and seek out the “best of
breed” hedge fund managers to diversify across strate-
gies and managers.
A fund of hedge funds incorporates single strategies
that are broadly available. Several long-term investors
may gain broad exposure through a fund of hedge fund
and seek to add single hedge funds to their portfolio.
Observations indicate that a sophisticated investor may
be able to compile their own fund of hedge funds
Using a single manager will result in lower fees than a
fund of hedge funds vehicle, where the investment
selection and monitoring fees of the fund of hedge funds
manager are additional to the fees of the underlying hedge
fund manager. If the investor is successful in selecting a
strategy and manager, the potential return generation can
be greater than a fund of hedge funds albeit with a more
concentrated level of risk by only investing in one strategy
with one manager. For a fund of hedge funds, the return to
the investor is a combination of the performance of the
underlying funds minus applicable fees. Using advanced
financial engineering techniques and optimisation analysis
to achieve targeted asset and risk combinations, the fund
of hedge funds manager creates a new product that seeks
to maximise the advantages and minimise the
disadvantages of the underlying holdings. In an analysis of
more than 1000 randomly generated hedge fund
portfolios, Morgan Stanley Dean Witter concluded that
portfolios with as few as 20 hedge funds typically preserve
the desirable properties of the indexes that cover the entire
hedge fund universe.
5.3 What portion of an Investor’s Portfolio should be
allocated to Hedge Funds?
An investor’s portfolio will exhibit certain return and
risk characteristics based on their investment objective,
time horizon and overall “comfort” with short-term
return volatility. There are many questions and debates
as to the appropriate amount an investor should allocate
to hedge funds. Even if a fixed allocation of say “10%” is
used as a starting point, which assets should be
redeemed to accommodate this investment? Hedge
funds are not necessarily a separate asset class that is as
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 15
1 Convertible Arbitrage: Interest rate
risk, credit risk, equity volatility risk
2 Fixed-income Arbitrage: Interest rate
risk, credit risk, model risk
3 Equity Market-neutral: Individual
equity risk, model risk
1 Merger Arbitrage: Deal risk/corporate
event risk, equity volatility risk
2 Distressed/High-yield Securities:
Corporate event risk, credit risk, equity
volatility risk, interest rate risk, liquidity
risk
1 Equity Hedge: Equity market risk,
equity volatility risk
2 Global Macro: Equity market risk,
interest rate risk, currency risk, model
risk
3 Managed Futures: Commodity market
risk, interest rate risk, currency risk,
model risk
4 Emerging Markets: Equity market risk,
interest rate risk, political risk, credit
risk, currency risk, liquidity risk
1 Relative Value
2 Event Driven
3 Opportunistic
Typical Risk Exposure by Strategy
Hedge Fund
Category
Source: AIMA
The risks associated with Hedge Fund Strategies
Using a single manager will
result in lower fees than a fund
of hedge funds vehicle, where
the fees of the fund of hedge
funds manager are additional
to the fees of the underlying
hedge fund manager
easily definable as equities, fixed interest or cash as the
risk/ return profile of a hedge fund will vary according to
the strategy used, the assets invested and the geography.
However a hedge fund investing in equity markets or
fixed income markets will not necessarily take on the
characteristics of that particular market. As an example,
within the equity based category of hedge fund strategies
a long/short equity portfolio or an equity market neutral
portfolio or a short bias portfolio may deliver risk/return
characteristics over time that are quite different to those
of broader equity markets and therefore cannot always be
considered an appropriate replacement for equities.
When using portfolio modelling (such as mean-variance
optimisation) to make asset allocation decisions, it is best
to use the expected risk/ return characteristics of different
asset classes that are based on market factors and not a
particular manager’s ability to add value over the market.
Given manager capability is removed from all other asset
class returns (namely equity, property, fixed interest and
cash) it is not appropriate to use manager based hedge
fund benchmarks as proxies for the return of all hedge
funds. These benchmarks provide an indication of the
average manager skill available rather than passive (mar-
ket based) returns available from this form of investing.
However there is no data available to forecast hedge fund
returns given there is no passive benchmark. There are
limitations to portfolio modelling of hedge funds, and this
form of analysis should be used only as a tool, not a driver
of the decision. The question of allocating a portion of a
client’s portfolio to hedge funds therefore becomes one of
a market specialisation within the portfolio. Market spe-
cialisation categories include active versus passive, value
versus growth, large cap versus small cap and now market
based versus skill based strategies. One could therefore
argue that the choice of investing in hedge funds (skill-
based strategies) is part of the active versus passive man-
ager selection decision, rather than part of the traditional
asset allocation decision.
5.4 Factors to consider before Investing
The decisions of whether to invest in hedge funds and
how much of the investor’s portfolio to allocate require
consideration of the following factors:
• The investor’s investment objective, incorporating
their return objective and risk tolerance. This will nec-
essarily consider whether the investor’s aim is to
improve the return profile or reduce the risk profile of
their existing portfolio position. As demonstrated
above in general terms, where an investor aims to
substantially improve the return profile of their port-
folio, an allocation from fixed interest to a fund of
fund hedge fund may be appropriate. As an improve-
ment to the return expectation implies taking on addi-
tional risk, the opposite case applies for a reduction
in the return expectation.
• Which asset class to allocate funds from, for invest-
ment in hedge funds will depend on the return/risk
objective of the hedge fund being considered.
• Whether the investor has the time and knowledge to
research individual hedge fund managers offering sin-
gle strategies to bring together their own “fund of
hedge funds”.
• The time frame to invest, considering any lock up
period the hedge fund manager may impose.
• Fund of Hedge Funds offering may be more suited
to conservative investors in improving the return pro-
file at a slightly lower risk.
• An appropriate allocation to a single manager will
depend on whether the hedge fund has fixed interest
or equity like characteristics.
• An investor’s income and taxation position should
be considered. Generally income distributions from
hedge funds will be treated as ordinary income with
very little or no capital gains or dividend imputation.
This is a result of frequent trading employed by most
hedge funds. However, the tax treatment of distribu-
tions, gains and deemed gains may vary depending
on the legal structure of the hedge fund and the
nature of the investors’ participation.
• The need for professional guidance in manager/fund
selection and the appropriate allocation within an
investor’s portfolio.
APPENDIX:
REFERENCES, ADDITIONAL READING, AND WEBSITES
References and additional reading
• BARRA RogersCasey: “An Introduction to Hedge Funds. The first in the BRC
Hedge Fund Series”; BARRA RogersCasey; 2001
• Fraser E: “Hedge Funds 101: Trustee Education”; January 2004.
• Ineichen AM: “Absolute Returns. The Risk and Opportunities of Hedge Fund
Investing”; John Wiley and Sons; 2003.
• Jaeger L: “Managing Risk in Alternative Investment Strategies: Successful
Investing in Hedge Funds and Managed Futures”
• KPMG Financial Services and Investment Advisory: “Hedge Fund
Investments”; September 2003.
• Lowenstein R: “When Genius Failed: The Rise and Fall of Long Term Capital
Management”; Fourth Estate; 2002.
• Rahl L: “Hedge Fund Risk Transparency: Unravelling the Complex and
Controversial Debate”
• Schneeweis T: “Dealing with Myths of Hedge Fund Investment”; The Journal
of Alternative Investments, Winter 1998.
Websites
• AIMA http://www.aima.org
• Financial Services Board http://www.fsb.co.za
• HedgeWorld http://www.hedgeworld.com/
• Hedge Fund Research, Inc. http://www.hedgfundresearch.com/
• InvestHedge http://www.hedgefundintelligence.com/ih/index.htm
• Van Hedge Fund Advisors http://www.hedgefund.com/
16 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
The choice of investing in hedge
funds (skill-based strategies) is
part of the active versus passive
manager selection decision,
rather than part of the traditional
asset allocation decision
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THE FOLLOWING ARE EXCERPTS FROM MFA'S SOUND PRACTICES
FOR HEDGE FUND MANAGERS RE-PRINTED HERE WITH THE KIND
PERMISSION OF THE MANAGED FUNDS ASSOCIATION.
RECOMMENDATIONS
I. MANAGEMENT AND INTERNAL TRADING CONTROLS
A Hedge Fund Manager should establish for
each Hedge Fund, the investment objectives
and risk parameters applicable to such Hedge
Fund and the trading parameters and risk
limits designed to achieve these objectives.
Suitably qualified personnel should be retained and ade-
quate 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 operations, as well as risk
levels, effectively. If third-party service providers perform
key business functions (such as net asset value calcula-
tion or risk monitoring), they also should be subject to
appropriate controls and review processes.
1.1 A Hedge Fund Manager should establish manage-
ment policies and practices commensurate with the size,
nature and complexity of the Hedge Fund Manager’s
trading activities and the Hedge Funds it manages.
Management policies should be established for trading
activities, valuation, risk analysis, compliance and other
key areas as appropriate (see specific recommendations
in the sections that follow). A Hedge Fund Manager
should adopt an organizational structure that facilitates
effective monitoring of compliance with management
policies. Policies and practices should be reviewed and
updated as appropriate (e.g., when changes in structure
or strategy are adopted, when extraordinary market
events occur or when new applicable regulations are
adopted).
1.2 A Hedge Fund Manager should determine the invest-
ment, 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 targeted risk profile.
Allocations should be reexamined periodically and
adjusted as appropriate. In addition, appropriate trading
parameters and risk limits should be established
consistent with these allocations. These principles are
developed more fully in Section IV— Risk Monitoring.
1.3 A Hedge Fund Manager should impose appropriate
controls over its portfolio management and trading
activities to ensure that these activities are undertaken
on a basis consistent with allocated investment and
trading parameters.
A Hedge Fund Manager’s senior management should
analyze and evaluate trading activities by regularly
reviewing the performance of each Hedge Fund’s
portfolio and the associated risk levels. Internal report-
ing should provide the Hedge Fund Manager with
information regarding the performance and risk
levels of the different investment strategies employed
and should identify deviations from trading parameters
and risk limits.
1.4 A Hedge Fund Manager should determine the
allocation of capital among portfolio managers and
should establish policies for monitoring their perform-
ance.
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 (e.g., monthly
performance review of a passive investment in a Hedge
Fund versus more frequent review of a significant man-
aged account investment).
1.5 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 (e.g., those related to prime brokerage,
risk monitoring, valuation or business continuity/disaster
recovery functions) and consistently monitor their per-
formance.
The roles, responsibilities and liability of key
third-party service providers should be clearly defined in
written service agreements. The performance of mission-
critical 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.
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Sound Practices
for Hedge Fund Managers
II. RESPONSIBILITIES TO INVESTORS
A Hedge Fund Manager should work together
with the Hedge Fund so that Hedge Fund
investors are provided with information
regarding the Hedge Fund’s investment objec-
tives 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.
2.1 A Hedge Fund Manager should create a management
environment that recognizes its responsibility to act in
the interest of the Hedge Fund and its investors as set
forth in the investment management 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 man-
agement agreement 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.
2.2 A Hedge Fund’s prospective and existing investors
should be provided with information regarding the Hedge
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 invest-
ment objectives and strategies will enhance the ability of
investors to form appropriate expectations as to the
Hedge Fund’s performance and therefore facilitate a
good match between investor and investment product. A
Hedge Fund Manager should therefore seek to ensure
that appropriate disclosures are prepared for dissemina-
tion 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
determine whether given the circumstances of the
change, disclosure is necessary and whether consent
should be obtained from Hedge Fund investors. Given
that there is substantial breadth of objectives or strate-
gies employed by and disclosed to investors in connec-
tion with a number of Hedge Fund strategies, for exam-
ple 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. See Recommendation 2.4 below for a further
discussion of material risk factors that a Hedge Fund
should consider disclosing to Hedge Fund investors.
2.3 A Hedge Fund Manager should assess whether its
operations or particular circumstances may present
potential conflicts of interest and seek to ensure that
any conflicts of interest that may be material are appro-
priately 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.
2.4 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 strategy
or types of investment instruments;
• Risk associated with limited liquidity;
• Risks associated with the use of leverage and margin;
• Risks associated with the loss of key management
personnel; and
• Potential conflicts associated with any performance
fee or use of affiliated brokers.
2.5 A Hedge Fund Manager should prepare periodically
certain base-line performance and other relevant infor-
mation 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.
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Sound Practices
2.6 Appropriate disclosures should be made about any
agreement between a Hedge Fund and Hedge Fund
investors that varies the material terms of the arrange-
ments 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 con-
nection with their investment in the Hedge Fund.
2.7 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 Hedge Fund investors in a timely
manner.
III. 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 (as defined below) and its man-
agement 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, recognizing 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 portfolio valuation for purposes of internal
risk monitoring of the portfolio.
Fair Value
3.1 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 gener-
ally accepted accounting principles (GAAP),
recognizing 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 statements 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 typically
requires the use of “fairvalue” in determining the value
of an investment or instrument. However, if there are cir-
cumstances where a Hedge Fund Manager believes that
the application of fair value would not produce an accu-
rate or fair valuation for a given instrument, it may
employ alternative means to value an instrument as per-
mitted by agreement. A Hedge Fund Manager may appro-
priately develop policies for making fair-value determi-
nations that take into consideration market sector trends
and company fundamentals.
Fair, Consistent and Verifiable
3.2 A Hedge Fund Manager’s valuation policies and pro-
cedures should be fair, consistent and verifiable.
A Hedge Fund Manager should either calculate or verify
the accuracy of prices independent of the trading func-
tion 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 appropriate external price quotes are not rea-
sonably available (as discussed further below under
Pricing Sources). 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 purposes
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
utilize 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 stan-
dard in a material way.
Pricing Policies and Procedures
3.3 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 proce-
dures is a critical element of the control structure sur-
rounding a Hedge Fund Manager’s pricing of portfolio
investment instruments. These policies should be estab-
lished by senior management, based upon a thorough
review and understanding of the totality of the Hedge
Fund Manager’s business structure (e.g., range and
complexity of instruments traded, stipulations contained
in the Hedge Fund’s governing or offering documents,
liquidity terms offered to Hedge Fund investors, etc.). The
pricing policies and procedures should explicitly author-
ize 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
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 21
price an instrument. In addition, these policies should be
reviewed with the Hedge Fund’s governing body (if differ-
ent than senior management) 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
practicable.
Hedge Fund Managers should develop practices and/or
systems for capturing pricing data for their positions
from independent sources on a daily basis where practi-
cable. Procedures for periodically verifying the accuracy
of pricing data should also be adopted, and material
discrepancies between price sources should be investi-
gated. Where an instrument is not traded actively or
where obtaining price information requires significant
effort, weekly (or less frequent) pricing may be appropri-
ate depending on the nature and the size of the position.
For positions traded over-the-counter or derivative
instruments, where the only external source of fair value
may be quotes from relevant market-makers (the number
of which, based on the liquidity of the position, may be
very limited), the number of quotes sought by Hedge
Fund Manager to gain comfort with the fair value should
also be considered. This may also lead to model pricing
(as discussed below in Recommendation 3.4). Where
market prices do not exist or are not indicative of fair
value, a Hedge Fund Manager should clearly establish
the valuation methods to be used for NAV purposes. In
valuing certain instruments, for example, Hedge Fund
Managers may appropriately seek the input of their port-
folio management team in the valuation process in order
to take advantage of the portfolio manager’s expertise.
Pricing Sources
3.4 A Hedge Fund Manager should choose reliable and
recognized pricing sources to the extent practicable.
In general, where market prices for an instrument are
readily available from organized exchanges for markets
or recognized 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 recognized 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 available, for certain over-the-
counter derivative instruments and structured or dis-
tressed securities from well-established, recognized pric-
ing services, or use appropriate valuation models devel-
oped by third-party pricing services or recognized indus-
try standard 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 trad-
ed, the only market for these instruments may be with
the counterparty to the transaction itself. Such instru-
ments 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
parameters used in determining the valuation.
Valuation of Instruments
3.5 A Hedge Fund Manager should establish policies for
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 multiple time zones,
and certain over-the-counter derivatives. 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.
3.6 A Hedge Fund Manager should evaluate the use
of alternative methods for valuing illiquid, or
otherwise hard-to-value, securities or other investment
instruments.
A Hedge Fund Manager may appropriately use alterna-
tive approaches for valuing illiquid, or otherwise hard-to-
value, securities or other investment instruments. Among
the various approaches to the valuation of illiquid and
hard-to-value investment instruments that may be avail-
able to Hedge Fund Managers is the use of “side-pock-
ets”, if their use has been disclosed in the Hedge Fund’s
offering documents 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 illiquidity or
similar issues—are held either at cost or at fair value
(depending on the Hedge Fund Manager’s valuation poli-
cies) until either a liquidation or other valuation-generat-
ing event occurs (e.g., acquisition of a private company).
22 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
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 transac-
tion designated for the side-pocket is executed are typi-
cally permitted to participate in the subsequent profit and
loss when the position is eventually disposed or there is
an event that makes it become a marketable security
(e.g., an initial public offering). Hedge Fund Managers
should bear in mind that issues associated with manage-
ment fees and high water marks, among other things,
may impact valuation and the use of side pockets.
Price Validation
3.7 A Hedge Fund Manager should establish practices for
verifying the accuracy of prices obtained from data ven-
dors, 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 less liquid instruments,
dealer quotes, prices generated by models or other esti-
mation methods used should be checked periodically
against realized 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
3.8 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 periodic 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 internal purposes. A Hedge Fund Manager
should establish 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 (e.g., upon request or
through a website posting). See Recommendation 4.13
for additional guidance.
IV. RISK MONITORING
Current market practice is to focus on three
categories 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 (i.e., 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 liquidity 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 potential 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
recognize and evaluate the overlap that exists between
and among market, credit and liquidity risks.
Structure of Risk Monitoring Function
4.1 A Hedge Fund Manager should establish a Risk
Monitoring 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 investments. To the extent
appropriate, risk analysis with respect to a particular
investment strategy or portfolio should be performed
independently of portfolio management personnel
responsible for that strategy or portfolio, so that trad-
ing activities and operations may be effectively super-
vised 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 appropriate
breakdowns by category of risk for review by appropri-
ate members of senior management. The Risk
Monitoring Function, in consultation with relevant port-
folio management personnel, should conduct 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.
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 23
Sound Practices
Market Risk
Encompasses interest rate risk, foreign exchange rate
risk, equity price risk, and commodity price risk, as well
as asset liquidity risk.
4.2 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 ( e.g., 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 determined. A Hedge Fund
Manager should employ a consistent framework for
measuring the risk of loss for a portfolio (and relevant
subcomponents of the portfolio), such as a “Value-at-
Risk” (or 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 limita-
tions, including the impact of any model breakdown.
Consistent with disclosure made to Hedge Fund
investors, the Hedge Fund Manager should determine 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 Hedge Fund or strategy.
This overall level of market risk should then be appropri-
ately allocated, among, for example, individual portfolio
managers, investment strategies or asset classes. Once
the market risk allocation is determined, portfolio man-
agers 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 period(s) deemed appropriate depend-
ing on the markets traded and the risks assumed. The
holding period(s) should take into account the time neces-
sary to liquidate and/or neutralize positions in the portfolio.
The role of the Risk Monitoring Function is to: (1) iden-
tify 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 estab-
lished by senior management, and (3) disseminate the
resulting risk information to senior management and
portfolio managers, as appropriate. The factors affecting
risk (e.g., market rates and prices, credit spreads,
volatilities, correlation) should be incorporated into the
risk monitoring process and, where appropriate, be
included in the market risk model.
Positions managed as separate accounts by external
portfolio managers on behalf of the Hedge Fund Manager
should be incorporated in the routine risk assessment of
the overall portfolio. Passive investments in funds man-
aged by external portfolio managers should be monitored
as appropriate.
Hedge Fund Managers should recognize that market risk
measures such as VAR do not give a complete 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.
4.3 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 contrac-
tual 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 relationship
between portfolio value and the size of the market move. In
addition, in performing stress tests or liquidity analyses, a
Hedge Fund Manager may consider, for example, contrac-
tual rights of counterparties to terminate or otherwise
unwind trading relationships or increase margin/collateral
requirements upon the occurrence of certain events (such
as declines in NAV).
A Hedge Fund Manager also should consider conducting
“scenario analyses” to benchmark the risk of a Hedge
Fund’s current portfolio against various scenarios of mar-
ket behavior (historical or prospective) that are relevant to
the Hedge Fund Manager’s trading activities (e.g., 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)).
4.4 A Hedge Fund Manager should “backtest” its market
risk models.
For internal control purposes, the Risk Monitoring
Function should perform backtesting of its market risk
models (e.g., VAR). It should compare the distribution 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 portfolio
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 scruti-
nized to determine its source. If, after investigation, the
Hedge Fund Manager 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 Manager’s
ability to continue trading in times of stress. Funding
24 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
liquidity analysis should take into account the
investment strategies employed, the terms governing the
rights of Hedge Fund investors to redeem their interests
and the liquidity of assets (e.g., 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 counter-
parties such as prime brokers. Adequate funding liquidi-
ty 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.
4.5 A Hedge Fund Manager should evaluate the effec-
tiveness 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 poli-
cies, a Hedge Fund Manager should consider cash flow
needs based on the risk and funding profile of the port-
folio and investor subscription and redemption windows.
4.6 A Hedge Fund Manager should employ appropriate
liquidity measures in order to gauge, on an ongoing
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.
4.7 A Hedge Fund Manager should evaluate the stability
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 drawdown
and stressed market conditions, taking into account
potential investor redemptions and contractual arrange-
ments that affect a Hedge Fund’s liquidity (e.g., notice
periods for reduction of credit lines by counterparties).
Hedge Fund Managers should periodically forecast
their liquidity requirements and potential changes in liq-
uidity 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 sce-
nario tests, Hedge Fund Managers should consider
including the potential response to a creditor experienc-
ing a liquidity problem during times of market stress
(e.g., reluctance to release collateral), as well as a uni-
lateral 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 Hedge Fund’s performance
and the availability of credit lines.
4.8 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 provided.
The extent of disclosure to be provided should be mutu-
ally agreed with such parties depending on their require-
ments and the extent and nature of the relationship.
A counterparty’s credit department should be required
to provide assurances that financial and other confiden-
tial information furnished by the Hedge Fund Manager
will only be used for credit evaluation 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
4.9 A Hedge Fund Manager should understand and man-
age a Hedge Fund’s exposure to potential defaults by
trading counterparties.
A Hedge Fund Manager should identify acceptable coun-
terparties 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
(e.g., 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 appropriately moni-
tored. A Hedge Fund Manager should also seek to estab-
lish appropriate collateral arrangements with the counter-
party (see Recommendation 6.4) and establish the ability
to make, if possible, and to respond to collateral calls.
Leverage
A Hedge Fund Manager should recognize 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 liquidity risk. Recognizing
the impact that leverage can have on a portfolio’s expo-
sure 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 SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 25
Sound Practices
4.10 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 utilization of leverage is
appropriate for each individual Hedge Fund is for its
Hedge Fund Manager to manage its own leverage associ-
ated with its strategies, using appropriate risk monitor-
ing 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 contractual and other measures it takes to address
the consequences to a Hedge Fund in the event of signif-
icant losses.
4.11 A Hedge Fund Manager should develop and monitor
several measures of leverage, recognizing 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 recognize that leverage
is not an independent source of risk; rather, it is a factor
that influences the rapidity with which changes in mar-
ket risk, credit risk or liquidity risk factors impact the
value of a Hedge Fund’s portfolio. A Hedge Fund Manager
should seek to assess leverage while taking into account
the limitations inherent in different leverage measures,
as noted below and discussed in further detail in
Appendix I of the full report.
Risk-Based Leverage
A Hedge Fund Manager should track a Hedge Fund’s
leverage using “risk-based leverage” measures reflect-
ing 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. Risk-based leverage
measures that could perform this function are described
in Appendix 1 of the full report. Some of the liquidity
measures discussed in Appendix 1 can also be viewed as
risk-based leverage measures.
The Hedge Fund Manager should be aware of limita-
tions of the models used and should guard against plac-
ing too much reliance on mathematical measures of
leverage alone. For example, market risk measures such
as VAR are incomplete measures of market risk because
they focus on “standard” market movements rather than
extreme events. Consequently, the Hedge Fund Manager
should consider assessing the impact of extreme events
by comparing a market risk measure derived from analy-
sis of extreme event scenarios (or stress tests) to the
Hedge Fund’s capital. In addition, it is essential 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 leverage or by reduc-
ing the level of risk that is being accepted (e.g., 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 lever-
age as part of its financial reporting or in connection
with the analysis and interpretation of certain risk-based
leverage measures or funding liquidity. However, a Hedge
Fund Manager should recognize that although such
measures can provide useful information if they are
understood fully and interpreted correctly, they have a
number of weaknesses, particularly as stand-alone
measures of leverage, as discussed in greater detail in
Appendix I of the full report.
Operational Risk
4.12 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.
Hedge Fund Managers should consider the following
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 activities;
• Monitoring of risk, either internally with an appropri-
ate level of checks and balances to ensure objectivity
of risk analysis, or through reliance on external service
providers;
• Maintenance of a single, centralized position data
set (to avoid the errors inherent in maintaining multi-
ple or regionalized 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 confirmation of
trades and positions, etc.; and
• Reviewing the operational risk – including legal
26 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
compliance, and transactional policies – issues that are
covered in the Recommendations of Sections V and VI.
Risk Monitoring Valuation
4.13 A Hedge Fund Manager should establish policies for
determining when risk monitoring valuation methods may
differ from NAV for operational or risk analysis reasons.
Portfolio values used to calculate NAV should also be
used for risk monitoring valuation unless the Hedge Fund
Manager has determined that operational or risk analy-
sis reasons may justify a different approach. For exam-
ple, in order to examine potential effects on the portfolio
of changes in market conditions, the Hedge Fund
Manager may permit the Risk Monitoring Function to use
alternative values or make adjustments to the position
values calculated in accordance with GAAP for NAV pur-
poses. Similarly, in volatile markets, a Hedge Fund
Manager may wish to discount prices for risk analysis
purposes if the Risk Monitoring Function does not believe
that quoted bids or offers are prices at which a trade
could actually be executed. See Recommendation 3.8 for
additional guidance.
[SECTION V HAS BEEN OMITTED FROM THIS EXTRACT AND IS AVAILABLE IN THE
FULL REPORT ONLINE AT WWW.MFAINFO.ORG]
VI. TRANSACTIONAL PRACTICES
A Hedge Fund Manager should pursue a consis-
tent and methodical approach to documenting
transactions 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
6.1 A Hedge Fund Manager should establish transaction
execution and documentation management practices
that seek to ensure timely execution of necessary trans-
action documents and enforceability of transactions.
To the extent practicable, a Hedge Fund Manager may
wish to implement the following practices:
• Require that all trading counterparties be approved
prior to executing any transactions and verify counter-
party authorizations;
• Establish documentation requirements for all trading
(including confirmation requirements and documenta-
tion of master agreements as appropriate); and
• Ensure that appropriate security interests are creat-
ed and perfected when collateral is received as part of
a transaction.
6.2 A Hedge Fund Manager should track the status of
documentation and the negotiation of key provisions and
terms such as termination events and events of default
(including use of a database if needed) to seek to ensure
consistency and standardization across Hedge Funds and
counterparties to the extent appropriate and feasible.
6.3 A Hedge Fund Manager should seek consistent bilat-
eral terms with counterparties to the extent appropriate
and feasible in order to enhance stability during periods
of market stress or declining asset levels.
For example, a Hedge Fund Manager may seek to negoti-
ate standardized events of default and other termination
or collateral events to achieve consistency in documen-
tation with different counterparties to the extent appro-
priate and feasible. A Hedge Fund Manager may also
endeavor to avoid including provisions that permit coun-
terparties to terminate or make demands for collateral
solely at their discretion or based upon subjective deter-
minations.
6.4 A Hedge Fund Manager should seek to negotiate
bilateral collateral agreements that require each party to
furnish collateral, taking into account the relative credit-
worthiness of the parties.
To the extent feasible, a Hedge Fund Manager should
seek to establish collateral arrangements either internal-
ly or through reliance on external resources that permit
the Hedge Fund Manager to effectively and regularly
make calls for deliveries and returns of collateral from
counterparties when permitted.
6.5 A Hedge Fund Manager should have appropriate doc-
umentation and approval processes for retaining exter-
nal traders as well as administrators, prime brokers or
other third-party service providers.
Best Execution
6.6 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 prod-
ucts traded by the Hedge Fund Manager;
• The clearing brokerage fees;
• The commission rate or spread involved when the
clearing broker executes transactions;
• The clearing broker’s responsiveness to the Hedge
Fund Manager;
• The ability of the clearing broker to maintain the confi-
dentiality of all proprietary position information provided;
• The clearing broker’s financial responsibility; and
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 27
Sound Practices
• The clearing broker’s credit worthiness.
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 transac-
tions of size in both liquid and illiquid markets at com-
petitive market prices without disrupting the market for
the security traded;
• The ability of the executing broker to maintain the
confidentiality of all proprietary position information
provided;
• The executing broker’s execution fees;
• The range of services offered by the executing broker,
including the range of markets and products covered,
quality of research services provided and recommenda-
tions made by the executing broker;
• The quality and timeliness of market information pro-
vided 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 various
structured and derivative products, Hedge Fund
Managers, in evaluating counterparties, should consider
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 pro-
viding confirmation, documentation, timely settlement
and on-going 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 counterparty;
• The counterparty’s financial responsibility;
• The availability of the particular derivative product;
and
• The counterparty’s credit worthiness.
6.7 Hedge Fund Managers should periodically examine
the performance of the brokers executing transactions on
behalf of a Hedge Fund to assess whether it continues to
provide best execution. Hedge Fund Managers should
include in its recordkeeping policies documentation of
evaluations of the execution quality of the brokers.
Soft Dollar Arrangements
6.8 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 provided by a broker
and should develop policies relating to the use of these
arrangements.
If applicable to its business model, a Hedge Fund
Manager should develop policies related to Soft Dollar
Arrangements, including the proper allocation of prod-
ucts or services with mixed uses (i.e., computer hard-
ware that assists an adviser in research functions 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 execution 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
customized advisory arrangements.
Policies should include procedures and documentation
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 arrangements, address-
ing, as appropriate, approved broker-dealers and prod-
ucts/services, reliance on the Section 28(e) of the
Securities Exchange Act of 1934, as amended, safe har-
bor (described below) (“Section 28(e)”), personnel
authorized to approve the product/service and agree-
ments or commitments regarding commission quotas or
thresholds. Policies should also address retention of cor-
respondence, including, if applicable, emails related to
directed brokerage and step-out arrangements and
records of and the value, quantity, purpose and ratios of
each product/service.
6.9 A Hedge Fund Manager should fully disclose that it
may engage in Soft Dollar Arrangements prior to engag-
ing in such arrangements and should clearly disclose its
policies with respect to such arrangements, including:
1. Whether it may use the products and services pro-
vided by a broker pursuant to Soft Dollar Arrangements
to benefit Hedge Funds other than those whose trades
generated the relevant brokerage commissions or fees;
and
2. The types of products and services that may be
received through Soft Dollar Arrangements in an appro-
priate level of detail.
6.10 If a Hedge Fund Manager relies on the safe harbor
provided by Section 28(e), which protects the adviser
from even a claim of breach of fiduciary duty solely
because the adviser causes an account managed by the
Hedge Fund Manager to pay for Soft Dollar
28 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
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 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 discretionary
accounts;
2. Disclose Hedge Fund Manager’s policies and proce-
dures relating to such Soft Dollar Arrangements; and
3. Determine whether the brokerage and research serv-
ices 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 assistance to the money manager in the
carrying out of his responsibilities”.
6.11 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 following:
1. Assuming that the services are not covered within
the Section 28(e) safe harbor, the Hedge Fund Manager
should utilize 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 rea-
sonable in relation to the value of the services provid-
ed 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.
Investor Services Journal thanks the Managed Funds
Association for their kind permission to reprint this extract
For a complete copy of the MFA's Sound Practices for
Hedge Fund Managers please visit MFA's Web site at:
www.mfainfo.org.
NB: THE MANAGED FUNDS ASSOCIATION IS THE SOLE
COPYRIGHT OWNER OF THIS CONTENT WHICH IS NOT
TO BE REPRODUCED IN ANY FORM WITHOUT THE
EXPRESS PERMISSION OF THE MFA.
ANTI-MONEY LAUNDERING PROGRAMS
THE FOLLOWING IS AN EXCERPT FROM ONE OF THE
SIX OF APPENDICES OF THE MFA'S 2005 SOUND
PRACTICES FOR HEDGE FUND MANAGERS. CITATIONS
OMITTED.
APPENDIX III
MFA PRELIMINARY GUIDANCE FOR HEDGE
FUNDS AND HEDGE FUND MANAGERS
ON DEVELOPING ANTI-MONEY
LAUNDERING PROGRAMS
The attached Preliminary Guidance for Hedge Funds
and Hedge Funds Managers on Developing Anti-Money
Laundering Programs was published by MFA in 2002. At
the time of the publication of MFA’s 2005 Sound
Practices for Hedge Fund Managers, anti-money launder-
ing regulations applicable to Hedge Funds and Hedge
Fund Managers were still pending before the Treasury
Department. Accordingly, the most up-to-date lists main-
tained by the Financial Action Task Force on Money
Laundering and the Office of Foreign Assets Control, and
referred to in the appendices to this Appendix III, can be
found at the websites: www1.oecd.org/fatf and
www.treas.gov/ofac, respectively.
Preliminary Guidance for Hedge Funds and Hedge Fund
Managers on Developing Anti-Money Laundering
Programs Preamble
Preamble
Purpose of Guidance. On October 26, 2001, President
Bush signed into law the USA PATRIOT Act. Title III of
the USA PATRIOT Act, entitled the “International Money
Laundering Abatement and Anti-Terrorist Financing Act
of 2001”, requires all “financial institutions” to establish
an anti-money laundering program by April 24, 2002. In
particular Section 352 of the USA PATRIOT Act states that
each financial institution must establish an anti-money
laundering program that includes at a minimum:
• The development of internal policies, procedures and
controls;
• The designation of a compliance officer;
• An ongoing employee training program; and
• An independent audit function to test programs.
As defined in the USA PATRIOT Act, the term “financial
institution” includes, among other things, any entity that
is “an investment company”, as well as any entity that is
registered (or required to register) as a commodity pool
operator (“CPO”) or a commodity trading advisor
(“CTA”) under the Commodity Exchange Act. Although it
is not entirely clear whether the reference to an invest-
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 29
Sound Practices
ment company could be construed to include a hedge
fund excepted from the definition of investment company
under the Investment Company Act of 1940, Managed
Funds Association (“MFA”) believes that hedge funds
and their Hedge Fund Managers should adopt and imple-
ment anti-money laundering programs consistent with
Section 352 of the USA PATRIOT Act as a matter of sound
practice. Consequently, this preliminary guidance
(“Guidance”) is intended to highlight what MFA believes
to be key elements for hedge funds and Hedge Fund
Managers to consider in developing an effective anti-
money laundering program.
Role of MFA. MFA is the only U.S.-based association of
managed funds professionals. MFA is a national trade
association of more than 690 members that represents
the alternative investment industry globally. MFA and its
member firms have long been strong supporters of the
industry’s anti-money laundering efforts.
MFA recognizes that anti-money laundering compli-
ance will be undergoing great change as regulations
implementing the USA PATRIOT Act are promulgated
and as industry practice develops. MFA is publishing this
Guidance at this time in order to help hedge funds and
Hedge Fund Managers implement or enhance their anti-
money laundering programs in a timely manner. MFA
may update this Guidance in the future to reflect regula-
tions promulgated under the USA PATRIOT Act that may
be applicable to hedge funds and Hedge Fund Managers
and changes in industry practice.
Applicability of Guidance. This Guidance is intended
primarily for U.S.-based hedge funds and Hedge Fund
Managers. MFA also believes that the Guidance may be
applicable to offshore hedge funds and Hedge Fund
Managers to the extent that they utilize U.S.-based prime
brokers, since, in order to comply with the requirements
of the USA PATRIOT Act and implementing regulations,
these prime brokers may require comfort regarding their
fund clients’ anti-money laundering policies, procedures
and controls. Similarly, the Guidance may also be applied
more generally to commodity pools, CPOs and CTAs
based in the United States.5 In light of MFA’s expectation
that most hedge funds will rely on their Hedge Fund
Managers for development of and compliance with an
appropriate anti-money laundering program, the
Guidance has been written from the perspective of the
Hedge Fund Manager. If a hedge fund were to develop an
anti-money laundering program without involvement of
its Hedge Fund Manager, the Guidance would apply
equally to the hedge fund itself.
One Size Does Not Fit All. Given the considerable dif-
ferences among Hedge Fund Managers and the investors
with which they deal, MFA believes that no one standard
or model anti-money laundering program can be appro-
priate for all hedge funds. Hedge funds vary not only in
size, strategy and organizational structure, but also in
the profile of their investor bases. Some hedge funds
may have mostly natural persons as investors, whereas
others may have primarily an institutional client base;
some maintain relationships with investor intermediaries
and nominees, while others have predominantly direct
investors; some have an international client base, while
others are purely domestic; some may limit their
investors to insiders and other investors that are known
to the Hedge Fund Manager, while others deal with
investors from a wide variety of sources. The characteris-
tics of a hedge fund’s investor base should influence the
types of anti-money laundering policies and procedures
adopted by the Hedge Fund Manager.
Individualized Assessment and Application of
Guidance. The Guidance focuses on the responsibilities
of an established, global Hedge Fund Manager and con-
tains aspects that are aspirational in nature. Each Hedge
Fund Manager should assess the Guidance in light of the
characteristics of its investor base, its business model
and the resources of its organization, and, based upon
this assessment, apply the Guidance as appropriate.
Certain aspects of the Guidance may not be relevant or
appropriate to every Hedge Fund Manager. Consequently,
the Guidance should not be viewed as definitive require-
ments that could be rigidly applied by all Hedge Fund
Managers or that could serve as a basis either for audit-
ing a Hedge Fund Manager’s anti-money laundering poli-
cies and practices or for any legal claim or action. Nor
should the Guidance be viewed as exhaustive or address-
ing the only issues to consider in developing an anti-
money laundering program. In evaluating the relevance
of the Guidance and its ability to implement the recom-
mended policies and procedures, a Hedge Fund Manager
should recognize that, while some recommendations can
be implemented easily or unilaterally, others may require
planning, and in some cases negotiation with, and coop-
eration by, third parties.
No Substitute for Professional Advice. The Guidance is
not intended to serve as or be a substitute for profession-
al advice, and neither hedge funds nor their Hedge Fund
Managers should rely upon the Guidance as such. In
developing an anti-money laundering program, a Hedge
Fund Manager should consult with its professional legal
and accounting advisors.
I. Fundamental Elements of Anti-Money Laundering
Programs
1.1 General
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Broad Policy Statement. As part of its anti-money laun-
dering program, a Hedge Fund Manager should adopt a
broad statement, at its highest executive level, that clear-
ly sets forth its policy against money laundering and any
activity which facilitates money laundering or the funding
of terrorist activities.
Objectives. The Hedge Fund Manager should clearly
state the objectives of its anti-money laundering pro-
gram, which may include the detection and deterrence of
instances of money laundering, terrorist financing and
other illegal activity.
1.2 Role of Senior Management and the Anti-Money
Laundering Compliance Officer
Involvement in Policy Development and Enforcement.
Senior Management and the Anti-Money Laundering
Compliance Officer (designated in accordance with 1.4
below) should be involved in the development, adoption
and enforcement of written anti-money laundering poli-
cies, procedures and controls so as to ensure the efficacy
of the Hedge Fund Manager’s anti-money laundering
program.
Involvement in Decision-Making. The anti-money laun-
dering policies, procedures and controls should provide
that the decision to accept or reject an Investor should
involve the Anti-Money Laundering Compliance Officer,
who, consistent with the Hedge Fund Manager’s policies,
may consult with Senior Management on such decisions
as appropriate.
Determinations Regarding Third Party Reliance. As dis-
cussed in Part III, the Anti-Money Laundering
Compliance Officer should be involved in any decision to
rely upon Investor Identification Procedures performed
by a third party.
1.3 Investor Identification Policies and Procedures
Establishing Investor Identification Policies and
Procedures. The Hedge Fund Manager should establish
written policies and procedures regarding investor identi-
fication that are reasonably designed to be both feasible
and effective in achieving the stated objectives of the
anti-money laundering program. Key elements to consid-
er in developing these procedures are addressed in Part
II. The Guidance also addresses reliance upon third par-
ties for the performance of investor identification proce-
dures in Part III.
Review and Update as Necessary. Hedge Fund
Managers should periodically review and update their
anti-money laundering policies and procedures based on
applicable amendments to existing anti-money launder-
ing legislation and regulations, as well as changes in the
characteristics of the investor base of the hedge funds
managed. In this regard MFA may periodically update
the Guidance to reflect changes in anti-money laundering
law and regulation applicable to the hedge fund industry.
In particular a Hedge Fund Manager should ensure that
investor due diligence checklists and procedures are
updated on a periodic basis and that changes are inde-
pendently reviewed and approved by the Anti-Money
Laundering Compliance Officer.
1.4 Designation of Anti-Money Laundering Compliance
Officer
The Hedge Fund Manager should designate an Anti-
Money Laundering Compliance Officer and should pro-
vide the Anti-Money Laundering Compliance Officer with
adequate authority and resources to effectively imple-
ment the Hedge Fund Manager’s anti-money laundering
program.
The Anti-Money Laundering Compliance Officer’s
responsibilities should specifically include:
• Coordination and monitoring of the Hedge Fund
Manager’s day-to-day compliance with applicable anti-
money laundering laws and regulations and its own
anti-money laundering program;
• Conducting employee training programs for appropri-
ate personnel related to the Hedge Fund Manager’s
anti-money laundering program; and
• Reviewing any reports of suspicious activity from per-
sonnel of the Hedge Fund Manager.
The Anti-Money Laundering Compliance Officer may
serve other functions and may serve multiple depart-
ments within the Hedge Fund Manager’s organization.
However, the Anti-Money Laundering Compliance Officer
should not be responsible for functional areas within the
organization where money laundering activity may occur.
1.5 Ongoing Employee Training Program
Establishment and Content of Program. The Hedge
Fund Manager should establish anti-money laundering
training programs for all relevant personnel to be con-
ducted on a periodic basis, as appropriate. The training
programs should, among other things:
• Review applicable anti-money laundering laws and
regulations and recent trends in money laundering,
including the ways in which such laws and trends relate
to hedge funds; and
• Address elements of the Hedge Fund Manager’s own
anti-money laundering
program, particularly its Investor Identification
Procedures and policies regarding detection of
suspicious activity.
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 31
Sound Practices
Requiring Attendance. The Hedge Fund Manager should
develop and maintain policies, procedures and controls
reasonably designed to ensure that all appropriate per-
sonnel attend the anti-money laundering training pro-
grams as required.
Recordkeeping. Records of all anti-money laundering
training sessions conducted, including the dates and
locations of the training sessions and the names and
departments of attendees, should be retained for at least
five years, or for such longer period as may be required
by applicable law or regulation.
1.6 Independent Audit Function
The Hedge Fund Manager’s anti-money laundering pro-
gram should include an
independent audit function to assess compliance with
and the effectiveness of its anti-money laundering pro-
gram on a periodic basis. The independent audit function
should involve:
• Evaluation by the Hedge Fund Manager’s legal and
compliance director or officer or by external auditors or
counsel of compliance with applicable anti-money laun-
dering laws and regulations and the Hedge Fund
Manager’s own anti-money laundering program; and
• Reporting of the results of such evaluation to the
audit committee of the board of directors or similar
oversight body of the hedge fund or Hedge Fund
Manager.
The Hedge Fund Manager’s anti-money laundering
program should also provide for appropriate follow-up to
ensure that any deficiencies detected in the course of the
audit of its anti-money laundering program are
addressed and rectified.
II. Investor Identification Policies and Procedures
2.1 General Objective. As part of an anti-money launder-
ing program, a Hedge Fund Manager should establish
and maintain reasonable procedures that are designed to
verify Investors’ identities to the extent reasonable and
practicable (such procedures are referred to generally as
“Investor Identification Procedures”).
Consider Characteristics of Investor Base. The Hedge
Fund Manager’s Investor Identification Procedures
should take into account the specific risks presented by
the Investor base of the hedge fund(s) it manages.
General Premise. The Hedge Fund Manager’s Investor
Identification Procedures should further be based on the
premise that the Hedge Fund Manager should accept an
investment from a new Investor only after:
• The Hedge Fund Manager has confirmed the identity
of the Investor and that the Investor is investing as
principal and not for the benefit of any third party;
• If the Investor is investing on behalf of other underly-
ing investors, the Hedge Fund Manager has confirmed
the identities of the Investor and the underlying
investors; or
• The Hedge Fund Manager has determined that it is
acceptable to rely on the investor due diligence per-
formed by a third party, such as a fund administrator or
an investor intermediary, with regard to the Investor
(and underlying investors, if applicable). Reliance upon
Investor Identification Procedures performed by a third
party is addressed in Part III.
2.2 Investor Identification Procedures
Perform Procedures Appropriate to Type of Investor.
Where the Hedge Fund Manager undertakes to confirm
the identity of an Investor (rather than relying on its fund
administrator or another third party, as discussed in Part
III), it should conduct Investor Identification Procedures
based upon the specific characteristics presented by an
Investor. Possible identification procedures are presented
in 2.2.1. and 2.2.2, and procedures for screening for pro-
hibited Investors are addressed in 2.3. Possible enhanced
procedures for addressing “high risk” Investors are
addressed in 2.4. These procedures are provided as
examples only and are not intended to be prescriptive or
exhaustive. For example, a Hedge Fund Manager may
elect to apply alternative Investor Identification
Procedures based upon the specific characteristics of an
Investor or apply enhanced measures for reasons other
than those discussed in the Guidance.
Timing. A Hedge Fund Manager should complete
appropriate Investor Identification Procedures with
regard to an Investor prior to accepting an investment
from the Investor.
Due Diligence Checklists. A Hedge Fund Manager may
wish to develop a due diligence checklist to facilitate the
performance of Investor Identification Procedures.
Document Procedures Undertaken. The Hedge Fund
Manager should retain copies of all documents reviewed
or checklists completed in connection with its Investor
Identification Procedures in accordance with its investor
records retention policies (see 2.5.).
Include Appropriate Identity Provisions in Subscription
Documents. Fund subscription documents should
require an Investor to:
• Represent and covenant that all evidence of identity
provided is genuine and all related information fur-
nished is accurate;
• Agree to provide any information deemed necessary
by the Hedge Fund Manager in its sole discretion to
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comply with its anti-money laundering responsibilities
and policies; and
• In the case of a Direct Investor, represent that it is
investing solely as principal and not for the benefit of
any third parties.
2.2.1 Natural Persons as Investors
In order to confirm the identity of a natural person, a
Hedge Fund Manager should take reasonable steps to
ascertain satisfactory evidence of the Investor’s name,
address and date of birth (such as official driver’s license
with photograph, passport or other government-issued
identification). In certain circumstances, to gain addi-
tional comfort regarding an Investor’s identity, a Hedge
Fund Manager may wish to consider obtaining:
• The Investor’s social security number or taxpayer
identification number, if applicable;
• Additional forms of identification (not necessarily
government-issued) from the Investor which may be
used to confirm the Investor’s identity (e.g., a utility bill
containing the Investor’s name and address); or
• Reports from credit bureaus or other generally avail-
able public information confirming the Investor’s iden-
tity.
2.2.2 Corporations, Partnerships and Comparable Legal
Entities as Investors
In order to confirm the identity of a legal entity, the
Hedge Fund Manager should obtain satisfactory evidence
of the entity’s name and address and its authority to
make the contemplated investment. Where the Investor
is neither a publicly traded company listed on a major,
regulated exchange (or a subsidiary or a pension fund of
such a company) nor a regulated institution organized in
a FATF-Compliant Jurisdiction,10 the Hedge Fund
Manager may wish to gain additional comfort regarding
the Investor’s identity by obtaining certain of the follow-
ing, as
appropriate under the circumstances:
• Evidence that the Investor has been duly organized in
its jurisdiction of organization;
• If the Hedge Fund Manager believes it would be rea-
sonable to rely upon a certification from the Investor, a
certification from the Investor that it has implemented
and complies with anti-money laundering policies, pro-
cedures and controls that, for example, seek to ensure
that none of its directors, officers or equity holders are
prohibited Investors, as set forth in 2.3 (such a certifi-
cate, an “AML Certificate”), or, alternatively, a list of
directors, senior officers and principal equity holders
(in order to ensure, for example, that none of these
persons are prohibited Investors, as set forth in 2.3);
• In the case of a trust, evidence of the trustee’s author-
ity to make the contemplated investment and either an
AML Certificate from the trustee (if the Hedge Fund
Manager believes it would be reasonable to rely upon
such a certificate) or, alternatively, the identities of ben-
eficiaries, the provider of funds (e.g., settlor(s)), those
who have control over funds (e.g., trustee(s)) and any
persons who have the power to remove trustees, as
well as of authorized activity of the trust and the per-
sons authorized to act on behalf of the trust;
• Description of the Investor’s primary lines of busi-
ness;
• Publicly available information from law enforcement
agencies or regulatory authorities; or
• If appropriate, Investor’s financial statements and/or
bank references.
2.3 Prohibited Investors
Listed Investors. A Hedge Fund Manager should not
accept an investment from or on behalf of any Investor (a
“Listed Investor”) whose name appears on:
• The List of Specially Designated Nationals and
Blocked Persons maintained by the U.S. Office of
Foreign Assets Control (“OFAC”); or
• Such other lists of prohibited persons and entities as
may be mandated by applicable law or regulation.
Necessity to Check for List Updates. A Hedge Fund
Manager should update the information that it maintains
and relies upon for purposes of checking the above lists
as necessary in order to ensure that it does not accept an
investment from a prohibited Investor.
Foreign Shell Banks. Hedge Fund Managers should not
accept investments from or on behalf of a Foreign Shell
Bank. With respect to Investors that are Foreign Banks,
Hedge Fund Managers may wish to consider obtaining a
representation that the bank either (i) has a Physical
Presence; or (ii) does not have a Physical Presence, but is
a Regulated Affiliate.
2.4 High Risk Investors
Prior to accepting an investment from an Investor that
the Hedge Fund Manager has reason to believe presents
high risk factors (a “High Risk Investor”) with regard to
money laundering or terrorist financing, the Hedge Fund
Manager should conduct enhanced due diligence with
regard to the Investor in addition to routine Investor
Identification Procedures.
The enhanced due diligence procedures undertaken
with respect to High Risk Investors should be well docu-
mented, and any questions or concerns with regard to a
High Risk Investor should be directed to the Anti-Money
Laundering Compliance Officer.
The following are examples of types of Investors that
may be deemed to present high risk factors with regard
to money laundering or terrorist financing:
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 33
Sound Practices
• A Senior Foreign Political Figure, any member of a
Senior Foreign Political Figure’s Immediate Family, and
any Close Associate of a Senior Foreign Political Figure;
• Any Investor resident in, or organized or chartered
under the laws of, a Non-Cooperative Jurisdiction;
• Any Investor resident in, or organized or chartered
under the laws of, a jurisdiction that has been designat-
ed by the Secretary of the Treasury under Section 311 or
312 of the USA PATRIOT Act as warranting special
measures due to money laundering concerns;
• Any Investor who gives the Hedge Fund Manager rea-
son to believe that its subscription funds originate
from, or are routed through, an account maintained at
an “offshore bank”, or a bank organized or chartered
under the laws of a Non-Cooperative Jurisdiction; and
• Any Investor who gives the Hedge Fund Manager rea-
son to believe that the source of its subscription funds
may not be legitimate.
Examples of enhanced due diligence procedures that a
Hedge Fund Manager might consider in order to address
high risk factors presented by Investors are detailed in
2.4.1.(for natural persons) and 2.4.2. (for legal entities).
2.4.1 Natural Persons as High Risk Investors
Below are examples of measures a Hedge Fund
Manager might consider, as appropriate, in order to seek
comfort with respect to certain High Risk Investors who
are natural persons:
• Reviewing pronouncements of U.S. governmental
agencies and multilateral organizations such as the
Financial Action Task Force on Money Laundering
(“FATF”) with regard to the adequacy of anti-money
laundering and counter-terrorism legislation in the
Investor’s home country jurisdiction;
• Assessing the Investor’s business reputation through
review of generally available media reports or by other
means;
• Considering the source of the Investor’s wealth,
including the economic activities that generated the
Investor’s wealth, and the source of the particular funds
intended to be used to make the investment;
• Reviewing generally available public information, such
as media reports, to determine whether the Investor
has been the subject of any criminal or civil
enforcement action based on violations of anti-money
laundering laws or regulations or any investigation,
indictment, conviction or civil enforcement action
relating to financing of terrorists.
2.4.2 Legal Entities as High Risk Investors
Below are examples of measures a Hedge Fund
Manager might consider, as appropriate, in order to seek
comfort with respect to certain High Risk Investors who
are legal entities:
• Reviewing pronouncements of U.S. governmental
agencies and multilateral organizations such as FATF
with regard to the adequacy of anti-money laundering
and counter-terrorism legislation in the Investor’s
home country jurisdiction;
• Reviewing recent changes in the ownership or senior
management of the Investor;
• If applicable, determining the relationship between
the Investor and the government of its home country
jurisdiction, including whether the Investor is a govern-
ment-owned entity;
• Reviewing generally available public information to
determine whether the Investor has been the subject of
any criminal or civil enforcement action based on viola-
tions of anti-money laundering laws or regulations or
any criminal investigation, indictment, conviction or
civil enforcement action relating to financing of terror-
ists.
2.5 Investor Records Retention
The Hedge Fund Manager should establish procedures
requiring that copies of documents reviewed as part of
the performance of its Investor Identification Procedures
be retained for an appropriate period of time and, at a
minimum, the period of time required by applicable law
or regulation. For example, a Hedge Fund Manager might
require that documents be retained for so long as an
Investor remains invested in one of the hedge funds it
manages and for a minimum of five years following the
final redemption by the Investor.
The following are examples of the types of documents
that the Hedge Fund Manager might wish to retain as
part of its investor records retention policy:
• Copies of documents reviewed in connection with
Investor Identification Procedures or enhanced due dili-
gence procedures.
• Investor identification checklists, if any, or similar due
diligence documentation.
• Any other documents required to be retained by appli-
cable anti-money laundering legislation.
2.6 Risk-Focused Review of Existing Investors and
Detection of Suspicious Activity
As appropriate, a Hedge Fund Manager should under-
take a periodic review of its existing Investor base in
order to ensure that no Investor is a Listed Investor, as
defined in 2.3. Based on its own risk assessment, a
Hedge Fund Manager should periodically review, for
example, as part of the audit function addressed in 1.6,
the adequacy of due diligence performed on existing
Investors.
In addition a Hedge Fund Manager’s policies, proce-
dures and controls should provide for the detection of
suspicious activity and should include examples of the
34 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
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types and patterns of activities that may require further
review to determine whether the activity is suspicious.
For example, in some circumstances, the following activi-
ties, none of which per se constitutes suspicious activity,
may be indicative of activity that may require further
investigation:
• Investor exhibits an unusual concern regarding the
hedge fund’s compliance with government reporting
requirements, particularly with respect to the Investor’s
identity, type of business and assets, or the Investor is
reluctant or refuses to reveal any information concern-
ing business activities, or the Investor furnishes unusu-
al or suspect identification or business documents;
• Investor wishes to engage in investments that are
inconsistent with the Investor’s apparent investment
strategy;
• Investor (or a person publicly associated with the
Investor) is the subject of news reports indicating pos-
sible criminal, civil or regulatory violations;
• Investor appears to be acting as the agent for another
entity but declines, or is reluctant, without legitimate
commercial reasons, to provide any information in
response to questions about such entity;
• Investor has difficulty describing the nature of his or
her business or lacks general knowledge of the industry
he or she is apparently engaged in;
• Investor attempts, with unusual frequency (taking into
account the differences between Direct Investors and
investor intermediaries as appropriate), to make invest-
ments, request redemptions or transfer funds;
• Investor engages in unusual or frequent wire transfers
(taking into account the differences between Direct
Investors and investor intermediaries as appropriate),
particularly to unfamiliar bank accounts; and
• Investor transfers funds to jurisdictions other than its
home country jurisdiction.
The Hedge Fund Manager’s anti-money laundering pro-
gram should require any employee who detects suspi-
cious activity or has reason to believe that suspicious
activity is taking place to immediately inform his or her
immediate supervisor as well as the Anti- Money
Laundering Compliance Officer. In addition, as discussed
in 3.3 below, a Hedge Fund Manager should seek to
establish effective lines of communication for addressing
suspicious activity detected by its fund administrator or
another third party on which the Hedge Fund Manager
relies for investor due diligence and provide, for example,
that the fund administrator or other third party should
immediately notify the Hedge Fund Manager’s Anti-
Money Laundering Compliance Officer of any suspicious
activity relating to the Hedge Fund Manager’s funds.
III. Reliance Upon Investor Identification Procedures
Performed by Third Parties
3.1 Relationships between Hedge Fund Managers and
Third Parties
As in the banking and mutual fund industries, Hedge
Fund Managers often rely on third parties for the intro-
duction of investors and the processing of fund invest-
ments and subscription documents. For example,
investor intermediaries and nominees may introduce
their investor clients to a hedge fund or may invest in
hedge funds on their clients’ behalf. Similarly, a “fund of
funds” may make investments in a hedge fund on behalf
of its investors. In addition, hedge funds typically rely on
their fund administrators for the processing of subscrip-
tion documents and compliance with anti-money laun-
dering laws and regulations applicable in the fund’s juris-
diction of organization.
These third parties often have direct contact and main-
tain the primary relationship with the Investor and are
consequently in the best position to “know the cus-
tomer”. As a result, a Hedge Fund Manager may, directly
or indirectly, rely upon the Investor Identification
Procedures performed by such third parties, as set forth
below. Given the complexity and importance of appropri-
ately allocating investor identification responsibilities to
such a third party, the Anti-Money Laundering
Compliance Officer should be directly involved in the
decision to rely upon a particular third party to perform
investor due diligence.
3.2 Deciding to Rely Upon Investor Identification
Procedures Performed by Third Parties
(i) Determination of Circumstances Where Reliance May
Generally Be Appropriate
The Anti-Money Laundering Compliance Officer should
be directly involved with the determination of circum-
stances in which the Hedge Fund Manager may appropri-
ately rely on third parties for the performance of Investor
Identification Procedures. In order to direct its due dili-
gence efforts where they are most likely to be productive,
the Anti- Money Laundering Compliance Officer might
determine, taking into account applicable law and regula-
tion, its own risk assessment and available resources,
that it believes it will generally be appropriate (absent
any suspicious circumstances) to rely on the Investor
Identification Procedures performed by certain categories
of third parties. For example, a Hedge Fund Manager
might establish a policy providing that it will generally
rely upon the Investor Identification Procedures per-
formed with respect to Investors by:
• A U.S.-regulated financial institution where the
Investor is a customer of the U.S.-regulated financial
institution and the Investor’s investment funds are
wired from its account at the U.S.-regulated financial
institution;
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 35
Sound Practices
• An investor intermediary, nominee, fund of funds or
asset aggregator that is itself a U.S.-regulated financial
institution; or
• A regulated foreign financial institution organized in a
FATF-Compliant Jurisdiction. To the extent that the
Hedge Fund Manager believes that the Investor
Identification Procedures performed by a regulated for-
eign financial institution, although reliable, may not
include procedures that the Hedge Fund Manager is
required to perform, e.g., verification of whether an
Investor is a Listed Investor as defined in 2.3, the
Hedge Fund Manager should either expressly request
that the foreign financial institution confirm that it has
performed the necessary additional procedures or oth-
erwise provide for the performance of such procedures
prior to accepting an Investor through the financial
institution.
(ii) Case-by-Case Assessment of Third Parties’ Investor
Identification Procedures
In some cases a Hedge Fund Manager may conclude that
it must assess whether to rely on certain third parties on
a case-by-case basis, for example, when dealing with
unregulated entities or entities that are not based in
jurisdictions that have been predetermined to be accept-
able to the Hedge Fund Manager. In determining whether
the Investor Identification Procedures of such third par-
ties may be appropriately relied upon, the Hedge Fund
Manager may wish to consider various factors, as appro-
priate, such as:
• Jurisdiction in which third party is based and the exis-
tence of applicable anti-money laundering laws and
regulations. In order to gain comfort regarding the
anti-money laundering regime of another jurisdiction, a
Hedge Fund Manager may wish to review pronounce-
ments of U.S. governmental agencies and multilateral
organizations regarding the anti-money laundering
laws and regulations in such other jurisdiction.
• Regulatory status of third party and affiliates.
• Reputation and history of third party in the invest-
ment industry.
• The anti-money laundering and investor due diligence
policies, procedures and controls implemented by the
third party.
(iii) Further Assurances
Should the Hedge Fund Manager determine that further
assurances from a third party are warranted, it may also
wish to consider some of the following possibilities:
• Requiring the third party to provide the Hedge Fund
Manager with a copy of its anti-money laundering and
investor due diligence policies, procedures and con-
trols and to promptly notify the Hedge Fund Manager
of any amendment thereto.
• Requiring the third party to certify and covenant that
it complies and will continue to comply with its anti-
money laundering and investor due diligence policies,
procedures and controls.
• Requiring meaningful written representations and
covenants as to Investors verified by the third party,
e.g., a covenant that it will ensure that no such
Investors are prohibited Investors, as set forth in 2.3.
• Requiring the third party to provide access, upon
request, to copies of documents reviewed by the third
party in performing investor due diligence.
• Requiring the third party to submit to a review or
audit of its anti-money laundering policies, procedures
and controls and its compliance with them as they
relate to the funds managed by the Hedge Fund
Manager.
• In the case of an intermediary or nominee, obtaining
evidence of or representations as to its authority to
make the contemplated investment.
3.3 Allocation of Responsibilities Between the Parties
Agreements with Third Parties Generally. As discussed
below, agreements with third parties that either introduce
or process hedge fund investments should clearly allo-
cate anti-money laundering responsibilities between the
third party and the hedge fund and its Hedge Fund
Manager, as appropriate. As noted above, the Hedge
Fund Manager may wish to obtain a copy of the third
party’s anti-money laundering and investor due diligence
policies, procedures and controls and to require that the
third party promptly notify the Hedge Fund Manager of
any amendment thereto. Agreements with third parties
should also seek to establish effective lines of communi-
cation for addressing investor due diligence issues and
suspicious activity or circumstances as they arise. Such
agreements should also contemplate means by which a
hedge fund or its Hedge Fund Manager may periodically
verify or audit the third party’s compliance with its anti-
money laundering policies, procedures and controls.
Agreements with Fund Administrators. A hedge fund’s
agreement with its fund administrator should specifically
allocate between the administrator, on the one hand, and
the fund and the Hedge Fund Manager, on the other
hand, their respective obligations for compliance with
applicable U.S. anti-money laundering law and regulation
as well as the law and regulations applicable in the
fund’s home country jurisdiction.
Agreements with Investor Intermediaries. A Hedge
Fund Manager’s agreement with an introducing firm or
asset aggregator should clearly allocate responsibilities
for investor identification in accordance with the policies
adopted by the Hedge Fund Manager.
FOR A COMPLETE COPY OF THE MFA'S SOUND
PRACTICES FOR HEDGE FUND MANAGERS
PLEASE VISIT MFA'S WEB SITE AT:
WWW.MFAINFO.ORG
36 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
The worldwide hedge funds industry is currently
valued at just over $1 trillion, and rising. A majority
of the growth is owed to the increasing flow of insti-
tutional money into these funds and the diversity of
other alternative investments, which appeal to the
retail investors.
Previously the domain of a select handful of skilled
managers, traditional long only managers have
longed for a piece of the action and have left the
comfort zones of their worldwide asset management
houses to set up their own hedge funds.
A report, titled CREATE-KPMG hedge fund report,
surveyed managers of hedge funds and fund of
hedge funds, with US$250 bn funds under manage-
ment, mainstream fund managers, with US$18 tril-
lion funds under management, administrators of
hedge funds, with US$950 bn funds under adminis-
tration and pension funds, with US$3.5 trillion of
investments.
Among other key
findings, the report
concluded that hedge
funds will still remain
one of the ways to
achieve absolute
returns, mainstream
fund managers are
emulating hedge fund
type strategies and
structures, hedge
funds are diversifying
into long only and pri-
vate equity, using their
own tools and more pension funds will dip their toes
in the water with relatively small allocations. In the
last year worldwide regulatory bodies have sought to
examine the sys-
temic risks
involved in hedge
funds, because
unlike most safe
investments, hedge
funds affect every
aspect of the finan-
cial market place.
Commenting of the
effect of hedge
funds on systemic risk, Professor Amin Rajan, CEO
of CREATE and principal author of the CREATE-
KPMG hedge fund report, says: “The major source
for systemic risk occurs when individual hedge funds
leverage their funds by borrowing a lot of money
from their prime brokers. Although Long Term
Capital Management had about $5 bn worth of
assets, they were leveraged by a factor of 25. They
place bets of over $125 bn on one particular kind of
strategy and came unstuck. They put too many eggs
in one basket.
“With individual hedge
funds the risk is not as signifi-
cant in one sense but very sig-
nificant in another. It is
insignificant in that most of
the hedge funds are very
small.
“Even if they were heavily
leveraged, individually, they
cannot make much difference
because they are probably just
a drop in the ocean. However,
if most of the hedge funds fol-
low an identical strategy, as
they have done with credit derivatives and with col-
lateralised debt obligations in the recent past, you
will have a similar risk to that of Long Term Capital
Management in that vast amounts of money is going
into the same strategy.
“It doesn’t matter
that individuals are
putting money in, if
there is a blow-up in
that strategy, it could
have the same effect
as LTCM because
they are all putting
money into the same
area. There is a
potential for systemic
risk for funds that
adopt the same
strategies. However,
prime brokers are being very careful in terms of the
amount of leverage they allow.
“None of the hedge fund managers we interviewed
for the CREATE-KPMG report were leveraged or over-
leveraged. In
that respect,
although the
potential for
systemic risk is
there when
funds follow
the same strat-
egy, there isn’t
enough money
Hedge Fund Services Market Guide
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 37
Hedge Funds -.
Past Present &
Future
ISJ analyses the development of the
hedge funds industry from inception
to present date
Amin Rajan
CREATE
10 20 30 40 50 60
0
5
10
15
20
25
30
35
40
Last 3 years
Next 3 years
%
o
f
r
e
s
p
o
n
d
e
n
t
s
%
Growth
Bands
Annual annual growth in Hedge Funds under
management - Administrators
Source: CREATE-KPMG
10 20 30 40 50 60
0
5
10
15
20
25
30
35
40
45
50
Last 3 years
Next 3 years
%
o
f
r
e
s
p
o
n
d
e
n
t
s
%
Growth
Bands
Annual annual growth in Hedge Funds under
management - Hedge Funds and Fund of Hedge
Funds
Source: CREATE-KPMG
Less than 25 = 37%
26-40 = 10%
41-60 = 25%
61-80 = 13%
81-100 = 15%
Source: KPMG-CREATE
What percentage of your company's core capacity for
hedge fund management or administration is currently
being used? Hedge Funds
Less than 25 = 40%
41-60 = 10%
61-80 = 20%
81-100 = 30%
Source: KPMG-CREATE
What percentage of your company's core capacity
for hedge fund management or administration is
currently being used? Administrators
pouring into these strategies, through leverage,
which could convert the risk into reality.”
Systemic risk is closely observed by central bankers
and by regulators such as the Financial Services
Authority in the UK. “Because regulators are watch-
ing, prime brokers are making very sure blow ups
don’t happen,” says Rajan. “The reputational risk for
prime brokers is huge.”
In addition to LTCM, the year 2005 was rocked by
the collapse of REFCO owing to a lack of proper due
diligence. “When REFCO was launched on the stock
exchange three months ago, the company’s invest-
ment banks, accountants and lawyers were not fully
aware of the obligations that REFCO already had,”
says Rajan.
“They were parking certain liabilities outside of
their balance sheet. The collapse of the company was
a governance issue and not an investment issue.
Somebody was not transparent enough in revealing
the true accounting situation. Investment bankers
and accountants should have picked this up.
“In the end it wasn’t picked up by anybody and it
suddenly came to light. These things always come to
light when you park vast amounts of liability outside
of the balance sheet. REFCO was similar to ENRON
but on a very small scale. I don’t think REFCO poses
any kind of systemic risk because it is very small.
“The underlying business is good. There are inci-
dents of wrongdoing and they are probably isolated
incidents of wrongdoing. But the underlying busi-
ness, in my view, is good. I can’t really see a big fall
out from their efforts to sell the company.”
The relationships between a hedge fund and its
service providers has been emphasised in so far as
the relationships can enable the fund to be compliant
with best practices. The ideal relationship, according
to Rajan, will have prime broking and administration
combined under the same umbrella. “For example,
Banc of America is very interested in the administra-
tion function and prime broking. At the moment
prime brokers are part of investment banks and
administrators are completely far removed from these
banks. Evidently, a hedge fund manager will in the
first instance go to a prime broker and then to an
administrator.
“The ideal model would be a one stop shop
approach. This would help to ensure all fiduciary,
risk, compliance issues and risk management issues
are being handled by a group of professionals who
are very concerned about their own repetitional risk.
“That is the ideal model. Hedge funds go to invest-
ment banks and then to administrators to raise their
comfort level for customers. Administrators do the
valuation, performance monitoring and all of the set-
tlement functions. It means administrators are
becoming extremely important as the guardians of
the investors’ interests. Although they are paid for by
hedge fund managers, institutional and high net
worth investors really look to the administrators to
ensure their is transparency, proper reporting and
proper accounting.
“Administrators are playing a critical role and some
of them work very closely with people in the front
office to the extent that they are almost part of the
front office. But the administrator should avoid
going native by working too closely with the buy side.
“Once they go native the investors’ interests would
not be protected. The current model of service provi-
sion is quite unsatisfactory. It is better than what it
was when fund managers did their own administra-
tion. 50 per cent of fund managers still do their own
administration and that is not a good idea because
their strategies are very opaque. Somebody needs to
provide independent valuation to those strategies.”
Despite the growth of the hedge funds industry to
date, Rajan is confident of a bright future. “The
opportunities are there,” he says.
“They have reinforced the absolute return revolution.
Having tasted the fruits of absolute return, investors
are never likely to go back to the days of relative
return. Everybody wants capital protection and upside
in terms of income. The opportunities are boundless.
In our report we say that hedge funds are like the
physical universe. They don’t have any boundaries.
“They can expand in many directions, as long as
they can develop strategies, which capitalise on pric-
ing inefficiencies in the market place. It does not
matter whether the market place is in physical instru-
ments or in commodities or intangible assets.
“As long as there is mispricing they move in and
take advantage of that. As markets evolve, inefficien-
cies always abound. However, on the downside,
hedge fund managers have to evolve new strategies.
They are not able to do this right now, because there
isn’t much volatility in the market. Mispricing arises
when there is a huge amount of volatility. Secondly,
the second generation hedge fund managers are not
as innovative as the first generation hedge fund
managers.
When somebody invents a car that is a great thing.
But once a car has been invented you have to think
of something completely different or the returns
begin to fall. Newcomers have entered the market
and opportunities have been arbitraged away.
“The real challenge for hedge fund managers is to
invent new strategies as markets evolve. Unless they
can do that, they won’t be around for the next 10
years. If they can’t evolve new strategies the opportuni-
ty sets will be so limited that the hedge fund universe
will not be able to accommodate 8000 managers.”
38 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
The major source for systemic risk;
individual hedge funds leverage by
borrowing a lot of money from
their prime brokers
Hedge Fund Services Market Guid
Hedge fund performance data for the last three
years compared. Hedge Fund Research
Incorporated, a Chicago-based hedge fund
specialist has recorded performance levels for
hedge funds and fund of funds for the last
three years.
2003
• At September 2003, the HFRI Emerging Markets
Index delivered the best performance, with a rate of
return of 3.56.
• The HFRI Distressed Securities Index also performed
well during September 2003, with a rate of return of
2.71.
• The HFRI Market Timing Index had the least impres-
sive performance for September 2003, with a 0 rate of
return.
• The HFRI Fund Weighted Composite Index recorded
a rate of return of 1.16 for September 2003.
2004
• September 2004 presented the HFRI Indices with var-
ied fortunes. The top performer was the HFRI Emerging
Markets Index, which recorded a rate of return of 3.66.
•The HFRI Equity Non-Hedge Index also performed
well, with a rate of return of 3.36 for September 2004.
•The HFRI Convertible Arbitrage Index was the least
favourable performer, with a rate of return of -0.24 .
2005
•The HFRI Emerging Markets Index dominated during
September 2005, with a rate of return of 5.11.
•The HFRI Market Timing Index came away second
best, with a rate of return of 3.16 for September 2005.
• The least favourable performer at this time was the
HFRI Regulation D Index, which delivered a rate of
return of -0.38.
Fund of Hedge Funds
Fund of Hedge Funds performed favourably over the
last three years.
During September 2003, the HFRI Fund of Funds:
Market Defensive Index delivered a rate of return of
1.45.
• The HFRI Fund of Funds: Conservative Index also
performed well, with a rate of return of 1.23 for
September 2003.
• The worst performer was the HFRI Fund of Funds:
Strategic Index, with a rate of return of 1.09 for
September 2003.
• The HFRI Fund of Funds Composite Index delivered
a return of 1.18 for September 2003.
• The rates of return for September 2004 were some-
what different to September 2003.
2004
• The HFRI Fund of Funds: Strategic Index was the
top performer, with a rate of return of 1.55 for
September 2004.
• The HFRI Fund of Funds Composite Index performed
well, with a rate of return of 0.89.
• The HFRI Fund of Funds: Diversified Index showed
promise, with a rate of return of 0.82.
• The worst performer, the HFRI Fund of Funds:
Conservative Index, delivered a rate of return of 0.45,
for September 2004.
2005
• September 2005 presented the HFRI indices with a
reversal of fortunes, when compared with September
2004.
• With a rate of return of 2.02 for September 2005, the
The Rise of
Hedge Funds?
HFRI Fund Weighted Composite
HFRI Convertible Arb. I
HFRI Distressed Securities
HFRI Emerging Markets
HFRI Equity Hedge
HFRI Equity Market Neutral
HFRI Equity Market Neut.: Stat. Arb.
HFRI Equity Non-Hedge
HFRI Event-Driven
HFRI Fixed Income
HFRI Macro
HFRI Market Timing
HFRI Merger Arbitrage
HFRI Regulation D
HFRI Relative Value Arb.
HFRI Sector
0 0.5 1 1.5 2 2.5 3 3.5 4
Source: HFR
HFR Hedge Fund Index Rate of Return September 2003
HFRI Fund Weighted Composite
HFRI Convertible Arb.
HFRI Distressed Securities
HFRI Emerging Markets
HFRI Equity Hedge
HFRI Equity Market Neutral
HFRI Equity Market Neut.: Stat. Arb.
HFRI Equity Non-Hedge
HFRI Event-Driven
HFRI Fixed Income
HFRI Macro
HFRI Market Timing
HFRI Merger Arbitrage
HFRI Regulation D
HFRI Relative Value Arb.
HFRI Sector
-1 0 1 2 3 4 5 6
Source: HFR
HFR Hedge Fund Index Rate of Return September 200
HFRI Fund Weighted Composite
HFRI Convertible Arb.
HFRI Distressed Securities
HFRI Emerging Markets
HFRI Equity Hedge
HFRI Equity Market Neutral
HFRI Equity Market Neut.: Stat. Arb.
HFRI Equity Non-Hedge
HFRI Event-Driven
HFRI Fixed Income
HFRI Macro
HFRI Market Timing
HFRI Merger Arbitrage
HFRI Regulation D
HFRI Relative Value Arb.
HFRI Sector
-0.5 0 0.5 1 1.5 2 2.5 3 3.5 4
Source: HFR
HFR Hedge Fund Index Rate of Return September 2004
HFRI Fund of Funds: Strategic Index performed slight-
ly better then the HFRI Fund Weighted Composite Index,
which delivered a rate of return of 2.01 for Sept. 2005.
• Performance also improved for the HFRI Fund of
Funds Composite Index, which delivered a rate of
return of 1.52 for September 2005.
• The HFRI Fund of Funds: Conservative Index deliv-
ered a rate of return of 1.03 for September 2005.
• Comparing the performance levels of the HFRI Fund
Weighted Composite Index over the last three years,
performance peaked during Sept. 2005, when the index
delivered a rate of return of 2.01.
Market Benchmarks
In comparing performance among different market
benchmarks in September 2003, it is evident that the
Lehman Brother’s indices were the most prominent.
• The Lehman Brothers Aggregate Corporate Bond
Index delivered a rate of return of 3.77 for Sept. 2003.
• The Lehman Brothers Aggregate Government Bond
Index also performed well, with a rate of return of 3.15.
• The HFRI Fund Weighted Composite Index came third,
with a rate of return of 1.16 for September 2003.
• The worst performers were the S&P 500 w/dividends
index (with a return of -1.30) and the NASDAQ
Composite Index (with a return of -1.06).
The NASDAQ Composite Index enjoyed a whirlwind
recovery during September 2004 and delivered a rate of
return of 3.20.
• The MSCI Indices US$ World Index also performed
well, with a rate of return of 1.77 for September 2004.
• Performance for the Lehman Brothers Aggregate
Corporate Bond Index dropped substantially, with a rate
of return of 0.60 for September 2004.
• The Lehman Brothers Aggregate - US Government
Bond Index also performed less favourably than
September 2003, with a rate of return of 0.22.
The HFRI Fund Weighted Composite Index held its own
among market benchmarks, with a rate of return of 1.65
for September 2004.
The performance figures for September 2005 delivered
even greater misforturnes for the Lehman indices, which
outperformed other market benchmarks two years ago .
• The Lehman Brothers Aggregate Corporate Bond
Index took a dive to -1.60 during September 2005.
• The Lehman Brothers Aggregate - US Government
Bond Index experienced similar misfortunes, with a rate
of return of 1. 27 for September 2005.
• The NASDAQ Composite Index also suffered. The Index
posted a return of -0.02 for September 2005.
• The top performers include the MSCI Indices US$
World, which delivered a rate of return of 2.57 and the
HFRI Fund Weighted Composite Index, which delivered a
rate of return of 2.01 for September 2005.
40 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
HFRI Fund of Funds Composite
HFRI Fund of Funds: Conserv.
HFRI Fund of Funds: Diversified
HFRI Fund of Funds: Market Defensive Index
HFRI Fund of Funds: Strategic
HFRI Fund Weighted Composite
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6
Source: HFR
HFR Fund of Hedge Funds Indices Rate
of Return September 2003
HFRI Fund of Funds Composite
HFRI Fund of Funds: Conserv.
HFRI Fund of Funds: Diversified
HFRI Fund of Funds: Market Defensive Index
HFRI Fund of Funds: Strategic
HFRI Fund Weighted Composite
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8
Source: HFR
HFR Fund of Hedge Funds Indices Rate
of Return September 2004
HFRI Fund of Funds Composite
HFRI Fund of Funds: Conserv.
HFRI Fund of Funds: Diversified
HFRI Fund of Funds: Market Defensive Index
HFRI Fund of Funds: Strategic
HFRI Fund Weighted Composite
0 0.5 1 1.5 2 2.5
Source: HFR
HFR Fund of Hedge Funds Indices Rate
of Return September 2005
Lehman Brothers Agg. - US Govt Bond
Lehman Brothers Agg. Corp. Bond
MSCI Indices US$ World
NASDAQ Composite
S&P 500 w/ dividends
HFRI Fund Weighted Composite
-2 -1 0 1 2 3 4
Source: HFR
Market Benchmarks Rate of Return
September 2003
Lehman Brothers Agg. - US Govt Bond
Lehman Brothers Agg. Corp. Bond
MSCI Indices US$ World
NASDAQ Composite
S&P 500 w/ dividends
HFRI Fund Weighted Composite
0 0.5 1 1.5 2 2.5 3 3.5
Source: HFR
Market Benchmarks Rate of Return
September 2004
Lehman Brothers Agg. - US Govt Bond
Lehman Brothers Agg. Corp. Bond
MSCI Indices US$ World
NASDAQ Composite
S&P 500 w/ dividends
HFRI Fund Weighted Composite
-2 -1.5 -1 -0.5 0 0.5 1 1.5 2 2.5
Source: HFR
Market Benchmarks Rate of Return
September 2005
Hedge Fund Services Market Guide
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 41
With 23 years of experience in the investments
fund servicing industry, Sean Flynn, Managing
Director of UBS Hedge Funds Services in the
Cayman Islands, exudes a growing fascination
for hedge funds and predicts continued growth
and business opportunities in the years ahead.
“We have not seen the same asset inflows in
2005 as we did in 2004 but sustained growth is
a defining characteristic of the hedge funds
industry,” he says. “With current assets of just
over $1 trillion invested in the hedge funds
industry, it is fair to say that this is still a small
amount in the context of worldwide investable
assets. But the assets will continue to grow.”
Of particular importance to the hedge funds
industry is the current interest from pension
funds and other institutional investors. While
these investors are not yet making the leaps of
faith associated with transitions from equities
to bonds in their investment portfolios, there is
little doubt that their 'softly-softly' approach
towards hedge funds will turn into greater
commitment in the years to come. “In addition
to institutional investors, hedge funds are mov-
ing along the curve into the realm of the retail
investor,” says Flynn. “In terms of retail
investors a minimum investment would vary
between $10,000 to $20,000" With this trend it
can be expected that more regulation will follow.
As the hedge funds industry continues along
a path of growth, enthusiasts such as Flynn
testify to a continued separation of the
functions of the asset manager and the fund
administrator. “Substantial consolidation has
occurred on the back of hedge fund growth, the
end result being that the average asset manager
now has a clear choice of which
company should supply administration
services,” says Flynn.
As a consequence of con-
solidation within the fund
administration industry, the
barriers to entry are
extremely high. Flynn adds:
“Administrators need to
invest in experienced quali-
fied staff in order to deal
with the valuations Issues
associated with complex
Instruments. In addition to
the staff requirements, the
investment in information
technology is a must, especially when the chal-
lenge has moved from the ability to produce not
only monthly but daily NAVs and process
information for multi strategy funds using mul-
tiple prime brokers. A concentration of fund
administration providers currently dominates
the established hedge fund domiciles such as
Cayman, Bermuda and Dublin. But this is not
where the hedge fund opportunities begin and
end. Savvy providers have watched with interest
as quick-to-market regulators enhance their
rules to allow for hedge funds to be set up
onshore. The three main onshore hedge fund
centres in Europe include Germany, France and
Italy. To test drive the hedge funds industry,
these countries have introduced fund of hedge
funds. “But the role of service providers,
including prime brokers, in these countries
needs due attention,” says Flynn.
The role of the prime broker is not the only
challenge for sell side providers in the great
hedge fund equation. “Staffing is a major cause
of concern for fund administrators,” says Flynn.
“The labour market is extremely tight and the
increasing regulator requirements impacts
Words of
Wisdom
Sean Flynn
UBS
Hedge fund services expert
Sean Flynn traces the
development of the hedge
funds industry and predicts an
exciting future
heavily on staff exchange.”
Will these pressures translate into further
consolidation in the foreseeable future?
“Consolidation might be a trend, particularly as
fund performance levels are not what they used
to be,” said Flynn. “The barriers to entry are
rising and providers have external pressures to
worry about too. These include Sarbanes Oxley
and the capital adequacy requirements
presented by Basel 2 (these have an indirect
impact on the hedge funds industry). The
European Union Savings Directive has impacted
the European market, as it compels the paying
agent of investment funds to declare the names
of their investors or pay a withholding tax.
Thankfully this has had little impact on funds
that are domiciled in Cayman.”
The SEC’s investment advisor registration
requirements, which require hedge fund
managers to register with the Commission by
February 2006, serve to affect hedge fund
managers with US investors in the short term.
This raises the bar to entry for US hedge fund
managers. “Regulations will continue, especially
given the expected continued growth of the
hedge funds industry,” Flynn concludes.
Sean Flynn
Head of Hedge Fund Services. UBS Fund Services -
CEO . UBS in Cayman Islands - Managing Director
Years of investment industry experience: 23
Education: University College Dublin (Ireland), BCom.
Sean Flynn is responsible for the overall management
and development of the hedge fund administration busi-
ness for UBS Global Asset Management in the Cayman
Islands. He is also responsible for the development and
implementation of the hedge fund services business in
Ireland.
Sean began his career at UBS in 1986 as an Accountant
in the Trust division, before starting the fund
administration business in the Cayman Islands in 1992.
Before joining UBS, he worked as an Audit Senior with a
financial services company in Grand Cayman and prior to
that with KPMG in Dublin. Sean is a fellow of the
Institute of Chartered Accountants of Ireland.
The hedge fund industry has experienced
significant growth over the last few years,
with assets now in excess of USD1trillion,
and the expectation of continued growth. As
a result, hedge fund trading has become a
significant contributor to the trading activity
on all major stock exchanges.
The distribution of hedge funds goes beyond
high net worth individuals to include
institutional investors (such as pension
funds, insurance companies, etc.) with
products being developed to target retail
investors. Many of these products use
leverage as part of their strategy. These
developments have caught the attention of
regulators in the United States and Europe.
Given that this growing asset class tends to
be domiciled offshore, regulators often have
little information on its activity, including the
amount of leverage used, and no oversight of
its operations.
In the United States, the SEC approach has
been to require all investment advisors with
more than 14 clients (which includes
investors in funds) to be registered by
February 2006. At present, there does not
appear to be any further planned increased
regulatory requirements in the US. In Europe,
The EU is reviewing the hedge fund industry
and it is not clear at this time what, if any,
increased regulations will be proposed. Our
view is that the increased regulation of hedge
funds in the United States represents an
opportunity for top-level service providers of
the hedge fund industry.
We anticipate that the increased transparency
that this new regulation supports will also be
aligned with a ‘flight to quality’ in the service
providers hedge funds select, which in itself
creates opportunities for an organisation such
as UBS.
42 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
Staffing is a major cause of
concern for fund administrators
Hedge Fund Services Market Guide
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 43
Apart fromthe funds themselves, the hedge
fund administration industry is impacted by a
host of internal and external changes. The most
notable of these changes can be observed by
comparing the existing landscape of providers
with that of five years ago.
Having noticed the alarming growth of the
hedge funds industry in recent years, global
banks recognised the potential and sought to
acquire independently owned administrators as
a quick way to gain the expertise.
Recent examples include the acquisitions of
Bank of Bermuda by HSBC, Forum Financial by
Citigroup, Hemisphere by Bisys, International
Fund Services by State Street, International
Fund Administration by the Bank of New York,
DPM by Mellon Bank and Tranaut by JPMorgan.
As a result of these acquisitions only a few
independent providers are left and their quest,
in relation to the larger
hedge fund community, is to provide tailor
made services to fund managers and their
investors. Among these independent hedge
fund administrators is ATC Fund Services,
based in Curaçao, Netherlands Antilles.
General Manager Robert
Chin is a firm believer in
the longevity of hedge
funds and has committed
his company to the provi-
sion of fund accounting
and investor services such
as maintaining the relevant
registers of investors and
monitoring the fund's bank
account, processing all
investor-related transac-
tions and undertaking com-
pliance and anti-money laundering procedures
on investors in accordance with applicable inter-
national and local requirement. These services
compel Chin and his team to pay close atten-
tion to various regulatory developments that
have impacted the hedge funds industry. “In the
past few years, key regulatory developments
include the Repeal of the Ten Commandments,”
he says. The Ten Commandments, adopted by
the US Treasury Department in 1968, required a
US managed fund to have ten administrative
functions performed at outside the US for the
fund not to be subject to certain US taxes on its
US source income. The Ten Commandments
spawned the development of the offshore fund
administration industry for US-managed hedge
funds. However, the Taxpayer Relief Act signed
into US law on August 5, 1997, led to the repeal
of the "Ten Commandments" effective
December 31, 1997. The repeal made it possible
for hedge funds to self-administer their offshore
funds or to consider other on-shore alternatives.
Most funds decided to maintain their relation-
ships with offshore administrators, primarily
because of the sense that many foreign
investors had a preference of keeping their
records offshore. But over time the repeal had
A Changing
Landscape
ISJ speaks to Robert Chin about
how regulation and consolidation
have impacted on the global
hedge funds industry
Robert Chin ATC
an adverse effect on offshore providers in that
many administrative functions were moved back
on shore.
“Apart from the repeal, the USA Patriot Act
had wide ranging impacts on the regulatory
requirements of the hedge fund community,”
says Chin. Passed in October 2001, the Act
introduced various know-your-customer and
anti money laundering requirements for hedge
funds and other investment funds. “More
recently, the requirement from the Securities &
Exchange Commission for hedge fund man-
agers with 14 or more investors to register with
the Commission by January 2006 presents yet
another regulatory hurdle for the hedge funds
industry,” says Chin.
According to Chin, Europe is some way ahead
of the US as far as compliance-enforcing regula-
tion is concerned. “European countries have
allowed certain types of hedge funds under
UCITS III. The regulators here are looking for
ways to increase oversight of these funds in a
way that makes regulation in one European
Union country applicable to regulation in oth-
ers. While the US and Europe strengthen the
rules governing hedge funds, the offshore cen-
tres face global pressure to increase regulatory
environment and oversight.”
Competition
With a ring side seat to developments unfold-
ing in the hedge funds industry, Chin has
observed a series of changes to affect the firms
who manage the money. “Numerous hedge
fund boutiques are opening up, but the average
size of the start up hedge fund manager is
smaller than compared to 10 years ago,” he
says. “Also, annual returns tend to be lower due
to the efficiency of markets and increased com-
petition.”
The increased competition within the hedge
fund management community is a result of
more investors seeking investments in hedge
funds. “We are seeing an increased interest in
hedge funds from European and Asian
investors,” says Chin. Due to the growing
impact of hedge funds on capital markets the
industry faces a host of compliance-related
requirements. “In addition, institutional
investors are requiring more transparency, liq-
uidity and independent administrators,” says
Chin. “At the same time, the fees charged by
administrators, particularly for services to fund
of hedge funds instruments, are coming under
increasing pressure.”
Hedge fund administrators are not the only
players who are feeling the heat of competition
in the industry. Prime brokers are increasingly
challenged by new service providers and admin-
istrators who have included front and middle
office services, performance measurement, cap-
ital introduction and financing in their package.
“In response some prime brokers are expanding
their services to include capital contributions
and fund administration services,” says Chin.
Consolidation
Major financial institutions have engulfed the
fund administration community over the last
year. “These large institutional administrators
are focusing on the larger hedge funds,” says
Chin. "Their annual fees are higher as their
operational cost has increased as a result of
overhead expenses charged by the parent com-
pany. Consequently smaller hedge fund shops
can no longer afford these administrators and
are seeking refuge among the smaller, more
niche fund administrators. Smaller administra-
tors cater for the needs of hedge fund bou-
tiques,” says Chin. As consolidation within the
fund administration community continues, the
division between the large bank-owned fund
administrators on the one hand and the small,
niche fund administrators on the other, is set to
intensify. “As a niche provider, ATC strives to dif-
ferentiate itself from the competition by focus-
ing as much attention on support services for
fund managers as we do on delivering a quality
service, allowing managers to focus their
resources on their investments, confident in the
fact that every aspect of administration is being
taken care of by us,” says Chin.
Robert Chin is the general manager of ATC Fund
Services
offshore centres face global
pressure to increase regulatory
environment and oversight
44 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
We are seeing an increased
interest in hedge funds from
European and Asian investors
Gibraltar
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 45
Gibraltar has positioned itself as a primary
location for alternative investment funds.
James Lasry reveals what makes this
domicile an ideal choice
1. Gibraltar
The significant global expansion in funds has put consid-
erable pressure on established
fund centres such as Dublin,
Luxembourg and the Caribbean,
giving rise to delays in fund estab-
lishment. Fund administrators
have become more selective,
creating a healthy overspill to
other jurisdictions that have
previously been unexploited.
Funds are a creative form of
investment. Independent asset
managers may wish to pool assets
and streamline administration, so
are increasingly using collective investment vehicles. Funds
are also becoming the preferred investment structure for
family estates and trusts, offering professionally managed
investment structures that are tailor made to the family's
profile and objectives.
There are a number of funds currently domiciled in
Gibraltar and others that are administered from Gibraltar.
A significant number of these are hedge funds that are
registered in the Caribbean but whose promoters require
the administration to be carried out in the European time
zone. Gibraltar also has branches of the major names in
accounting services to provide audit and other support
services, as well as banks to provide
custody services.
The combination of high regulatory standards, the
flexibility of a small jurisdiction and the availability of a
quality infrastructure at low cost is increasingly making
Gibraltar an attractive fund location.
Gibraltar is part of the European Union by virtue of its
relationship with the United Kingdom. It has transposed
all relevant EU banking directives & and all of the finan-
cial services directives so that its financial services sector
is firmly within the integrated structured financial services
system contemplated by the European Union.
The 'passporting' of banking and insurance services has
been in place in Gibraltar for some years and financial
services passporting was brought into effect in July 2003.
This allows financial services firms and certain funds to
offer their services and products throughout Europe on
the basis of their Gibraltar licence .
2. Regulatory Regime
The regulatory regime for licensing funds is set out by
the following pieces of legislation:
i. the Financial Services Ordinance 1989;
ii. the Financial Services Ordinance (Collective
Investment Schemes) Regulations 1991;
iii. the Financial Services (Collective Investment
Schemes) Ordinance 2005 ; and
iv. the Financial Services (Experienced Investor Funds)
Regulations 2005.
These laws effectively divide the licensing requirements
on funds that may be incorporated in Gibraltar into three
categories:
i. experienced investor funds;
ii. non-undertakings for collective investment in trans-
ferable securities (UCITS) retail funds; and
iii. UCITS funds.
a. Experienced investor funds
Under the Financial Services (Experienced Investor
Funds) Regulations 2005 experienced investor funds
(EIFs) are funds designed for professional, high net-worth
or experienced investors. Investors in these funds must
have a net worth in excess of ¤1 million or invest a mini-
mum of ¤100,000 . An EIF may be set up in a matter of
days. For authorization to trade, an EIF need only notify
the Financial Services Commission within 14 days of
establishment . The notification is made by the adminis-
trator and is accompanied by the fund's offering docu-
ments and an opinion from counsel that the fund com-
plies with the EIF regulations . An EIF must have two
Gibraltar-resident directors who are pre-approved by the
commission, a custodian or prime broker and a Gibraltar-
based administrator . EIFs must also produce annual
audited accounts .
This is a niche area for funds currently in Gibraltar. EIFs
do not have to go through the regular procedure for regu-
lation and licensing, but are structured both to ensure
adequate investor protection and comfort and to allow for
expansion. Set-up time and costs are quite competitive.
GIBRALTAR:
An Alternative
Fund Jurisdiction
in the EU
James Lasry
Hassans
46 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
b. Non-UCITS retail funds
The second category is the non-UCITS compliant public
fund. These funds are licensed by the commission. The
licensing procedure, which usually takes three to six
months, involves the submission of the fund's formation
documents and prospectus to the commission, along
with application forms for the fund and its directors or
investment manager. It is possible to structure these
funds (as well as EIFs) as umbrella funds, hedge funds,
feeder funds, funds of funds and mutual funds.
The licensing requirements under the financial services
ordinance are that the company must have a paid-up
share capital of at least £50,000 and at least two Gibraltar
resident directors. The directors and managers must be
fit and proper persons and must have adequate invest-
ment experience in order for the commission to consent
to grant them a licence. It is good practice to have a face-
to-face meeting between the directors or promoters and
the commission's investment services supervisor. Unlike
EIFs, all of the directors and managers of a non-UCITS
retail fund must be approved by the commission, rather
than just the Gibraltar-resident directors.
Various restrictions are imposed on the type of invest-
ments made. However, it is possible for non-UCITS funds
to obtain derogations from these regulations by making a
case before the financial services commissioner. The end
result is that these funds may, with the commission's con-
sent, invest in almost any type of investment including
hedge funds, real property and even private equity. The
introduction of the Financial Services (Experienced
Investor Funds) Regulations 2005 is likely to lessen the
use of this fund category, which until now has been used
for both retail and experienced investor funds, as most of
the uses of this type of fund can be attained through the
EIF regime, aside from the fact that EIFs are restricted to
experienced investors.
c. UCITS funds
Where the intention of a public fund is to invest solely
in transferable securities, namely stocks and bonds listed
on a EU or other recognized stock exchange, a fund may
be licensed in compliance with the European UCITS direc-
tives . These funds are generally meant for retail
investors. Since Gibraltar is in the European Union by
virtue of Article 299(4) of the Treaty of Rome , it has the
right to passport its financial services throughout Europe.
Therefore, Gibraltar UCITS funds may passport their serv-
ices within the European Union on the basis of their
Gibraltar licence . Unlike EIFs and non-UCITS retail
funds, UCITS funds must comply with the Financial
Services Ordinance (Collective Investment Schemes)
Regulations 1991 with regard to investment restrictions
and structure. For example, no more than 10% of the
fund's assets may be invested in the securities of any one
issuer and the fund can invest in only up to a total of 10%
of the share capital of any one entity. Such funds must
also engage European-licensed custodians and adminis-
trators.
3. Protected Cell Companies
Gibraltar has implemented the Protected Cell Company
Ordinance 2001, which allows for the incorporation of
protected cell companies. Protected cell companies
enable the statutory segregation of assets and liabilities in
different cells. The protected cell company legislation
allows a fund to be set up so that there is segregation of
assets and liabilities in an umbrella structure (i.e., includ-
ing different sub-funds) where it is essential to ensure
that there is no liability contamination between sub-
funds. Instead of the client relying on a purely contractual
arrangement between shareholders, the legislative regime
gives statutory basis for the segregation of assets that is
also binding on third parties. Sub-funds or cells can be
used by separate clients or by one client wishing to pro-
mote several investment strategies. Protected cell com-
panies may be licensed as either EIFs (for professional
investors) or as retail funds.
4. Legal Structure
In Gibraltar, funds are usually structured as open-ended
investment companies in order to allow investors to exit
the investment and redeem their shares at any time, pre-
sumably on certain conditions of liquidity being satisfied.
Investors are issued redeemable preference shares that
they can redeem subject to the satisfaction of certain con-
ditions, which are determined in advance by the fund.
The fund's memorandum and articles must be drafted
to allow redemptions of shares at the prevailing net asset
value if the fund is to be open-ended. Typically, the fund
will have ordinary shares that carry the most voting rights
and participation shares that carry economic rights.
Participation shares are the units purchased by investors
at the net asset value - these do not usually have any vot-
ing rights, but they may have if desired by the promoters
of the fund. The ordinary shares are normally issued to
the investment manager or to the directors, depending on
who manages the fund.
The fund can be managed by its directors or by invest-
ment managers. Investment managers that manage
funds in Gibraltar may require a licence from the Financial
Services Commission in Gibraltar to do so. Directors who
manage a fund do not require any specific licensing, save
for Gibraltar-resident directors in EIFs, who must be
approved to act as directors of such funds . Most funds
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 47
have personal rather than corporate directors who hold
regular board meetings in order to ensure that manage-
ment and control are fully exercised in Gibraltar.
Gibraltar funds can be structured as closed funds as
well. These are usually used for private equity or property
funds. Whether open-ended or closed, funds may take
the form of a corporate vehicle or a unit trust, although
the latter has become less common in recent years.
5. Taxation and Confidentiality
Licensed funds in Gibraltar, including EIFs, are exempt
from income and company tax upon receipt of a certifi-
cate from the commissioner of income tax. There are no
capital gains, gift or wealth taxes in Gibraltar. Stamp duty
of £10 is payable on the increase of capital and on the
transfer of shares.
Gibraltar is committed to preventing money laundering
and it was the first jurisdiction to implement an anti-
money laundering regime for all crimes. As with any reg-
ulated entity, the fund must know the identity of each
investor by obtaining a passport copy and utility bills
showing his or her residential address along with a sup-
porting reference from a lawyer, accountant or banker.
This information is protected by common law confiden-
tiality. It is possible for the shareholder to remain anony-
mous on the Corporate Register by registering the shares
in the name of a nominee. The nominee will then hold
the shares in trust for and under the direction of any par-
ticular investor and his or her name will not be disclosed
in any public register.
6. Custodians, Fund Administrators and Net Asset Values
Investments may be made by the fund's custodian or, in
some cases, directly by the fund. EIF closed funds and
hedge funds with a prime broker of a P1/A1 rating do not
require custodians. Several banks in Gibraltar have ample
experience and capabilities in providing this service.
The fund must be administered by a professional fund
administrator. In the case of an EIF, the administrator
must be Gibraltar-based. Subscriptions and redemptions
are typically made directly through the administrator with
the consent of the directors.
Where the assets of the fund are publicly traded securi-
ties, the administrator can usually produce the net asset
value of the fund and distribute it to shareholders.
The net asset value will be the figure at which shares are
purchased and redeemed by shareholders.
Where the fund holds private equity such as shares in
private companies, real estate or chattels, a net asset
value must be compiled by competent valuers such as
accountants or valuation firms. Redemptions of shares in
such funds are often restricted in time and scope so that
the directors or managers may have ample opportunity
properly to dispose of any such assets in order to redeem
shares.
7. Auditors
Fund administrators can usually provide management
accounts as part of their package of services. EIFs and
public funds must be audited by an auditor registered in
Gibraltar*. Although the UK Generally Accepted
Accounting Principles are often used as the accounting
standards for funds, there is a movement in the industry
towards International Financial Reporting Standards.
These will eventually become mandatory.
8. Comment
Although Gibraltar has been used in recent years as
a fund jurisdiction on a modest scale, it is in the
process of revamping its legislation to provide
competitive alternatives.
The advent of the EIF regulations has given a tremen-
dous boost to the Gibraltar funds industry as it is now
possible to set up a fund (be it a hedge fund, a property
fund or even a fund of funds) for professional or experi-
enced investors quickly and efficiently. EIFs can even be
set up as protected cell companies.
The coming reform in retail fund legislation that imple-
ments the UCITS II and III directives is likely to attract
retail funds that can be passported throughout Europe
while remaining in a fiscally efficient jurisdiction.
Gibraltar's effective and efficient regulatory regime, its
position in the European Union and its favourable fiscal
treatment of funds make it a competitive alternative fund
jurisdiction.
James Lasry is a Partner at Hassans International Law
Firm in Gibraltar. He specialises in corporate and finan-
cial services law. He advised the Government of Gibraltar
on the regulatory and tax treatment of funds. James was
also involved in the drafting of Gibraltar's new
Experienced Investor Fund regulations. A member of the
Society of Trust and Estates Practitioners, James advises
professional trustees on complex trust matters. James
serves on the boards of various private investment com-
panies and funds in Gibraltar and abroad. He was educat-
ed at Johns Hopkins University and at Bar-Ilan University
from which he holds an LLB. Born in New York, James is
fluent in English, French, Spanish and Hebrew.
FOR FURTHER INFORMATION ON THIS TOPIC PLEASE CONTACT JAMES
LASRY AT HASSANS BY TELEPHONE (+350 79000) OR BY FAX (+350
71966) OR BY EMAIL ([email protected]). THE HASSANS WEB-
SITE CAN BE ACCESSED AT WWW.GIBRALTARLAW.COM.
Gibraltar
48 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
The numbers speak for
themselves. Canada has
experienced rapid growth
in hedge funds and relat-
ed products over the last
six years. Based on infor-
mation provided by
Investor Economics, the
number of Hedge Funds
in Canada has grown
from 46 in 1999 to over
200 in December 2004.
In the
same period of time assets have grown from
CAD$2.5 billion to CAD$15.4 billion. Of the 200
funds at the end of 2004, 106 were stand-alone
funds, 55 were pure fund of funds and 39 were
principal protected products.
Although the average size of Canadian Hedge
Funds is smaller than their counterparts in larger
jurisdictions, Canadian managers are attracting
attention from international investors. This in
large part is due to Canadian managers offering
a specialized product to the global marketplace
as Canada has a strong resource based
economy. A unique characteristic of the
Canadian market is the abundance of Trust
Units. These are essentially flow-through
entities representing an interest in an underlying
business. Due to the nature of this vehicle,
taxation is limited at the operating level. Most,
if not all, of their cash flows through to unit
holders where they are taxed. While the trust
structure is not unique to Canada, in other
markets they are typically limited to REITS and
the energy sector. In Canada, creative teams of
lawyers, accountants and bankers have taken
this a step further and found ways to expand this
structure to other types of businesses.
To facilitate international investments, there
has been a move by many managers to establish
offshore funds in various locations such as
Bermuda, Bahamas and the Cayman Islands.
Canada offers a unique alternative for asset
allocators who are looking for different
opportunities in a crowded market. Gary Selke,
President and CEO of Front Street Capital, one
of Canada’s largest funds, explains:
“Canadian capital markets are an
undiscovered gem in the context of the world-
wide search for alpha. With a MSCI weighting
of approximately 2% for Canadian securities
most international investors have ignored
Canada and are only now rediscovering the
opportunities available.
The boom in natural resource investing, largely
in energy and mining, has enabled domestic
hedge fund managers to earn excess returns for
their clients as the equity markets begin the
process of revaluation of Canadian stocks.
Hedging opportunities abound, in strategies
such as pairs trading and merger arbitrage,
particularly within the energy sector. Leading
domestic managers in this sector have been
generating returns in excess of 20% per annum
for the past five years.
In spite of these numbers and the opportuni-
ties, current estimates of capital employed in
hedge strategies in Canada are between $10-15
billion, less than 2% of the hedge capital
employed worldwide. In fact most of this money
has been reallocated outside of Canada to
various Fund of Fund players in Europe and the
U.S. This results in tremendous opportunity for
Canadian domestic managers who are active in
and focus on Canada.
Most astute observers believe that capital will
continue to migrate to Canada for the next few
years, likely with a positive impact for security
returns. The likely beneficiaries are those
investors who see the opportunity and are will-
ing to move on it.”
Canadian grown support for the hedge fund
industry is significant. There are many domestic
service providers who are focused on building
dynamic infrastructures to assist hedge fund
managers in their daily operations. These
include prime brokers offering execution, trade
clearance and settlement; custody, leverage,
stock lending, web-based reporting and capital
introduction services. While Canadian prime
Canada
Calling
Canada is keen to establish
itself as a centre for hedge
funds. Lionel deMercado
presents what this market
has to offer
Lionel deMercado
TD Securities
brokers may not be as seasoned as their U.S and
European counterparts they are quickly coming
up to speed in terms of their offerings, especially
in dealing with technology. In addition, domestic
broker dealers are continuing to expand their
menu of derivative products to compliment their
traditional offerings. On the legal front, there
are many law firms with groups dedicated to the
hedge fund industry with strong experience in
structuring both domestic and offshore prod-
ucts. A number of local administrators provide
services in shareholder record keeping and fund
accounting.
Canada has long been considered as an estab-
lished hub for doing business. With a mature
banking system and financial market, the coun-
try is well primed to cater to the hedge fund
industry. In recent years Canada has enjoyed a
strong dollar, stable inflation and low interest
rates. The Toronto Stock Exchange (TSX) is a
publicly listed company with a fully electronic
trading platform. Canada boasts a conservative
regulatory environment with several different lay-
ers of market oversight. Participants in the mar-
ket are subject to the rules and regulations of
their respective Provincial Securities
Commissions or Administrators. The
Investment Dealers Association of Canada (IDA)
is a self-regulatory organization (SRO) which
regulates the activities of its member firms.
Market Regulation Services Inc., also an SRO, is
an independent regulator of the Canadian equity
markets and as such monitors the daily trading
activities of exchange participants to ensure
market integrity. The various regulators work
together to towards building a stable and effi-
cient environment.
Like in other major markets, Canadian regula-
tory scrutiny is increasing along with growth in
the industry. This has recently intensified, espe-
cially in the wake of two highly publicized hedge
fund scandals. While the Canadian market is
not unique in having its share of hedge fund
problems, these issues have drawn increased
attention to the sector, particularly as they
involved retail investors. This raises additional
suitability issues. The IDA recently issued a
report entitled “Regulatory Analysis of Hedge
Funds” which highlights these concerns.
Canadian Hedge Fund Regulations ( Source:
courtesy of AIMA Canada)
The key issues relating to hedge fund regulations
in Canada are summarized below.
• Registration: Anyone engaged in trading securi-
ties or advising with respect to investing in secu-
rities in Canada, is subject to the registration
requirements of securities law. For a hedge fund,
this means that the portfolio manager(s) must
be appropriately registered as an adviser, or be
able to rely on a registration exemption.
Registered advisers are subject to numerous reg-
ulations related to matters such as proficiency,
record keeping and capital requirements.
Portfolio managers not resident in a jurisdiction
may have limited registration exemptions avail-
able to them. However, in some cases, it may be
necessary for the fund to have an adviser regis-
tered in the local jurisdiction. Trading in securi-
ties can include marketing activities and not just
buying or selling securities. As a
result, it may be necessary for the fund manager
to obtain registration even if it is not in direct
contact with potential investors. In some cases,
registration for trading or advising may be nec-
essary to rely on exemptions from the require-
ment to provide investors with a prospectus.
• Disclosure: Hedge funds in Canada are sold
primarily in the exempt market (i.e., without a
prospectus). There are three commonly used
prospectus exemptions: the minimum invest-
ment exemption, the “accredited investor”
exemption and the offering memorandum
exemption.
1. Minimum Investment Exemption: The mini-
mum investment exemption allows hedge funds
to sell their securities without a prospectus to
investors who make a prescribed minimum
investment. The prescribed minimum invest-
ment is not the same in all provinces and
territories (ranges from $97,000 to $150,000),
and there are also specific restrictions in each
jurisdiction.
2. “Accredited Investor” Exemption: A prospec-
tus exemption for “accredited investors” is avail-
able in a number of Canadian jurisdictions. An
The boom in natural resource
investing, largely in energy and
mining, has enabled domestic
hedge fund managers to earn
excess returns for their clients
as the equity markets begin the
process of revaluation of
Canadian stocks
50 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
Hedge Fund Services Market Guide
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 51
“accredited investor” is defined broadly to cover
many different entities including pension funds,
trust companies and corporations with net
assets of at least $5 million. Individuals may be
“accredited investors” if they own (alone or
together with a spouse) financial assets
exceeding $1,000,000, or if they have net
income before taxes exceeding $200,000 (or
$300,000 if combined with that of a spouse) in
each of the two most recent years and have a
reasonable expectation of exceeding the same
net income level in the current year. Once again,
the rules are not consistent in all jurisdictions.
3. Offering Memorandum Exemption: A number
of jurisdictions provide an exemption from the
prospectus requirement if the issuer delivers an
offering memorandum to investors in the pre-
scribed form and within the prescribed time.
An offering memorandum may also be the pri-
mary disclosure document provided to investors
in conjunction with either the minimum invest-
ment exemption or the “accredited investor”
exemption. An offering memorandum provides
investors with a right of action for rescission or
damages against the issuer, if there is a misrep-
resentation in the offering memorandum. It is
possible that securities regulators may deem any
kind of offering materials provided to prospec-
tive investors as an “offering memorandum.”
This could occur if the offering materials fall
within the definition of an “offering memoran-
dum” in the applicable securities legislation.
• Reporting: Once a hedge fund in Canada com-
pletes the sale of securities pursuant to a
prospectus exemption, a report of trades must
be completed and filed with the appropriate reg-
ulators. A report of trades sets out the name and
address of the issuer (or seller), the name of the
investor(s), a description of the securities, the
date of the trade(s) and the particulars of the
trade(s), such as the number of securities sold
and the purchase price. The deadline for filing
such reports varies across the country. In order
to address this issue, it is possible to request
exemption orders to co-ordinate the filing obliga-
tions. Most of the provinces and territories
require a fee for filing a report of trades. Most
fees are flat fees but some set maximum filing
fees based on a percentage of the gross value of
the securities distributed pursuant to the exemp-
tion.
• Financial Statements: Although hedge funds
that are not sold pursuant to a prospectus are
not “reporting issuers” under securities law, they
may still have financial statement reporting obli-
gations. Some jurisdictions require that funds
established under local law must file interim and
annual financial statements, even if they do not
distribute securities pursuant to a prospectus.
Statements must be filed in electronic format on
the System for Electronic Document Analysis
and Retrieval (SEDAR). Once filed on SEDAR,
the financial statements are available to the pub-
lic on the Internet. Regulators have granted
exemptions from this filing requirement. The
exemptions are subject to a number of
conditions, which include retaining the financial
statements indefinitely and providing them to
regulators upon request.
• Privacy: Hedge funds are subject to applicable
provincial or federal privacy legislation with
respect to information about their investors.
Privacy legislation addresses the collection, use,
disclosure and disposal of personal information.
• Money Laundering and Terrorist Financing:
Hedge fund managers must comply with
applicable reporting requirements of anti-money
laundering and anti-terrorist financing legisla-
tion. Suspicious or large cash transactions must
be reported to the Financial Transactions and
Reports Analysis Centre of Canada (FINTRAC).
Registered advisers or dealers are also required
to make monthly reports to securities regulators,
stating whether they have had any dealings with
persons on official lists of terrorists.
The Canadian Alternative Industry is expected
to grow steadily over the next few years.
Canada’s robust economy and strong Canadian
dollar continue to create opportunities for
talented managers. As Canada moves into the
international spotlight, new investment is sure to
follow. Canada is well positioned as a place to do
business. Support from prime brokers,
administrators and other service providers will
continue to evolve and adapt to industry
demands, ensuring a stable environment for
investment.
Lionel deMercado, Managing Director, Global
Head of Equity Finance, TD Securites
Canada’s robust economy
and strong Canadian dollar
continue to create opportunities
for talented managers
The Dubai International
Financial Centre (DIFC), the
world’s newest global financial
hub, was declared open for
business in 2004.
The DIFC, ideally located to
bridge the gap between existing
financial centres of London and
New York in the West and Hong
Kong and Tokyo in the East,
completes the global financial
network.
It services a region with the
largest untapped emerging
market for financial services.
Vision
The vision of the DIFC is to shape tomorrow’s
financial map as a global gateway for capital and
investment. Its mission is to be a catalyst for
regional economic growth, development and
diversification, just as New York, London and
Hong Kong and Wall Street have contributed to
the growth of the US, European and Asian
economies.
The Dubai International Financial Centre was
conceived by the Government of Dubai for the
benefit of the UAE and the wider region as a
whole. Its remit is to create a regional and
international capital market, offering investors
and issuers of capital world-class regulations
and standards. Its hallmarks are: integrity,
transparency and efficiency.
Service Hub
A hub for institutional financial services, DIFC
has been designed to:
i divert the regional liquidity back into investment
opportunities within the region and contribute to
its economic growth
ii facilitate planned privatisations in the region;
enable initial public offerings by privately owned
companies; give impetus to the programme of
deregulation and market liberalisation through-
out the region
iii create added insurance and reinsurance capac-
ity - 65 per cent of annual premiums are re-
insured outside the region
iv develop a global centre for Islamic finance -
this is now an over $260 billion market serving
large Islamic communities stretching from
Malaysia and Indonesia to the United States
Attraction
Since launch, DIFC has attracted international
firms of the calibre of Merrill Lynch, Mellon
Global Investments, Barclays Capital, Lloyds TSB,
Credit Suisse and Deutsche Bank who have all
applied for or received the licence to operate
from the DIFC.
All of these institutions will receive benefits
such as 100 per cent foreign ownership, zero per
cent tax rate on income and profits, a wide net-
work of double taxation treaties available to the
UAE incorporated entities, no restrictions on for-
52 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
Dubai
An international
financial centre
“The vision of the DIFC is to
shape tomorrow’s financial map”
Dr Omar Bin
Sulaiman
Director General,
DIFC Authority
Dubai International Financial Centre
eign exchange, freedom to repatriate capital and
profits without restrictions, high standards of
rules and regulations, ultra-modern office
accommodation, sophisticated infrastructure,
operational support and business continuity
facilities of uncompromisingly high standards.
Focus
Focusing on seven primary sectors: Banking
Services; Capital Markets; Asset Management
and Fund Registration; Reinsurance; Islamic
Finance; Business Processing Operations and
Ancillary Service Providers, the goal of the
DIFC is to be universally recognised as a hub
for institutional financial services not just in the
region but worldwide.
It also aims to create a global centre for
Islamic Finance and enhance reinsurance
capacity in the region.
As with established international financial
centres, at the heart of the overall DIFC concept
is an independent regulator, the Dubai Financial
Services Authority (DFSA).
The DFSA is the independent regulatory and
supervisory body which grants licences and
regulates the activities of financial institutions
in the DIFC. It has been created using principle-
based primary legislation modelled closely on
that used in London and New York, and its
regulatory regime will operate to standards that
meet those in the world's major financial
centres.
Independence
The independent status of the centre is fur-
ther enhanced by the establishment of the DIFC
Courts. The laws establishing the DIFC Courts
have been designed to ensure the highest
international standards of legal procedure thus
ensuring that the DIFC Courts provide the cer-
tainty, flexibility and efficiency expected by the
global institutions operating within the DIFC.
As a subsidiary of DIFC, the Dubai
International Financial Exchange (DIFX) is the
region’s first truly international exchange. Being
a liquid and transparent electronic market
trading securities, bonds and derivatives, the
DIFX was launched on 26 September 2005.
It has been created to provide both investors
and issuers with a larger and more liquid
securities market than currently exists elsewhere
in the region.
Marketing and managing the DIFC is the
responsibility of the DIFC Authority. This is the
core body established by federal law and is the
body that issues all the laws and regulations for
all the non-financial entities that will operate in
the DIFC. In addition the DIFC Authority is
responsible for the Company Registry and
Security Registry.
Composition
So much more than just a financial district,
the DIFC is planned as a ‘city within a city’ that
will comprise of a unique integration of
buildings and open spaces with over 65 per cent
of the total site landscaped with specific green
zones. It will ultimately provide over 22 million
square feet of ultra modern office space,
residential and leisure areas which will include
offices, serviced apartments, hotels, shops,
restaurants, a museum, an art gallery and a
performing arts centre.
Designed by leading international architects,
Gensler, the landmark ‘Gate’ building repre-
sents the spirit of the DIFC – a gateway to the
region. It houses the DIFC Authority, the DFSA
as well as global financial firms.
Location
Guaranteeing the DIFC’s success is its
location. The cosmopolitan city of Dubai has a
safe, secure, economically, politically and
socially stable environment with superb
infrastructure and a highly skilled, educated and
multi-cultural workforce.
With such a sophisticated physical
infrastructure, a visionary leadership and a
stringent regulatory framework, the DIFC is
poised to tap the largest emerging market for
financial services within a region of 1.8 billion
people and a combined economy worth $1.5
trillion in terms of GDP, growing at an annual
rate in excess of 5 per cent.
The world’s newest international financial
centre has become a reality and both the
region and the world’s financial community
are set to benefit.
Dr Omar Bin Sulaiman is the Director General,
DIFC Authority
“The laws establishing the
DIFC Courts have been
designed to ensure the highest
international standards”
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 53
Amongst fund managers
and other financial intermedi-
aries, the subject of tax recla-
mation is often overlooked.
Dividends on foreign shares
are typically taxed twice - once
in the country where the asset
is registered and once in the
country of the owner of the
asset. Double Taxation
Agreements exist between gov-
ernments to allow some of
that tax to be reclaimed. If,
however, an investor fails to
make a reclaim or fill in the proper form correctly
within the time frame, then the rule is simple. The
foreign government keeps the cash.
Back in 2002, we estimated that nearly 73% of
reclaimable tax on overseas dividends was being
successfully retrieved by custodian banks on behalf
of their clients – yet despite this high success rate,
the remaining unreclaimed 27% still represented a
loss of over ¤6bn. For the UK, investors’ lost cash
in unreclaimed tax on foreign shares stood at
¤621m; in the US, $830m; and in Germany, ¤308m.
Red tape is the most frequently cited reason for
non-reclamation of withholding tax. The process of
making a reclaim is laborious, and requires an in-
depth knowledge of different tax regimes and
reclaim formats across many different geographies
and legislatures. However, for hedge funds,
investor losses are more complicated – and the
exact figures are opaque - because of the unregulat-
ed nature of the sector. Non-reclamation could be
due to funds being based offshore and therefore
not subject to Double Taxation Agreements, or
because the hedge fund managers do not want to
disclose the identities of their underlying investors
to custodian banks who could handle the reclama-
tion process for them.
The hedge fund perspective
The reality is that reclamation levels amongst
hedge funds are nowhere near the average for insti-
tutional investors. Some commentators go as far
as claiming that virtually no tax is reclaimed. In the
past, this was not of such significance because
hedge funds had little interest in equity invest-
ments and were therefore isolated from stock mar-
ket corrections, but this situation is changing. As
hedge funds begin to show greater enthusiasm for
equities, the issue of dividend taxation will certainly
affect them. There are also clear market signs that
sophisticated retail investors are placing a greater
emphasis on hedge funds as the high-yield element
of their investment portfolio. Furthermore, institu-
tional investors with the longest view – pension
funds – have fundamentally re-engineered their
portfolio balance and pension fund investment in
hedge funds has also increased dramatically in
recent years. For high net-worth individuals and
profit-squeezed pension funds, non-reclamation
means lost returns.
Custodian banks and fund managers are now
actively seeking automated methods of being
able to predict investor portfolio returns, taking into
account the effect of withholding tax reclamation
cash flows. In fact, leading custodians have recog-
nised the market opening represented by effective
tax reclamation services, both for their FM clients,
and as an interbank services opportunity.
Automated reclamation facilities have now made
the provisionof such services highly profitable, in a
market climate where other revenue streams are
declining. Hedge fund managers who remain reti-
cent to reclaim tax could be missing out on a sub-
stantial market opportunity.
With the hedge fund industry on the rise, there is
much debate over industry regulation. Both the
Securities and Exchange Commission in the US
and the Financial Services Authority in the UK
appear to firmly set on the path towards regulation.
Eurohedge recently estimated that there were over
250 new European hedge funds set up last year,
raising combined total assets of well over $22bn,
which compares to $21bn raised by nearly 230 new
funds in 2003. It is also to be noted that many
major mainstream financial institutions are becom-
ing more interested in hedge funds, either by
acquiring the funds or by setting up their own ‘in-
house’. It could be argued that the involvement of
large institutions with a long track-record of regula-
tory compliance will add weight to the regulation
argument, as they are well used to presenting finan-
cial transparency to the market and are unlikely to
resist any moves towards regulation. Although
many hedge funds are opposed to regulation, the
Hedge Funds -
Are investors
losing out?
Tax reclamation is barely on the
radar for hedge fund managers.
Stephen Everard, outlines why
investors and fund managers
should be crying foul
54 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
Stephen Everard
GOAL
Dividend Witholding Tax
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 55
increased transparency would undoubtedly facilitate
greater awareness of tax reclamation and certainly
boost returns from dividend income.
Private investors
We have already noted that retail investors are
becoming interested in hedge funds. We recently
conducted research to investigate the retail invest-
ment perspective, and found that a staggering
90% of reclaimable tax is not reclaimed by private
investors, amounting to a total wastage of annual
returns of some £251m for UK investors alone.
Overall, up to 13-14% of dividend returns on for-
eign stocks that could be reclaimed from withheld
tax are simply being thrown away.
Foreign securities holdings average around 20%
across all world markets. This compares with US
investors who hold an average 12% in foreign
stocks. Bearing in mind the global average portfo-
lio proportion in cross-border equities at 20%, this
tells us that the non-US investment community a
typical foreign equity holding of nearer 30%.
According to the UK Shareholders Association, for-
eign owners hold 33% of UK shares, up from 16%
in 1994. Even these averages often mask individ-
ual portfolio balances that are highly exposed to
the non-tax-reclamation problem. For instance, in
Switzerland, the withholding rate is 35% and the
reclamation rate 20%. A portfolio biased towards
this geography could therefore suffer a consider-
able loss of earnings if withholding tax is not effi-
ciently and effectively reclaimed.
An answer for funds - and their investors
The losses incurred by investors through non-
reclamation of tax on foreign securities is hardly
unrecognised. Proshare, the private shareholders
community organization, is quoted as saying,
“Depending on where you invest, you may be
liable to local taxation charges. This could mean
you are going to pay tax twice (in the country
where you made your investment, AND in the UK
on your income and gains received here). You,
hopefully, will receive benefit for the overseas tax
through double taxation relief, but you need to be
very aware of this. Your stockbroker should be
able to outline the taxes that are specific to the
country where you want to invest, but you must
make yourself aware of them before you start to
invest.”
The disparity in reclamation rates between insti-
tutional and retail investors is, we believe, mainly
because financial advisors, stockbrokers and
accountants find it difficult to deliver a return on
investment for assuming the plethora of required
knowledge and detail. However, for institutional
investors, the sums do add up, because the
amounts available for reclaim are far higher. In the
case of hedge funds who may not wish to work
with a custodian bank, it is now possible to out-
source the reclamation process to an independent
third-party using a secure, web-based system. This
opens up a new market opportunity for them and
will help them provide greater return on invest-
ment from the equities portion of their portfolios.
There is good news for individual private
investors, too. The processes and systems devel-
oped for the hedge funds and custodian banks are
now being scaled down to come within the reach
of private individuals, their accountants and their
stockbrokers. The knowledge-base used to
process claims, automatically generate the right
forms, and ensure that they are filled in correctly,
are just the same for private individuals as for
investment funds and their underlying investor-
customers.
Summary
Unreclaimed withholding tax remains a problem
for investors globally, both retail and institutional,
and their financial advisors. In the region of
13-14% of dividend returns are being lost due to
non-reclamation, and those losses are being
disproportionately shouldered by larger private
investors such as those who invest in hedge funds.
Hedge fund managers now have the option of
using third-party secure technology solutions to
manage the reclaim process for their clients, in
order to provide a valuable additional customer
service, and to improve the financial return their
clients are obtaining from dividend income.
Furthermore, high net worth individuals can use
such solutions themselves to simplify their
dealings with foreign tax authorities.
Stephen M. Everard, Managing Director,
Global Operations & Administration Limited.
Stephen has over twenty five years of securities
experience and has held senior management positions
with Mercury Asset Management Ltd, Bank of America N.T
& S.A and most latterly with Citigroup N.A. where he was
Senior Vice President within their Operations group.
He joined Goal in October 2002 and has fundamentally
restructured the group and expanded its product range
and client base thereby enhancing service delivery and
shareholder value.
As hedge funds begin to show
greater enthusiasm for equities,
the issue of dividend taxation
will certainly affect them
56 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Robert N. Chin, General Manager, ATC Fund Services
Robert 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. Robert's professional experi-
ences include a seven-year tenure as CFO of Dutch brokerage
firm where he was a member of the European Option Exchange
and the Amsterdam Stock Exchange. Robert spent the first 8
years of his career with Ernst & Young in Amsterdam.
Stephen M. Everard, Managing Director, Global Operations &
Administration Limited. Stephen has over twenty five years of
securities experience and has held senior management posi-
tions with Mercury Asset Management Ltd, Bank of America
N.T & S.A and most latterly with Citigroup N.A. where he was
Senior Vice President within their Operations group. He joined
Goal in October 2002 and has fundamentally restructured the
group and expanded its product range and client base thereby
enhancing service delivery and shareholder value.
Sean Flynn, Head of Hedge Fund Services, UBS Fund Services
CEO UBS in Cayman Islands, Managing Director
Years of investment industry experience: 23
Education: University College Dublin (Ireland), BCom
Sean Flynn is responsible for the overall management and
development of the hedge fund administration business for
UBS Global Asset Management in the Cayman Islands. He is
also responsible for the development and implementation of
the hedge fund services business in Ireland.
Sean began his career at UBS in 1986 as an Accountant in the
Trust division, before starting the fund administration business
in the Cayman Islands in 1992.
Before joining UBS, he worked as an Audit Senior with a
financial services company in Grand Cayman and prior to that
with KPMG in Dublin. Sean is a fellow of the Institute of
Chartered Accountants of Ireland.
Vicki Juretic, Vice President & Sr. Relationship Manager, TD
Securities. Vicki is responsible for overseeing the daily activities
of the Prime Brokerage relationship managers. In addition,
she has an active role in the ongoing development of the Prime
Brokerage business. Prior to joining TD, Vicki had 10 years of
experience in a variety of roles within the Securities Lending &
Finance Group of a major Canadian financial institution, most
recently as a trader on the securities lending desk. Vicki joined
TD Securities in 2003.
James Lasry is a Partner at Hassans International Law Firm in
Gibraltar. He specialises in corporate and financial services law.
He advised the Government of Gibraltar on the regulatory and
tax treatment of funds. James was also involved in the drafting
of Gibraltar's new Experienced Investor Fund regulations. A
member of the Society of Trust and Estates Practitioners,
James advises professional trustees on complex trust matters.
James serves on the boards of various private investment com-
panies and funds in Gibraltar and abroad. He was educated at
Johns Hopkins University and at Bar-Ilan University from which
he holds an LLB. Born in New York, James is fluent in English,
French, Spanish and Hebrew.
Comment on the key developments to impact the hedge
fund industry in the last few years.
Chin: Starting with the regulatory environment, as far as the
US is concerned, the first major change was the repeal of
the Ten Commandments in 1998. Another key development
was the US Patriot Act and finally the pending regulation
requiring investment advisors with more than 14 US
investors to register with the SEC. In Europe and Asia, sev-
eral countries are in the process of allowing hedge funds to
both allow hedge funds to be domiciled as well as market-
ing their shares to local citizens. Finally, the offshore cen-
ters are under global pressure to implement/ increase regu-
lation and supervision on hedge funds
Everard: Hedge funds were previously regarded as unusual
instruments. Even today, people hear lots of nasty things
about the bad guys who are driving markets down or who
are making all the money. There are a lot more of these
hedge fund managers and literally hundreds of hedge
funds. There is also a general market awareness of what
these managers do and how they do it. A lot of the people
HEDGE FUND SERVICES
PANEL DEBATE
Sean Flynn Vicky Juretic James Lasry
Stephen Everard Robert Chin
Hedge Fund Services Market Guide
Hedge Fund Services Panel Debate
who set up funds in the first place appear to have gained a
bit of experience in one area and have moved on to set up
in competition with their previous employer.
Flynn: The industry is changing to the extent that the
investor base is changing from family offices and high net
worth individuals. The new wave of money flowing into
hedge funds is coming from the institutional investor base,
particularly pension funds. This has created an environ-
ment of more transparency and more requirements on the
fund administrator to complete independent NAVs. The
long only, traditional managers are moving into hedge fund
strategies. Hedge funds are moving into long only and pri-
vate equity strategies. Many of the hedge fund managers,
particularly the larger players, are using multi strategy, mul-
tiple prime brokers and are investing in complex securities
in order to chase a higher return for their investor base.
This creates issues for the fund administrator in terms of
valuing some of these complex instruments. A lot of the
investment banks have expanded their interest into the
hedge fund space and are setting up, within their opera-
tions, proprietary trading desks and hedge funds teams in
order to launch hedge fund products.
Juretic: The hedge fund industry has experienced incredible
growth over the last few years. While hedge fund investors
have historically been comprised of sophisticated and afflu-
ent investors, double-digit returns over the last few years
have started to attract a large influx of funds from institu-
tional investors looking to enhance their returns. The hedge
fund industry has traditionally been very exclusive and highly
guarded. While managers have informed their investors of
the overall strategies they employ to generate profits, the
lack of transparency has made it very difficult for investors
to quantify the associated risk of their investment.
All this is now starting to change. The recent surge of
hedge fund scandals, frauds and collapses has brought a
great deal of media attention and regulatory scrutiny to the
industry. Institutional investors are starting to demand
timely and accurate reporting from managers – they are
looking for details on strategies, portfolio composition, per-
formance, and risk measures employed.
To keep pace with this growth and looming regulation serv-
ice providers and hedge funds themselves have significantly
increased their spending on technology. This trend is
expected to continue over the next few years.
Lasry: Low returns from classical investments coupled with
reluctance to invest directly in the capital markets have
spurred growth through alternative investments - particu-
larly hedge funds. Regulation has also played a role in the
industry's growth as regulators gain more understanding of
the particular needs of these investments.
Please comment on the impact of regulation on the hedge
fund industry. Is this regulation set to intensity?
Chin: As hedge funds are now an accepted asset class and
become accessible to retail investors I believe that regula-
tion will intensify. However, it is still unclear how the various
regulators will co-operate to regulate these “cross-border”
funds. Imagine you have a Cayman domiciled fund, adminis-
tered out of Dublin, the investment manager is based in the
UK and the fund has more than 14 US investors. The invest-
ment manager is regulated by the FSA in the UK and must
register with the SEC. The administrator is subject to the
supervision in Ireland. Cayman regulation requires the annu-
al Financial Statements to be signed off by a Cayman based
auditor whereas most of the audit work will be done in the
UK/Dublin. All of this will ultimately result in higher operat-
ing expenses for the fund. Regulatory oversight itself is good
for the industry but it must be done in an efficient manner.
Everard: There will be more and more regulations. It is a
double-edged sword for the funds because an increasing
number of regulations will make hedge funds more attrac-
tive to a wider audience. The industry needs regulation
because hedge funds have been on the receiving end of bad
press. The traditional fund manager would welcome more
regulation for hedge funds because they will feel that they
are on a level playing field with these funds. At the moment
there is a lot of regulation for traditional fund managers
and this regulation may not be in place for hedge funds.
Flynn: As the industry develops, the investor base changes
to a more institutional focus and moves into the retail
investor base and the distribution base changes for hedge
funds, you can expect further regulation to occur. It is
inevitable that regulation will continue as hedge funds grow
in importance and in asset size. Regulation is in some
respects a good thing, particularly for the institutional
investors as it gives them an additional level of comfort. The
down side is that it probably raises the barriers to entry for a
lot of the smaller, boutique start up hedge fund managers,
particularly those who have to become SEC regulated.
Lasry: Years ago, people went offshore to set up hedge
funds as it was not really possible in their home jurisdic-
tions. Today, many offshore centres are refocusing on the
A lot of the people who set up
funds in the first place appear to
have gained a bit of experience
in one area and have moved on
to set up in competition with their
previous employer
SECURITIES LENDING MARKET GUIDE 2005 INVESTOR SERVICES JOURNAL 57
need for investor protection even if they realise that the
alternative investment market can't cope with typical retail
fund regulation. In Gibraltar, for example, the financial serv-
ices (experienced investor funds) regulations, 2005 provide
speed in setup and flexibility in management while putting
systems in place to protect investors.
Does regulation have an overall positive or negative impact
on the hedge funds industry?
Chin: Regulation will have a positive impact on the industry,
provided it is done in an efficient manner. However, regula-
tion alone will not prevent recent blow-ups like Bayou Fund
and other hedge funds from happening again. It is unfortu-
nate that the industry has received a lot of negative atten-
tion following these and other cases in the past. But was
Refco not subject to regulatory oversight? Because of Refco,
not all of a sudden the whole prime brokerage industry is
risky!
Everard: From an investor point of view regulation certain-
ly does have a positive impact. The actual hedge funds
may not necessarily agree with that statement. Regulation
usually means more work. My company is looking at the
possibility of an AIM flotation but when considering the
amount of paperwork required, one has to ask whether we
are not better off staying private.
Juretic: There is no clear-cut answer. Investors/service
providers and hedge funds often times find themselves on
opposite sides of the issue.
As a service provider, I believe the overall effect of regu-
lation will be positive. There is a strong need for managers
to provide more transparency – on trading, controls, risk
management and pricing of complex and illiquid instru-
ments. This is not necessarily a bad thing for the industry
as it levels the playing field. There needs to be a higher
degree of accountability and discipline for hedge fund
managers. It is in everybody’s best interest to protect their
investments and mitigate risk
One of the main arguments against regulation is that by
forcing managers to abide by tight rules and regulations it
goes against the very nature of a hedge fund’s activities.
The primary characteristic of hedge funds is their flexibility
to invest in a broad spectrum of investment vehicles and
their quick entry and exit into new trading ideas.
Regulatory policies may slow down this process, and there
is a fear that increased transparency will provide outside
investors with sufficient information to imitate a fund’s
trading activities. There is already a feeling that too many
managers are chasing the same strategies. Will increased
transparency intensify this?
The other main concern is the cost of compliance.
Adherence to increased regulatory obligations by fund
managers will come at a cost as they struggle to adapt to
the new environment. Managers will have to allocate addi-
tional resources to compliance, technology and third-party
service providers. These increased costs which some peg
at in excess of $50,000 may also act as a possible barrier
to entry for new emerging managers.
Lasry: There is no question in my mind that regulation has
a positive impact on the industry. Lack of regulation
engenders weak corporate governance. Having said this,
regulation must be suited to the product. Furthermore
effective regulators will always try to work with the service
providers to ensure a better fund.
Hedge funds: are we likely to see a bubble burst, will con-
solidation occur or is there stillroomfor skilled managers /
providers wishing to enter the industry?
Chin: I don’t believe that we will see a bubble burst. The
industry clearly is maturing, changing from an unregulated
(offshore) environment into a regulated (onshore) environ-
ment. Also, a recently published report indicated that hedge
funds are responsible for a significant part of the revenue
stream of Wall Street firms. Due to the ongoing require-
ments of investors and regulators there will be fund man-
agers and service providers who will be forced out of busi-
ness, creating room for others to enter the market. who, for
a variety of reasons, will not be successful. Once the unsuc-
cessful ones disappear, there will be room for new entrants.
The growth will stabilise but there are still new fund man-
agers starting up.
Everard: Consolidation is inevitable. Not everybody in the
world can be successful and there is only a finite pot of
expertise. Certain players will see the sense in becoming a
slightly bigger fish in the pond. This happens in every
industry. I can’t see the bubble bursting, because the
traders who run these hedge funds are some of the most
intelligent people I have ever met. They can’t all be wrong,
can they? Not likely. We’ll still have investors putting money
into hedge funds and I just can’t see it going bang in the
next five years. Five years ago people weren’t even talking
about hedge funds and 5 years is a very long time.
Flynn: Hedge funds are here to stay. They are part of an
acceptable asset class. They also offer value to a broad
range of investors. The industry is currently estimated at $1
58 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
“There is a strong need for man-
agers to provide more trans-
parency – on trading, controls,
risk management and pricing of
complex and illiquid instruments”
Hedge Fund Services Panel Debate
trillion. The question is where will the growth come from
and where is it going? Returns have been relatively poor
over the last two years. However, institutional investors will
continue to make more allocations to hedge funds. Given
the size of their assets, they don’t have to make substantial
increases in order to create significant inflows of money
into the hedge fund marketplace. The expectation is that
growth will continue, probably not at the same rate as it has
over the last number of years. But the product is here to
stay and will probably grow at a rate of 10 to 20 per cent per
year.
Juretic: There will always be room for skilled managers
looking to enter the industry. Hedge funds thrive on find-
ing new areas and products to enhance their returns. Since
they are not limited in the range or type of assets they can
invest in, opportunities will always exist for flexible and
innovative managers.
I expect to see continued growth as managers leave existing
positions from both the buy & sell side to set up their own
shops. Managers with a solid track record should have little
problem in raising capital provided they build a strong
operational foundation with the appropriate checks and
balances in place. However, to make way for this new talent
there will doubtless be continued closures of funds for a
variety of reasons.
Service providers will continue to probe this space in an
attempt to capture revenue from this lucrative business.
That said, the cost of entry is high and new providers must
be willing to accept the fact that depending on stature, they
may be niche players.
Lasry: Although, to an extent, the industry has a life of its
own, it is still very much dependent on the traditional mar-
kets. Thefore, there is always room for skilled managers. It
may be more difficult to break in to the market due to the
plethora of alternatives. Most investors today will insist on
a clear investment philosophy and a good track record
before committing funds.
What advice would you give to investors, who are consider-
ing whether to allocate money towards hedge funds?
Chin: Most investors are aware of what needs to be done
before allocating money to a specific hedge fund. Especially
institutional investors are used to perform extensive due
diligence of the investment manager and the service
providers associated with the fund.
I noticed that some investors limit their due diligence on
administrators to completion of a questionnaire and the
size of the organization. One advice to potential investors:
schedule an on-site visit to the administrator and speak to
the staff that will be involved with the fund. Again, the
Refco case clearly showed that reputation/size alone is no
guarantee!
Everard: I would check the backgrounds and past track
records of all of the people who are participating in their
industry and their strategy. But the people who are going
into these investments are nobody’s fools – to them an
investment is not just a few hundred ICI shares, but some-
thing a lot greater. It is important to approach a manager
with a good solid track record. There are so many of them
out there and today’s top performer may not be tomorrow’s
top performer. When investing in a hedge fund, you should
acknowledge that there is a high level of risk. You should be
prepared to invest knowing you stand to gain a lot but
equally that you could lose a lot of your initial investment.
Flynn: Any investor, whether it be institutional, private or
family office, needs to conduct due diligence on the invest-
ment manager and on the fund administrator. They need to
check that the net asset value calculation on the fund is
independently valued by the administrator. They need to
ensure this is actually being done, as opposed to somebody
making a representation to them that it is being done. They
need to know their hedge fund manager, the fund manag-
er’s track record and that the strategy pursued by the fund
manager suits their requirements.
Juretic: Do your research. With the abundance of products
in the market, it is very important that investors understand
what they are purchasing in order to make an informed
decision. No two hedge funds are created equally. There
are many factors to take into consideration when deciding
on making an allocation to a fund. Manager’s background
and track record, fee disclosures, lock-up period, use of
leverage, detailed information on risk factors and invest-
ment policies are all crucial.
Another key (and often missed) point is to do your due
diligence on the fund’s operations. It is important to note
that most hedge fund failures are a result of poorly man-
aged operations, not bad investment decisions. While
managers may have strong investment skills, they often
lack experience in the day-to-day running of the fund.
There are many questions that must be asked - What inter-
nal controls are in place? Are there independent adminis-
trators? How are complex financial instruments priced?
What compliance procedures are in place? Are reporting
systems adequate? What are the capabilities of the prime
broker? Does the manager have a vested interest in the
fund? In order to make a proper assessment of a fund it
is vital to take all these factors into account.
“the product is here to stay and
will probably grow at a rate of 10
to 20 per cent per year”
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 59
Lasry: The investment philosophy has to be comprehensi-
ble to the average investor and it has to be expressed clear-
ly in the prospectus. If possible, try to speak with the hedge
fund managers and get a personal impression.
Comment on the impact of STP and automation on the
hedge funds industry. Does technology have the ability to
make or break the industry and what key technology devel-
opments are likely to occur?
Chin: Technology will contribute to make the industry more
efficient. On the investment management side it will help
in areas such as risk management. On the administrator’s
side it will help in speeding up the process of net asset
value calculation. Despite their claim having straight
through processing in place, there are still funds out there
whose nav’s are issued 30 business days after month end.
Everard: I’m not too sure what the STP can do for the actu-
al hedge fund itself. They will have their own trading sys-
tems and they can obviously benefit from platforms that are
out there (such as SWIFT).
Flynn: Technology is very important to this industry because
of the increasing demand for net asset value calculation to
be delivered on time. The use of multiple prime brokers by
hedge fund managers and administrators requires a certain
level of STP with those prime brokers. Pricing services need
to be electronically fed into hedge fund administrators’ sys-
tems. The challenge is for systems to cope with the increas-
ing complexity of some of the structures and the increas-
ingly complex instruments that some of these funds are
investing in.
Juretic: In order for the alternative investment industry to
continue to expand at an accelerated pace, managing
investor’s funds more effectively is essential to the growth
of the business. Investors are becoming more and more
demanding of their managers to provide them with suffi-
cient and timely information. As a result the software indus-
try is responding by developing new systems and technolo-
gy catering specifically to the hedge fund market.
Advanced technology is the key to run an efficient opera-
tion. STP and greater automation assist in reducing risk
and processing errors. In terms of STP, the perfect scenario
exists when a trade can flow directly from execution to
being processed into the hedge fund’s account at the prime
broker, who in turn has an automated link to the adminis-
trator. Automation in the transfer of data via FTP or web
services type applications enables clients and service
providers to more quickly reconcile information and stay
informed.
As M&A activity among service providers increases, what
impact does this consolidation have on the managers? Is
there likelihood that these may be overlooked by some of
the larger service providers?
Chin: Many of the traditional offshore administrators have
been acquired by large financial institutions in the last 3-4
years. Lately many of these larger administrators have sig-
nificantly increased their fees. Consequently smaller fund
managers will be ignored by these administrators and even
existing clients who can/will not pay these minimum fees
are being forced out the door. This creates an opportunity
for niche players such as ATC.
Everard: I think it’s possible, but unlikely. The people who
run these funds are extremely thorough and I cant imagine
that there would be anyone who is over looked. If you are
half decent as a fund manager, service providers will try to
get you early before you reach success.
Flynn: It depends on each company’s service model. Our
service model consists of a dedicated client relationship
management person for the client. Irrespective of their size,
the client still receives a specialised service. There is a dan-
ger that the larger the fund administrators become, they
simply run their clients through a production process and
not a dedicated client relationship process.
Lasry: The funds industry is very much about relationships.
Your typical fund will be much smaller than the typical list-
ed company. Therefore consolidation of service providers
often puts managers at risk in the short to medium term,
as new relationships have to be forged. The up side is that
the consolidation unites different sets of experience and
provides opportunities for quicker growth.
Retail or institutional? Will hedge funds become more retail
focused or will they remain the domain of institutional and
high net worth investors?
Chin: Difficult to say. For the time being most of the
capital inflow will come from institutions and high net
worth individuals but some hedge funds will be marketed
to retail investors. These hedge funds are likely to be
launched by financial institutions that already have this
client base “in house”.
60 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
“Investors are becoming more
and more demanding of their
managers to provide them with
sufficient and timely information”
Hedge Fund Services Panel Debate
Everard: The retailisation of hedge funds is natural evolu-
tion because there are so many of them. This may be in the
form of a unit trust that invests in a hedge fund of fund. A
high street investor isn’t going to have the money to put
into these funds. The investment involves a lot of money
and a lot of high street investors together are not going to
achieve this. Retailisation will be a natural evolution. There
is a huge market out there for retail investors.
Flynn: The industry will be more institutional-focussed for
some time to come. The institutions have just begun to dip
their toes into the water by investing in hedge funds. We
have to go through that cycle where the institutions are
happy with their allocations. The regulatory environment
will need to be in place for distribution to the retail
investors.
Juretic: Both. As the industry grows, hedge funds will con-
tinue to evolve to accommodate a wide variety of investors.
I believe that over time Hedge funds will diverge to either
have a retail or institutional focus.
Traditionally, funds have been the realm of high net worth
individuals or institutions. Because they operate under the
radar, largely exempt from traditional securities regulations,
their audience has been limited to sophisticated and afflu-
ent investors. Coupled with the growth in institutional allo-
cations, these sophisticated investors will continue to dom-
inate the marketplace.
That being said, as hedge funds have gained momentum,
retail interest has grown. Fund of Funds products, which
often have lower minimums, are starting to attract the retail
investor. In addition, hedge fund managers are coming up
with unique products such as principal-protected notes,
which appeal to the retail investors as it provides an entry
point into this highly-guarded industry. Suitability will be a
concern and as such will attract further regulatory scrutiny.
Lasry: there is increasing interest on the part of retail
investors in hedge funds. Most responsible regulatory
regimes, however will not allow purely retail investors to
invest in hedge funds. In some cases, the manager will set
up a parallel fund or a wrap of some sort that will afford the
investor protection levels that retail investors require. On
the other hand, the minimum threshold for investment has
been lowered in many jurisdictions. In Gibraltar, for exam-
ple, Euros 100,000 will qualify an investor to invest in expe-
rienced investor funds.
How integral/ interwoven is the relationship between fund
administrator, prime broker and hedge fund like to
become?
Chin: I don’t foresee a significant change in this relation-
ship. It has been there in the same format for many years
and is likely to continue this way. There are administrators
who have expanded their service package and now provide
additional services such as leverage and financing facilities
that used to be the area of the prime brokers. On the other
hand there are prime brokers who also offer fund adminis-
tration services to hedge funds in addition to prime broker-
age. However, the majority of the funds will use administra-
tors and prime brokers who are not related. This structure
provides additional checks and balances.
Everard: The relationship between the prime broker and the
hedge fund has to be very cap in hand from the start. With
the increase in regulation, the fund administrators will only
get closer and closer. As institutional clients and pension
funds start putting more and more into hedge funds they
are going to want to know how the fund is doing from an
intra-day, or at worst an overnight evaluation perspective.
During my time at the Banc of America Citigroup I was
revaluating hundreds of funds on a daily basis, before the
advent of hedge funds, which are slightly more volatile.
Flynn: It will become increasingly more interwoven between
the prime broker and the administrator. There has to be a
close connectivity between systems. Quite a few of the
prime brokers have moved into the fund administration
business by acquiring existing fund administration units or
launching their own fund administration businesses. The
provision of a one stop shop value chain of services for the
hedge fund manager, from start up services to valuation
and reporting is important.
Juretic: The relationship between hedge funds and their var-
ious service providers continues to be of paramount impor-
tance and exists in a symbiotic relationship. The hedge
funds are the bread and butter of the prime brokers and
administrators but they in turn provide much needed serv-
ices to the funds themselves. Most hedge fund clients rely
heavily on their prime brokers and administrators to pro-
vide services such as execution, trade clearance and settle-
ment, financing, leverage, calculation of NAV’s and share-
holder recordkeeping. In order for a hedge fund to be oper-
ationally efficient, it is vital that there be well-established
lines of communication and automation between the vari-
ous service providers. As the hedge fund business has
grown, so have trade volumes, reporting and reconciliation
requirements and the complexity of investments. Going
forward, competition is expected to become fierce among
the various service providers as they all rush to meet these
“If you are half decent as a fund
manager, service providers will
try to get you early before you
reach success”
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 61
demands. The services offered by Prime Brokers are
expanding beyond the traditional services such as securi-
ties lending, custody, financing, settlement and clearance,
etc. They are evolving to provide enhanced services, such
as P&L reporting, benchmarking, risk measurements, and
in some instances in-house fund administration. The
trend is moving towards setting up a “one stop shop” for
the fund manager. Consolidation is likely to occur among
the larger players. This will make it harder for smaller
firms to compete and stay in the game. As the various
service providers start to encroach on each other’s space,
there will likely be duplication of services offered. That
being said, as hedge funds grow, the use of multiple prime
brokers will always require an independent administrator
to bring all of a funds data together under one umbrella.
Lasry: The relationship between the service providers and
counterparties to funds is absolutely crucial. The fund
business is really about bringing different disciplines
together and creating an ultimate product that gleans from
each discipline. This can only happen when the counter-
parties have good communication.
Comment on the key challenges and opportunities for the
hedge funds industry in the year's to come.
Chin: One of the main challenges for the industry is to
become widely recognized as an acceptable asset class.
Key factor will be the extend to and the manner in which
the industry is regulated. For the industry to continue to
grow it is important that funds can do cross border mar-
keting without having to face different regulatory require-
ments in various countries. Case in point is the European
Community where it is still difficult to sell shares of a fund
domiciled in one European country to citizen of another
European country.
Everard: The hedge fund industry will benefit from
increased credibility, which only comes through more regu-
lation. There are a lot of people who don’t fully know what
a hedge fund is. These companies advertise hedge funds
but, looking at their websites, they don’t say a lot about
what a hedge fund is. I wouldn’t call the hedge funds
industry a closed shop but it certainly isn’t open. More
openness would make things more interesting, but the
very nature of hedge funds and the high risks they take
prevent them from being open.
Flynn: One of the key challenges for fund administrators
will be employing the right quality of staff. Many of the
hedge fund administration centres are based in jurisdic-
tions where there are already high levels of employment.
As growth continues, those operations will be looking for
more staff and this could present an issue in many of
these locations. Coupled with the increasing complexity of
hedge funds, including the move into multi-strategy, com-
plex instruments and illiquid securities, the ability to
attract qualified experienced staff to value these instru-
ments will be a crucial factor. The day of servicing the long
short only funds is fast disappearing.
Juretic: Hedge funds as an asset class are here to stay.
Institutional investments in the space are expected to grow
substantially over the next few years and this will have a
dramatic impact to the whole structure of the hedge fund
industry. To be successful, hedge fund managers will have
to find a careful balance between investment skill and solid
operational foundations. There will likely be some shake-
out of existing managers who will not be able to keep up
with the demands of the new environment. New emerging
managers will be faced with several challenges in launch-
ing their funds, as they will be expected to allocate signifi-
cant resources towards building a solid operational frame-
work. As hedge funds move into the mainstream, regula-
tory scrutiny will continue to increase. As regulators con-
tinue to come to grips with the industry there will likely be
tighter controls put into place, which in turn will bring
about new hurdles and challenges for the managers.
The key to making this all work will be technology. In the
coming years we will continue to see a substantial amount
of resources being poured into building sound and dynam-
ic technological infrastructures to keep pace with the rapid
growth. To remain competitive, some consolidation is like-
ly to occur among service providers.
Lasry: Keeping up with growth is likely to present the
industry with a challenge as investors increase their allo-
cations to hedge funds. Naturally, this is a tremendous
opportunity for those who can grow in pace with the
industry. Corporate governance will become an increas-
ingly important issue as the industry tries to preserve its
reputation. ISJ
62 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Services Market Guide
“The provision of a one stop
shop value chain of services for
the hedge fund manager, from
start up services to valuation and
reporting is important”
“There is no need to over
regulate by placing additional
burdens on the hedge fund
manager and the hedge fund”
Which due-diligence
procedures do you
perform on hedge funds
before accepting a
mandate as Administrator?
Robert Aaron DPM MELLON
Ask the Experts
DPM Mellon
DPM Mellon usually does not establish a
business relationship until all the relevant par-
ties to a relationship have been identified and
the nature of the business they intend to con-
duct has been established. DPM Mellon is also
required by the regulations to establish clear
responsibilities and accountabilities to ensure
that it has effective internal controls and poli-
cies to deter criminals from utilizing DPM
Mellon’s services to launder money.
As part of the procedures the salesperson, the
relationship manager or the client services offi-
cer is responsible for obtaining client KYC
(Know Your Customer) documentation such as
certified articles of incorporation, certified copy
of the certificate of incorporation or equivalent,
partnership agreement, independent informa-
tion verification source (e.g., credit reporting
agency), referral from another financial institu-
tion, copies of the latest financial statements,
copies of powers of attorney, or any other
authority, affecting the operation of the entity,
government-issued business license or regulato-
ry approval, copies of valid passport, Cayman
Islands employer ID card, copies of the list/reg-
ister of directors, evidence of the authority to
enter into the business relationship (for exam-
ple, a copy of the Board Resolution authorizing
the account signatories) …etc.
If the only source of the client information is
via mail, telephone or the internet, considera-
tion should be given to verifying the information
with a third party such as a credit report. If
third party verification is not used, two pieces of
evidence should be reviewed. All identification
documents are provided to the Treasury
Services team to perform the verification and
background check. The Treasury Services team
must compare the names to Government or
Bank Restricted lists (i.e. OFAC). Any potential
hits to such lists must be researched further
and reviewed with management of the Treasury
Services team to determine if the results were
positive or false. If management cannot ascer-
tain that a hit was false, the name will be pro-
vided to the Compliance officer in Mellon GSS
(parent company). Once an ongoing relation-
ship has been established, the client's activities
and the activities of its investors are assessed
against the expected pattern of activity of the
client and/or its investors. Any suspicious
activity is reviewed to determine whether there
is suspicion of money laundering.
Robert M. Aaron, CEO, DPM Mellon
Mr. Aaron has over 25 years of experience in trading
operations and risk management, asset allocation
and investment accounting, and has become a rec-
ognized expert in the hedge fund industry. He has
published several articles on hedge funds, on both
operational and risk transparency issues. Mr. Aaron
is currently Chairman of the Board of Managed
Funds Association, having previously served as a
Director and Treasurer for this U.S. hedge fund
industry trade association. He also serves as
Conference Chairman and oversees the production
of MFA’s two annual conferences. Mr. Aaron is a
member of the Founder’s Council of the Greenwich
Roundtable. Prior to founding DPM, Mr. Aaron
served as President of Tricon U.S.A., Inc., a diversi-
fied trading company and investment manager. He
previously served as Assistant Controller of
Commodities Corporation (U.S.A.), a trading and
investment management company, and Chief
Financial officer of its Bermuda affiliate, Hamilton
Securities Ltd. Tricon was a spin-off of Commodities
Corporation in 1984. He began his career as a
C.P.A. with Arthur Young & Company, after earning
a B.S. in Accounting from Fordham University.
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 63
Ask the experts...
Hedge Fund service providers answer questions.
Comment on the
importance of hedge
fund insurance.
Brian Horwell Miller Insurance
Ask the Experts
Miller
Insurance
What is the difference between Professional
Indemnity (PI) and Directors &Officers (D&O) insur-
ance? D&O insurance protects the directors and offi-
cers for their functions as a director and officer of the
entity. It does not cover them for their professional
functions. For example, many funds will have a mem-
ber of the fund manager on the board. The represen-
tative of the fund manager has a totally separate legal
duty to perform as a member of the funds board.
They are not covered for their functions as a manager
of the fund. Professional indemnity covers their pro-
fessional duty as a manager. Why buy insurance?
Directors and officers are functioning in an increas-
ingly litigious environment and the most likely source
of any claim against a board is from its shareholders.
Any director or officer is subject to unlimited personal
liability, and is liable for any act that is negligent, out-
side their authority or in breach of duty or trust.
D&O insurance can provide effective indemnity. PI
can be seen as a competitive advantage in an increas-
ingly competitive world. Institutional investors tend
to be more attune to the need to purchase PI insur-
ance as investor protection and both regulators and
institutional investors will often see it as a part of any
risk management review. If you are a multi manager,
litigation in one fund could cause serious implica-
tions for the other funds under management and it is
wise to have the insurances in place to protect the
reputation of the manager. “As long as the fund is
making money, claims will not occur.” Hedge funds
are now judged over a shorter period of performance
and are constantly offering stock. Expectations of per-
formance and not reality can often bring complicated
and costly litigation. “As a director or a professional I
am covered by the fund - so why do I need insur-
ance?” All prospectus’, be they fund or public compa-
ny, make reference to the ability of the entity to
indemnify its directors. This indemnity, in certain
types of shareholder action, can be withdrawn and
relies on the entity having sufficient assets to cover
the costs. It also relies on the current board sanction-
ing the indemnity. D&O insurance not only covers the
individual in the event they are not indemnified by the
fund, but also reimburses the fund for any monies it
may have expended on behalf of its directors. As a
professional, whilst the fund may indemnify you, as a
minimum they will usually exclude acts of gross negli-
gence or wilful default, and this indemnity does not
exclude litigation in tort. “The Prospectus gives share-
holders little basis for any claim.” It is true that most
hedge fund prospectuses offer the directors and their
professionals a very wide scope in terms of responsi-
bility and strategy. However, in selling the fund many
statements are made and inferred outside of the
Prospectus that investors can be expected to rely
upon. Also, just because a claim may not be success-
ful does not mean that costs cannot be incurred, and
there is often very little prospect of full costs being
awarded even if a claim is successfully defended.
“The exclusions in the policies mean it is not worth
buying insurance.” You should look to your insurance
broker to ensure that your insurance coverage suits
your needs, to protect your interest when it comes to
dealing with your insurers and that a description of
the coverage is provided to allow you to make an
informed decision. Who can sue? The most likely
source of any suit is investors, followed by regulators
and employees. The separate legal identity of the
fund does restrict the exposure of the managers to
investors but still leaves the directors of the fund
exposed. As a director of the fund manager am I
exposed to litigation from investors in the fund? As a
limited company, the only way the corporate veil of
the manager could be pierced and that the principles
or employees found personally liable as directors and
officers would be in the case of fraud and then only in
the case of those committing or condoning the fraud.
It could be possible in the case of wilful default or
gross negligence lawyers may seek to establish per-
sonal liability of the directors and officers on the basis
that the wilful default or gross negligence was tanta-
mount to fraud but this would be hard to prove and
therefore unlikely to succeed. What do underwriters
take into consideration when looking at funds and
fund managers? Whilst underwriters do not profess
to be fully aware of the differences in all of the strate-
gies hedge fund managers employ, underwriters do
seek to look at the strategy, leverage, management
controls, investor base, performance history, the qual-
ity of the professionals employed by the fund and the
CV’s of the directors of the fund.
Brian Horwell, Director, Miller Insurance
64 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
In the most basic terms, the hedge fund
portfolio manager devises an investment strate-
gy which it executes with its trading counterpar-
ties. On a regular basis, the portfolio manager
provides its prime broker
with details of these transactions (usually via an
automated upload). The prime broker settles,
clears and places the hedge fund’s securities in
custody. It may lend cash to the hedge fund to
facilitate leverage, using assets in its custody as
collateral. It maintains portfolio records, acts as
the fund’s bank account and assists with any
other financing and execution requirements that
may arise. The fund administrator receives posi-
tion and portfolio information from the prime
broker which is reconciled with the records
maintained by the hedge fund, and subsequent-
ly used to generate net asset value (NAV) state-
ments, and to assist with investor reporting.
As investment strategies and traded instru-
ments become increasingly sophisticated, effi-
cient, timely and comprehensive communica-
tion between hedge fund, prime broker and
fund administrator is ever more important.
Technology can ease this process and DrKW’s
cross-product prime brokerage platform allows
hedge fund, prime broker and fund administra-
tor to access trading and portfolio information
in real time via a web-delivered interface.
Positions can be uploaded from the hedge fund
automatically or on an ad-hoc basis. DrKW
account managers and clients can use the sys-
tem to view the settlement status of trades,
access standard and user-defined reports, and
to communicate with operations staff.
Communication by more traditional means is
still important, however. When a client or fund
administrator contacts a prime broker by tele-
phone, they should be able to speak directly to
their account manager. The account manager
should be familiar with the account, its struc-
ture and strategy, and should be able to resolve
most queries immediately. Where the account
manager needs to refer to a colleague to resolve
an issue, he should be able to revert to the
client within a reasonable, agreed period of
time. For a variety of reasons, hedge funds may
choose to use multiple prime brokers. Where
this is the case, the administrator plays an
important role as the sole overall aggregator of
the fund’s portfolio constituents. Therefore
accurate and timely transfer of position infor-
mation from the portfolio manager to the prime
brokers, and thence to the fund administrator is
essential. Files must be sent from each prime
broker in a format which not only captures all
the relevant parameters of each trade, but which
is easy to upload into the administrator’s
accounting systems. Problems in aggregating
position information, especially for more
sophisticated funds using OTC instruments
which are already time-consuming and compli-
cated to price, can lead to delays in delivering
investor reporting and the preparation of
accounts.
Hamish Anderson graduated from Durham
University in 1995 with a degree in modern lan-
guages. He was recruited on the milkround by J.
Henry Schroder & Co. to their Graduate Training
Programme. In early 1996, Hamish joined the
Financial Markets Division where he sold derivatives
to corporate and institutional clients. Hamish
became a manager in the Structured Products
Group in 1999, with a focus on equity derivatives. In
January 2002 he was hired as Head of UK Sales by
Reech Capital, the risk and derivatives advisory group
now owned by SunGard. Hamish was promoted to
Head of European Sales in 2003, with a special
remit to develop and manage relationships with
hedge funds and hedge fund service providers.
Hamish joined Dresdner Kleinwort Wasserstein in
October 2004 and is Head of Prime Brokerage Sales.
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 65
Briefly describe the
operational relationship
between the Hedge Fund,
the Prime Broker and the
Fund Administrator.
How should this function?
Hamish Anderson DrKW
Ask the Experts
Dresdner
Kleinwort
Wasserstein
Dr. John Bates Progress Apama
Ask the Experts
Progress
Apama
Not at all. Like Darwin's theory of evolution,
the sophistication of algorithmic trading tech-
niques will continue to evolve. Indeed, we are at
the very beginning of that evolution.
You can think of algorithmic trading like cook-
ing. All great chefs have at their disposal the
same basic ingredients, yet they continuously
innovate by combining those ingredients in
unique and innovative ways – new styles
emerge and unique styles differentiate tradition-
al styles. Similarly, the algorithms of today rep-
resent the most basic ‘spices’.
For example, volume weighted average pric-
ing, or VWAP, is the ‘salt’ of algorithmic trad-
ing; a key basic ingredient to the innovative
algorithms of tomorrow.
Darwinian analogy goes further: unlike cook-
ing, the creation of innovative algorithms is a
resoundingly arcane field of financial engineer-
ing. New techniques are traditionally discovered
through experience, trial and error.
More recently, techniques typically only
applied to fields like biotechnology, such as
genetic tuning are now being applied to algo-
rithmic trading.
The complex ‘DNA’ of the financial markets is
being unlocked by computing and simulation
computing techniques.
Financial engineers, coupled with powerful
research and simulation tools, are searching for
the latest market aberrations in a quest for hid-
den trading opportunities. This is the new guard
of algorithmic trading engineering.
Like genetic tuning for algorithms, innovative
firms are inventing new ‘strains’ of algorithmic
genetic codes, simulating them, finding the
most powerful variants of those codes, and
deploying them in the market, every day.
The worst performing variants are taken out
of the market, and the stronger variants contin-
ue to evolve. As more firms discover the new
techniques, the generic strain is improved.
For example, ‘spread trading’, an ubiquitous
algorithmic trading technique, takes advantage
of the statistical correlation of movements of
certain pairs, or groups, of securities.
For example with high tech stocks such as
IBM and HP; when IBM moves, HP tends to
move with a similar direction and velocity.
However, generic tuning techniques can now
be used to search for new pairs of securities
that tend to be correlated or even used to
search across previously unexplored correla-
tions, like cross-asset class correlations.
For example, is their a correlation between the
pound and a basket of UK based equities?
So the opportunities to discover and capitalise
on the millions of combinations of securities,
and the varied ways to combine and intermix
the relationships among them, are limitless.
Dr. John Bates – Vice President Products, Progress
Apama John Bates is a respected expert in the area
of distributed computer systems, with specific inter-
ests in complex event processing. A co-inventor of
Apama's patented technology, he has fronted the
company's technology development and strategy
since co-founding Apama in 2000. After complet-
ing his PhD in distributed computing systems at
Cambridge University in 1993, John became a
Fellow of St Catherine's College and a Cambridge
University lecturer, leading a research group to
investigate event-based computing systems.
66 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
The rapid growth of the hedge
fund industry has created a
new market for trading systems.
As more hedge fund firms
begin to use algorithmic trading
techniques, will competitive
advantage disappear?
Comment on recent
developments in the
South African hedge
funds industry
Ian Hamilton IDS
Ask the Experts
Investment
Data
Services
The South African hedge fund industry is
relatively new and playing catch up to more
developed economies. There are a number of
limitations on this market as South Africa has
currency exchange controls resulting in all struc-
tures and investments being domestic. These
limitations as at November 2005 are as follows:
1. Regulation/Structures
2. Style
3. Capacity
4. Currency.
Nevertheless, the market is evolving at a rapid
rate and addressing many of these issues and it is
suggested that a check be made to see whether
any of these restrictions have been removed.
1. Regulations and Structures
Regulations: Discussions have been held and
are ongoing to be able to offer a regulated
framework for hedge funds. Hopefully in 2006
initial regulations will be introduced which will
allow for some types of hedge funds to enter
the broader investment domain.
Current Structures: Lack of regulation has lead
to the use of a number of structures to accom-
modate multiple investors. The types of struc-
tures used are as follows:
a) Limited Liability Partnerships.
b) Variable Rate Debenture Companies
c) Trusts
d) Insurance wrapped portfolios.
a) Limited Liability Partnerships
The partnership has a disclosed or managing
partner (usually the fund manager or a compa-
ny set up by the fund manager) and nineteen
other investors.
It is suitable for the high net worth investor.
However, drawbacks are:
i. Taxation of income and capital gains has a
degree of uncertainty.
ii. In funds with leverage there is no absolute
certainty that the undisclosed partner would not
incur liabilities beyond the invested amount.
iii. The number of investors is limited to twenty
that means that fund managers are not inter-
ested in smaller investors.
b) Variable Rate Debenture (VRD) Companies.
These companies offer variable rate debentures
that are linked to both the income and the capital
growth. The VRD advantage is improved tax cer-
tainty. Unlimited liability is ring- fenced. There is
no limit as to how many investors can be taken
on. But there are drawbacks as regards the rate of
tax and level of interest that can be paid.
c) Trusts - When it comes to tax uncertainty and
liabilities ring fencing, trusts are even vaguer.
However, the purveyors of funds using a pure
trust structure seem to be certain that their offer-
ing has the protection and also is not a contraven-
tion of the Collective Investment Schemes Act.
d) Life Assurance Wrapped FundsThese are a
usually a combination of one of the above struc-
tures with a five year endowment wrapper. The
addition of the wrapper may protect the investor
from any further liabilities and also provide cer-
tain tax benefits but comes at a considerable
extra cost and possible long lock up periods.
2. Style.
While South Africa has sophisticated economy
and well-developed financial markets the fund
offerings are mainly long/short funds. While
most funds are equity based, a number of fixed
interest funds will shortly be launched.
3. Capacity.
Because of currency controls funds can only
invest in the South African market. This limits
the investment opportunities resulting in the
current fund size being between R300m ($48m)
and R500m ($70m).
4. Currency.
Foreign investors wanting to remove the currency
risk must hedge the currency outside of South
Africa as all funds are Rand denominated.
Ian Hamilton, CEO, IDS
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 67
Describe your overall risk
reporting capabilities.
Gary Enos State Street
Ask the Experts
State Street
International Fund Services (IFS), a State
Street Company, offers comprehensive risk
management solutions developed to deliver
accuracy, transparency, flexibility and functional-
ity that are unparalleled in the marketplace. As
a leading service provider catering specifically to
the hedge fund community, IFS is uniquely posi-
tioned to deliver solutions ideally suited to its
clients’ demands. IFS provides risk solutions to
meet the ever-increasing complexity of instru-
ments and offer new approaches to viewing
both total risk and the composition of risk. Its
proprietary systems provide a consistent and
reliable suite of tools to aid customers in all
aspects of investment decision-making. IFS
offers two risk systems with complementary
functionalities: One that focuses on position-
based analysis and the other on return-based
analytics. The first system consists of an ASP-
based service that spans asset classes and
enables managers and institutional investors
the ability assess their risk in alternative and tra-
ditional investments alike. IFS’ truView risk
management service includes:
i. Configurable simulation engine that provides cus-
tomized scenario generation using historical, parametric
and Monte-Carlo methodology.
ii. Wide variety of statistics measures and analytical meth-
ods including NPV, Value-at-Risk, Sensitivities, Stress-
Testing, “What-if” Analysis, Tracking-Error and Risk
Decomposition.
iii. Flexible, web-based reporting that enables users to cus-
tomize both statistics and aggregation levels dynamically.
iv. Particular strength in complex OTC derivative products
coupled with a wide-variety of proxy tools to assist in com-
plete portfolio coverage.
v. Leveraging a state-of-the-art data architecture and redun-
dancy that ensures acceptable performance and back-up.
In addition to identifying and analyzing risk in
a more conventional manner, IFS has developed
a web-based platform that enables institutional
investors to maintain all critical data relating to
their hedge fund program and use this data to
dynamically analyze, construct, and monitor
their portfolios. This solution spans the entire
investment process including due diligence,
investment selection, performance evaluation
and benchmarking, information standardiza-
tion, documentation and organization, portfolio
construction and maintenance, and internal and
external reporting. Key features of this system
include the ability to:
i. Store portfolio and underlying fund data including fund
definitions and terms of investment, returns and market val-
ues, risk characteristics and performance data.
ii. Dynamically construct a portfolio utilizing user-defined cri-
teria and change funds within a portfolio to understand varia-
tions in performance and risk characteristics.
iii. Use the system as a document repository for performance
and NAV reporting as well as holdings and financial reporting.
IFS’ risk professionals work directly with each
client to truly customize their reporting require-
ments and ensure that their customers’ unique
needs are being met.
Gary Enos, Executive Vice President and Head of State
Street's alternative investment servicing team. He is also
responsible for Offshore and Canadian Investment
Services. In 1987 Mr. Enos was appointed to service US
mutual fund clients beginning to invest internationally,
and in 1989 a department was created under him to
develop and leverage State Street's global mutual fund
expertise. In 1995 Mr. Enos' operational responsibilities
grew to include the Cayman Island Trust Co. as well as,
mutual fund operations in Canada and Luxembourg.
His purview expanded in 1997 with his appointment as
Managing Director of Europe and overseeing our growth
in the UK, Germany and Switzerland. Enos led the suc-
cessful effort to purchase International Fund Services
(IFS), a leading provider of administrative services to
the hedge fund community in July of 2002. Mr. Enos
joined State Street in 1985 from KPMG Peat Marwick
where he specialized in financial services including
banks, insurance brokerage and mutual fund compa-
nies. His professional board memberships include State
Street Cayman Trust Co., State Street Trustees Ltd.,
State Street Ireland, Ltd. and IFDS GP. He also serves
as chairman and Executive Director of State Street
Bank Luxembourg.
68 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
How can some of the
systemic risks posed
by hedge funds be
mitigated?
Ian Morley Dawnay Day Olympia
Ask the Experts
Dawnay
Day
Olympia
In the Bible’s New Testament it says, “Let him
without guilt cast the first stone”. The irony of
this should not be lost when reading the headline
under which I am writing this article there is an a
priori assumption that hedge funds pose a sys-
temic risk to the global financial community. In
an article I wrote for the Financial Times on 2
November 2005: “Where is the evidence that
hedge fund failures are greater than in any area
of new business start up?”, “Where is the evi-
dence that standards of compliance and risk
management are lower than in traditional invest-
ments?” and “Where is the evidence that greater
fraud is in the industry than elsewhere?” The
point is that the only systemic hedge fund threat
to date has been LTCM. LTCM was the aberra-
tion not the norm. The levels of leverage used
were untypical of the industry as a whole and
while real losses occurred, the effect on the mar-
ket place was far less than that ENRON,
WORLDCOM, Parmalat or BCCI - all onshore
regulated entities – that does not mean that the
industry can be sanguine about potential sys-
temic risk and below I have addressed some
areas of concern and how they may be mitigated.
High use of leverage clearly is a double edged
sword. It is appropriate when trading true arbi-
trage where market anomalies are small and
leverage is required in order to make returns
meaningful. Consequently, leverage tends to be
applicable in those type of strategies but needs to
monitored very closely when used inappropriately
in areas such as long / short or market neutral
strategies. There may be elements of herding in
the hedge fund industry. Clearly there has been
higher correlation recently than in the past and
elements of pack animal behaviour need to be
monitored. Very large individual hedge funds
may have significant effects on the market at the
margin and in all probability as we go forward,
regulators will seek on a confidential basis infor-
mation concerning significant position risk where
they fear there could be some systemic fall out.
When properly understood and in perspective,
hedge funds are mostly acting as buyers when
others are sellers and sellers when others are
buyers. They tend to add liquidity to the market
and are often contrarian to the traditional market
players. For example, following the tragedy of
9/11, many traditional funds suffered serious falls
due to retail panic, structured products being hit
and insurance related investors being forced sell-
ers due to capital adequacy requirements.
Hedge funds, in contradiction to the ill-
informed myth at the time, were actually net buy-
ers of the market rather than sellers. Many of
them in fact, had been short in the market for
economic reasons and covered their shorts when
they saw the substantial falls. Contra-intuitively
therefore, I would argue that hedge funds may
well end up being the saviours of the financial
system when systemic risk is posed by more tra-
ditional failures. There is also another misunder-
standing, while hedge fund themselves are most-
ly offshore and unregulated, the fund managers
are usually onshore and highly regulated.
Similarly many of the funds are listed on the
stock market, such as Luxembourg and Dublin,
where they are similarly subjected to high
degrees of regulation. While it is clear there have
been accidents and will continue to be failures
within the hedge fund industry, the concern
about systemic risk is about fear and not yet
proven in fact. With an open dialogue with the
regulators, an element of transparency in regard
to large positions, it should be possible to be
aware and at best, be informed, as to possible
threats of risk which to date, have remained
more theoretical than real. It would help when
looking at the hedge fund industry if regulators
and other observers would occasionally allowed
the facts to get in the way of what they perceive
to be a good story or an unfounded fear.
Ian Morley is Chief Executive Officer of Dawnay,
Day Olympia Limited, a hedge fund of funds mar-
keting and sales company. Mr Morley was the
founding Chairman of The Alternative Investment
Management Association (AIMA).
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 69
Why do hedge funds
have such varied liquidity
for investors?
Chris Ring Shore Capital
Ask the Experts
Shore
Capital
The liquidity of an asset should always be an important criterion
for any investor, and the divergence in liquidity profiles within the
hedge fund universe has lately been attracting attention and criticism
from the investment industry as a whole. But why do funds have
such different terms and redemptions? Why do some funds price
daily, while others have annual or even multi-annual NAVS?
It is important to remember that hedge funds are a varied class
and that an extremely broad range of redemption terms exists.
Some funds allow redemptions as frequently as daily or weekly,
while others allow exits only semi annually or annually and the
extremes of the longer liquidity profile include 3 and even 5 years.
The liquidity of a hedge fund should be a function of the liquidity
of the underlying assets traded by the fund. If, for example, a
fund’s strategy is to trade large cap blue chip equities listed on glob-
al exchanges with a high daily trading volume, there is in theory no
need for the manager to protect his portfolio from sudden large
redemptions, since he should be able to liquidate his portfolio with-
out problem in a short space of time. As in any investment or busi-
ness, we return to the theory of matching assets to liabilities.
By the same argument, however, those hedge funds that trade less
liquid instruments (such as thinly traded micro-cap companies, dis-
tressed debt or, as is currently increasing amongst hedge funds, pri-
vate equity) need to protect themselves from the possibility that
they might have to fund redemptions whilst they are unable to exit
positions in their portfolio. The same applies to longer term strate-
gies (as opposed to instruments traded). An activist fund manager,
for example, who is trying to improve management’s performance
or their focus on shareholder value may be undermined or lose
credibility if he allows redemptions and sells a stock whilst talking to
the management.
Pricing Issues
As well as the issue of the difficulty, or inconvenience, of raising
the cash to finance redemptions among funds where less liquid
instruments are traded, there are also pricing issues inherent in the
situation. If a manager structures his fund to offer redemptions
monthly, the portfolio obviously needs to be priced monthly, even
when accurate prices at which the positions could be traded are dif-
ficult or impossible to obtain. If a NAV is produced based on inac-
curate prices, this could clearly be to the detriment of some or all of
the investors in the fund. Therefore, in order to treat all investors
equally, funds trading more illiquid instruments are usually struc-
tured with longer liquidity profiles. One way around this is for man-
agers to offer more frequent redemptions, based on a provisional
NAV, but to retain a percentage (usually around 5-10%) of the
investment proceeds to allow for adjustments when a final, often
annual, NAV is produced, and return the remainder of the assets to
the investor based on the final price.
Structures
Hedge funds operate in a large number of asset classes that have
intermediate levels of liquidity, from small and micro-cap equities,
to bonds of companies in bankruptcy and investments in non-trad-
able positions such as direct loans. If a manager of a hedge fund
trading instruments such as these exposed himself to a fast moving
investor base, it would make trading in such strategies difficult, if
not impossible. Managers therefore create term structures that
mimic the underlying instruments in which they invest. This is the
primary reason for the existence of such a broad range of terms
amongst hedge funds.
Some managers also argue that even with a fairly liquid strategy, a
fast turnover of the investor base can be damaging as costs mount
up, and the manager has to spend more time focusing on raising
replacement assets rather than investing. Longer liquidity profiles
(or the application of early redemption fees) are therefore an
attempt by fund managers to discourage investors from trading in
and out of their funds.
Variety
When it comes to funds of hedge funds, these also have a variety
of liquidity profiles, tending to reflect the nature of the funds in
which they invest, in a similar manner to single strategy hedge
funds. One thing to be aware of, however, is that while the majority
of the underlying holdings of, for example, a monthly-dealing fund
of hedge funds are likely to be of a similar liquidity profile (or more
frequent), there may be a percentage of funds in the portfolio that
are less liquid. For this purpose some funds of hedge funds (and,
indeed, single manager hedge funds) are structured with a “gate”
of, say, 10%, meaning that not more than 10% of total assets can be
redeemed in one month. It is important that before investing in a
fund of hedge funds, potential investors fully comprehend the liq-
uidity structure of the vehicle, since the liquidity constraints may not
be as straightforward as they immediately appear.
A Key Concern
Liquidity of hedge funds and funds of hedge funds is an important
and complex issue that must be considered when investing.
However, it is obviously only one of a number of factors that must
be considered when investing in hedge funds, and so long as the
issues and reasoning that surround the concept of the varying liq-
uidity profiles of hedge funds are fully understood, it need not be a
deterrent to investing.
Chris Ring joined Shore Capital in 2002 from NatWest Stockbrokers
Limited of which he was managing director between 1999 and 2001.
Within the Shore Capital Group, Chris is responsible for both the
private client portfolio and hedge fund management activities.
70 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
COMPANY BRIEF
THE DUBAI INTERNATIONAL FINANCIAL CENTRE (DIFC) IS AN
ONSHORE CAPITAL MARKET DESIGNATED AS A FINANCIAL FREE
ZONE DESIGNED TO CREATE A UNIQUE FINANCIAL SERVICES
CLUSTER ECONOMY FOR WEALTH CREATION INITIATIVES. IT IS
ESTABLISHED AS PART OF THE LARGER VISION OF HIS HIGHNESS
SHEIKH MOHAMMED BIN RASHID AL MAKTOUM AND THE
GOVERNMENT OF DUBAI TO CREATE AN ENVIRONMENT FOR
GROWTH, PROGRESS AND ECONOMIC DEVELOPMENT IN THE UAE
AND THE WIDER REGION. INTEGRITY, TRANSPARENCY AND
EFFICIENCY ARE THE GUIDING PRINCIPLES OF THE DIFC.
KEY SERVICES
THERE ARE SIX PRIMARY SECTORS OF FOCUS WITHIN THE DIFC:
BANKING SERVICES (INVESTMENT BANKING, CORPORATE
BANKING & PRIVATE BANKING); CAPITAL MARKETS (EQUITY,
DEBT INSTRUMENTS, DERIVATIVES & COMMODITY TRADING);
ASSET MANAGEMENT & FUND REGISTRATION (FUND
REGISTRATION, FUND ADMINISTRATION & FUND MANAGEMENT);
REINSURANCE; ISLAMIC FINANCE AND BACK OFFICE
OPERATIONS.
DR OMAR BIN SULAIMAN
DIRECTOR GENERAL, DUBAI INTERNATIONAL
FINANCIAL CENTRE AUTHORITY
DR. OMAR BIN SULAIMAN WAS APPOINTED
AS DIRECTOR GENERAL OF DUBAI
INTERNATIONAL FINANCIAL CENTRE
AUTHORITY (DIFCA) ON SEPTEMBER 7TH,
2004. UNDER HIS LEADERSHIP THE DIFC
IS ESTABLISHING ITSELF AS A UNIVERSALLY
RECOGNISED HUB FOR INSTITUTIONAL
FINANCE AND A GATEWAY FOR CAPITAL AND
INVESTMENT IN A REGION REACHING FROM
CENTRAL AND EASTERN AFRICA TO THE INDIAN SUBCONTINENT,
INCLUDING THE LAUNCH OF THE FIRST INTERNATIONAL FINANCIAL
EXCHANGE IN THIS REGION, DIFX (WWW.DIFX.AE) AFTER ONLY
ONE YEAR OF OPERATION. PRIOR TO JOINING THE DIFC, DR
OMAR BIN SULAIMAN WAS THE CHIEF EXECUTIVE OFFICER OF
DUBAI INTERNET CITY.
KEY CONTACTS
DIFC, DUBAI INTERNATIONAL FINANCIAL CENTRE
THE GATE, LEVEL 14
P.O. BOX 74777, DUBAI, UAE
T: +971 4 362 2222
F: +971 4 362 2333
Dr Omar Bin
Sulaiman
Dubai International
Financial Centre
HF Service Providers - DIFC
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 71
HF Service Providers - Aquin
COMPANY BRIEF
AQUIN IS A PAN-EUROPEAN GROUP WHICH HAS PROVIDED
SOFTWARE AND CONSULTING SOLUTIONS TO THE INVESTMENT
MANAGEMENT INDUSTRY SINCE 1993. AQUIN’S BLUE-CHIP CLIENT
BASE INCLUDES MANY OF THE WORLD’S LEADING FINANCIAL
INSTITUTIONS INCLUDING ALLIANCE/DRESDNER, ABN AMRO,
CDC IXIS, CITIGROUP AND CREDIT SUISSE.
AQUIN SPECIALIZES IN REGULATORY REPORTING, INVESTMENT
COMPLIANCE AND RISK CONTROLS AND HAS OFFICES IN
FRANKFURT, LONDON, LUXEMBOURG, NEW YORK, PARIS AND
ZURICH.
IN CO-OPERATION WITH INVESTMENT FIRMS, COMPLIANCE
PRACTITIONERS AND REGULATORS, AQUIN HAS DEVELOPED
INVESTMENT SOLUTIONS FOR:
· INVESTMENT MONITORING CONTROLS AND WORKFLOW;
· DATA WAREHOUSING;
· PRIME BROKER- HEDGE FUND RECONCILIATION;
· STATUTORY AND REGULATORY REPORTING;
· TRADE AND ORDER MANAGEMENT;
· EQUITY RESEARCH.
MICHAEL HARRIMAN, MANAGER,
INTERNATIONAL BUSINESS
DEVELOPMENT, AQUIN COMPONENTS GMBH
MICHAEL IS RESPONSIBLE FOR AQUIN'S US
AND UK OPERATIONS INCLUDING THE
PROVISION OF INVESTMENT COMPLIANCE AND
REGULATORY REPORTING SOLUTIONS. PRIOR
TO JOINING AQUIN, HE WAS THE FOUNDER
CEO OF SAMS, A COMPANY THAT
SPECIALISED IN PERFORMANCE
MEASUREMENT, ATTRIBUTION AND RISK
ANALYTICS FOR HEDGE FUNDS, PRIME BROKERS AND
INSTITUTIONAL INVESTORS. MICHAEL'S PREVIOUS FINANCIAL
SERVICES EXPERIENCE INCLUDES 15 YEARS AS A MANAGEMENT
CONSULTANT WITH PEAT MARWICK, SALOMON BROTHERS AND
UBS, HAVING COMMENCED HIS CAREER WITH IBM AUSTRALIA.
KEY LOCATIONS
Germany, Head Office
T: +49 (0)69 2193 66-600
E-Mail: [email protected]
United Kingdom
T: +44 (0)20 7266 1432
E-Mail: [email protected]
Michael Harriman
Aquin Components
72 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
COMPANY BRIEF
ATC FUND SERVICES PROVIDES COMPREHENSIVE ADMINISTRATIVE
SERVICES TO THE ALTERNATIVE INVESTMENT FUND INDUSTRY.
OUR PARTICULAR SPECIALIZATION IS IN HEDGE FUNDS.
OUR SENIOR MANAGEMENT TEAM HAVE A PROVEN TRACK
RECORD IN THE INDUSTRY, HAVING OVER 30 YEARS OF COLLEC-
TIVE EXPERIENCE IN DEALING WITH SOME OF THE LARGEST AND
MOST WELL-KNOWN FUNDS AND FUND MANAGERS IN THE INTER-
NATIONAL MARKET.
THERE ARE MANY FUND ADMINISTRATORS SERVICING ALTERNA-
TIVE INVESTMENT FUNDS. BUT ATC STRIVES TO DIFFERENTIATE
ITSELF FROM THE COMPETITION BY FOCUSING AS MUCH ATTEN-
TION ON SUPPORT SERVICES FOR FUND MANAGERS AS WE DO ON
DELIVERING A QUALITY SERVICE, ALLOWING MANAGERS TO FOCUS
THEIR RESOURCES ON THEIR INVESTMENTS, CONFIDENT IN THE
FACT THAT EVERY ASPECT OF ADMINISTRATION IS BEING TAKEN
CARE OF BY US.
WHEN FUNDS SELECT A FUND ADMINISTRATOR, THEY INVEST
IN THE EXPERTISE THAT AN ADMINISTRATOR CAN OFFER. OUR
STRATEGY IS TO PROVIDE A PERSONALIZED, MARKET-LEADING
SERVICE AT FEE LEVELS THAT REPRESENT A GOOD RETURN ON
THAT INVESTMENT.
ROBERT N. CHIN, GENERAL MANAGER, ATC FUND SERVICES
ROBERT 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.
ROBERT'S PROFESSIONAL EXPERIENCES
INCLUDE A SEVEN-YEAR TENURE AS CFO
OF DUTCH BROKERAGE FIRM WHERE HE
WAS A MEMBER OF THE EUROPEAN OPTION
EXCHANGE AND THE AMSTERDAM STOCK
EXCHANGE. ROBERT SPENT THE FIRST 8
YEARS OF HIS CAREER WITH ERNST &
YOUNG IN AMSTERDAM.
KEY CONTACTS
ROBERT CHIN
TEL: (5999) 738 1351
[email protected]
KEY LOCATIONS:
CURAÇAO
T: (5999) 738 1351
F: (5999) 738 1311
WEB WWW.ATCFUNDSERVICES.COM
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 73
Robert Chin
ATC Fund Services
HF Service Providers - ATC Fund Services
HF Service Providers - DrKW
COMPANY BRIEF
DRKW IS THE INVESTMENT BANK OF DRESDNER BANK AG AND A
MEMBER OF THE ALLIANZ GROUP. HEADQUARTERED IN LONDON
AND FRANKFURT, WITH OFFICES IN LEADING
INTERNATIONAL FINANCIAL CENTRES SUCH AS
NEW YORK AND TOKYO, IT EMPLOYS APPROXI-
MATELY 6,000 PEOPLE AROUND THE WORLD.
ONE OF THE FIRST INVESTMENT BANKS TO
REMOVE TRADITIONAL BARRIERS BETWEEN
PRODUCT AND SERVICE LINES, DRKW DELIVERS TAILOR-MADE
SOLUTIONS TO CLIENTS' BUSINESS PROBLEMS AND FINANCING
NEEDS.
KEY SERVICES
DRKW OFFERS A RANGE OF SERVICES TO HEDGE FUNDS, INCLUD-
ING:
CROSS-PRODUCT PRIME BROKERAGE - FULLY CONSOLIDATED
REPORTING AND MARGINING ACROSS ASSET CLASSES
INNOVATIVE FINANCING SOLUTIONS
COMPREHENSIVE EXECUTION CAPABILITIES
-EQUITIES
-FIXED INCOME
-FOREIGN EXCHANGE
-EMERGING MARKETS
-OTC & LISTED DERIVATIVES
-CREDIT & STRUCTURED CREDIT
AWARD WINNING RESEARCH
REVOLUTIONARY ONLINE SERVICES
HAMISH ANDERSON IS A DIRECTOR AND
HEAD OF PRIME BROKERAGE SALES AT
DRESDNER KLEINWORT WASSERSTEIN
(DRKW). HE HAS SPENT THE LAST 10
YEARS IN THE FINANCIAL MARKETS, IN A
VARIETY OF SALES AND ADVISORY ROLES. HE
JOINED DRKW IN 2004.
KEY CONTACTS
T: +44 207 623 8000
CONTACT: HAMISH ANDERSON
E: [email protected]
W: WWW.DRKW.COM
KEY LOCATIONS
LONDON FRANKFURT
NEW YORK TOKYO
Hamish Anderson
Dresdner Kleinwort
Wasserstein
74 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
COMPANY BRIEF:
GOAL IS THE WIDELY-ACKNOWLEDGED INDUSTRY LEADER IN PRO-
VIDING CREATIVE PRODUCTS, SERVICES AND SOLUTIONS TO AUTO-
MATE AND OPTIMIZE THE RECLAMATION OF WITHHOLDING TAX ON
CROSS-BORDER SECURITIES DIVIDEND INCOME AND ROYALTIES.
OUR RESEARCH HAS SHOWN THAT IN EXCESS OF US$6 BILLION
OF WITHHOLDING TAX REMAINS UNCLAIMED EACH YEAR BY THE
RIGHTFUL OWNERS AND BENEFICIARIES.
OUR PRODUCTS INCLUDE GTRS, GQI, E-RECLAIM, GOAL
TAXBACK, DMS AND BESPOKE SOFTWARE DEVELOPMENT.
STEPHEN M. EVERARD, MANAGING DIRECTOR,
GLOBAL OPERATIONS & ADMINISTRATION LIMITED.
STEPHEN HAS OVER TWENTY FIVE YEARS OF
SECURITIES EXPERIENCE AND HAS HELD
SENIOR MANAGEMENT POSITIONS WITH
MERCURY ASSET MANAGEMENT LTD, BANK
OF AMERICA N.T & S.A AND MOST
LATTERLY WITH CITIGROUP N.A. WHERE HE
WAS SENIOR VICE PRESIDENT WITHIN THEIR
OPERATIONS GROUP.
HE JOINED GOAL IN OCTOBER 2002 AND
HAS FUNDAMENTALLY RESTRUCTURED THE
GROUP AND EXPANDED ITS PRODUCT RANGE
AND CLIENT BASE THEREBY ENHANCING
SERVICE DELIVERY AND SHAREHOLDER VALUE.
KEY CONTACTS:
STEPHEN M EVERARD
T: +44 (0) 207 247 3094
WWW.GOALGROUP.COM / [email protected]
SAGHAR BIGWOOD
T: +44 (0) 207 247 3094
[email protected]
KEY LOCATIONS:
ADDRESS: GOAL GROUP, 10 EARL STREET, LONDON, EC2A
2AL UNITED KINGDOM
T: +44 (0) 207 247 3094
E: [email protected]
W: WWW.GOALGROUP.COM
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 75
Stephen Everard
Global Operations
& Administration
Limited
HF Service Providers - GOAL
HF Service Providers - Hassans
COMPANY BRIEF THE FIRM SPECIALISES IN PROVIDING INTERNATIONAL
TAX ADVICE AND SOLUTIONS. THE EVER-CHANGING MARKET CONDI-
TIONS DEMAND INNOVATION AND THE CONSTANT IMPLEMENTATION OF
NEW PRODUCTS. THE EXPERIENCE OF OUR LAWYERS, TOGETHER WITH
OUR IMPORTANT WORLDWIDE NETWORK OF CONTACTS ALLOWS US TO
OFFER THE MOST COMPREHENSIVE LEGAL, FINANCIAL AND TAX ADVICE,
WHICH IS INDIVIDUALLY DESIGNED TO PROTECT OUR CLIENT’S
INTERESTS IN THE INTERNATIONAL MARKET PLACE.
WE ARE ORGANISED INTO DEPARTMENTS THAT ENABLE US TO
COMBINE LEGAL EXPERTISE WITH THE SPECIALITY THAT EACH CASE
REQUIRES. IN ADDITION TO THIS HASSANS RELIES ON ITS AFFILIATED
TRUST AND COMPANY MANAGEMENT ARMS, LINE TRUST CORPORATION
LIMITED AND LINE MANAGEMENT SERVICES LIMITED, TO PROVIDE
DEDICATED TRUST AND COMPANY MANAGEMENT FACILITIES.
OUR GOAL IS TO USE OUR LEGAL EXPERTISE TO HELP YOU ACHIEVE
YOUR OBJECTIVES.
KEY SERVICES WE OFFER A SPECIALISED RANGE OF LEGAL SERVICES
INCLUDING:
I. CORPORATE AND COMMERCIAL ISSUES
II. INTERNATIONAL FINANCE AND BANKING
III. PRIVATE CLIENTS AND TRUSTS
IV. MARITIME AND TRANSPORT
V. COMMERCIAL AND RESIDENTIAL PROPERTY
VI. TELECOMMUNICATIONS
VII. DE-REGULATING INDUSTRIES.
JAMES LASRY, PARTNER, HASSANS
JAMES LASRY, BORN IN NEW YORK, IS A
PARTNER SPECIALISING IN INVESTMENT FUNDS
AND CORPORATE LAW. HE HAS ADVISED THE
GOVERNMENT OF GIBRALTAR ON THE REGULATORY
AND TAX TREATMENT OF INVESTMENT FUNDS AND
WAS INVOLVED IN THE DRAFTING OF THE
EXPERIENCED INVESTOR FUNDS REGULATIONS,
2005. JAMES IS ALSO A MEMBER OF THE
SOCIETY OF TRUST AND ESTATES PRACTITIONERS
(STEP) AND ADVISES PROFESSIONAL TRUSTEES
AND CLIENTS ON TRUST MATTERS AND OTHER
MATTERS RELATING TO HIGH NET WORTH INDIVID-
UALS. HE WAS EDUCATED AT JOHNS HOPKINS
UNIVERSITY WHERE HE STUDIED LITERATURE AND MUSIC AND AT BAR-
ILAN UNIVERSITY FROM WHICH HE HOLDS AN LLB. JAMES QUALIFIED AS
AN ADVOCATE OF THE ISRAEL BAR IN 1997 AND AS A SOLICITOR OF THE
SUPREME COURT OF ENGLAND AND WALES IN 2004.
KEY CONTACTS
JAMES LASRY
T: 00350 79000
[email protected]
KEY LOCATIONS
GIBRALTAR
T: 00350 79000 F: 00350 71699
WEB WWW.GIBRALTARLAW.GI
James Lasry
Hassans
76 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
COMPANY BRIEF
OGIER IS ONE OF THE WORLD’S LEADING PROVIDERS OF OFFSHORE
LEGAL AND ADMINISTRATION SERVICES WITH OFFICES IN THE CAYMAN
ISLANDS, GUERNSEY, JERSEY AND LONDON AND AN ASSOCIATED
TRUST COMPANY IN NEW ZEALAND.
OUR GLOBAL INVESTMENT FUNDS TEAM OF LAWYERS AND
FUND ADMINISTRATORS HAS ESTABLISHED A LEADING EXPERTISE IN
PROVIDING LEGAL AND ADMINISTRATION SERVICES IN THE AREA OF
INVESTMENT FUNDS. WE HAVE ESTABLISHED FUNDS OF ALL KINDS
INCLUDING HEDGE FUNDS, PRIVATE EQUITY AND REAL ESTATE FUNDS.
JAMES BERGSTROM IS HEAD OF THE INVESTMENT FUNDS TEAM
JAMES BERGSTROM IS HEAD OF THE FIRMS
INVESTMENT FUNDS TEAM. HE WAS CALLED TO
THE BAR OF ENGLAND AND WALES IN 1991 AND
WAS ADMITTED AS AN ATTORNEY IN THE CAYMAN
ISLANDS IN 1992 WHEN HE JOINED OGIER. HE
BECAME PARTNER IN 1998. JAMES SPECIALISES
IN ADVISING ON INVESTMENT FUNDS, PRIVATE
EQUITY, PARTNERSHIPS AND JOINT VENTURES. HE
ALSO ADVISES LOCAL COMPANIES AND FOREIGN
INVESTORS ON THE STRUCTURING AND LICENSING
OF INVESTMENT VEHICLES FOR LOCAL PROJECTS
AND BUSINESSES
KEY CONTACTS www.ogier.com
JAMES BERGSTROM
QUEENSGATE HOUSE, PO BOX 1234GT
GRAND CAYMAN, CAYMAN ISLANDS
ROGER LE TISSIER
COUTTS HOUSE, LE TRUCHOT , ST PETER PORT, GUERNSEY GY1 1WD
NICK KERSHAW
WHITELEY CHAMBERS, DON STREET ST HELIER, JERSEY JE4 9WG
GRAY SMITH
2 ROYAL EXCHANGE BUILDINGS, LONDON, EC3V 3LF
KEY LOCATIONS
Cayman Islands
Telephone: +1 345 949 9876
Fax: +1 345 949 9877
Guernsey
Telephone +44 1481 721672
Facsimile +44 1481 721575
Jersey
Telephone +44 1534 504000
Facsimile +44 1534 504444
London
Telephone +44 20 7220 1170
Facsimile +44 20 7220 1199
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 77
James Bergstrom
Ogier
HF Service Providers - Ogier
HF Service Providers - TD Securities
COMPANY BRIEF
TD SECURITIES PRIME BROKERAGE SERVICES IS ONE OF CANADA’S
LEADING SERVICE PROVIDERS TO THE ALTERNATIVE INVESTMENT
INDUSTRY. OUR CLIENTS INCLUDE A LARGE NUMBER OF CANADIAN-
BASED HEDGE FUND MANAGERS WITH A CANADIAN
FOCUS. STRATEGIES INCLUDE LONG/SHORT, ENERGY
FOCUSED, CONVERTIBLE ARBITRAGE, RISK ARBITRAGE
AND FIXED INCOME. OUR PRIME BROKERAGE PROFES-
SIONALS ARE ABLE TO OFFER CUSTOMIZED HANDS-ON
SUPPORT AND GUIDANCE IN THE AREAS OF TRADE EXECUTION, MAR-
GIN FINANCING, SECURITIES LENDING, SETTLEMENT AND CLEARANCE,
CUSTODY AND TECHNOLOGY . WE CAN ALSO PROVIDE INTRODUCTIONS
AND WORK WITH OTHER AREAS OF THE FIRM SUCH AS TRADING,
STRUCTURED PRODUCTS, FX, TAX STRUCTURING AND INVESTMENT
BANKING. OUR LARGE INTERNAL HOLDINGS AS WELL AS THE STRONG
RELATIONSHIPS WE MAINTAIN WITH AN EXTENSIVE NETWORK OF SECU-
RITIES LENDERS CAN GUARANTEE BOTH LOW BORROWING COSTS AND
EXCELLENT ACCESS TO DIFFICULT-TO-BORROW SECURITIES.
KEY SERVICES
I. TRADE EXECUTION, II. MARGIN FINANCING, III. SECURITIES
LENDING, IV. SETTLEMENT AND CLEARANCE V. CUSTODY,
VI.TECHNOLOGY
LIONEL DEMERCADO JOINED TD SECURITIES
(TDSI) IN JUNE 2001 AS MANAGING
DIRECTOR AND GLOBAL HEAD EQUITY FINANCE
WITH A MANDATE TO EXPAND ITS EQUITY
FINANCE OPERATIONS AND DEVELOP THE PRIME
BROKERAGE BUSINESS. TD SECURITIES PRIME
BROKERAGE SERVICES WAS SUBSEQUENTLY
LAUNCHED IN MAY 2002 AND HAS GROWN TO
BECOME ONE OF CANADA’S LEADING PRIME
BROKERS. PRIOR TO JOINING TDSI,
DEMERCADO WORKED FOR A LARGE CANADIAN
FINANCIAL INSTITUTION WHERE HE HELD SEVER-
AL SENIOR POSITIONS INCLUDING MANAGING DIRECTOR EQUITY
FINANCE AND VICE PRESIDENT OPERATIONS.
KEY CONTACTS
LIONEL DEMERCADO, MANAGING DIRECTOR
(1) 416 308 7321
[email protected]
VICKI JURETIC, VP, SR. RELATIONSHIP MANAGER
(1) 416 308 1560 [email protected]
KEY LOCATIONS
Ernst and Young Tower
222 Bay Street, 7th Floor
Toronto, Ontario
M5K 1A2 WWW.TDSECURITIES.COM
Lionel deMercado
TD Securities
78 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
TD SECURITIES IS A WHOLLY OWNED
SUBSIDIARY OF THE TD BANK FINANCIAL
GROUP. HEADQUARTERED IN TORONTO,
CANADA, WITH MORE THAN 52,000
EMPLOYEES IN OFFICES AROUND THE
WORLD, THE TORONTO-DOMINION BANK
AND ITS SUBSIDIARIES ARE COLLECTIVELY
KNOWN AS TD BANK FINANCIAL GROUP
(TDBFG). TD BANK FINANCIAL GROUP
OFFERS A FULL RANGE OF FINANCIAL
PRODUCTS AND SERVICES TO MORE THAN
14 MILLION CUSTOMERS WORLDWIDE.
AS OF APRIL 30, 2005, TD BANK
FINANCIAL GROUP HAD MORE THAN CDN
$359 BILLION IN ASSETS. TD BANK
FINANCIAL GROUP RANKS AS ONE OF THE
TOP ON-LINE FINANCIAL SERVICES
PROVIDERS IN THE WORLD WITH MORE
THAN 4.5 MILLION ON-LINE CUSTOMERS.
THE TORONTO-DOMINION BANK TRADES
ON THE TORONTO AND NEW YORK STOCK
EXCHANGES UNDER THE SYMBOL “TD”.
COMPANY BRIEF HEDGE FUND SERVICES, BASED IN THE CAYMAN
ISLANDS AND IRELAND, HOLDS A LEADING POSITION IN THE AREA OF
HEDGE FUND ADMINISTRATION, OFFERING A COMPLETE RANGE OF SERVICES
INCLUDING ACCOUNTING, NAV COMPUTATION, SHARE HOLDER SERVICES,
BANKING AND CREDIT FACILITIES. AT 30 SEPTEMBER 2005, WE ADMIN-
ISTERED OVER 730 FUNDS WITH USD 100 BILLION IN ASSETS. WE
CURRENTLY PROVIDE FULL ADMINISTRATION SERVICES TO MORE THAN 260
FUND OF FUNDS WITH USD 60 BILLION ASSETS AND HAVE A SPECIALIZED
TEAM TO SERVICE THE SPECIAL REQUIREMENTS OF FUND OF FUNDS SPON-
SORS. WE PROVIDE A FULL RANGE OF SERVICES, COVERING MULTI-CLASS
AND MULTI-CURRENCY CAPABILITIES ACROSS A WIDE RANGE OF HEDGE
FUND PRODUCTS SUCH AS MASTER FEEDER STRUCTURES, UNIT TRUSTS
AND PARTNERSHIPS. CUSTODY OF FUNDS OF HEDGE FUNDS INVESTMENTS
CAN BE UNDERTAKEN BY UBS AS WELL AS THE PROVISION OF A LIQUIDITY
LINE OF CREDIT AND FOREIGN EXCHANGE HEDGING SERVICES.
RISK REDUCTION IS AN INTEGRAL PART OF OUR SERVICE.ALL OUR
PROCESSES ARE SUBJECT TO RIGOROUS INTERNAL CONTROLS TO ENSURE
FULL COMPLIANCE AND THE TIMELY, ACCURATE AND COMPLETE PROCESSING
OF ALL TRANSACTIONS.
WITH THE DEDICATION AND EXPERIENCE OF OUR
PROFESSIONAL STAFF OF 140 AND OUR STATE-OF-
THE-ART WEB REPORTING, ACCOUNTING AND
SHAREHOLDER SYSTEMS WE ARE WELL POSITIONED
TO PROVIDE OUR CLIENTS WITH A FIRST CLASS
QUALITY SERVICE.
SEAN FLYNN, HEAD OF HEDGE FUND SERVICES,
UBS FUND SERVICES CEO UBS IN CAYMAN
ISLANDS, MANAGING DIRECTOR YEARS OF INVEST-
MENT INDUSTRY EXPERIENCE: 23 EDUCATION:
UNIVERSITY COLLEGE DUBLIN (IRELAND), BCOM SEAN FLYNN IS
RESPONSIBLE FOR THE OVERALL MANAGEMENT AND DEVELOPMENT OF THE
HEDGE FUND ADMINISTRATION BUSINESS FOR UBS GLOBAL ASSET
MANAGEMENT IN THE CAYMAN ISLANDS. HE IS ALSO RESPONSIBLE FOR
THE DEVELOPMENT AND IMPLEMENTATION OF THE HEDGE FUND SERVICES
BUSINESS IN IRELAND. SEAN BEGAN HIS CAREER AT UBS IN 1986 AS
AN ACCOUNTANT IN THE TRUST DIVISION, BEFORE STARTING THE FUND
ADMINISTRATION BUSINESS IN THE CAYMAN ISLANDS IN 1992. BEFORE
JOINING UBS, HE WORKED AS AN AUDIT SENIOR WITH A FINANCIAL SERV-
ICES COMPANY IN GRAND CAYMAN AND PRIOR TO THAT WITH KPMG IN
DUBLIN. SEAN IS A FELLOW OF THE INSTITUTE OF CHARTERED
ACCOUNTANTS OF IRELAND.
KEY CONTACTS WWW.UBS.COM/FUNDSERVICES
SEAN FLYNN/COLLEEN MONTAIN - UBS FUND SERVICES, 227 ELGIN
AVENUE, PO BOX 852 GT, GRAND CAYMAN
MARK MANNION - UBS FUND SERVICES, 1 GEORGE’S QUAY PLAZA,
GEORGE’S QUAY, DUBLIN 2
GUY MARTELL - UBS FUND SERVICES, 21 LOMBARD STREET, LONDON
EC3V 9AH
KIM WALDMAN - UBS FUND SERVICES, 51 WEST 52ND STREET, NEW
YORK, NY 10019-6114
HEDGE FUND SERVICES MARKET GUIDE 2006 INVESTOR SERVICES JOURNAL 79
Sean Flynn
UBS Fund Services
HF Service Providers - UBS
KEY LOCATIONS
CAYMAN ISLANDS
+1-345-914 1060
IRELAND
+353-1-436 3636
UK
+44-20-7901 5000
US
+1-212-882 5523
80 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2006
Hedge Fund Glossary
Accredited Investors - Refers to institutional investors or indi-
viduals with high net worth or high net income, as specified by
securities regulators, and therefore not requiring the protection of
a prospectus and registration requirements under securities law.
Active Risk (Tracking Error) - Refers to the variation between a
fund’s returns and a benchmark’s returns. A large tracking error
indicates a large variation from the benchmark, and implies a
high level of manager risk.
Alpha - A numerical value indicating a manager’s risk-adjusted
excess rate of return relative to a benchmark. Measures a man-
ager’s “value-added” in selecting individual securities, independ-
ent of the effect of overall market movements.
Arbitrage - To take advantage of disparate pricing between two
similar instruments in the same or different markets.
Asset Swap - An interest rate or cross currency swap used to con-
vert the cash flows from an underlying security (a bond or float-
ing-rate note), from a fixed coupon to a floating coupon, a floating
coupon to a fixed coupon, or from one currency to another.
Benchmark - A reference (security or index) against which a
comparison and evaluation of performance of an investment port-
folio can be made.
Beta - Measures the sensitivity of the manager’s returns to the
market return. It is the extent to which the manager’s return has
varied in line with movements in benchmark returns.
Beta Neutral - Describes a fund with no sensitivity to broad mar-
ket movements. Therefore, the fund’s beta is close to zero.
CTA Commodity Trading Advisor - CTA’s generally trade commod-
ity futures, options and foreign exchange and most are highly
leveraged.
Closed-end Fund- An investment fund whose securities do not
provide a right of redemption on demand based on a net asset
value. The fund’s securities may be listed on an exchange and, as
a result, may trade at a discount (or premium) to the fund’s net
asset value.
Correlation - A measure of how variables tend to move in relation
to one another. Variables that rise or fall in parallel on average
are positively correlated and those that move in opposite direc-
tions are negatively correlated. Correlations range from –1 to +1.
Credit Risk - The financial risk that debt will not be repaid,
resulting in a loss. For example, debt holders face the risk of not
receiving interest and/or principal from the issuer when payments
are due. Usually, the higher the issuer’s credit rating, the lower
the default risk, and vice-versa.
Credit Spread - The spread between Treasury securities and non-
Treasury securities that are identical in all respects except for
quality rating.
Derivatives - Financial instruments whose value is derived from
the value of an underlying security, asset or variable. Examples
include options, warrants, futures, forwards and swaps.
Diversification - Minimising of non-systematic portfolio risk by
investing assets in several securities and investment categories
with low correlation between each other.
Duration - The duration of a bond is a measure of how interest
rate changes affect a bond’s price. It is also a measure of how
long, on present value money-weighted basis, the holder of a
bond has to wait before receiving coupon payments and final
repayment.
Efficient Frontier - A two-dimensional risk-return chart showing
all optimal combinations of a portfolio’s expected return and
expected risk, given a specified set of asset classes/ investment
strategies.
Forward Contract - Agreement between two parties to buy or sell
an underlying asset at a specified future date for a specified
price. Not traded on an exchange, but between specific parties.
Fund of Funds - Investment partnership that invests in a series of
other funds. A portfolio will typically diversify across a variety of
investment managers, investment strategies, and subcategories.
Futures Contract - Standardised, exchange traded contract for
the future delivery or receipt of a specified amount of an asset at
a specified price.
Hedging - Transactions entered into (usually opposite transactions
within the same asset class or market) that protect against
adverse price movements and limit the exposure to a specific risk.
High Watermark - The assurance that a fund only takes fees on
profits once past losses are recovered.
Hurdle Rate - The minimum investment return a fund must
exceed before a performance allocation/incentive fee can be taken.
Leverage - The practice of borrowing money to add to an invest-
ment position when one believes that the return from the position
will exceed the cost of borrowed funds.
Long Position - Holding a positive amount of an asset.
Managed Account A trading account held with a broker and
owned directly by the investor (e.g. an individual investor or a
FOFs). Market Neutral Strategy - Taking long and short positions
in related assets (such as spread trades) in order to offset direc-
tional market risk.
Market Risk - Refers to risk factors that affect financial market
returns as a whole. This risk is present in all financial markets,
including the money, bond, stock, and currency markets.
Master-feeder Structure- In this structure, one or more invest-
ment vehicles (the feeder funds) with identical investment objec-
tives, pool their assets in a common portfolio held by a separate
investment vehicle (the master fund).
Multi Strategy Investment - philosophy allocating investment
capital to a variety of investment strategies, although the fund is
run by one management company.
Offering Memorandum - A document provided to a potential
hedge fund investor that describes the hedge fund’s business and
operations. Usually offered under a prospectus exemption.
Options - A financial instrument that gives the holder the right
but not the obligation to buy (call option) or sell (put option) the
underlying asset up to (American option) or on (European option)
a defined expiration date for a defined price.
OTC Over-the-counter trading - Trading of products between two
parties outside of exchanges
Pairs Trading - Non-directional relative value investment strategy
that seeks to identify two companies with similar characteristics
whose equity securities are currently trading at a price relation-
ship that is out of their historical trading range.
Prime Broker - The principal brokerage firm an investment fund
does business with.
Risk - Risk in a portfolio sense refers to the variation or volatility
of returns. It is generally measured by the standard deviation of
the portfolio returns.
Sharpe Ratio - Demonstrates the reward to risk generated by an
asset. The difference between the return on the portfolio and the
risk free rate, divided by the standard deviation of the portfolio.
Short Position - Holding a negative amount of an asset, whereby
assets are sold without owning them.
Standard Deviation - Standard deviation is a statistical measure
of the absolute variability of returns. It is the most commonly
used measure of the volatility of returns or investment risk.
Swap - An agreement between two parties to exchange cash
flows over time according to a predetermined formula.
Total Risk - The potential loss of invested capital. The goal of
absolute return managers is to manage total risk, which is to
avoid absolute financial losses, preserve principal and to actively
manage volatility.
Volatility - The degree of price fluctuation for a given asset, rate,
or index.
Warrant - An option in the form of a security. Banks or companies
issue warrants and can either be traded on exchanges or OTC.
Hedge fund administration services
from UBS.
© UBS 2005. All rights reserved.
We’re in this business, so you can fully focus on yours. Administration may not
be your first priority, which is why we’ve made it ours. Based in the Cayman Islands
and Ireland, our teams have over 15 years of experience providing hedge fund
administration services to third parties and administer over $100 billion in assets. We
work in partnership with you to create a winning solution, which is both flexible and
tailored, drawing on a breadth of services and advanced technology. All delivered
through a professional and knowledgeable single point of contact. Which gives you
the confidence to focus on your core business. You and us.
www.ubs.com/fundservices
You &Us

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