INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007

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HEDGE FUND SERVICES

MARKET GUIDE

2007

Mainstream or Alternative?
REGIONAL ANALYSIS - GIBRALTAR OUTSOURCING - ADMINISTRATION CANADIAN HEDGE FUNDS - PANEL DEBATE COLLATERAL MANAGEMENT - COST BENEFIT TREND ANALYSIS - ALTERNATIVE OR MAINSTREAM? THE BENEFICIAL OWNER AND ASSET MANAGER’S ANNUAL GUIDE TO HEDGE FUND SERVICIES

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Foreword AIMA

The Alternative Investment Management Association (AIMA) looks at what 2007 holds for the global hedge funds industry.

Emma Mugridge, Alternative Investment Management Association

In the coming months and years, the hedge fund
industry must consider how it will continue to develop. Like any industry, hedge funds face new challenges daily. The steep growth of hedge fund assets in recent years is expected to continue meaning that we will have to accommodate yet more clients and more funds. It is estimated that pension fund allocations alone will rise from USD400 bn in 2006 to USD950 bn by 2010: just on these figures, an extra USD550 bn will be look-

AIMA, with nearly 1100 corporate members globally, is the trade association that represents managers, brokers, administrators, lawyers, the full spectrum of those operating in the hedge fund industry. It is our role – and the industry’s collective responsibility – to focus on introducing positive change to meet the attentions of institutional investors, of regulators, of the media. It is our collective strength that we work this way. Results have been considerable. The hedge fund industry is a community. Through AIMA, it identifies the collective challenges. It works together to meet with regulators, investors and other interested parties to find common ground, to share understanding and to build on growth and to bring sound business practices, transparency and education to hedge funds and a wider audience. This includes initiatives such as sound asset pricing policies, refinement of use of side letters and developing the industry’s approach to communications. Indeed, hedge funds and those in the industry are often taken to task over the way that they communicate, resulting in false perceptions that the industry is opaque, funds are risky and unregulated. Nothing could be further from the truth but because of constraints on communication - some for legal reasons, some as a matter of business practice - hedge funds often go unheard. This information vacuum gives their detractors a golden opportunity to create negative and often distorted comment about the industry.

The size and maturity of the industry means that when the occasional hedge fund failure occurs it only causes ripples in the market place
ing for a home over the next four years. This influx of funds has been fuelled by the evidence of good returns even when traditional markets slump. For example, during the period of market difficulty in the early 2000’s hedge fund performance generally remained positive despite the S&P 500 index dropping over 22 per cent in 2002. From 1993 to the end of 2005, hedge funds cumulatively produced an annualised return of 7.33 percent compare with 4.91percent for the S&P 500 Index. The global industry has new reached almost 10,000 hedge funds with assets in excess of USD1.2 trillion; a colossal sum. However the size and maturity of the industry means that when the occasional hedge fund failure occurs it only cause ripples in the market place, rather than the waves of previous times. The increase in regulation and of sound practice guidelines, which the industry has progressively adopted, have played an important part in this new found maturity. As expected from a ‘cutting edge’ discipline, hedge funds now attract the best talent from the market place, who see its relative freedom and reward as highly attractive. Hedge funds are increasingly mainstream with institutional-strength controls and governance and are now perceived as an integral part of the institutional investors’ armoury.

Emma Mugridge joined AIMA in 1996 with responsibility for all external communications. She was made a Director in 1999 and is now the liaison point for all member and other activities throughout UK, Ireland, Benelux, Switzerland, North America (including AIMA Canada Chapter), the Middle East and South Africa. She is responsible for three of AIMA's five global committees: Alternative Investment Research, Communications and Asset Pricing. Her duties also include being Commissioning Editor for the AIMA Journal and she oversees the development and production of all educational material as well as responsibility for the Association’s website.

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 1

Foreword Hedge Fund Association

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

The Hedge Fund Association (HFA)

2 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007

INTRODUCTION

HEDGE FUND SERVICES

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

Mark Latham, Managing Editor
HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 3

Contents - Section 1
3 Introduction Forewords 1 AIMA 2 HFA 6 Which Way? Hedge Fund Services Market Guide 2007 Community Spirit in the Industry The Low-down on our Hedge Fund Guide The Routes to Market Ian Hamilton, IDS briefs us on the EMEA landscape

10 Hotting Up

12 Can You Tell What it is Yet? ISJ looks at the Changing Picture of the Hedge Funds Industry 16 Pool Runnings HFA looks at Diversified Hedge Fund Portfolios The Hedge Fund Services Panel Debate Are Hedge Funds still alternative or have they become mainstream? Is Gibraltar a foothold for Hercules in the world of hedge funds?

Special Feature 18 Discussion Section One 24 Hedge Funds in the Main
26 Sunny Side of the Street

monitor
30 Ask the Experts - topical questions answered by fund managers and service providers....

Section Two 36 Statistics

HFRI Stats and Analysis

40 Super Models 42 Administration Challenge 44 One on One

Technology Solutions - IFBS Outsourcing the Administration of Hedge Funds Working with the ‘Single Point of Contact’ Model

Special Feature 46 Discussion

The Canadian Hedge Fund Managers Panel Debate

Hedge Fund Guide 56 Introducing Hedge Funds - Background - What Are Hedge Funds - Strategies & Examples - Hedge Fund Risk/Return Drivers - Investing in Hedge Funds
62 Sound Practices for Hedge Fund Managers - Management & Internal Trading Controls - Reponsibilities to Investors - Valuation Policies & Proceedures - Transactional Practices

Appendix 72 Glossary
74 Company Profiles
4 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2007

Let’s talk about Canada.
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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] or Peter Boffo: 1 416 983 1356 / [email protected]

document has been prepared solely for information purposes by TD Securities. It is not an offer, recommendatio itation to buy or sell, nor is it an official confirmation of terms. Any transaction entered into is in reliance only u judgement as to financial suitability and risk criteria. TD Securities does not hold itself out to be an advisor in t mstances, nor does any of its staff have the authority to do so. The information in this document is subject to ch out notice. Not intended for US distribution at this time. Approved in the UK and Europe by TD Securities Limite

REVIEW / ROUTES TO MARKET

Which Way?
Brian Bollen examines whether routes to market are opening up for hedge funds...

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

Fund of funds managers won’t be thrown on the scrap heap just yet
achieve an investment portfolio tailored precisely to their own risk-reward appetite,” he says. They also, of course, remove the extra level of management and performance fees that
6 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007

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REVIEW / ROUTES TO MARKET
a fund of funds manager would charge. “The movement is really developing momentum, and is widespread in Andorra, Luxembourg and Switzerland,” he adds. There is no need, though, to take out one’s handkerchief to stifle the sobs just yet. Fund of funds managers won’t be thrown on the scrap will remain the starting point for the majority of institutions initiating a hedge fund investment programme and predicts that half of global institutional flows will go to fund-of-hedge funds over the next five years. Slightly ironically, perhaps, running contrary to the hyperbolic interest in hedge funds as a form of investment, customer satisfaction is not as great as one might expect. Another recent report, this time from Mercer Investment Consulting, indicates that few pension schemes satisfied with funds of hedge funds returns. Despite growing interest in the asset class, less than a quarter of pension schemes that invest in funds of hedge funds are satisfied with their investment returns, according to a new global survey by Mercer Investment Consulting. The survey found that only 23 per cent are satisfied while 48 per cent are neutral and 28 per cent are dissatisfied. When asked to rate overall satisfaction with their funds of hedge funds manager, the survey of over 180 large pension schemes worldwide found less than half (47 per cent) were satisfied. The definitions of “routes to market” may be several, including the paths to becoming a hedge fund, as well as the routes to the markets for executing orders, says Steven M. Simmons, senior vice president, institutional sales and trading at Terra Nova Financial Group, an independent agency broker dealer. An article purporting to cover said routes should also focus on the methods of getting capital to the fund, and getting the fund in front of the right people, he says. “When looking at driving forces within the industry, you can’t but help look to the latest debacle at Amaranth Capital [which posted losses of $6bn in September, following what the Financial Times descrived as a disastrous bet on natural gas prices] and realise that the topics du jour will continue to revolve around hedge fund scrutiny and security, and inevitably, the call will go up for increased regulation,” he continues. “Additionally, the discussion will turn to the idea that hedge funds again are the playgrounds for the wealthy that can afford to lose money at the expense of greater upside rewards, whereas the lay public can not. The problem of course is when public pension plans and endowments become involved.” “With some 7,000-plus hedge funds in the United States alone, the competition for capital is as cutthroat as it gets. The previously roman-

Less than a quarter of pension schemes that invest in funds of hedge funds are satisfied with their investment returns
heap just yet, if at all. According to a a new study of leading institutional investors, investment consultants and hedge funds, published recently by BNY and Casey, Quirk & Associates, direct investment will cannibalise FoFs only marginally, and FoFs will still account for an estimated 51 per cent of the hedge funds market in 2010, and that will be 51 per cent of a market that will be triple the size of today’s. Global institutional demand for hedge funds will triple by 2010, increasing from $360 bn currently to more than $1 trillion, according to the study, entitled “Institutional Demand for Hedge Funds 2: A Global Perspective”. It found that by 2010 institutions investing in hedge funds will increase to nearly 25 per cent of all institutions, up from 15 per cent today, representing a more than 60 per cent increase. Retirement plans globally will account for the vast majority of asset flows, with corporate and public pension plans in the United States accounting for the largest percentage increase overall. According to the study, institutional investors’ experience with hedge funds has and will continue to profoundly influence the way they invest broadly, indicating that “less constrained,” active investment techniques will become a standard component of investing moving forward. The study also found that institutional investors’ ability to identify and assess quality hedge fund managers will dramatically improve. As a result, hedge fund providers increasingly will be required to demonstrate operational excellence and comprehensive risk oversight, as well as offer fee structures that are more closely linked to value and performance. The study found that the fund-of-hedge funds

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Hedge Fund Services Market Guide
tic notion of working for a few years in a white shoe firm a la Goldman Sachs, then taking your windfall and staking your own fund with the additional backing from friends and family, chugging away for a few years with $10 million under management, getting oversized returns nascent and existing fund managers have a seven-minute forum to explain their fund’s strategy, and to pitch a specific idea they like. The audience is comprised of other funds as well as pension plans, foundations and qualified investors. This allows funds a spotlight and a chance to differentiate themselves, as well as allowing for a collegial sharing of ideas and brainstorming afterwards with cocktails in a more loosened, albeit heightened atmosphere.” Having the right plumbing in place is also a key component in reaching the market, and does not necessarily reflect the scale of a wouldbe provider. It is also integral to early days strategic thinking, says Fabian Schonenberg, Managing Director of Tromino Financial Services Ltd., a Bermuda-based provider of highly personalised fund administration, primarily within the hedge fund industry and the family office environment. “ It is crucial to market a hedge fund hand-in-hand with its supporting infrastructure, most importantly its custodian and administrator, its auditor and perhaps the fund’s legal advisers,” he argues. “When it comes to market a hedge fund in this context, it is important for the manager to realise that bigger is not necessarily better. Managers are often looking to appoint “brand name” administrators, believing that this will make them less vulnerable to operational risk and that it will facilitate to gain the confidence of potential investors. While the latter argument may be a valid one in some cases, I believe it is no longer true that small administrators in general pose a higher operational risk – today’s regulations under which fund administrators operate impose the same requirements to all providers, regardless of their size. The advantage of appointing a smaller provider is clearly their ability to provide services in a highly dedicated, personalised way, especially when it comes to non-standard structures and startups. Larger providers often lack the flexibility and dedication that the business model of smaller providers is built on.” “Obviously, technology is and continues to be absolutely crucial for the successful operation of a hedge fund. However, in my view this aspect is often over-emphasised by service providers – nowadays it is just a necessity without which a service provider can’t operate, much like being able to speak English. What is just as important, and often even more important, are the HFSMG soft skills of the service provider.”

Helping the funds get in front of the proper investing public is very much like getting a graduate student properly prepared for a job interview
and attracting outside investors to eventually run the fund up over $250 million, is slowly being dispelled, and is more akin to the romantic notion of working on Wall Street for several years and then opening up a bed and breakfast. Like the strongest onion, when the layers are peeled back, the reality (or nightmare) of the undertaking comes to the surface quickly.” “From my experience working with hedge funds and helping to raise capital, a wicked Catch 22 ensues. Many investors will say to a fund, we love your strategy, results etc, call us when you have over $50 million and we’ll talk again. For a fund with $5- $10 million under management, getting to $50 million under management is seemingly the equivalent of hitting 70 home runs in a season. On the rare occasion, it can be done, but quite possibly not without the help of performance enhancing drugs (in this case, let’s just call that oversized bets or enhanced strategies, both of which put the idea of mitigating risk to the test).” “We work closely with start-up hedge funds to make sure everything is in place to make the transition to the market place as smooth as possible. Enhanced electronic trading software full of automated algorithmic trading strategies, alerts and market minders, risk parameter controls as well as software to monitor quality of execution (in a world obsessed with the idea of best execution, the line is exceedingly blurred as to what truly constitutes best execution) are just some of the tools hedge funds need to be armed with just on the trading side.” Helping the funds get in front of the proper investing public is very much like getting a graduate student properly prepared for a job interview, he argues. “We have created a popular programme called the Alpha Exchange whereby

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 9

REVIEW / EMEA

HOTTING UP
Ian Hamilton

2006 on introducing structures under the Collective Investment Schemes Control Act (CISCA). The reality is that CISCA is still seen by the Regulator as something for retail investments such as unit trusts and not the broader

Most of the structures used by South African hedge fund managers are classified as unlisted or other types of investments.
market of funds for institutional and professional investors. Single strategy hedge fund managers in general do not want to be in the realm of retail investments. The Financial Services Board (FSB) and other South African regulatory bodies are not keen to follow internationally accepted practice of having qualifications imposed upon the investors which would raise the investment threshold. 2. Fund Management It is not strictly correct to say that there are no regulations dealing with hedge fund managers. Currently all investment managers must be registered under the Financial Advisors and Intermediaries Services Act (FAIS). No distinction has been made for hedge fund managers. This is likely to change before the end of 2006 (or early 2007) with the introduction of a specific category for all investment managers managing and wanting to manage funds with alternative investment strategies. The proposed regulations cover additional experience and qualification requirements, as well as contractual disclosures. 3. Investor Restrictions Investor restrictions apply to the institutional investors such as retirement funds. A specific restriction comes in the form of Regulations 28 which controls the asset selection of retirement funds. There is no specific category for hedge funds. Most of the structures used by South African hedge fund managers are classified as unlisted or other types of investments. Under Regulation 28 this category of asset is restricted to 2,5 per cent of the total portfolio. Regulation 28 has been under review for the past five years. However, it is unlikely that a

Ian Hamilton, Investment Data Services Group looks at the past year for hedge funds in EMEA.

The South African hedge fund industry has had a strong year despite little happening on the regulatory front insofar as the establishment of regulated vehicles is concerned. Assets in single strategy funds are expected to more than double to R20bn ($2,8bn) by the end of 2006 with Funds of Hedge Funds and institutional investors accounting for at least half or more of the flow of funds. The AIMA South Africa Chapter has recognized the importance of the institutional market and created a portfolio position on the local board to deal with retirement fund and other institutional investor issues. This portfolio covers the legal and regulatory aspects of these investors.
Regulations and Structures Regulations that affect hedge funds in South Africa are divided into three areas: 1. Structure 2. Fund Management 3. Investor Restrictions 1. Structure To date little progress has been made during

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Hedge Fund Services Market Guide
conclusion to this review will be achieved before 2008. Taxation There will continue to be a degree of uncertainty on the tax treatment of hedge funds and the various structures currently used by hedge fund managers until approved structures are set up in South Africa. A further discussion paper has been issued covering the use of prime brokers by hedge funds. This is an attempt to rectify some of these conflicting issues. Closure of this discussion paper is mid November. It is essential that an industry body such as AIMA become more involved in the region to ensure that there is proper industry participation and feedback. Why Dubai? Wedged between Europe and Asia, buttressed by Africa, Dubai's encouraging tax regime in the Dubai International Financial Centre (zero tax for 50 years) make this an interesting alternative to the traditional locations for the setting up of funds, investment management and investment administration. Many readers will remember the old song: "They've Got An Awful Lot Of Coffee In Brazil ..." ? Well, if you are going to sing anything about the United Arab Emirates, the lyrics would go something like: "They've Got An Awful Lot Of Money In Dubai" !
Ian Hamilton Chief Executive Officer, Investment Data Services Group B Comm. LLb, MBA, Advocate of the High Court of South Africa. Ian is the Chief Executive Officer of Investment Data Services, which he founded in 2003. He has a wealth of expertise and an extensive network in the South African investment market. Ian has served as a director of the South African Association of Unit Trusts (now known as the Association of Collective Investments (ACI)), and currently sits on the Fund Management Committee of the South African Retirement Fund Association. Ian is also a founder board member, and now Chairman, of the South African Chapter of Alternative Investment Management Association (AIMA South Africa). Ian was appointed in June 2001 by the Minister of Finance, the Honourable Mr. Trevor Manuel, to the Advisory Board of the FSB. Ian has been actively involved in the debates surrounding the possible introduction of hedge fund regulations for the Collective Investment Schemes Control Act. He is presently involved in the setting up of the hedge fund industry in Dubai, as an alternative domicile to other off-shore jurisdictions. He has a number of hobbies which he would like to pursue if the hedge fund industry gave him some free time!

The Middle East has opened up to the hedge fund market through the introduction of Collective Investment Rules
Exchange Control A moderate relaxation of personal monies that South African citizens can invest internationally was introduced in the 2007/2008 budget. The foreign investment allowance was raised to R2m ($300 000 at the exchange rate prevailing at the time of the Budget) per individual. Foreign investors have few restrictions, but are still faced with the uncertain tax issues and the need to hedge the currency outside of the Republic. Foreign domiciled funds wanting to register for sale in South Africa are still prohibited given that there are no domestic regulations covering hedge funds. Dubai and the Middle East The Middle East has opened up to the hedge fund market through the introduction of Collective Investment Rules by the Dubai Financial Services Authority in March 2006. These regulations cover hedge funds as well and the first Dubai domiciled hedge fund, the Constans Crescent fund was launched in September 2006. It is never an easy task for a regulator to put out a discussion paper for the introduction of new regulations when there is no established market to provide comment or feedback. Therefore, the registration of hedge funds has not been without difficulty. The Regulator has adopted a very cautious approach to collective investment schemes in general. As a result some of the general provisions in certain instances clash with what are alternative investment schemes generally accepted practices.

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 11

REVIEW / THE INSTITUTIONALIZATION OF HEDGE FUNDS
untied to market performance, and targeted instead at an absolute return. Recently however, this picture has become blurred around the edges, with significant consequences: as we will see, the phenomenon known as ‘institutionalisation’, is serving to significantly change the way in which the hedge fund market functions, its regulatory profile and its future topography. In the past two years, traditional equity returns have shrunk. Consequently, institutional asset managers, which historically tended to favour ‘long only’ investment strategies, have begun to cast an envious eye over their smaller, more nimble counterparts. The resulting trend has seen alternative investment strategies gain rapid ground among swathes of the traditional buy side community, as it attempts to compete in an increasingly cutthroat financial environment. Graham Phillips, European hedge fund practice leader for PricewaterhouseCoopers, and author of a recent report on the development of the hedge fund industry, comments: “The institutional fund managers' decisions are being driven by the institutional investors that wanted within their portfolios some strategies which are absolute return; that’s been an ongoing trend since about 2002-2003, when institutions started moving away from more traditional investments such as

Can You Tell What It Is Yet?
Evolution is rife in financial markets the world over. Michelle Price looks at the changing picture of the hedge fund industry.
Despite the proliferation of material, and frequency of debate, inspired by this section of the financial markets, no one, it seems, has grown bored of discussing hedge funds. Now estimated to represent USD1,200 bn with more than 9000 active funds, the bulging hedge fund industry continues to command considerable attention, for reasons that the ill-fated Amaranth Advisors and Vega Asset Management have recently illustrated. The very public downfall (or at least speculator stumble) of two global hedge funds has given shape to pressing questions that, until very recently, lingered in the background, unformed. These relate to the stability of the hedge fund space, and its wider risk to the financial markets: are these isolated events, or sign of an overarching market trend? How exactly, is the hedge fund market evolving, and where will it take the wordwide economy? And, oh yes, what exactly is a hedge fund nowadays anyway? In particular, the latter question is becoming ever harder to answer, as the traditional profile of a hedge fund has begun to change. Historically, hedge funds received their start-up capital from private equity investors and high net worth individuals, giving rise to the image of the boutique fund populated by independent individuals, funded by sickeningly rich sponsors. The latter were driven by the desire for capital protection (which allows an investor some exposure to financial assets while protecting the capital invested) and annualised compound returns

What exactly is a hedge fund nowadays anyway?
equities, cash, bonds and property.” This trend is bolstered by the fact that the fund managers running these absolute return strategies are normally amongst the brightest fund managers in the market, he adds: “So it is logical that institutions would want some of their money run by such managers and have benefited from moving away from the institutional fund management scene itself.” This development has prompted a spate of inhouse hedge fund launches from a variety of investment houses, such as Henderson Global Investors and Threadneedle Investments. In addition, planned sponsors and pension funds, which have traditionally assumed a conservative approach to their asset allocation, are now finding the hedge funds increasingly attractive investment

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Hedge Fund Services Market Guide
vehicles, with around 11 per cent of Continental European pension funds now allocating to hedge funds. “Commentators, including the press, have criticised trustees of pension funds or insurance funds, who appointed the institutional fund managers, for being too conservative in their investment strategies,” Phillips explains. In particular, the Myners report, the influential investment Treasury research published in 2001, recommended that a “good portfolio strategy” involved more than just traditional investments, Phillips points out. Paul Myners, who is now chairman of Jerseybased fund of hedge funds Ermitage Group, recently reiterated his recommendations in October, urging pension funds to allocate between 15 per cent and 30 per cent of their money to the hedge funds. “So there has been pressure on trustees and guardians of other people’s money to follow a more diverse investment approach,” Phillips confirms. In the US, these sources of asset allocation have been significantly augmented by the university endowments. The latter currently account for a sizeable chunk of market-wide capital in the US hedge fund space, having significantly accelerated the proliferation of the market in the early 1990s. Establishments like Harvard and Yale for instance, now manage more than 60 per cent of their portfolios in alternative assets, including property, private equity and hedge funds. Thus, institutional money now accounts for a significant proportion of global hedge fund assets. According to a recent survey conducted by IFI Research for Northern Trust’s Global Fund Services, for instance, one in five institutional investors in Europe invested in hedge funds or fund of hedge funds in 2003, a figure that increased to one in three by 2005, and this trend seems yet to peak. But it is not only the large asset managers that are throwing off their traditional investment profile. Blurring buy side delineations further, many of the hedge funds themselves are now looking to operate more traditional ‘long only’ strategies, as fund managers who cut their teeth managing portfolios at the giant asset managers, break free to set up their own start-up funds. And, at the larger end of the scale, multi-billion-dollar hedge funds, such as Citadel, DE Shaw and Perry Capital, are now, in many respects, indistinguishable from the traditional asset management firms. This is evident not only in their size but also in their strategies, which have begun to move away from the typical hedge fund model that tends to emphasise more value, with less stress on asset gathering. In short, therefore, many of the traditional asset managers have become more like hedge funds, and more of the hedge funds have become like traditional asset managers. But what does this convergence, in which the term ‘hedge fund’ becomes, as best vague, at worst entirely nebulous, mean for the hedge fund market, and why should anyone care in any event? First, and perhaps most importantly, the hedge fund market, which, for so long, has languished in a near regulatory vacuum, will experience increased scrutiny by the regulators in future years. According to the Northern Trust survey mentioned above, 80% of respondents predicted increased participation of institutional investors

Institutional money now accounts for a significant proportion of global hedge fund assets
would bring an additional regulatory and reporting burden, the likes of which is already beginning to rear its head. Most notably, abortive efforts made in June of this year on behalf of the US Securities and Exchange Commission (SEC), in which it was proposed hedge fund managers be required to register with the financial market watchdog, have undoubtedly served as the precursor to future regulatory action. It has also, as Matt Nelson, analyst at Towergroup argues, highlighted issues surrounding best practices. “Part of the good that came out of the short-lived SEC registration in the US, was that hedge funds can't be a fly by night operation, they need to have controls in place for their clients,” he contends. US regulatory rumblings are also being echoed in Europe. The Financial Times reported in October, for example, that Germany has determined to put hedge fund transparency on the agenda of next year’s summit of the eight leading industrial nations (G8), due not in small part to Amaranth Advisor’s latest calamities. Analysis and investigations of this nature will serve to highlight the glaring white regulatory space that the hedge funds have thus far occupied, and will no doubt accelerate debates on filling that space with legislation. Even without legislation however, the developments discussed above are already exerting pressure on the hedge fund managers. While independent ratings agencies, such as Standard & Poor’s and Moody’s, are also turning the screw, having recently announced their intention to rate hedge funds based on their facility for risk control,

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 13

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

14 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007

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

Moody’s Management Quality Rating
is the creator of

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

and the

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

If you would like further detailed information on Custom House, please contact: Dermot Butler or David Blair [email protected] / [email protected] Custom House Administration & Corporate Services Limited 25 Eden Quay, Dublin 1, Ireland Tel: (353) 1 878 0807 / Fax: (353) 1 878 0827

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

www.customhousegroup.com
Custom House Administration & Corporate Services Limited is authorised by the Irish Financial Regulator under the Investment Intermediaries Act, 1995

REVIEW / HFA

Pool Runnings
The Hedge Fund Association examines the myths and market open to a hedge fund investor. “Unregulated pools of capital with high fees that are only available to those who have the stomach to withstand high volatility and who can afford to lose the entire investment.” This is the false, single-dimensional portrayal of hedge funds that has historically been perpetuated by the media and less informed participants in the financial industry who may see hedge funds as a threat to their livelihood. As a result, many investors are misinformed about hedge funds and have a negative perception about what this investment alternative really is and what it can do for them. Nonetheless, hedge funds have continued to grow in popularity, and are now the investment of choice for many pension funds, endowments, family offices and high net worth individuals. Should you be investing in hedge funds? This article may help you better decide. A hedge fund is a term commonly used to describe any fund that charges performance fees and that isn't a conventional investment fund -that is, any fund using a strategy or set of strategies other than investing long in shares (unit trusts/mutual funds), bonds, money markets (money market funds), real estate, venture capital or LBOs (leveraged buy-outs). Hedge fund strategies, also referred to as alternative investment strategies, include selling stocks short, hedging against market downturns by short selling or by using options, investing in asset classes such as currencies or distressed securities, and utilizing return-enhancing tools such as leverage, derivatives, and arbitrage. There are over 9,000 hedge funds in the world today, though the general investing public probably hasn’t heard of most of them as advertising and other regulatory restrictions attempt to keep hedge funds away from unsophisticated investors. Although many of the larger hedge fund managers have registered with SEC as registered investment advisers, this does not however change the fact that hedge funds continue to be managed in a largely regulatory free environment. This lack of regulation gives hedge funds defensive (as well as opportunistic) flexibility that mutual funds, which are subject to strict regulatory control and disclosure requirements, generally don’t enjoy. Despite the fact that there is no formal regulation stipulating what hedge funds can and cannot invest in,

most hedge funds do manage their funds within written mandates, and generally keep their investments and strategy within an area of specialization. This happens because many hedge fund investors are sophisticated individuals, professionals managing funds of hedge funds, or institutions, who demand that hedge fund managers invest within

A diversified portfolio of hedge funds generates more consistent returns than mutual funds/unit trusts
their mandate as specified in the hedge fund’s offering memorandum. For example, if our company, a manager of funds of hedge funds, were to find a market neutral fund manager suddenly making unusual returns due to a large directional exposure in the equity market, we would redeem our investment because we have other specialist managers who take a directional view on the equity market. Investors can also take comfort in the fact that the vast majority of hedge funds are audited, are administered by an independent administrator, and have their assets held by a reputable custodian bank or prime broker. While media stories about hedge funds in the past have usually focused on funds generating exciting returns, the vast majority of hedge funds make consistency and stability of return, rather than magnitude, their primary goal. Historical data indicates that a diversified portfolio of hedge funds generates more consistent returns than mutual funds/unit trusts. Hedge funds, unlike unit trusts and mutual funds, have the ability to make money in both up and down markets through the use of derivatives, short selling and other strategies not available to traditional unit trusts. During the bear market of 2001 and 2002, hedge funds, unlike other long only investments, were able to offer investors an asset class that preserved capital, and in many instances appreciated. This, in contrast to unit trusts and mutual funds, that experienced losses in line with, and often even greater than those suffered in equity markets. Hedge funds were able to preserve and grow capital during 2001 and 2002 because many hedge funds, as the term implies, "hedge their bets”. They may sell shares short to cover themselves against a drop in stock prices. They may buy put options, which give them the right to sell a stock at a specified future price, in order to lock in a sell price in the event of a severe market drop. They may buy interest-paying bonds or trade claims of companies undergoing reorganization, bankruptcy, or some

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Hedge Fund Services Market Guide
other corporate restructuring, counting on events in a company, rather than more random macro trends, to affect their investment. By the same token, these defensive strategies tend to cause hedge funds to under-perform unit trusts and mutual funds in bull markets. However, with the bear market of 2001 and 2002 still fresh in investors minds, many investors have turned to hedge funds to help preserve their wealth, and perreturns and who do not have the time, expertise or resources to analyze, identify and monitor the hedge funds most suitable for their portfolio. If you prefer to select individual hedge funds yourself, as opposed to investing in a fund of hedge funds, the following are some important tips: First, always understand what it is the fund manager is doing. If the fund manager is not willing to provide the level of transparency that allows you to understand their strategy, and if the fund manager refuses when asked to disclose the fund’s largest holdings and exposure, do not invest. You can also help avoid fraud by performing extensive due diligence on a manager. A prudent investor can perform background checks on the manager before investing in a fund. Contact any universities the fund manager claims to have attended. If he or she lies about a degree, would you trust this manager with your savings? A visit to a fund manager’s office can also be beneficial. Is the back office in good order? Are there checks and balances in place that make fraud less likely? A first-hand look may detect signs that either confirm or raise concerns about your choice of hedge fund manager. Verify all statements made by the fund manager, especially those made in the offering document to lure investors. Contact the administrator, prime broker, auditor and custodian to ensure that they have, in fact, been employed by the fund. When looking at past performance numbers, verify if they are audited. Diversify, across both the number of hedge fund managers and style and strategies employed by the various hedge funds. The recent $5 bn loss suffered by Amaranth should not scare you away from investing in hedge funds – it should however stress the importance of having an adequate understanding of what the fund strategy is, what some of the major risks are, and the need to be adequately diversified. If this sounds like too much work to perform prior to investing in a hedge fund, use a consultant to assist you in your choice or invest in a fund of hedge funds. Well-established funds of hedge funds and competent consultants can provide these services for you. They dedicate themselves to understanding the vast array of hedge fund strategies, identifying the leading managers implementing these strategies, and performing extensive due diligence. So, next time you hear that hedge funds are unregulated pools of capital that are only available to those who have the stomach to withstand high volatility and who can afford to lose the entire investment, you’ll know better. You may even know enough to invest in one. HFSMG

The broad range of hedge fund strategies can confuse the average investor
haps you should too. There are a variety of strategies for investors to consider. The more conservative of these strategies are generally not correlated to equity markets, and deliver steady profits with low volatility. More aggressive hedge funds that seek high returns, albeit with higher volatility, are also available. These strategies generally have a directional bias to the market, either long or short (long/short equity), or seek to speculate on future market moves in equity markets, currency markets and bind markets (global currency funds). Aggressive funds have the potential to enjoy large gains, but unless the fund manager is perceptive enough to identify market turns in advance, the fund may be susceptible to volatile returns. The broad range of hedge fund strategies and the many complex styles available can confuse the average investor. Unless you have a real understanding of the characteristics and risks associated with the different hedge fund strategies, the best approach for investing in hedge funds is to use a consultant well versed in hedge fund strategies or to invest in an established fund of hedge funds. A fund of hedge funds is a diversified portfolio of hedge funds that allows investors to access a variety of hedge funds with a relatively small investment. Typically, the minimum investment in a hedge fund ranges anywhere from $250,000 to $5 million, whereas the average minimum investment into a fund of hedge funds ranges from $50,000 to $250,000. Further, by investing in a fund of hedge funds, investors are able to access a wide range of different hedge fund strategies, providing wide diversification often with exposure to a variety of markets, with one easy to administer investment. As a result of this added diversification, funds of hedge funds are often able to provide more consistent returns than individual hedge funds. Consequently, funds of hedge funds are ideal investment vehicles for investors who are seeking stable

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 17

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

Moody’s Management Quality Rating
is the creator of

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

and the

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

If you would like further detailed information on Custom House, please contact: Dermot Butler or David Blair [email protected] / [email protected] Custom House Administration & Corporate Services Limited 25 Eden Quay, Dublin 1, Ireland Tel: (353) 1 878 0807 / Fax: (353) 1 878 0827

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

www.customhousegroup.com
Custom House Administration & Corporate Services Limited is authorised by the Irish Financial Regulator under the Investment Intermediaries Act, 1995

PANEL DEBATE Alternatives?

Rober Chin

Ryan Kennelly

Stephen Swindon

Don McClean

THE HEDGE FUND SERVICES

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

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Hedge Fund Services Market Guide
To what extent do you feel hedge funds are still alternative? Chin: Although hedge funds are definitively becoming more mainstream I believe they are still alternative. I would argue that as long as it is unclear how regulators in advanced economies in Europe, the US and the Far East will regulate the industry and whether or not “smaller” investors are allowed to invest in this asset class, hedge funds are still alternative. Although hedge funds are still alternative investments, going forward they look set to move more into the mainstream. McClean: There has been a convergence between the market exposure of hedge funds and mutual funds in recent times as illustrated most recently by the under performance of hedge funds during the May/June market correction. Where previously there existed a gap between hedge funds and mutual funds today there is a grey area where the two overlap. Hedge fund structures investing in exotic instruments remain at one end of the continuum and mutual funds at the other. Therefore, although there has been a convergence of certain hedge fund and mutual fund exposures in the centre of the spectrum, in large, hedge funds are still alternative (some more alternative than others) offering an alternative risk profile, alternative targeted returns and alternative investment strategies. Where will the next stage of growth in the hedge funds industry come from? McClean: It is difficult to predict within the hedge fund business from where the next alternative strategy will emerge. We have seen large sums of capital moving into emerging markets in the last couple of years and are seeing an increased focus on private equity and venture capital at the moment. It could be, however, that growth of the industry is driven through increased distribution to new markets and more institutional investors rather than through the offering of new and more diversified investment strategies. These opportunities present challenges. As an illustration, the tax reporting considerations in Germany will have to be addressed before wide-scale distribution into that market can be attained. These challenges are constantly being tackled and the market is beginning to open up. Kennelly: Although it is expected that retail clients will significantly increase their allocation to hedge funds on a relative basis over the next 5 years, the most significant growth in AUM in the hedge fund industry will come from Pension Funds. Pension funds are rethinking how they manage assets. Old investment paradigms like

“Regulatory scrutiny of hedge funds has also increased.”
Swindon: As the demand for alternative investments have grown and more ex-investment bankers take the plunge into the hedge fund space, some of the larger hedge funds have started to resemble their institutional cousins. Indeed, some of the institutions have started hedge funds themselves and it is not uncommon to see investment houses with a range of long only funds and hedge funds in addition to offering funds of funds to a broader range of investors. Inevitably, this has moved hedge funds more into the mainstream from the point of view of the management of their underlying processes and transparency of controls. Regulatory scrutiny of hedge funds has also increased and it is inevitable that hedge funds will have to adopt some of the responsibilities of the institutions such as assuring themselves of investor competence, particularly with the advent of MiFID (Markets in Financial Instruments Directive). However, events such as the recent large loss at Amaranth (around $6bn) has reminded everyone that hedge funds are not for the uninitiated and remain at the racier end of the investment spectrum. Kennelly: Hedge funds are becoming increasingly part of the mainstream. Recent efforts in the US to regulate hedge funds, the rating of hedge funds by established fund rating agencies and the generally lower average risk in the industry is bringing hedge funds increasingly into the mainstream. There tend to be major differences across nations with regards to regulations and access that retail investors have to hedge funds. However, as regulatory bodies become more comfortable with the asset class in general, access to the wider investing public will open up.

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 19

PANEL DEBATE Alternatives?
Liability Driven Investment have become increasingly popular. This has led to increased interest in suitable long term assets such as UK 30 Yr Gilts, real estate and infrastructure. Furthermore, there is now increased accessibility to low cost beta, through for example ETFs and Futures, which has led to increased interest in alpha generating strategies, such as hedge funds. to convince institutional investors (e.g. pension funds) to allocate more assets to hedge funds. Another driver for growth might be coming from the Far East, especially China. How does UK hedge fund exposure compare to that in other advanced economies? McClean: Some of the biggest and best performing hedge fund managers in Europe exist in the UK and these managers have proven track records. We exist in a global market and in the UK we see the same spectrum of risk and exposure to hedge funds as there is elsewhere. The success of hedge fund managers in the UK is apparent when you look at the returns they have generated in recent years. Swindon: The UK has traditionally been the largest centre for hedge funds outside of the US. This is as a result of the regulatory regime, the infrastructure and access to investors (particularly the increase in institutional investors in hedge funds). There are no signs of this diminishing in the future and, if anything, the UK’s hedge fund exposure will more than likely increase depending on how the FSA intends to regulate hedge funds going forward. Kennelly: The UK is the dominant investment management location for Europe. More than 75 per cent of European investment managers are located in London. New York and London are now increasingly seen as the hedge fund centres of the World. However the UK pension fund industry has lagged behind the rest of Europe and the US when it comes to investing in hedge funds. This is expected to change over the coming years as institutions become more comfortable with the asset class. Furthermore, this year there have been several high profile listings of FoHFs on the AIM stock exchange, enabling retail investors to gain hedge fund exposure through the purchase of these listed securities. With the number of hedge funds continually growing, the hedge fund administration business is becoming increasingly competitive. What strategies will hedge fund administrators use to keep their competitive edge?

“The days of phone trading, manual blotters, hand written trade tickets and manual reconciliations are numbered.”
Currently most of the larger pension funds have an allocation to hedge funds. These allocations are expected to increase as they become more comfortable with the asset class. The smaller pension fund managers are expected to follow. Pension fund allocations to alternative investments, including hedge funds, is likely to increase dramatically over the next 5 years. Swindon: From an IT standpoint, as more long-only institutions start up hedge funds, there is increased demand for trade order management platforms which can support hedge and long-only funds as well as a drive towards Straight-Through Processing (STP) through increased use of electronic trading, automatic trade matching and reconciliation. Recent developments such as algorithmic trading are also driving the need for a more sophisticated operations and technology infrastructure. The days of phone trading, manual blotters, hand written trade tickets and manual reconciliations are numbered. Hedge funds want to be able to scale up their operations without a big increase in their operational staff. This has required hedge funds to review and, often, re-design their business processes to enable them to benefit from increased automation and resultant scalability. This increased reliance on technology has brought with it a need to hire technology professionals to ensure issues such as BCP are properly addressed. Chin: It depends on what form the regulatory oversight will be imposed on the industry. Sufficient regulation and supervision is likely

20 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007

Hedge Fund Services Market Guide
Chin: Competition among administrators is increasing due to new service providers entering the industry. At the same time more due diligence is done on administrators by institutional investors. The big administrators are focussing on the larger funds (USD 500MM plus) by demanding higher minimum fees that bringing together the suite of services available through a global financial institution by servicing all the financial needs of a hedge fund rather than just providing administration. Furthermore, it is increasingly important for service providers to offer clients multiple services within a ‘single point of contact’ client focussed model. Sounds easy! However, bringing together the many and varied parts of multiple services required for hedge funds and fund of hedge funds requires experienced and qualified client facing people in a controlled and well managed environment. What affect has the emergence of newer hedge fund servicing centres (Guernsey, Jersey, Malta etc) had on the more ‘traditional’ servicing locations? Chin: If we are talking about the domicile of the fund I believe that some of these jurisdictions will be able to attract business from managers located in the European time zone that otherwise would have gone to the more traditional jurisdictions. Whether these jurisdictions will be able to attract the fund administration business is still to be seen as they will face competition from the traditional offshore servicing centres as well as the onshore servicing centers. Kennelly: Recent changes or introduction of regulations have led to newer hedge fund servicing centres being created. These are quickly becoming a viable alternative to the traditional servicing locations. The local regulatory environments in these regions are pro-actively seeking to increase the assets under administration/custody in their respective region. This combined with a rise in the number of hedge funds in existence and the increasing allocation to hedge funds should see these regions continue to grow. For European hedge fund managers the newer centres mentioned also have the advantage of being in the European time zone. However, it would be difficult to conceive that in the near future they will challenge the Caribbean/traditional servicing locations. McClean: Hedge fund administration becomes more competitive as the number of administrators increase and we have seen a growing number of administrators in the Irish market

“Introduction of regulations have led to newer hedge fund servicing centres being created.”
smaller hedge funds are likely not willing to pay. As a niche player ATC Fund Services can offer its clients a flexible, service-oriented approach that is often lacking with providing its clients the smaller funds. Swindon: Added value services such as automated reconciliations; outsourcing of middle office operations and links into specialist pricing services to provide better price accuracy. Kennelly: There has already been consolidation in the administration industry and we can expect more of this to continue. Larger administrators are offering the full range of services to mainstream hedge fund strategies. Competition is putting pressure on administrators to offer connectivity, service, speed of valuation and support. An administrator also has certain fiduciary responsibilities to investors to oversee and verify valuations. As such, for niche strategies smaller administrators will survive offering better service, a local presence, and or niche experience and valuations skills. McClean: Hedge fund administration becomes more competitive as the number of administrators increase and we have seen a growing number of administrators in the Irish market place, particularly over the last two years. Quality is the differentiating factor between administrators. Service quality covers a number of issues including timeliness and accuracy of service delivery, ability to process NAVs on a more frequent basis, independent pricing, catering for complex instruments and structures, and being able to constantly stay at the cutting edge of the IT infrastructure that is necessary to deliver these top class services to clients. Of growing value is the capability of

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 21

PANEL DEBATE Alternatives?
place, particularly over the last two years. Quality is the differentiating factor between administrators. Service quality covers a number of issues including timeliness and accuracy of service delivery, ability to process NAVs on a more frequent basis, independent pricing, catering for complex instruments and structures, and being able to constantly stay at the cutting edge of the IT infrastructure that is necessary to deliver these top class services to clients. Of growing value is the capability of bringing together the suite of services available through a global financial institution by servicing all the financial needs of a hedge trade lifecycle as possible with the ultimate aim of achieving STP. As well as increased scalability and control, this provides increased ability to focus on the management of risk and tighter cost controls rather than simply ensuring the day to day operation does not break. McClean: IT processing of data is extremely important to the hedge fund administration industry. Being able to take information in an electronic format, automatically upload it into the administrator’s accounting records, pricing portfolios automatically and independently, automatically reconciling cash and portfolios back to the manager and prime broker or custodian are all essential to being able to offer a robust and efficient administration service to clients. Organizations are utilising earlier time zones and outsourcing internally within their business in order to standardize these processes and be able to support more frequent valuation cycles. This type of continual IT development requires a significant capital spend and this has led to a top tier of administrators emerging comprised of global financial institutions and those able to continually fund the IT development that is required to stay at the forefront of these IT developments. The efficiency created through these types of system capabilities is becoming ever more important to the services offered by an administrator. This type of processing reduces risk, assists with more frequent and accurate reporting thereby creating time for the administrator to better ‘service’ clients. It is a fact that in the hedge fund world it is difficult to ‘process’ all trades (esoteric instruments) however the challenge to the administrator is ‘process’ as far as possible in order to offer enhanced services. It is critical when dealing with funds that trade in these esoteric instruments that state-ofthe-art IT systems are complemented with experienced, professional staff who are capable of providing a personalised service to their clients. Kennelly: Despite the growth in assets of Hedge Funds they are still in their infancy technologically. Subscription or redemption of an underlying fund still involves faxing forms to the fund's administrators, getting confirmation of receipt both verbal and faxed and

“Manual processes, often with key steps omitted, are commonplace.”
fund rather than just providing administration. Furthermore, it is increasingly important for service providers to offer clients multiple services within a ‘single point of contact’ client focussed model. Sounds easy! However, bringing together the many and varied parts of multiple services required for hedge funds and fund of hedge funds requires experienced and qualified client facing people in a controlled and well managed environment. Hedge funds are ramping up their use of technology. What are the current levels of automation and STP within the industry? Swindon: Hedge funds have experienced enormous growth over the last few years but, in many cases, their operations and technology infrastructure have not kept pace with this growth. Manual processes, often with key steps omitted such as reconciliations, are commonplace. In addition, investments in technology such as trade processing and position management systems are often not fully leveraged. However, many hedge funds have woken up to the fact that their operations processes are not sustainable in their current form. This is due to pressure from investors who want up to date information on demand, as well as evidence that the hedge fund has the appropriate controls in place. It also due to regulators who want to assure themselves that operational risks are actively managed. A direct result of this is a desire within hedge funds to automate as much of their

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ensuring that the cash has been sent or is going to be received on time. Valuations for certain strategies are still not received by investors in a timely fashion. As pension funds increase their allocations the demand for transparency and timeliness of valuation information will grow.

The rapid growth in hedge funds has prompted many prime brokers to establish, or boost, international prime brokerage platforms. As hedge funds become ever more global, how may the role of the prime broker evolve? Kennelly: The prime broking business has become more and more competitive. Prime brokers now aim to offer a full service solution. Whilst traditionally offering custody, clearing and reporting, they are now regularly being asked to support complex strategies, provide stock loan services, leverage, risk management, marketing services, technology solutions and tailored reporting. Going forward, there will be a rise in the demands from hedge funds for prime brokers to meet their needs. Chin: I believe that the evolution in the prime brokerage industry as far as hedge funds are concerned will be somewhat comparable to what happened with the hedge fund administrators. There will be a few large players capable of servicing global clients while others will be focussing on certain strategies and/or becoming niche players. Swindon: Added value services as well as a desire to lock in their hedge fund clients including increased stock lending services; more sophisticated prime brokerage platforms e.g. electronic (and algorithmic) trading, better reporting and possibly trade matching services. McClean: There are a growing number of managers who are launching macro or multi-strategy funds. This means that prime brokers are having to develop their cross-asset class offerings. In order for prime brokers to remain competitive, it is necessary that they develop a platform that can offer full reporting, valuations and client service across all asset classes globally - equities, fixed income, derivatives (listed and OTC) including fixed income derivatives and credit products. Implementing the above services means that the considerable investment into IT and staff-resourcing that has been the trend at prime brokers for the last few years will continue, if not increase significantly.
HFSMG

“Many fund managers trade securities based on corporate action information.”
Furthermore, three way reconciliation between the manager, prime broker and administrator is becoming more of a requirement. There has been extensive investment by prime brokers and administrators to provide automated trading systems, web access, connectivity and price feeds to hedge fund managers, who are becoming more demanding. Automation and Straight through Processing is the cornerstone of this activity. Managers’s technology needs are on the rise as they look to trade either complexity or efficiency. To keep up with these requirements, service providers are investing in technology. Investment in technology spending, by hedge funds and service providers is expected to increase by multiples in the coming years. How important is corporate action event information for the alternative investment/hedge fund industry? Swindon: Corporate action event information is essential for all hedge funds and ranks alongside daily price information in importance. Chin: As the timeliness and frequency of information reporting is becoming more important, so is corporate action event information. Kennelly: Many fund managers trade securities based on corporate action information. For these managers, for example those in long short equity or certain event driven type managers, the information is very important. However, not every strategy focuses on or is concerned with corporate actions. For all strategies, if there is any relevant corporate action event, the information needs to be received in an accurate and timely manner.

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Hedge Fund Operation - ATC Fund Services

Hedge Funds In The Main
There is no clear definition of an “Alternative Investment Fund” but hedge funds are commonly considered to be part of this asset class. Due to the significant inflow of capital over the past five years and the publicity that came along with it, hedge funds seem to have become as common as (regulated) mutual funds.
Does this mean that hedge funds are now no longer alternative and should be considered mainstream?
Let’s take a look at various operational aspects unique to hedge funds. Regulation Since the collapse of Long Term Capital Portfolio in 1998 there have been ongoing discussions about the need to regulate the hedge fund industry. Recently fuel was added to this discussion due to significant losses incurred by Amaranth Advisors. In the US efforts have been made to regulate the hedge fund manager (the requirement for hedge fund managers to register with the SEC by February 1, 2006 was

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

Robert Chin

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funds but exemptions are easily granted if the fund meet certain requirements. Most, if not all hedge funds will meet these requirements and therefore are not subject to supervision. Investment strategy In general investment strategies used by hedge funds differs significantly from those used by mutual funds. Hedge funds typically have no investment restrictions, can maintain short positions, make use of derivatives and most will use a certain degree of leverage. Recently some mutual funds managers started to use the administrator of a hedge fund by means of a letter. This often causes problems for custodians as their systems cannot handle these investments due to the fact that most hedge funds do not have international security identification numbers. Liquidity This is an area where significant differences between hedge funds and regular funds exists. Hedge funds typically offer monthly liquidity (some even quarterly), have a lock-up period (1 to 2 years), can have redemption gates (e.g. only 20 per cent of the fund’s net assets can be redeemed at any redemption date) and require advance written notice for redemption (30 to 90 days). Mutual funds typically offer greater liquidity, have no lock-up period and do not use redemption gates. Performance This is probably one of the few areas where there are hardly any differences left between mutual funds and hedge funds. The days when hedge funds posted double digit returns seem long gone and performance is now much more in line with those posted by mutual funds. Conclusion In many areas the differences between hedge funds and mutual funds are less than they once were. However, from an operational/administrative perspective there are still significant differences. This is evidenced by the fact that these funds are each administered by specialized administrators. It is fair to say that a traditional mutual fund administrator does not have the expertise to administer a hedge fund while a specialized hedge fund administrator is not equipped to deal with the large number of investors and often huge trading volumes typical to mutual funds. In conclusion I believe that hedge funds should not be considered mainstream. It is more likely that there will be two types of hedges funds; hedge funds allowing for retail investors and subject to increased regulatory oversight and therefore more likely to become mainstream and ii) the more traditional hedge funds catering toward high net worth individuals and institutional investors.

The days when hedge funds posted double digit returns seem long gone.
strategies used by hedge fund managers such as short positions. Similarly hedge fund managers are branching out and invest in other instruments such as private equity, insurance policies, art etc. Compensation The traditional compensation for a hedge fund manager consists of management fees and incentive/performance fees while a manager of a mutual fund only charge a management fee. However, some mutual fund managers are considering charging an incentive fee while some hedge fund managers have significantly reduced or even waived the incentive fee. In order to charge incentive/performance fees in an appropriate manner to the investors, hedge funds use one of two methods to account for this: series of shares or equalization of shares. Both methods often cause confusion to those not familiar with the concept. Offering Most hedge funds are still being launched as private placements and hence are not available to the general public. Investors in hedge funds must meet a list of qualifications (eligible investor) and submit various documents (subscription agreement, certified copy of legal documents, bank reference). Settlement of subscriptions/redemptions Settlements of subscriptions/redemptions are not done through the traditional clearing systems. These transactions are confirmed by

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Gibraltar - HASSANS

Sunny Side of the Street
Gibraltar through its introduction of Experienced Investor Funds and through the general revision of its fund regime has placed itself as a serious alternative fund jurisdiction.
The significant and sustained global expansion in funds has put considerable pressure on established fund centres such as Dublin, Luxembourg, the Channel Islands and the Caribbean. These pressures have given rise to delays in fund establishment and greater selectivity by fund administrators creating a healthy overspill to other jurisdictions which had previously been unexploited. There are a number of funds currently domiciled in Gibraltar and others that are administered from Gibraltar. The recent crackdown by Inland Revenue on offshore hedge funds demonstrates the need to have genuine substance in the jurisdiction of incorporation of a fund. At a distance of 2 hours from London and Paris, Gibraltar is ideally placed as a hedge fund domicile. Furthermore, the time zone and proximity to the European financial centres make Gibraltar an ideal choice for European based hedge funds. Gibraltar has the major names in accounting services to provide audit and other support services

as well as banks to provide custody services. High regulatory standards combined with 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.

Time zone and proximity to European financial centres makes Gibraltar an ideal choice for European based hedge funds.
Gibraltar has transposed all relevant EU Banking, Insurance and Investment Services Directives so that its financial services sector is firmly within the integrated structured financial services system contemplated by the EU. ‘Passporting’ of banking and insurance services has been in place in Gibraltar for some years and financial services passporting was brought in to 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. The Gibraltar Regulatory Regime The Financial Services Ordinance, 1989, the Financial Services Ordinance (Collective Investment Schemes) Regulations, 1991, the Financial Services (Collective Investment Schemes) Ordinance, 2005, the Financial Services (Collective Investment Schemes) Regulations, 2006 and the Financial Services (Experienced Investor Funds) Regulations, 2005 effectively divide the types of licensing requirements on funds that may be incorporated in Gibraltar into four categories: Private Funds, Experienced Investor Funds, Non-UCITS Retail Funds and UCITS Funds. 1. Private Schemes The recently passed Financial Services (Collective Investment Schemes) Regulations, 2006 codify what has been industry practice in Gibraltar for several years. In effect, a fund that is promoted to a restricted category of persons whose number is less than 50 is exempt from any licensing requirements and may be promoted to that category of persons in the following conditions: a. the offer is addressed directly to the identifiable category of persons by the promoter or his agent. b. the members of this category of persons are

James Lasry

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the only persons who may accept the offer. c. the offerees must have sufficient information in order to evaluate the offer. d. the scheme will remain a private scheme for a year from the date of offer. In practice, as long as the investors are friends, family or close clients of the promoters, or, perhaps, employees of a firm, a fund can establish itself as Private Scheme. Private funds in Gibraltar generally produce an offering document in order to ensure that the investors have sufficient information in order to evaluate the offer. Good corporate governance dictates that in addition to the production of annual audited accounts, private schemes engage the services of fund administrators and custodians where appropriate although there is no statutory requirement to do so. Non-UCITS Retail Funds The third category is the Non-UCITS compliant public fund. These funds are licensed by the FSC as opposed to the “deemed authorisation” in the case of EIFs. The licensing procedure which normally takes between three and six months, involves the submission of the formation documents of the fund and its prospectus to the FSC along with application forms on the fund, its directors and, investment manager, if any. 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 requirements for licensing under the Financial Services Ordinances are basically that the company must have a paid up share capital of at least £50,000 and it must have at least two Gibraltar resident directors. The directors and managers must be ‘fit and proper persons’ and must have adequate investment experience in order for the FSC to consent to grant them a licence. Unlike with EIFs, all of the directors and managers must be approved by the FSC and not solely the Gibraltar-resident directors. There are also various restrictions on the types of investments, however, it is possible (in the case of non-UCITS funds) to obtain derogations from these regulations by making a case before the Commissioner of the FSC. The end result is that these funds may, with consent from the FSC, invest in almost any type of investment including hedge funds, real property and even private equity. The advent of the Financial Services (Experienced Investor Funds) Regulations, 2005 will probably lessen the use of this category of fund, which heretofore was 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, save for the fact that EIFs are restricted to experienced investors. Public Funds (UCITS Where the intention of a public fund is to invest solely in “transferable securities” namely stocks and bonds listed on a recognised European Community or other recognised stock exchange, a fund may be licensed in compliance with the European directives on Undertakings in Collective Investment in Transferable Securities (“UCITS”). These funds are generally, but not always, meant for retail investors. Since Gibraltar is in the European Union by virtue of Article 299(4) of the Treaty of Rome, it has been given the right to passport its financial services throughout Europe. Gibraltar UCITS funds may therefore passport

EIFs do not have to go through the regular procedure for regulation and licensing.
2. Experienced Investor Funds Probably the most exciting and competitive innovation in the Gibraltar fund industry is the possibility to set up funds for experienced investors that are highly versatile and lightly regulated. Experienced Investor Funds (“EIFs”) under the Financial Services (Experienced Investor Funds) Regulations, 2005 (“the EIF Regulations”) are funds designed for professional, high net worth or experienced investors. Investors in these funds must have a net worth in excess of ¤1,000,000 or invest a minimum of ¤100,000. An EIF may be set up in a matter of days. For authorisation to trade, it need only notify the Financial Services Commission (“FSC”) within 14 days of establishment. The notification is made by the administrator and is accompanied by the fund’s offering documents and an opinion from counsel that the fund complies with the EIF Regulations. An EIF must have two Gibraltar-resident directors who are pre-approved by the FSC, a custodian or broker to hold its assets and a Gibraltar-based administrator. EIFs that are closed ended or invest in real estate do not require a custodian. 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 regulation 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.

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Gibraltar - HASSANS
their services within the European Union on the basis of their Gibraltar license. Unlike EIFs and non-UCITS retail funds, they must comply with the Financial Services Ordinance (Collective Investment Schemes) Regulations, 2006 with regard to investment restrictions and structure. Such funds must also engage European-licensed custodians and administrators. Protected Cell Companies Gibraltar’s Protected Cell Company Ordinance, 2001 allows for the incorporation of protected cell companies (“PCCs”). PCCs enable the statutory segregation of assets and liabilities in different cells. Long used captive cell insurance companies, the PCC legislation allows a fund to be set up so that there is segregation of assets and liabilities in an umbrella structure (i.e. that includes different sub-funds) where it is essential to ensure that there is no liability contamination between subfunds. Instead of the client relying on a purely contractual arrangement between shareholders, the legislative regime gives statutory basis for the segregation of assets that binds third parties as well. Sub-funds or cells can be used by separate clients or by one client wishing to promote several investment strategies. PCCs may be licensed as either EIFs for professional investors or as licensed funds for retail investors. The establishment of a PCC as an EIF has become a popular method of structuring property funds in Gibraltar. Segregated cells are established either for specific property investments or for subscription over a certain time period for investment in multiple projects. Investment in PCCs is however by no means limited to property. A fund manager may establish a PCC as his or her business vehicle in order to provide a regulatory framework for investment. Individual cells may then be established according to investment strategy, geographical emphasis or even for certain clients such as insurance companies or pension funds that may require asset segregation under the terms of their own mandates. There is no limit to the number of cells a PCC may create. Legal Structure Funds in Gibraltar are usually structured as open-ended investment companies (“OEICs”) although it is also possible to structure them as unit trusts and limited partnerships. The fund’s constituting documents – the Memorandum and Articles, trust or partnership deed as the case may be - must be drafted to allow redemptions of shares at the prevailing Net Asset Value (“NAV”) if the fund is to be openended. Typically, an OEIC fund will have ordinary shares that carry most voting rights and participation shares that carry economic rights. Participation shares are the units purchased by investors at the NAV. Although the participation shares usually do not have any voting 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 investment managers. Investment managers that manage funds in or from Gibraltar require a licence from the FSC in Gibraltar to do so. Directors who manage a fund do not require any specific licensing, save for the Gibraltar resident directors in EIFs who must be approved to act as directors of such funds. Most funds have personal rather than corporate directors who hold regular board meetings in order to ensure that management and control is fully exercised in Gibraltar.

“Funds in Gibraltar are usually structured as open-ended investment companies.”
Third party investment managers must be authorised to provide such services in their jurisdiction of operation. It is noteworthy that licensed European investment managers or advisers whose licences conform with the European Investment Services Directive to passport their services into Gibraltar. The anomaly that UK investment firms faced in this regard whereby they could not passport into Gibraltar due to the fact that the UK and Gibraltar are part of the same Member State albeit separate jurisdictions was rectified in July of this year. Gibraltar funds can be structured as closed funds as well, thus locking investors in for a determined amount of time, usually subject to one or more extensions. These are usually used for private equity or property funds where investment is deal-specific rather than being intended to allow for constant buying and selling of investments by the fund. Gibraltar funds may also be listed on a variety of exchanges. A stock exchange is currently being established in Gibraltar to allow for fund and company listing. Taxation & Confidentiality Licensed funds in Gibraltar (including EIFs

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which are “deemed authorised”) are exempt from income and company tax in Gibraltar upon receipt of a certificate 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 authorised capital. Redemptions of shares in such funds are often restricted in time and scope so that the directors or managers may have ample opportunity to properly dispose of any such assets in order to redeem shares. Auditors Fund administrators generally provide management accounts as part of their package of services. EIFs and public funds must be audited by an auditor registered in Gibraltar. Although UK GAAP is often used as the accounting standard for funds, there is a movement in the industry toward International Financial Reporting Standards (“IFRS”). This will eventually become mandatory. Conclusion Gibraltar is fast becoming a serious alternative to the Caribbean as a fund jurisdiction – and particularly so for European based investors and managers. The advent of the EIF Regulations has given a tremendous 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 experienced investors quickly and efficiently. EIFs can be set up as PCCs thus allowing the simplicity of one vehicle for a variety of segregated investment strategies. The reform in retail fund legislation that implements 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 are geared to make it a competitive alternative fund jurisdiction. James Lasry, partner in the Tax and Overseas Property Department, Hassans.
Mr Lasry is a highly regarded practitioner who has been instrumental in setting up the majority of Gibraltar’s funds, including the first Experienced Investor Fund and the first Protected Cell Company Fund. Prior to joining Hassans in 1999, Mr Lasry was at the Ministry of Industry & Trade where he gave legal opinions on international trade and consumer protection, as well as advice on international R&D contracts to the Chief Scientist. He also served as counsel to the Israeli delegation in trade accord negotiations with the Czech and Slovak republics. On joining Hassans, Mr Lasry has focused his expertise on funds, trusts, corporate law and financial services, advising the Government of Gibraltar on the regulatory and tax treatment of investment funds. James also assisted in drafting the Financial Services (Experienced Investor Funds) Regulations 2005.

“Gibraltar is fast becoming a serious alternative to the Caribbean.”
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 regulated 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 supporting reference from a lawyer, accountant or banker. This information is protected by common law confidentiality. As regards third parties, it is possible for the shareholder to remain anonymous 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 particular investor and his or her name will not be disclosed in any public register. Custodians, Fund Administrators and NAVs Investments may be made by the fund’s custodian or, in some cases, directly by the fund. EIFs that are closed ended do not require custodians. Brokers that are authorised to hold client assets may act as depositaries of a fund’s assets. Although several banks in Gibraltar have ample experience and capabilities in providing this service, banks and brokers from other jurisdictions may be used to carry out this function. The fund must be administered by a licensed 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 securities, the administrator can usually produce the NAV of the fund and distribute it to shareholders. The NAV 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, an NAV must be compiled by competent valuers such as accountants or valuation firms.

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 29

ASK THE EXPERTS

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

Lord Calum Graham Advent

Last year we saw a lot of upgrading in automation and STP in hedge funds in the US in anticipation of regulation by the SEC. This year that concern faded, although many upgrade plans were wisely seen through to completion, nonetheless. 2007 will be Europe’s turn to goad on the hedge fund sector. Brussels looks more set in its ways with the Markets in Financial Instruments Directive (MiFID) than was its US counterpart last year. There are fewer counter-lobbies at the fundamental level than was the case with the SEC’s intended ruling last February. True, many funds might consider themselves exempt from MiFID with offshore domicile, but at the time of writing the jury is still out on the implications on those funds with marketing arms in Europe. Nonetheless, even for those hedge funds that expect not to fall under MiFID’s regulation, there are wider forces pressing them to upgrade to greater STP, more robust, secure, functionally rich systems and greater transparency in reporting. Firstly, MiFID will force greater efficiency, transparency and ‘best execution’ in relevant markets for those institutions unquestionably under its jurisdiction so connectivity and automation of these markets will broaden and improve. Even the more esoteric OTC derivatives look set to benefit from new electronic markets. Regardless of jurisdiction, hedge fund managers will need sound technology simply to access these markets, let alone compete with their peers.

Secondly, from our vantage point at least, we see new entrants opening for business with ever higher transaction volumes. Their challenge here is not simply automating to handle execution flow and eliminate execution errors. That part addresses barely a handful of the data points that a trade accumulates from a wide range of input points before its impact is incorporated in the books and records. The challenge is in automating to manage the inherent ‘cancel and correct’ that the entire cycle brings at whatever level of transaction activity. Without the help of automation, this becomes a major cost area for many hedge funds and an impediment to scaling the business. Managers are facing the decision to upgrade from entry-level systems earlier. Thirdly, the allocations of institutional money that the hedge fund industry has invited to its party have brought with them their actuarial mathematicians, scrutinizing whatever is being passed around the revelers. To keep institutional money, managers must become more answerable, needing sophisticated systems for risk analysis, performance reporting, audit trailing and accounting to recognised standards. Fortunately there are now sophisticated core systems with far greater stability and ease of installation than were available only ten years ago. High demands from users and years of engineering have had a similar effect as they did on the car, where core engineering is hardly an issue any more – when was the last time you felt the need to check the oil and water in your engine between services? Lord Calum Graham, Advent
Lord Calum is a member of the Advisory Board to Advent Software EMEA, having previously been Regional Director for The UK and Ireland. Prior to joining Advent he was European MD for Lexit, a Direct Market Access broker subsequently bought by Neonet. In 1999, prior to Lexit, Lord Calum co-founded Fleming Lincoln Limited to provide strategic direction and transaction management to small and medium sized enterprises. He graduated with a BSc in both Computer Science and Zoology at the University of Cape Town and has a MBA from INSEAD.

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

Dermot Butler Custom House

There has been much talk about ‘Regulatory Creep’ in the Hedge Fund Industry over the past few years and this has become almost a daily phenomenon. Although it would take an anarchist to reject all forms of regulation, there is no doubt that much of the regulation that we have seen has been ill thought out, is not productive and has proved very expensive. In this area I would cite particularly the European Savings Directive (‘ESD’), which caused many administrators to spend huge sums of money in amending their systems in order to meet its requirements, only to be told that it has proved to be an absolute fiasco, raising a negligible amount of tax, which was the whole raison d’être of the exercise in the first place. It would be quite laughable, if it hadn’t been such a totally unnecessary waste of time and money. The other great regulatory debacle of the last few years was the SEC’s decision to require US and foreign Hedge Fund managers to register under the Investment Advisor’s Act, if they had 15 or more US clients. As a result, the industry spent tens if not hundreds of millions of dollars on compliance with the new regulations. Some Managers changed their fund and incorporated private equity so that they could justify having a two year lock up, which made them exempt from registration. Seminars and conferences were held all over the world because the US Government, in its usual

fashion, decided that it had extra territorial powers and could regulate non-US Managers. So what happened? In the end one stalwart hedge fund manager in the United States, Phil Goldstein, sued the SEC, claiming they had no legal authority to change the law and a year after everybody who was going to comply had complied and written their cheques to their lawyers, the appellate court in Washington threw the SEC’s case out and within a week or two, the SEC had totally capitulated. Again, almost laughable, but my complaint is that the SEC’s decision appears to have been based on evangelistic and political objectives and not on good law. Furthermore, it did not appear that registering hedge fund managers was going to help any investors and indeed the net result is that investors in Hedge Funds have or will indirectly pay a huge amount of money, because eventually all the costs incurred by the Administrators, the Managers and the Funds will pass to the investors. As I said at the beginning, I have nothing against regulation, but let’s hope that in future the regulators, in particular those in the EU and the SEC can take off their political and evangelistic blinkers and look at the broader picture, before they make such rash judgements and take such draconian steps. Dermot Butler is Chairman of Custom House Administration & Corporate Services Ltd.
Mr Butler has over 35 year’s experience in the financial services industry. He has worked variously as a Stock Broker and Stock Jobber, before becoming a Commodity Broker and Market Maker in Metal Options on the London Metal Exchange. In 1983 Mr Butler helped set up McDonnell & Co., the Bermuda fund management company and issuer of the McD range funds. He sold his interest in that company and moved to Dublin in 1989 when he established Custom House.He is a director of several fund companies listed in the Irish Stock Exchange and is Deputy Chairman of the Alternative Investment Management Association (AIMA).

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ASK THE EXPERTS

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

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Hedge Fund Services Market Guide

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

Marc Russell-Jones Northern Trust

In 2003, one in five institutional investors in Europe invested in hedge funds or fund of hedge funds. By 2005 this had increased to one in three, as a recent Northern Trust survey entitled “The Forced Institutionalisation of the Hedge Fund Industry” highlighted. Other recent industry surveys indicate that industry growth rates have doubled in the first six months of 2006 compared to the same period in 2005. Increased inflows are impacting the hedge fund industry right now and will act as a catalyst to the emergence of a two tier hedge fund industry in Europe, namely: 1) Boutique managers servicing private clients and high net worth individuals. 2) “Supra” alternative asset managers with the infrastructure to service institutional clients. The Northern Trust study further concluded that there were three key effects that institutional asset flows would have on the hedge fund industry. 1) Increased regulatory environment: this will have the single biggest influence on the future of the hedge fund industry. The focus of the regulator will be on areas such as asset valuation, risk monitoring and internal operational and management controls. A byproduct of institutional flows will be increased standardization benefiting both managers and investors in areas such as asset identification, pricing and subscription and redemption documentation. An

improvement in professional standards and increased regulation will create conditions for more investors to diversify into alternative strategies. 2) Asset allocation: portfolio diversification and non-correlated absolute returns are driving asset allocation. The portfolio transparency argument has moved on to focus on operational transparency leading to the emergence of “supra” alternative asset managers who offer in-house, multi-strategy, multi-structure product offerings coupled with an established compliance and reporting infrastructure. 3) Administration and custody: 77% of institutional investors allocate assets to hedge funds through the fund of hedge fund route today, as a result more emphasis is being placed on core administration and custody competencies. With over 40 hedge fund administrators in Dublin alone, consolidation is inevitable as we have seen within the traditional custodian banks over the last ten years who have the infrastructure, scale, expertise, technology and banking services to accommodate the diverse requirements of institutional investors and managers alike. As a result of the inevitable increase in regulation, the greater focus on operational transparency and the demand for institutional type fund administration, it is clear that one size most certainly does not fit all. Ultimately it is the target investor who will dictate the profile of the administrator/custodian and asset manager for alternative assets. Marc Russell-Jones, Northern Trust
Mr Russell-Jones has over 13 years experience in business development, sales and product management in European financial markets. He joined Northern Trust in 2005, following the company’s acquisition of Barings Fund Services. Mr Russell-Jones, who is based in London, is vice president of global fund services, responsible for alternative investment sales for Northern Trust in Europe.

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 33

ASK THE EXPERTS

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

Compliance concerns, investor communication and data requirements, along with new investment strategies involving things like bank debt, OTC derivatives, private placements, and futures demand more from back and middle office providers. With qualRobert Goldbaum ity systems in place and highly experienced people Spectrum throughout the organization, administrators can significantly reduce the angst that is so prevalent in the typical client-administrator relationship and provide more services to help managers focus their resources on portfolio management. Fund administrators’ accounting, valuation, reconciliation and shareholder transaction processing efforts are the core of the services they provide and should be centered on significant automation and process controls to ensure accuracy, consistency, and data security. Even for more complex portfolios and seemingly onerous investor reporting requirements, an administrator should be able to systematize most of the processes involved from securities transactions to investor statements to supporting the audit. Many fund managers never ask to see the process, people or systems involved in their outsourced back office, assuming that an established administrator with a household name can deliver no matter what the issue. Faced with novel circumstances, however, controls typically break down, the laws of physics take over and things move toward chaos. Fund managers do not see the results of this chaos until the outputs (portfolio valuation, investor statements, and audit support) are delayed, inaccurate or simply cannot be produced. There are circumstances where manual work

cannot be avoided and having a quality staff with rounded experience in financial markets makes all the difference. These people drive the structure and execution of tasks necessary to complete the job and also formulate the plan to automate for the future. If administrators do not control and (are willing to) develop the systems used to do the work, however manual effort becomes the culture and all involved suffer. Understanding the development cycles of administrators’ systems has thus become a key point when managers choose a provider. Administrators are also perfectly situated to provide services beyond accounting and investor servicing. Acting as a true partner of their fund manager clients, it is important to offer dedicated services to assist CCO’s and CFO’s with compliance oversight as well as the preparation of GAAP schedules and hands on support to streamline the audit process. These complimentary services also provide value internally to the administrator by continually refining internal processes and procedures along side their clients. The fund administration business has grown significantly in the last 5 years and firms that situate themselves with appropriate systems, people and complimentary services are poised for better relationships with their clients and achieving lasting success in an ever-evolving industry. Robert Goldbaum, Spectrum Global Fund Administration
Prior to joining Spectrum Global Fund Administration, Mr Goldbaum was VP of SS&C Technologies after the acquisition of Financial Interactive Inc., (FundRunner) a firm he co-founded. Before FundRunner, he was COO of KSP Capital Management, and was the Operations Manager at Robertson Stephens Investment Management and Secretary of their public investment trust.

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Hedge Fund Services Market Guide

StateStreet
As hedge fund managers continue to expand into new markets with new products and strategies, how will administrators ensure the continued delivery of consistent service quality?
International Fund
Services (IFS), State Street’s hedge fund administration subsidiary, combines a proven service model focused on creating “centers of excellence” with scalable technology and decades of industry expertise to deliver consistently high quality administration services. its global locations, IFS is well positioned to ensure that a customer investing in Toronto will have access to the same high-quality services as a customer investing in Paris or Tokyo. Proprietary systems enable IFS to create flexible; customised solutions on behalf of each customer. Clients benefit from many unique product offerings, including market-leading accounting platform, specialised middle-office services (with particular expertise in pricing OTC derivatives) and front-office services including two complementary risk management solutions – one to measure market risk and the other to evaluate portfolio risk via data management, analysis, portfolio construction and reporting tools. Because the risk management platform is linked to our accounting platform, risk management customers benefit from unparalleled data integrity, analytical sophistication, reporting flexibility and customer support. Customers also benefit from our continual investment in technology to augment and refine our servicing platforms. Between 20 and 25 percent of IFS and State Street’s annual operating budget is allocated to IT development and more than 15 per cent of IFS employees are dedicated to information technology – a clear advantage in ensuring that our customers stay ahead of the technology curve. Gary Enos, executive Vice President and head of Offshore and Alternative Investment Services and Credit Services, State Street Corporation.
Enos joined State Street in 1985 from KPMG Peat Marwick and has held numerous management positions focused on supporting State Street’s global business growth. In 2001 he was selected to direct State Street’s entry into the alternative investment servicing arena. Enos led the successful effort to purchase International Fund Services (IFS), a leading provider of administrative services to the hedge fund community, in July of 2002. He also oversees the company’s risk management and credit services, which focus on risk accountability and liquidity lending for State Street’s Investor Services business globally.

Centers of Excellence IFS’s approach to meeting the needs of hedge fund investors focuses on establishing centers of excellence that ensure high and consistent service quality among each operation. In the past, serving our customers in multiple time zones meant simply taking advantage of the time difference between Europe and North America. Today, as hedge fund servicing demands have increased, it means developing a scalable service model that we can adapt to any of our operations, regardless of where hedge funds are distributing their products and where their investors are located. IFS has built upon this approach in Ireland by adding operations in Drogheda and Naas in addition to its Dublin office. This has enabled IFS to leverage geographic proximity – as well as the exceptional accounting and risk management expertise of the local labor markets – to ensure consistency and excellence in all three locations. We will also look to follow this same model in North America. Technology Complements Service Technology is another critical component of IFS’ hedge fund administration service model. The ability to deliver a consistent level of service in markets around the world depends in large part on having proprietary systems and a single technology platform. Because the same technology is offered in all of

Gary Enos StateStreet

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 35

Hedge Fund STATISTICAL ANALYSIS

Developing Data

The hedge fund industry is performing positively, according to research from Hedge Fund Research Incorporated. ISJ presents the latest data.

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

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

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Hedge Fund Services Market Guide

3: Funds of Hedge Funds Indices The big winner in August was the HFRI Fund Strategic Index with 0.51 rate of return over July. The Strategic funds are funds that seek superior returns by primarily investing in funds that engage in opportunistic methods, e.g. emerging markets, sector specific, and equity hedge. The funds are more volatile yet tend to perform well in up markets; in juxtaposition with the short selling index this highlights the upward trend in the market. However the big loser was the Market Defensive Index. This links with the fall shown in the HFRI Short Selling Index (Graph 1). The market defensive index shows Funds of Funds that generally engage in short-biased strategies such as short selling and managed futures. As the market is on a somewhat upward trend, the Market Defensive Index tends to show lower returns. The Bigger Picture Looking back at the past few years, the Rate of Return has stayed high, but as mentioned the HFRI Short Selling Index has shown a loss over three years. The HFRI Equity Non-Hedge Index has shown one of the highest Rate of Return with 13.39 Trailing Three Years. Nonhedge funds do not always have a hedge in place and are predominantly long equities. The highest Rate of Return comes from the Emerging Markets. Investments are primarily long and include markets in Latin America, Eastern Europe, the former Soviet Union and parts of Asia. Global funds become like hot money, moving around according to regional market conditions.

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 37

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

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

urich, Phone +41 (0)44 218 14 14 www.ifbs.com [email protected]

Company Article IFBS

Super Models
How the future of Securities Lending impacts on technology.

tion it depends on which perspective you look. One can make a general distinction between the end-user, principal intermediaries including universal bank, and the agency custodial lenders. The End-user The end-user such as hedge funds require more transparency regarding market supply and prices and would like to cut out the intermediary dealing directly with beneficial owners. However, the beneficial owner may not have the skills, the processes in place and the risk appetite to deal with end-users and will therefore still have to depend on an intermediary. Still the pressure by the end-user will lead to decreasing spreads for intermediaries and the requirement to improve the overall service level and the need to get more volume to make up for smaller profit margins. Investment and Universal Banks Investment Bank and Universal banks can also be endusers or act as principal intermediaries. One of the key challenges for these institutions is to integrate its securities finance activities across product boundaries such as equity finance, fixed income repo and other collateral processes. This is to service external clients more effectively and to streamline its treasury funding and investment processes. Collateral is becoming increasingly a “currency”. Through the effective use of collateral the risk capital of the institution is used more efficiently. Furthermore a global collateral view will serve to reduce liquidity risk in any market or financial institution specific crisis. The Custodial Lenders Over the last few months there was a lot of discussion about the role of custodial lenders and the debate as to whether beneficial owners will increasingly use different distribution channels such as auction platforms and “exclusives”. I do believe that these alternative distribution channels may currently make sense for certain very large lenders. On the other hand, the custodial lenders will not lose any significant market share, as long as they keep on developing products and markets. With decreasing spreads the upside for a beneficial owner to go direct will narrow going forward. Furthermore, the complexity of Securities Lending is increasing. The global custodian, which is the process owner for position keeping and valuation, risk and collateral management, tax reporting etc., may seem the better choice from an operational risk standpoint. What we are also seeing is that the custodial lenders jointly together with the beneficial owner are working together with auction platforms, in order get the optimal deal for all parties involved. it is anticipated that global custodians being part of a large universal/wholesale bank, will also look at the principal side of the business. This may include the principal securities lending offering to beneficial owners and a closer internal cooperation with the treasury and clearing function of the bank.

Felix Oegerli

As a leading vendor of technology solutions we have to
think broadly about the future of the market in which we sell software solutions technology. This is important in order to assure that our technology solution meets future market requirements and demand. Since the market will continue to evolve over time, we are not going to see dramatic shifts in business models and processes overnight. Keeping this in mind when referring to the future, I am addressing the period between 2010 and 2015. Market Demand and Pricing Further strong growth of the business in terms of volumes, but further market consolidation in terms of active participants, can be anticipated. The demand and spreads for dividend enhancement transactions will decrease and eventually be very minimal over time due to cross border double-taxation, harmonisation and antiavoidance rules regarding the use of tax credits. Demand in other specials will increase further due to increased growth of derivatives and hedge fund investment strategies. Furthermore, it is safe to predict a strong growth of more complex securities lending and funding structures and increased activities in Asia, Eastern Europe and Central/South America. Collateral trading will become more of a core treasury activity for many financial institutions acting as principal. Spreads for GC versus GC trading/collateral trading will increase due to the higher cost of capital implied by Basel II. The GC versus GC curves will become more transparent using the respective repo cash benchmark curves. Business Models and Distribution The critical mass to run a highly profitable securities finance business has increased over the years. In the future you will be required to have a large diversified lending pool of over hundred billion US Dollars or a large captive demand. This would be either in-house or from hedge funds, through the prime brokerage product. Talking about the future business model and distribu-

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Hedge Fund Services Market Guide
Distribution channels Further standardisation and commoditization of the business will force market participants to manage the business over processes and IT because volume insensitivity and low unit cost is going to be critical in the future. This is why electronic trading platforms are gaining in imporchanges. Multiple departments have to be coordinated, which is also slow and costly. Future The requirements incumbent on technology to support the future securities finance business model are substantially higher than traditional product silo or transaction processing systems. The challenge is to provide a consolidated view on a broad variety of products and processes while supporting a high volume of transactions throughout their life-cycle. In order to achieve this goal, a system architecture would ideally be service oriented (SOA). Service-based architectures will also provide the way to integrate systems across the company and Internet based network, mainly by using Web Services. Transaction processing services for settlement, audit trail, accounting etc. should be loosely coupled, using message-oriented middleware as the separation layer. Most importantly, real-time information has become a necessity. In cross-product systems, multiple users with different business intentions may use the same positions. Only real-time updates on positions, preferably on a ‘push’ basis, meaning the user does not have to actively query the system, will prevent the overuse of positions or not actively funding or selling positions. Counterparty and trading positions must be kept and updated real-time for risk management purposes. Real-time profit & loss figures will provide the required information to automatically optimise the book and close out unprofitable transactions or to replace with cheaper sources. On a mandatory basis, the data model of such an application must be designed for maximum flexibility from the beginning. All existing, but also new, trade types must be supported. This includes single security, security vs. cash and even security versus security transactions. All future flows of financial instruments must be presented as cash flows, which will allow for Cash-for-difference and Total-Return-Swap transactions but also for other future transaction types. To conclude, technology has to cover different business models, be flexible to incorporate changes, scalable regarding functional extensions, high-performance and last but not least, low cost. Felix Oegerli, CEO, IFBS
Felix Oegerli was born in Solothurn, Switzerland. He obtained a post graduate degree as a Swiss Federal Banking expert. He began his financial services career with UBS, assuming a variety of roles in Zurich, New York and London, including: Global head of prime brokerage and Deputy global head of securities lending and repo. Oegerli is Founder and CEO of IFBS, a consulting and solutions firm for the financial industry.

“The complexity of Securities Lending is increasing”
tance. I estimate that in 5-10 years well over 50% of the market value volume will be traded electronically. Business Concentration In the long term future, the securities finance business will be as commoditised as the foreign exchange business is today. This may mean that a few very large players make up the majority of the business flow. However, concentration in the securities finance and collateral market may amplify the dynamics that collateral can create or contribute to turbulent markets. A market crisis and a specific crisis at one of the few major players might put substantial pressures on the markets for securities used as collateral. Securities Finance including collateral management is absolutely crucial for an efficient capital market, but it also will elevate systemic risk exposure to the next level. This is why collateral risk management in stress testing scenarios will become as important as the asset and liability management function of a financial institution. Processes and technology Past and current: In the past, available technology mainly covered standard product centric functionality. Today, business vision and strategies are defined and aligned together with an understanding of the technology involved. IT follows strategy. However, IT enables new strategy. Depending on the business model and the size of an organisation, the securities lending business is more integrated into other business lines such as repo and OTC-derivatives and collateral management. This is either in the form of integrated processes or even combined organisations. One of the key success factors for a successful integration of the business lines is a horizontal position-focused IT platform. However, typically there is no single IT platform supporting this business model. A variety of vendor systems are being used, mostly for the books and records. Very often, in-house functional add-ons or additional data collection are developed to at least partly fulfil the business requirements for a consolidated view on the positions and transactions. Consequently, a large number of heterogeneous systems and interfaces must be supported and reconciled, leading to enormous maintenance costs and the risk of poor data quality. As the IT structure typically mirrors the business structure, there is often no single point of responsibility for

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 41

Outsourcing - TELEKURS

Administration Challenge
Outsourcing has been likened to “the beginning of the Finance Industry’s industrial revolution”. This refers to the search for a reliable partner who has standardised processRichard Newbury es which can be applied on an industrial scale to produce similar results for a similar dataset. Fund of (investment) Funds administration can be outsourced to a degree. Some data vendors are now able to offer bespoke data collection and management activities on an outsourced basis. How hard can it be to find a similar service for Funds of Hedge Funds? There is a one word answer: “Very”. Boutique type companies have been established which cover part of the market, but it is difficult to gauge the breadth of the data coverage of these firms or how industrial their processes may be. To find a more valuable answer requires that we look at the issues the administrator of a fund of hedge funds may face. Firstly, for open ended investment funds, investors can buy into the fund at a stated price at any time, indeed if there are no available units, the fund promoter can create new units to sell. The price paid by the investor reflects the dilutive effect that their purchase will have on the overall value of the fund. Buying into a hedge fund, is less simple. Either an institutional investor or a High Net Worth individual investing in a hedge fund will typically make a large investment and may get special terms. This means that any administrator can only provide client data if they have access to statement information. The first issue that outsourcing of client level data raises is that of confidentiality – both of the fund and of the investor. How does a data vendor deal with this concern? Well, a data vendor’s traditional role has been to take in as much data as possible and to resell it as many times as possible to interested parties. However, many contributors and

exchanges do not permit all clients to see their data without licence fees being levied, so systems to restrict certain exchange level data have been put into place. Restricting whole tranches of data though would require a new approach from data vendors as to how client level information is dealt with. Yet, it is not impossible to envisage how such an infrastructure could work. For example, closed user groups could be built, even using distinct networks. As data vendors look to provide ever more value added services, bulk processing of confidential information will allow hedge fund operators to be able to rely on both the reliability of the data vendor, through its size, and the confidential way in which data is handled, because of the vendors’ expertise. A further item for consideration: once the infrastructure has been built, will a hedge fund manager or even the hedge fund client be happy enough to have their confidential information shared with a further third party? Of course expansion means greater access to data for entities that would not normally have access to this data. Off shoring, for example, now has India’s NASSCOM and the UK’s FSA looking into the illegal sale of client information in India. It is clear that to gain the trust of hedge fund operators and clients, numerous failsafe systems would need to be implemented with strict controls over access to data. One of the ways of assuring confidentiality would be for a hedge fund administrator to issue only an external client identifier to the data vendor and for the hedge fund manager to use the same code when communicating externally. The external identifier could then be mapped back to a single client, or to a group of clients with the same terms, without the data vendor ever knowing the whole chain. So, given the will of a data vendor to build the infrastructure and make the requisite investment and the desire of the fund administrator to outsource this arduous task to someone whose core business it is to collect data, why is outsourcing so difficult? As in many areas of data management, the questions of standards (there are no hedge fund ISINs for example), the will of issuers (are administration issues even on the hedge fund managers’ radar?) and knowledge in the market place all conspire to slow down the inevitable trend toward outsourcing. Another one may be of service expectation. High Net Worth individuals rightly require care

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Hedge Fund Services Market Guide
and attention to their portfolios. The hedge fund manager might not feel that their administrator outsourcing their responsibility is the best way to provide the required level of service. Things are changing though. A new report from Bank of New York et al. claims that there is to be a 60 per cent increase in investment from institutional investors. With margins being squeezed, talented administrators who understand hedge funds being hard to find and the requirements of auditors and institutional investors for transparency and low cost administration, outsourcing activities or parts of administration activities makes perfect sense, providing that the client confidentiality issues to allow them to make the required returns and to concentrate on their business. Data vendors are specialists in obtaining data and tied to the capacity for innovative solutions can look forward to working with hedge fund managers and administrators to assist them in their next phase of growth. The hedge fund industry has exploded since the mid-1990s and is now worth almost ¤1.2 trillion, with over one third of these funds, worth ¤400 billion, serviced by fund administrators in Ireland. Hedge funds account for more than 2,000 of the 8,500 people who work in the fund management industry in Ireland. Data vendors’ own research shows that local support is vital and numerous vendors have offices giving various degrees of support in Dublin. This is important for the support of the hedge funds business in Ireland as recent statistics show that around: • 57% of European Hedge Funds are administered in Ireland • 3027 alternative investment entities are domiciled in Ireland • 62% of which are hedge funds and • 31% of which are funds of hedge funds The market grew (number of funds) on average by 41 per cent per annum between 20022005 So data vendors are developing both the technical solutions and the physical presence needed to provide support to new hedge fund clients in Ireland, or wherever they may be based. Some vendors are also developing tools which allow their clients to scour their client database automatically to find Politically Exposed Persons and to verify the identity of their clients at the point that the relationship starts. This will help hedge funds with ‘Know Your Customer’ regulations which are now being imposed on them around the globe. So outsourcing is still in its infancy where hedge funds are concerned. Cost, regulation and commercial pressure will undoubtedly come to bear over the coming years and will bring about many more outsourcing opportunities for hedge fund administrators. Data vendors are making the required investment now and are ready for the challenge. Richard Newbury, Head of Product Services Telekurs (U.K.) Ltd.
Mr. Newbury joined Telekurs Financial's UK subsidiary as Head of Product Services in June 2004. His primary focus is the development of customised solutions for clients as well as leading Telekurs Financial’s (UK) involvement in a wide range of industry initiatives such as MiFID and EUSD.

A large part of any back office data vendor’s existing business lies in helping fund managers to value their funds
can be overcome. How else can traditional data vendors help hedge fund managers or investors in this environment? Data Vendors are experienced entities who are keenly aware of the service levels that will be demanded by hedge fund managers and administrators. A large part of any back office data vendor’s existing business lies in helping fund managers to value their funds. Depending on the breadth and depth of the company’s coverage often existing mechanisms can be used to provide hedge fund managers with the information that they need to provide the transparency that regulators are looking to achieve. In response to regulation such as UCITS III and Basel II, data vendors are devising ways in which clients can build groups of companies in their own systems to ease credit risk management. More and more regulation is expected in the hedge fund industry and with potentially more money being invested in funds, greater transparency is another thing that hedge fund managers can expect to have to provide. Such company hierarchies will become invaluable to hedge fund managers, in the same way that other risk managers are discovering now. The need for high quality data to meet the regulatory requirements will become important to hedge funds as it has to more traditional fund companies. Innovative solutions – including partial outsourcing - will be needed to help hedge funds keep costs down whilst continuing

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 43

Fund Administration Service - UBS

One on One
Hedge funds continue to become more complex, whether through strategy, investment valuation or legal structure. Under these increasing complexities, it is valuable for investors and managers to be able to work with a single contact who knows and understands all aspects and features of each Colleen Montain fund. UBS takes a unique approach to providing hedge fund administration services through a ‘single point of contact’ model. While some in the industry have shifted to automated telephone call centres, touch tone selection menus and general delivery e-mail addresses, UBS has remained consistent in providing fund managers and investors alike with a ‘live’ person to speak to. This person is a qualified professional, responsible for all aspects of the fund service delivery from shareholder trades, to calculation of NAV, banking transactions and investor ‘Know Your Client’. By being a hands-on, professionally qualified accountant with responsibility for overseeing all aspects of the fund, this person can immediately answer questions that a client has, as well as being highly knowledgeable about the instruments being traded and the valuation methodologies used. The current trend, for many fund administrators, is the offshoring of a variety of components of the administration process. For example, shareholder services are going to the Caribbean, portfolio pricing to India, NAV computation is being kept onshore, and client relationship officers are in the local market. Without a single point of contact, it can become a very challenging model for fund managers to navigate, involving the need to contact several different offices to obtain answers to all questions. Hedge funds continue to operate in an environment of low regulation and managers can be unregulated depending on their jurisdiction. The fund administrator is in a good position to see a high level overview of the fund and have a detailed understanding of the portfolio and the

inherent valuation issues. Where a top tier administrator is engaged, strong control processes are in place that lend comfort to investors that a third party is reviewing the activities of the fund. The fund administration industry is also facing a human capital crisis and staff turnover is a chronic issue for most administrators. UBS's ability to consistently attract and retain staff is largely a function of the single point of contact service model. By hiring qualified professional accountants and providing a job environment where they have direct contact with the fund managers and shareholders, and responsibility for the fund relationship in its entirety, the business model provides professional challenge and results in retaining staff for years beyond that typical in the industry. Not only do clients talk directly to a fully informed person, they also build a relationship with this person over many years which enables service at a level not attainable were the environment is one of constant staff turnover. Additionally, as the fund grows in complexity, so does the contact's experience and knowledge of the fund. With a low staff turnover, knowledge is built and retained, which is beneficial to the fund relationship, thus providing investors with greater confidence. As fund products develop, so UBS is keeping up the ability to price new and unusual instruments, and evolve in line with the complexity that hedge funds offer. Any administrator operating at the top-tier level is required to continuously invest in supporting and evolving the global business year on year. Tech-nology needs to be flexible, robust and able to support the varying needs of clients and UBS is committed to making the necessary investment to remain at the forefront of technological development. Being organised and able to focus on each client’s needs is fundamental to business success. As the hedge fund industry continues to develop and grow, opportunities for administrators to support and grow with it will continue apace. Colleen Montain, CFA Head of Business Development/Client Relationships, Hedge Funds Executive Director
Colleen Montain has global responsibility for business development and client relationships for Hedge Fund Services. She is also responsible for the oversight and management of shareholder services for Fund Services in the Americas and is a member of the Fund Services Management Board.

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Canadian Hedge Funds

Jim McGovern

Gordon Cheeseborough David Fawcett

Gary Selke

Don Short

THE CANADIAN HEDGE FUNDS

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

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 45

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

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Hedge Fund Services Market Guide
and demand. While we may enter 2007 with weaker oil and gas fundamentals we will exit the year in a much stronger fundamental position. Cheeseborough: As mentioned in the previous question, many Canadian hedge funds tend to be resource-focused, particularly oil and gasthe Canadian credit and provincial markets and with very little resource exposure. The Canadian fixed income market has experienced significant growth in issuance over the past couple years due to an increasingly diverse group of issuers in Canada, including many foreign “Maple” issuers. This added diversity and liquidity in the fixed income market has led to a growing list of arbitrage opportunities. Short: Our firm focuses exclusively on opportunities in the energy sector, so commenting on opportunities in addition to the resource sector is outside our area of expertise. There are some very good reasons for investors to look at Canadian hedge funds as an option for resource based investment. For example, we believe that the concentration of oil and gas companies in Calgary has resulted in a globally competitive energy industry and that being located in Calgary, within blocks of the head offices of these companies is a source of competitive advantage for a fund manager based in Canada. Fawcett: Canada does offer other opportunities beside the resource sector. Take for instance the Income Trust sector. This is a USD250 bn market capitalization sector. Companies typically do not pay income tax and pay monthly cash distributions. The monthly distribution attracts a high retail component and thus creates a more inefficient sector. We believe fundamental research can generate excess profits in this area. Another theme is growth companies in Canada. Canadian company’s often grow to be the dominant player in Canada and are then consolidated by international firms. Research in Motion has over a $20 billion market capitalization. It is a Canadian company that develops and manufactures a product in Canada that has been able to grow market share against the likes of Motorola, Nokia and Palm. The number of hedge funds in Canada continues to grow at a noticeable rate. What strategies will Canadian hedge funds use to differentiate themselves? Fawcett: We believe fund managers will differentiate with sector specific strategies. Resource and Energy only funds are likely to gain in popularity. McGovern: The number of funds and size of the hedge fund industry continues to grow in

Many Canadian hedge funds are focused on resource companies
focused. Many of these funds are long only and focus on small cap companies. If you believe that the bull market in oil and commodities (especially the metals) will continue, these hedge funds will continue to out-perform. While many foreign investors regard Canadian Hedge funds as resource centric for their portfolios, comment on the Canadian market and opportunities in addition to the resource sector? Selke: Clearly the Canadian market is dominated by resource opportunities, however there are a number of special situation opportunities both long and short, which can provide opportunities to generate alpha for their relevant portfolios. Experienced Canadian managers providing advice to hedge funds is one way to take advantage of some of these non-resource opportunities. In addition, the Canadian capital markets are underresearched relative to larger world markets and for those managers and funds that are aware and nimble their funds can take advantage of these market inefficiencies. McGovern: Resources currently make up 40 per cent of the market cap of the TSX (Toronto Stock Exchange) indicating a wide range of other sectors and sub sectors to potentially exploit. In particular, income trusts where many retail investors have “stretched” quality for yield appears poised for consolidation. High yield, convertible and sub prime mortgage issuance has been steadily growing but is not well followed or researched allowing for arbitrage opportunities. Additionally, there are a growing number of activist funds on offer in Canada. Cheeseborough: Blair Franklin Capital Partners runs a hedge fund focused on opportunities in the fixed income market, investing primarily in

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PANEL Hedge Fund Manager Debate
Canada. Current estimates have the industry at over USD30 bn in aggregate. The fastest growing segment has been in the single manager category as existing firms have grown rapidly and new entrants have emerged. Canadian managers will differentiate themselves in a number of ways relative to their U.S. counterparts. The ket has proven beneficial. As well, in many cases, Canadian based hedge funds are in closer contact with and have greater exposure to management of Canadian companies, particularly micro and small cap stocks. Additionally, many fixed income credits do not issue into foreign markets and the bonds are not available to be purchased by foreign investors, so opportunities for foreign hedge funds to invest in Canadian securities are limited. What are the main challenges faced in starting a hedge fund in Canada? Fawcett: Oddly enough one of the main challenges is that Canadian institutional investors have not yet widely supported Canadian hedge funds. Therefore, it takes more time and money to either attract high net worth clients domestically or offshore investors as a start-up firm. Short: The biggest challenge to starting a hedge fund in Canada or any other part of the world is gaining the initial critical mass of sponsors and investment capital required to take the first step. The other aspects (regulatory, legal, operations, relationships with service providers) are daunting when viewed as a whole, but can be accomplished with time and persistence. McGovern: The main challenges in starting a hedge fund in Canada is the initial or seed capital. The broader institutional marketplace in Canada has been slow to embrace hedge funds and the large plan sponsors, while committed to hedge funds, have focussed on more globally oriented hedge fund managers. While incubators such as JP Morgan and others have found success in Canada, there remains a void in terms of start-up funding. The local prime brokers (Canadian bank subsidiaries) have become much more sophisticated in terms of the package of services they provide, but they have only started this year to focus on capital introduction globally. This leaves the high net worth market as the market that domestic managers initially focus upon. Cheeseborough: The Canadian investor is not as educated about hedge funds as investors are in U.K. or the U.S. Also, administration and regulation issues arise as they do elsewhere. Selke: There is no shortage in intellectual capital and there is no shortage of investment opportu-

Differentiation in the Canadian market requires niche strategies
relative small number of funds and assets relative to the size of the Canadian capital markets; niche strategies focused on resources, income trusts, high yield, convertibles, risk arbitrage that do not make it to the radar screens of large U.S. hedge funds; and finally, there is a tremendous pool of talented managers and traders with availability of capacity. These are all differentiating features in Canada. Selke: Canadian hedge fund managers are challenged in terms of their ability to grow their businesses to world scale levels. It is difficult to differentiate one self in a market that is essentially dominated by large cap financials, oil and gas and mining (70%+). Differentiation in the Canadian market requires niche strategies, which are often not scalable. Although the number of hedge funds is increasing in Canada, the ability to grow will continue to be the most significant challenge for Canadian hedge fund managers. Short: Many of the traditional hedge fund strategies (event driven, merger arbitrage, convertible arbitrage) can become crowded rather quickly, particularly in a relatively small market such as Canada. As a result I think future growth will focus more on the equity long/short and market neutral categories in areas where there are market inefficiencies such as small cap stocks, special situations or private equities. These funds will either need to push further into areas dominated by conventional funds and become more widely accepted by the investing public or carve new territory in non-traditional investment areas. Cheeseborough: Our hedge fund (the Blair Franklin MultiStrategy Fund) focuses on opportunities in the Canadian fixed income market, an area we believe is underserved. Significant trading experience in the Canadian fixed income mar-

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Hedge Fund Services Market Guide
nity in Canada. There is, however, a shortage of indigenous institutional capital to support a world scale business. Consequently, in order for hedge fund firms to grow they must choose either a) a Canadian retail-oriented growth strategy or b) market themselves outside the country to non-resident institutions. In order to attract eign competitors. This will surely change as the hedge fund industry continues to expand in Canada. Selke: Hedge funds receive high levels of service from domestic prime brokers, administrators and the local legal and accounting community in Canada. There are a number of options for prime brokerage, custody, administration, accounting and legal support in Canada available to hedge fund managers. Moreover, these service providers are well qualified both intellectually and financially to advise and service Canadian hedge funds. In addition, there is a high level of skilled personnel in the financial community capable of serving domestic as well as non-resident hedge funds, should they wish to operate in the Canadian market. Fawcett: Presently the services provided are fine. We would like to see the level of legal support improve and more competition evolve although we expect it will. Is the Canadian Hedge Fund industry sufficiently regulated? Cheeseborough: Yes. McGovern: The Canadian hedge fund industry is sufficiently regulated. Canadian hedge fund managers must be registered with the provincial securities commission in which they reside. Registrants must pass certain proficiency and working capital requirements in order to manage public money. Selke: Canadian regulatory rules require high levels of standards to be met before a fund/manager/advisor can hold themselves out as providing investment advisory services to the public. Both firms and individuals must be registered with the appropriate provincial security regulators (which registration must be maintained and updated annually in most cases) and, in order to achieve registration in the first instance must have demonstrated high levels of skill, experience and proficiency. In addition, there are significant on-going regulatory reporting requirements at fund, manager and marketing levels to protect the investor and the reputation of the industry generally. Fawcett: We believe the industry is sufficiently

The difficulty in Canada is that there are proportionally few accredited investors relative to the United States
the latter class of clients, one must have a scalable strategy and sufficient infrastructure to support the high levels of service that non-resident institutional investors demand and expect. Most firms are challenged to reach the necessary scale where they can deliver the required level of service. As a result, the hedge fund environment in Canada is characterized by 2 larger single manager funds, 2 mid-size, and a significant number of small and micro-sized hedge funds. How would you describe the standard of services available for hedge funds from administrators, legal support and prime brokers? Short: The standard of services available to hedge funds from the service community is very high. This high level of service and support reduces many operational and governance related risks and increases the overall quality of the product provided to investors. The availability of quality third party service providers allows fund managers to concentrate on managing money and outsource some non-core activities. McGovern: The standard of hedge fund service providers in Canada is first rate. The firms involved in legal, accounting and tax, shareholder services and valuation having the necessary local and international expertise to facilitate any hedge fund manager requirements. The market for these services, including prime brokerage is very competitive. Cheeseborough: Considering there are significantly fewer Canadian hedge funds and that the industry is less developed than in the UK or the US, it is not surprising that the services available to hedge funds have also lagged behind their for-

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PANEL Hedge Fund Manager Debate
regulated. All hedge funds must register with provincial security regulatory bodies and are subject to periodic reviews. Short: Yes, our provincial regulators do a good job of ensuring that fund managers meet the basic requirements necessary to successfully have become increasingly sophisticated. The ability to quantify risk in multi-manager/multi strategy portfolios through such tools as VAR analysis and scenario testing is very impressive. For our purposes the most suitable risk management policies and procedures actually involve going back to the basics. This involves monitoring the appropriate use of leverage, establishing position limits and ensuring reasonable diversification, properly matching the liquidity requirements of your investments and investors and ensuring proper governance. One approach to risk management does not apply in all situations and the proper matching of your risk management policies to your investment strategy and corporate structure is an important consideration. Selke: Generally speaking, risk management is quite strong within the Canadian environment and it is clear that additional regulatory requirements are being imposed on the investment industry ensure that investors continue to be protected. However, despite the regulatory infrastructure and trend towards increasing risk management, breakdowns in the system can happen. The recent example of Amaranth is evidence that when humans intervene to ignore or abdicate their responsibilities, problems can and will occur. The issues surrounding Portus and Northshield were not investment or hedge fund issues but rather more fundamental breeches of the securities laws, specifically, selling product without proper disclosure or a mismatch in the redemption schedule relative to the underlying investment strategy. Accordingly, although there is a regulatory framework requiring risk management practices of fund managers, which framework is evolving and expanding daily, there is nothing like a good dose of common sense (including understanding the consequences of not complying with laws, etc.) to help managers and investors assess the degree of risk in their strategies. McGovern: A competitive market for hedge funds will demand excellence in risk management. The level and type of disclosure will be key to allowing investors to measure and manage risk according to their requirements. The key metrics in our opinion, are the level of leverage employed (if any) and liquidity of the underlying investments compared to capital employed. The reporting timelines to investors will be clearly very important given the aftermath of Amaranth. HFSMG

In the wake of several headline grabbing hedge fund blow-ups, investors will likely demand rigorous risk management
operate a hedge fund. However, regulation is only one part of the equation. The involvement of independent service organizations such as fund administrators, prime brokers and self regulating bodies are at least as important as regulators in reducing the potential risk of investing in the hedge fund industry. Investor education and the ability to properly evaluate and understand the risks involved in a potential investment and the right questions to ask a fund manager is another important component. Investors continue to demand suitable risk management policies and procedures. As scrutiny increases, how will risk management practices continue to evolve? Fawcett: We believe investors will continue to request additional details on risk management policies and procedures. At Epic Capital, we see this as an opportunity to provide investors with additional details on our risk management practices including highlights on our portfolio construction limits, current positioning and ongoing risk control processes. Cheeseborough: Hedge funds will have to become more proactive and actively work to distinguish their risk management practices from firms with less extensive practices. In the wake of several headline grabbing hedge fund blow-ups, investors will likely demand rigorous risk management, possibly including third party mid and back-office services and risk measurement calculations (such as VAR) performed by independent third parties. Short: Risk management systems and practices

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Alogorithmic Trading REUTERS

Touching Technology
The phenomenal growth of hedge funds over the past decade has driven rapid developments in trading technology. High volume strategies pioneered by hedge funds have been instrumental in pushing technology vendors to deliver high volume, high speed straight through processing, Kirsti Suutari to the point where those leading the field now measure latency in microseconds rather than milliseconds. But whilst some large hedge fund managers have built significant technology and trading infrastructures over time, what options are there for smaller hedge funds that do not have the capacity to employ large IT teams but who still wish to implement automated trading strategies to maintain an edge in this highly competitive market? It’s difficult to pick up a trade publication these days without running into some reference to programme or algorithmic trading. One might interpret from the buzz that the practice is therefore ubiquitous, well understood and broadly applied. There is a plethora of suppliers hawking wares all claiming to serve the needs of programme trading. Where to start? How to establish the shopping list of component parts to make it all come together? And how to accomplish this without the army of technology gurus that their prop trading broker associates may employ? First, it’s worth noting there is more than one way to trade programmatically. It simply depends on your goals. If all you want is efficient execution (best for infrequent trading and reducing the market impact inherent in moving large positions), then hedge funds should talk to their broker about the structured algorithms they make available. Certainly the commissions are lower than full-touch trading, the results are reasonably consistent and established at the outset, and the hedge fund benefits from retaining greater anonymity and control. It is likely that at least one broker on the contact list offers algorithms for agency use, and all that will likely be needed to take advantage of their services is a standard vendor quote terminal.

On the other hand, if a hedge fund is seeking to automate opportunistic alpha generation, then a standard VWAP algorithm is not the answer. This will require a proprietary programme trading system, and as imposing as that might seem, starting out with a checklist can shorten the process and reduce the IT expenditure required to set up and operate. At a high level such a system needs technology to serve as the engine, and data to fuel its operation. As a hedge fund, let’s look at the factors you need to consider: Low latency streaming market data Regardless of the asset class you choose to trade, you will need real-time quotes to drive your trade decisions. If the market is highly liquid or fast, you will need to pay attention to latency measurements and the means by which they are measured. There is no point in making trade decisions on opportunities that have already expired by the time you act on them! If your data service is also managed on your behalf, you will have removed a significant IT headache; dealing with all the changes that the source exchanges create on a regular basis. If you are trading across multiple venues, it would also be helpful to know that the data outputs from your streaming data feeds are standardised. Tick history - A source of historical tick by tick trading data is essential for a number of purposes: researching your strategies, regression testing, and generating predictive analyses to run your models in production. It’s also helpful for analysing your trading success, and for compliance purposes. Pay attention to completeness and accuracy, and of course, you will want to have content for all the asset classes you wish to trade. Corporate actions and reference data - Without corporate actions data it will be difficult to explain certain price fluctuations, or to normalise data when required for predictive analyses, e.g., to accommodate the effect of a stock split on the price. And certainly you will want your models to be suitably informed as to the status of the issue, to protect you from perhaps acquiring a futures contract at the point of expiry. Now let’s look at technology: Rules or events processing engine - The core of the system is the application in which you build, test, and run your strategies. They come in all shapes and sizes, with varying levels of programming expertise required to operate them. Most, however, have user interfaces that are built for the purpose. Depending on their sophistication,

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Hedge Fund Services Market Guide
they may offer a standard set of models that you are at liberty to modify. They may also take on some of the execution readiness of the trading signals generated by your strategies. Your choice here will have much to do with your preferences for their features and functions. ures across elements that need to interact with each other in an efficient fashion. For example, historical data should fit easily in your data warehouse, and applying corporate actions to the raw data should be uncomplicated. High output from one component should not cause queuing in another. And a change to one component should have minimal impact on those with which it interfaces. To the extent that they natively plug and play together, your implementation, operation, and performance metrics will benefit. The ability to link to other services, such as risk management and post trade processing, will also move you a step closer to all the benefits of straight through processing. And if all this seems too much, there is also the final option of speaking to your broker. Some brokers offer white labelled services that permit you to create your own models and run them in your broker’s infrastructure. The benefits are obvious; you need only invest in the generation of the models themselves and not in the construction, operation and maintenance of the infrastructure to run them. You may not have the interfaces or features that you prefer, however the trade-offs can be worthwhile as you get used to operating in a fast frequency trading environment. All of the above ignores the creative brain power that will use these tools. But if you didn’t have that already, you wouldn’t be considering programme trading in the first place. Guard these resources carefully. An efficient programme trading facility will permit you to make the most of all of these resources to the ultimate benefit of your bottom line. Armed with this check list, you improve the potential to shorten your implementation cycle and reduce your initial and ongoing IT requirements. You needn’t be big to be smart; with an efficient programme trading system, you can focus on your investments, not on your systems, and still sleep at night. Kirsti Suutari, Global Business Manager, Algorithmic Trading, Reuters
Kirsti Suutari has worked in the financial services industry for 27 years with extensive experience in trading, equity, derivatives, and market data. Her current role within Reuters is Global Business Manager for Reuters Algorithmic Trading. Suutari is responsible for the development and packaging of Reuters products for use by customers engaging in algorithmic trading. Prior to joining Reuters, Suutari held roles in product management with The Financial Post Data Group and in consultancy with Interactive Data Corporation.

There is no point in making trade decisions on opportunities that have already expired by the time you act on them
Data warehouse - Efficient execution models will need a local source of historical data to generate predictive analyses that serve as the basis for their trading decisions. The ease of storage and ease and speed of access will be essential in choosing your offering. Streaming analytics engine - If your strategy requires inputs that require a level of calculation such as greeks, index values, yield curves, moving averages or volatility measurements, consider a streaming analytics calculator/publisher to do the leg work. Certainly your events processing engine will appreciate the ready-to-use supply of these values, and can concentrate on what it does best which is to run the strategy. Assuming these two work well together, your system’s performance will benefit. And if your model also needs analytical calculations on historical values, then look for an analytics engine that works equally well on stored data as it does on streaming values. Order execution system - Once the trade signals have been generated by your model, it’s time to get the order to market. Ideally this would be done using a Direct Market Access (DMA) platform with some form of application interface that will receive the trade signal and route it into the market, a number of which are provided by brokers. If not provided by your broker, check with your quote terminal vendors, as DMA order types are increasingly in demand and may be available as part of their offering. Certainly you can use traditional methodologies to send your trade signal to your broker, however time-sensitive opportunities will not be served by this methodology. Integration - As anyone that has ever put together flat pack furniture knows, once you have chosen the component parts the key is putting it all together correctly. The performance of any given element can very easily be overcome by fail-

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Risk Roles - RISK CONTROL

Risk Officer Changing Role

This makes the risk officer’s job difficult. Just as you get everything nicely organized, the front office innovates and creates a new instrument that you do not have a method to control. There are risk managers that view innovation as a problem that must be stopped. This is the same innovation that drives the profit at your firm. It cannot be stopped and the rate of innovation will only increase.

The innovation in financial products that increases profit also makes the carefully constructed risk rules obsolete
John Lewis

With the recent nine sigma events that brought about the demise of several hedge funds, the importance of risk managers has received a three sigma event increase. It is questionable if risk metrics would have made much difference at Amaranth. The concentration in one asset was evident without using sophisticated mathematics. However, losses of this magnitude drive the selection of any and all techniques that can help prevent any repeat of these results. Senior management at our clients are much more receptive to the comments from their risk managers. They get a fair and complete review of their points rather than a perfunctory managed by the trading staff. Not only are buy side firms hiring risk management staff – they are listening to them. Before we get too carried away with jubilation for the rise of risk control, we should state that this is an event triggered behavior pattern. The question is whether it will persist past a few weeks of newspaper headlines. If a pattern of greater risk management does persist, I am betting on the front office staff to figure out a way around the metrics that were created to prevent another Amaranth wilt. The easy way for front office staff to get around any set of controls is innovation. The innovation in financial products that increases profit also makes the carefully constructed risk rules obsolete. Human beings are very good at reverse engineering constraints and finding ways around them.

Instead of seeing the creative ability as a means to make rules obsolete, risk managers should look at it as a opportunity to innovate the risk control methods at the same rate. Risk management must change its view from that held in the savings and loan days to a cooperative venture with the developers of financial products. Risk officers must embrace innovation like the front office has done. If they do not, they will fail their organizations by not having an understanding of the instruments and the ability to prevent the risks like those that brought down Amaranth (It should be stated that several other hedge funds have closed in the past few weeks – so enough of picking on Amaranth). We do see the first evidence that the risk groups are embracing innovation. As senior management gives more credence to the opinions of the risk groups, the front office must enter a detailed debate with them. Instead of blanket statements, the front office are providing detailed papers explaining their position. We have helped several risk groups interpret those documents and prepare detailed responses. The risk groups are being pulled towards innovation because the trading groups are being pushed to provide positions that can be debated and examined in detail. Much of this debate centers on the fact that the risk groups want to use the existing frameworks that they have created in the past for other exposures. A new structured product often requires a new set of risk models. The use of a risk model from another exposure type as an approximate solution either under

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

John H. Lewis Jr. has worked in the software, analytics and fund management industries for 25 years and is a cofounder of Risk Control LTD. John is CEO of Risk Control and was previously CEO of Scrittura, a venture backed enterprise software firm serving the OTC derivatives market, until its sale. John holds a BA in computer science from the University of Georgia and an MS in financial economics from Boston University.

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GUIDE The Hedge Fund Guide
THE ALTERNATIVE INVESTMENT MANAGEMENT ASSOCIATION / ISJ HEDGE FUND INTRODUCTION...

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 significant 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 decimation 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 facilitated the development of sophisticated investment strategies without the need for backing by large investment houses1. In addition, the success of highprofile 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

Hedge Fund Guide

and conventional funds being massively invested in the bond markets, an unexpected 0.25% increase in US interest rates interpreted as signalling increasing inflation and therefore interest rates, rumours about the financial stability of a significant banking institution (Bankers Trust), a political assassination 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 concept had become a generally accepted means of managing the risks of investing in a single hedge fund. Both the amount invested in hedge funds and the number 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 Hedg ge Fund Industry Chicago-based Hedge Fund Research reports that the second quarter of 2006 saw $42 billion in asset inflows into the hedge fund industry, the largest quarterly amount since they began tracking the industry in the early ‘90’s. This increase brings their estimate of the hedge fund industries assets to $1.225 trillion. On strategies, HFR says equity hedge funds saw the largest quarterly increase at $13 billion, followed by an $8.4 billion increase by global macro and $4.8 billion by event driven. Fixed income arbitrage had the largest outflow at $164 million. Funds of funds (FoF) saw an inflow of $15.6 billion compared with a $6.4 billion increase in the first quarter of 2006. In the US, Hedge Fund Intelligence has estimated that the US hedge fund industry grew to $984 billion by mid 2006, a 32% jump from the same figure in 2005, as high net worth investors continue to demand hedge fund products. According to the Bank of New York, since 2004 US institutional investment, excluding banks, has more than doubled, from $66 billion to $136 billion with endowments and foundations taking the lions share. A similar picture exists in Europe where the hedge fund industry enjoyed dramatic growth in the first half of 2006, with total assets under management growing to over $400 billion, according to a survey of the industry by specialist hedge fund information provider EuroHedge, part of the HedgeFund Intelligence group. The growth in overall industry assets – to $401 billion at the end of June – represents an increase of 23% from $325 billion at the beginning of 2006 and of 44% since June 2005, when total assets were just $280 billion. The survey also showed the overwhelming dominance of London as the leading centre of the European hedge fund industry. Almost 80% of the assets managed in the European industry were run by UK-based firms as of June 2006 – up from 76% a year before. In addition to asset growth from performance and from new investor inflows, the industry’s overall growth continues to be supported by the record numbers of new hedge funds being

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launched in Europe. The EuroHedge fund survey, July 2006, showed that over 170 new European hedge funds launched in the first half of 2006 – raising combined assets of around $11.5 billion. In the Asia-Pacific region, the hedge fund market posted solid overall growth in assets of around 12% during the first half of 2006, according to the latest mid-year industry assets by AsiaHedge. Overall, Asia-Pacific hedge fund assets grew just over $13 billion during the first six months of 2006, bringing the total to about $128 billion – up from $115 billion at the beginning of the year. The steady growth over the past six months returns to the industry’s more normal pace of expansion after a period of explosively fast growth during the second half of 2005. In that period, assets grew by nearly $40 billion over the six months. 1.3 Who Invests in Hedge Funds? Historically high net worth individual investors, who desired and absolute return and a reduced level of risk have been the main investors into hedge funds. The landscape has changed with institutional investors, particularly, pension funds, increasing their allocation to hedge funds, as they seek out investments that offer low correlation to traditional portfolios of cash, bonds and equities. A survey by Mercers, October 2006, showed that 33% of institutional investors used FoF, while a further 19% expect to invest in FoF within the next two years. Of those institutional investors currently invested in FoHF, they have a 5% median allocation to hedge funds and this is predicted to rise to 7.8% in the next two years. Strong demand by investors for hedge funds has also drawn the attention of regulators world wide. In the US, the SEC are currently reassessing their regulatory regime after their registration was struck down by a Washington Court of Appeal decision. In Europe, the FSA continues to develop and effective ‘light touch’ approach that has resulted in London becoming the leading fund management centre in outside the US. Meanwhile the EC are issuing a White Paper in late 2006, to outline their views on pan-European investment regulation, including hedge funds. Regulators are aware that whilst the hedge fund industry requires regulation to protect investors, the regulation should not be too onerous and should encourage both buyers and sellers to benefit.
Comparing Traditional Investing to Hedge Fund Investing
Characteristic 1 Return Objective 2 Benchmark 3 Investment Strategies Traditional Investing 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 Hedge Fund Investing 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
Source: AIMA

2 WHAT ARE HEDGE FUNDS? 2.1 Hedge Funds Defined While there is no standard international definition of hedge funds, these investment structures typically display the following common characteristics: • The funds utilise some form of short asset exposures 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 associated 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 traditional sense varies markedly across managers. 2.2 Com mparing Hedge Fund Managers to Traditional Investment Managers Hedge fund managers differ from traditional active managers managing benchmark relative funds in a number of ways. The two most significant are the approaches to risk and return. 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 Ma anager Hedge Funds • Hedge funds are typically organised as limited partner-

4 Market Correlation 5 Performance

6 Fees

7 Manager’s Investment 8 Liquidity 9 Investment Size

10 Structure

11 Regulation

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ships, 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 performance above a certain level. • Typically, a proportion of the partner’s or principal’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.
Typical Structure of a Hedge Fund Offering
Source: AIMA

geographical location, industry sectors, or return drivers. 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 mispricing 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 relative value strategies include convertible arbitrage, fixedincome 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 combination of various instruments, and the parcel as a whole may have a different price than the sum of the component parts. If the price is different, there is an opportunity to buy (sell) the parcel and sell (buy) the various component parts to lock in a profit. Therefore the generation of “alpha” is independent from the general direction of markets. A typical investment 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 e 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 mortgagebacked securities market is complex, and primarily trades overthe-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.

Investor

Fund Administrator
Processes the subscriptions & redemptions. Calculates the value of investors’ holdings (NAV or partnership shares).

Hedge Fund

Custodian
Holds the fund’s assets. Monitors and controls thecapital flows to meet margin calls.

Prime Broker
Executes the transactions ordered by the fund manager.

Hedge Fund Manager
Sets and manages the fund’s investment strategy.

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). • 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. 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,

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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. 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. 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 subcategories 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 profitability 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
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.

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 Yi ield 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. Investors in distressed securities seek capital appreciation of the debt rather than an income stream. Performance depends on how well the managers analyse eventspecific 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 manager may use quantitative tools, however the final investment 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 expectation 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 riskreturn spectrum and try to distinguish their performance from that of the asset class as a whole. Returns will therefore deviate substantially from the underlying market return. Portfolios will also tend to be more concentrated than those of traditional longonly 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 capitalisation stocks. Managers may use futures and options to hedge. The focus may be regional, such as long/short US or

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European equity, or sector specific, such as long and short 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 allocating 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 strategies, with the manager often taking a top-down thematic approach and investing on an opportunistic basis, moving 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 opportunities identified. Most funds invest globally in both developed and emerging markets.
Strategies

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.

direction in market prices of currencies, commodities, 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 discretionary. Systematic traders tend to use price and market specific 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 positions and the managers are trend followers. They seek to 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.
High
Directional

Low
Non-directional

Market Exposure

1 Relative Value

2 Event . Driven

3 Opportunities

Convertible Arbitrage Fixed-Income Arbitrage

Merger (Risk) Distressed/High Arbitrage yield Securities

Equity Hedge (Long/Short) Global Macro

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 difference between trading is that the investment decision is not automated. The manager will make the final investment 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 market and the impact on the fund’s risk and Emerging Markets return. Fundsare generally constructed with specific targets and strategies, such that the investor knows to anticipate a certain risk/return profile. In general, 3.5 Emerging Markets the higher the degree of “directionality”, or investing in market Broadly defined, an emerging market is a country direction, the higher will be the potential return and volatility. making an effort to change and improve its economy with the For hedge funds with absolute return objectives, it is more goal of raising its performance to that of the world’s more meaningful to measure correlations and risk which evaluate both advanced nations. The World Bank classifies economies with a the upside and downside deviations relative to each fund’s speGross National Income per capita of $9,266 and above as highcific objective, than performance relative to an index or peer income countries. Emerging markets however are not necessarily group. The emerging markets strategy exhibits the greatest negasmall or poor. China, for example, is considered an emerging tive monthly return throughout the period. Not surprisingly, the market even though it has vast resources, has launched satellites smallest negative return for a month occurred within the equity into space and a population of more than a market neutral strategy that nullifies any market risk through billion people. The emerging markets strategy used by hedge holding a portfolio of overall equal long and short positions. funds involves equity or fixed income investing in emerging marWhile all strategies and equity market returns have delivered at kets around the world. Because many emerging markets do not least one negative monthly return during the period, the majority allow short selling, nor offer viable futures or other derivative of hedge fund strategies have delivered substantially smaller negproducts with which to hedge, emerging market investing often ative returns than traditional equity markets. It is important to employs a note here that while an absolute return objective implies a posilong-only strategy. As the currency of many emerging tive return over the long term, short-term volatility can result in markets cannot be hedged through the use of derivatives, an negative monthly returns for hedge fund strategies through the investment in an emerging market results in exposure to the market cycle. movements in currency of the underlying country. The risks associated with each strategy will depend on the type of strategy and the degree to which it is exposed to market fac3.6 Managed Futures tors. The most common risks associated with each strategy are A managed futures strategy is based on speculation of the detailed in the table opposite:
Equity Market-neutral Managed Futures

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Other risks of investing in hedge funds are non-quantifiable risks specifically including liquidity issues, transparency, 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 opportunities. The difficulty with investing in any market is identifying when these opportunities will rise and positioning 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 opportunity 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 dedicated 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 of the broad equity market. Those strategies that are implemented through investment in equities demonstrate 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
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.

nature of hedge fund strategies and consequently 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 manager will focus on a particular asset class or trading strategy 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 strategies 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 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.

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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 abilisider 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 portfolio, an allocation from fixed interest Distressed Debt Example Source: AIMA to a fund of fund hedge fund may be appropri1 Loan of USD10 million issued. ate. As an improvement to the return expectaTel Co. uses financing to repay debt and to restructure. Custod i an Co . tion implies taking on additional risk, the oppoTel. Co. (Borrower) (Lender) site case applies for a reduction in the return 3 Tel Co. defaults on loan expectation. repayments to Finance Co. 2 Tel Co. then has financial • Which asset class to allocate funds from, for difficulty and files for Hedge Fund bankruptcy. investment in hedge funds will depend on the Manager return/risk objective of the hedge fund being considered. 4 & 5 Hedge fund manager buys core position of debt or • Whether the investor has the time and knowlequity in Tel Co. Passive Investment Active Investment edge to research individual hedge fund managers offering single strategies to bring together Buy debt or equity at a discount and become Buy debt or equity at a discount actively involved in restructuring/refinancing their own “fund of hedge funds”. and wait for appreciation. to influence process to fund’s advantage. • The time frame to invest, considering any lock up period the hedge fund manager may impose. Distressed Debt example: • Fund of Hedge Funds offering may be more suited to conIn a typical situation depicted above: servative investors in improving the return profile at a slightly a) A financial institution (Finance Co.) makes a loan to a borrower (Tel lower risk. Co.). Tel Co.uses the funds to restructure the company and/or repay • An appropriate allocation to a single manager will depend some debt. on whether the hedge fund has fixed interest or equity like b) Tel Co. then finds itself in financial difficulty, resulting in bankruptcy characteristics. or nearbankruptcy. • An investor’s income and taxation position should be conc) Tel Co. defaults on its debt, resulting in a decrease in the value of the loan. sidered. Generally income distributions from hedge funds will d) A Distressed Debt specialist analyses the situation for possible be treated as ordinary income with very little or no capital investment, either in the debt or equity of the company considering gains or dividend imputation. This is a result of frequent tradthe following questions: ing employed by most hedge funds. However, the tax treat• Does the business have long-term value? ment of distributions, gains and deemed gains may vary • Is the company in trouble because of problems, such as overdepending on the legal structure of the hedge fund and the leveraging, that can be rectified? nature of the investors’ participation. • Are the company’s operating metrics declining? • What class of debt will have the most power in the restructuring? • The need for professional guidance in manager/fund selection and the appropriate allocation within an investor’s portfolio. ty 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 APPENDIX: based hedge fund benchmarks as proxies for the return of all REFERENCES, ADDITIONAL READING / WEBS SITES hedge funds. These benchmarks provide an indication of the References and additional reading average manager skill available rather than passive (market • BARRA RogersCasey: “An Introduction to Hedge Funds. The first in the based) returns available from this form of investing. However BRC Hedge Fund Series”; BARRA RogersCasey; 2001 there is no data available to forecast hedge fund returns given • Fraser E: “Hedge Funds 101: Trustee Education”; January 2004. there is no passive benchmark. There are limitations to portfolio • Ineichen AM: “Absolute Returns. The Risk and Opportunities of Hedge modelling of hedge funds, and this form of analysis should be Fund Investing”; John Wiley and Sons; 2003. used only as a tool, not a driver of the decision. The question of • Jaeger L: “Managing Risk in Alternative Investment Strategies: Successful allocating a portion of a client’s portfolio to hedge funds thereInvesting in Hedge Funds and Managed Futures” fore becomes one of a market specialisation within the portfolio. • KPMG Financial Services and Investment Advisory: “Hedge Fund Investments”; September 2003. Market specialisation categories include active versus passive, • Lowenstein R: “When Genius Failed: The Rise and Fall of Long Term value versus growth, large cap versus small cap and now market Capital Management”; Fourth Estate; 2002. based versus skill based strategies. One could therefore argue • Rahl L: “Hedge Fund Risk Transparency: Unravelling the Complex and that the choice of investing in hedge funds (skill-based strateControversial Debate” gies) is part of the active versus passive manager selection deci• Schneeweis T: “Dealing with Myths of Hedge Fund Investment”; The sion, rather than part of the traditional asset allocation decision. Journal of Alternative Investments, Winter 1998. 5.4 Factors to consider before Investing 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 necessarily conWebsites • 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/

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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. and evaluate trading activities by regularly reviewing the performance of each Hedge Fund’s portfolio and the associated risk levels. Internal reportingshould 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 performance. 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 managed 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 performance. The roles, responsibilities and liability of key third-party service providers should be clearly defined in written service agreements. The performance of missioncritical service providers should be periodically evaluated. “Mission-critical service providers” are those required by the Hedge Fund Manager to ensure prompt and accurate processing of transactions and to meet regulatory reporting requirements. 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 objectives and strategies, as well as periodic summary 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 management

Sound Practices
for Hedge Fund Managers
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 adequate systems established (either internally or through outsourcing) to put in place appropriate controls and review processes that permit the Hedge Fund Manager to monitor trading activities and operations, as well as risk levels, effectively. If third-party service providers perform key business functions (such as net asset value calculation or risk monitoring), they also should be subject to appropriate controls and review processes. 1.1 A Hedge Fund Manager should establish management 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 investment, risk and trading policies to be observed with respect to each Hedge Fund it manages based on the specific investment objectives of the Hedge Fund. A Hedge Fund Manager should allocate capital and risk (among, for example, portfolio managers, strategies and/or asset classes, as applicable) based on a Hedge Fund’s performance objectives and 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

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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 investment 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 investment 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 dissemination to Hedge Fund investors on a timely basis (without compromising proprietary information regarding the Hedge Fund’s positions). Where there are changes in objectives or strategies, a Hedge Fund Manager should evaluate, and consider consulting its legal counsel, to 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 strategies employed by and disclosed to investors in connection with a number of Hedge Fund strategies, for example in multi-strategy Hedge Funds, it is possible that many Hedge Fund Managers may fairly determine, after evaluating the circumstances, that no disclosure is required. 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 appropriately disclosed and that controls are in place to address them. Possible conflicts that may need to be disclosed include: • Relationships with brokers or service providers; • Conflicts generated by fee structures; • Use of Soft Dollar Arrangements; and • Other conflicts that may arise in the context of “side-byside” 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 information for distribution to the Hedge Fund based upon relevant characteristics of the Hedge Fund. Possible disclosures include: • Performance measures, such as quarterly or monthly net asset value calculations and periodic profit and loss statements; and • Capital measures, such as assets under management 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. 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 arrangements with certain Hedge Fund investors, for example through use of “side letters”, unless the ability to vary such terms is disclosed to Hedge Fund investors in connection with their investment in the Hedge Fund. 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 management 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 procedures should incorporate the concept of “fair value”. For NAV purposes, a Hedge Fund Manager generally should value investmentsaccording to applicable generally accepted accounting principles (GAAP), recognizing that Hedge Fund investors will both buy and sell shares of a Hedge Fund on the basis of NAV and that the

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Hedge Fund’s financial statements should reflect NAV. 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 circumstances where a Hedge Fund Manager believes that the application of fair value would not produce an accurate or fair valuation for a given instrument, it may employ alternative means to value an instrument as permitted by agreement. A Hedge Fund Manager may appropriately develop policies for making fair-value determinations that take into consideration market sector trends and company fundamentals. Fair, Consistent and Verifiable 3.2 A Hedge Fund Manager’s valuation policies and procedures should be fair, consistent and verifiable. A Hedge Fund Manager should either calculate or verify the accuracy of prices independent of the trading function to the extent practicable. To that end, a Hedge Fund Manager should seek to rely on price quotes from external sources whenever practicable and cost-effective to do so and establish policies for determining the value of assets for which appropriate external price quotes are not reasonably 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 standard in a material way. Pricing Policies and Procedures 3.3 A Hedge Fund Manager should establish pricing policies and procedures that assure that NAV is marked at fair value. The existence of written pricing policies and procedures is a critical element of the control structure surrounding a Hedge Fund Manager’s pricing of portfolio investment instruments. These policies should be established 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 authorize that, in circumstances where a Hedge Fund Manager believes that the application of such policies would not produce an accurate or fair price for a given instrument, senior management may use alternative procedures to price an instrument. In addition, these policies should be reviewed with the Hedge Fund’s governing body (if different than senior 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 practicable. Procedures for periodically verifying the accuracy of pricing data should also be adopted, and material discrepancies between price sources should be investigated. Where an instrument is not traded actively or where obtaining price information requires significant effort, weekly (or less frequent) pricing may be appropriate depending on the nature and the size of the position. For positions traded over-thecounter or derivative instruments, where the only external source of fair value may be quotes from relevant marketmakers (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 portfolio 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 distressed securities from wellestablished, recognized pricing services, or use appropriate valuation models developed by third-party pricing services or recognized industry 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

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nature. However, if these are unavailable, either because the transactions are “one of a kind” or not actively traded, the only market for these instruments may be with the counterparty to the transaction itself. Such instruments could be valued either by obtaining a quote or estimate from the counterparty or based on a pricing model, or any combination thereof. Where a pricing model is used, a Hedge Fund Manager should make sure that it is in a position to explain and support the model 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-thecounter 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 alternative 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 available to Hedge Fund Managers is the use of “side-pockets”, 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 policies) until either a liquidation or other valuation-generating event occurs (e.g., acquisition of a private company). Under one variation among a number of possible side-pocket methodologies, only those investors that hold a position in the Hedge Fund at the time that the transaction designated for the side-pocket is executed are typically 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 management 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 vendors, dealers or other sources. For certain actively traded instruments, it may be appropriate to establish multiple feeds from data vendors in order to compare and verify their prices. With respect to less liquid instruments, dealer quotes, prices generated by models or other estimation 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 providing 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

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responsible for the review of objective risk data and analysis of a Hedge Fund’s performance, current 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 trading activities and operations may be effectively supervised and compliance with trading parameters and risk limits can be controlled. Alternatively, a Hedge Fund Manager might seek to ensure the objectivity of risk analysis by providing for an appropriate level of checks and balances with respect to risk monitoring. To the extent appropriate, the Risk Monitoring Function should produce regular risk reports that present risk measures and appropriate breakdowns by category of risk for review by appropriate members of senior management. The Risk Monitoring Function, in consultation with relevant portfolio 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. 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 limitations, 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 appropriately allocated, among, for example, individual portfolio managers, investment strategies or asset classes. Once the market risk allocation is determined, portfolio managers should choose the market-specific risks to be assumed by the Hedge Fund consistent with the Hedge Fund Manager’s risk allocation and policies and then develop a process for monitoring the risk. A sound market risk monitoring process should incorporate the confidence level(s) and holding period(s) deemed appropriate depending on the markets traded and the risks assumed. The holding period(s) should take into account the time necessary to liquidate and/or neutralize positions in the portfolio. The role of the Risk Monitoring Function is to: (1) identify and quantify the factors affecting the risk and return of the Hedge Fund’s investments, both within individual portfolios and across the entire range of activities of the Hedge Fund Manager, (2) monitor the risk controls established by senior 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 managed 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 contractual relationships. A Hedge Fund Manager should perform stress tests to assess the impact of large market moves, taking into account relevant non-linearities in the 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, contractual 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 market 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

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statistical expectation based on the confidence level of the market risk model), such deviation should be scrutinized 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 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 counterparties such as prime brokers. Adequate funding liquidity gives a Hedge Fund Manager the ability to continue a trading strategy without being forced to liquidate assets when market losses occur. Cash should be actively managed. 4.5 A Hedge Fund Manager should evaluate the effectiveness of the cash management process and establish policies for investing a Hedge Fund’s excess cash, if any, based on established risk parameters and taking into account the credit risk presented by the party with whom cash is invested. In establishing cash management policies, a Hedge Fund Manager should consider cash flow needs based on the risk and funding profile of the portfolio 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 arrangements 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 liquidity measures. Hedge Fund Managers should perform scenario tests to determine the impact of potential changes in market conditions on a Hedge Fund’s liquidity. Among these scenario tests, Hedge Fund Managers should consider including the potential response to a creditor experiencing a liquidity problem during times of market stress (e.g., reluctance to release collateral), as well as a unilateral decision on the part of credit providers to increase haircuts and collateral requirements. Hedge Fund Managers should take into account in their liquidity planning redemption “windows” or other rights of Hedge Fund investors to redeem their interests. Hedge Fund Managers should also take into account the relationship between a Hedge Fund’s performance and redemptions and between a 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 mutually agreed with such parties depending on their requirements and the extent and nature of the relationship. A counterparty’s credit department should be required to provide assurances that financial and other confidential information furnished by the Hedge Fund Manager will only be used for credit 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 manage a Hedge Fund’s exposure to potential defaults by trading counterparties. A Hedge Fund Manager should identify acceptable counterparties based on an analysis of creditworthiness and set appropriate risk limits. Where a judgment call with respect to a particular counterparty is necessary, a Hedge Fund Manager’s senior management should determine whether the counterparty’s creditworthiness is acceptable (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 monitored. A Hedge Fund Manager should also seek to establish appropriate collateral arrangements with the counterparty (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 exposure to market risk, credit risk, and liquidity risk, a Hedge Fund Manager should assess the degree to which a Hedge Fund is able to modify its risk-based leverage in periods of stress or increased market risk. 4.10 Hedge Fund Managers should pay careful attention to leverage, whether such leverage is measured in terms of

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financial statement-based leverage or risk-based leverage. The best means of ensuring that utilization of leverage is appropriate for each individual Hedge Fund is for its Hedge Fund Manager to manage its own leverage associated with its strategies, using appropriate risk monitoring measures or implementation of its strategies. Special attention should be paid to the manner in which leverage impacts the ability of the Hedge Fund Manager to manage the risks to which the portfolio is subject. Note that a Hedge Fund’s exposure in the event of losses depends not merely on the amount of its leverage, but on the contractual and other measures it takes to address the consequences to a Hedge Fund in the event of significant 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 market risk, credit risk or liquidity risk factors impact the value of a Hedge Fund’s portfolio. A Hedge Fund Manager should seek to assess 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 reflecting the relationship between the riskiness of a Hedge Fund’s portfolio and the capacity of the Hedge Fund to absorb the impact of that risk. 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 limitations of the models used and should guard against placing 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 analysis 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 riskbased leverage by modifying (upward or downward) traditional leverage or by reducing 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 leverage 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 appropriate 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 multiple 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 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 analysis reasons may justify a different approach. For example, 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 purposes. 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]

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GUIDE The Hedge Fund Guide
VI. TRANSACTIONAL PRACTICES A Hedge Fund Manager should pursue a consistent 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 transaction 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 counterparty authorizations; • Establish documentation requirements for all trading (including confirmation requirements and documentation of master agreements as appropriate); and • Ensure that appropriate security interests are created 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 bilateral 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 negotiate standardized events of default and other termination or collateral events to achieve consistency in documentation with different counterparties to the extent appropriate and feasible. A Hedge Fund Manager may also endeavor to avoid including provisions that permit counterparties to terminate or make demands for collateral solely at their discretion or based upon subjective determinations. 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 creditworthiness of the parties. To the extent feasible, a Hedge Fund Manager should seek to establish collateral arrangements either internally or through reliance on external resources that permit the 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 documentation and approval processes for retaining external 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 products 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 confidentiality of all proprietary position information provided; • The clearing broker’s financial responsibility; and • 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 transactions of size in both liquid and illiquid markets at competitive 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 recommendations made by the executing broker; • The quality and timeliness of market information provided by the executing broker; • The execution broker’s financial responsibility; and • The execution broker’s credit worthiness. Because it is difficult to determine how to make a best execution determination in the context of 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 providing 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 deriva-

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tive 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 products or services with mixed uses (i.e., computer hardware that assists an adviser in research functions and in nonresearch 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, addressing, as appropriate, approved broker-dealers and products/services, reliance on the Section 28(e) of the Securities Exchange Act of 1934, as amended, safe harbor (described below) (“Section 28(e)”), personnel authorized to approve the product/service and agreements or commitments regarding commission quotas or thresholds. Policies should also address retention of correspondence, including, if applicable, emails related to directed brokerage and step-out arrangements and records of and the value, quantity, purpose and ratios of each product/service. 6.9 A Hedge Fund Manager should fully disclose that it may engage in Soft Dollar Arrangements prior to engaging in such arrangements and should clearly disclose its policies with respect to such arrangements, including: 1. Whether it may use the products and services provided by a broker pursuant to Soft Dollar Arrangements to benefit Hedge Funds other than those whose trades generated the relevant brokerage commissions or fees; and 2. The types of products and services that may be received through Soft Dollar Arrangements in an appropriate 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 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 brokerdealer, 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 procedures relating to such Soft Dollar Arrangements; and 3. Determine whether the brokerage and research services are covered within the safe harbor (as set forth in Section 28(e)(3)). In an interpretive release relating to this prong, the SEC indicated that “the focus should be on whether the product or service provides lawful and appropriate 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 reasonable in relation to the value of the services provided by the broker-dealer, in light of the terms of the particular transaction or the Hedge Fund Manager’s overall responsibilities with respect to its Hedge Funds; and 3. Disclose the Hedge Fund Manager’s policies and procedures relating to such Soft Dollar Arrangements. 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.

HEDGE FUND SERVICES MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 71

Hedge Funds GLOSSARY
Accredited Investors - Refers to institutional investors or individuals 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 manager’s “value-added” in selecting individual securities, independent 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 convert the cash flows from an underlying security (a bond or floating-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 portfolio 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 market movements. Therefore, the fund’s beta is close to zero. CTA Commodity Trading Advisor CTA’s generally trade commodity 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 directions 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 investment 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 directional 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 investment vehicles (the feeder funds) with identical investment objectives, 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 relationship 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. a proportion of trades executed by intermediaries. These transactions artificially inflate the overall value on loan and are, therefore, automatically removed prior to publication of the data. In brief, the process to exclude double counting removes transaction values where one participant is seen to lend and borrow the same security value from two other participants on the same day. The originating lender and end borrower values are retained to represent the true level of value on loan.

communicate

72 INVESTOR SERVICES JOURNAL HEDGE FUND SERVICES MARKET GUIDE 2007

GLOBAL CORPORATE ACTIONS, PRICING, CROSS-REFERENCE AND DESCRIPTIVE DATA.
Telekurs (U.K.) Ltd. 15 Appold Street London EC2A 2NE Telephone: +44 (0) 20 7550 5000 E-mail: [email protected] www.telekurs.co.uk Telekurs Financial is a leading provider of corporate actions, pricing, cross-reference and static information for international securities. Between our Head Office in Zurich and our international network of subsidiaries, we manage one of the world’s most comprehensive, global securities databases. As a founding member of the Association of National Numbering Agencies (ANNA), Telekurs Financial promotes industry standards to facilitate the trading and administration of securities. With over 2.7 million instruments, we source data directly from over 200 exchanges and 400 contributors. Data is available in a variety of formats including fully encoded data feeds optimised for automated processing, bulk file or selection. Whether you are active in investment consulting, asset management, financial analysis or securities processing and settlement, our data resources provide a unique combination of quality, depth and breadth of information. Telekurs Financial’s Corporate Actions Solutions offer: – Comprehensive, global coverage – Highly coded, structured and consistent data – ready for STP – Full cross-reference information including ISIN, SEDOL, CUSIP, VALOR and COMMON – Flexible delivery via Valordata Feed (VDF), TitelBulletin II (TBII) and customised corporate action reports – Delivery in ISO15022 format (also available via SWIFTNet)

Service Provider - PROFILES

Robert Chin

Company Brief: ATC Fund Services is a specialized hedge fund administrator who has consistently received excellent reviews from its clients. ATC provides full administration to hedge funds, including daily processing of all funds’ activities, nav calculation on a daily, weekly or monthly basis and registrar & transfer agency services. In addition, ATC takes a pro active approach in assisting start up hedge fund managers with the incorporation of their fund in jurisdictions such as the Cayman Islands, the British Virgin Islands and the Netherlands Antilles. Robert Chin, Chief Executive Officer, ATC Fund Services.

Prior to establishing ATC Fund Services in Curaçao in March 2003, Mr Chin was the managing director of Fortis Fund Services (Curaçao) N.V. since August 2002 where he was responsible for approximately 75 staff members and US$ 22 billion under administration. During the last four years of his tenure at Fortis Mr Chin was also a member of the management team of Fortis Fund Services International. Mr Chins previous professional experience includes a seven year tenure as CFO of Dutch brokerage firm where Robert was a member of the European Option Exchange and the Amsterdam Stock Exchange. Furthermore, he spent the first 8 years of his career with Ernst & Young, Amsterdam, The Netherlands.

Key Contacts: Robert N. Chin General Manager ATC Fund Services Bon Bini Business Center, units 2B2K & 2B2L Schottegatweg Oost 10 Curaçao, Netherlands Antilles Telephone: (+) 5999 738 1351 ext 11 Fax: (+) 5999 738 1311 E-mail: [email protected] Kedi J. Chang Managing Director ATC Fund Services Bon Bini Business Center, units 2B2K & 2B2L Schottegatweg Oost 10 Curaçao, Netherlands Antilles Telephone: (+) 5999 738 1351 ext 10 Fax: (+) 5999 738 1311 E-mail: [email protected] Website: www.atcgroup.info

74 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2007

Hedge Fund Services Market Guide

Dermot Butler

Company Brief: Custom House Administration & Corporate Services Ltd (“Custom House”) is one of the world’s leading specialist hedge fund administration companies. Based in Dublin, it also operates out of offices in Chicago and has plans to open offices in South East Asia. In addition to providing a full administration service, Custom House also assists emerging hedge fund managers in establishing their fund, helping produce the Offering Memorandum and all relevant documentation in cooperation with attorneys in the selected jurisdiction. Custom House currently acts for approximately 250 funds for some 100 clients, with total assets under administration in excess of $20 billion. Custom House, which is authorised and regulated by the Irish Financial Regulator under Section 10 of the Investment Intermediaries Act of 1995, is the only administrator in the world to have been awarded a Moodys Management Quality Rating. Dermot Butler, Chairman, Custom House Administration & Corporate Services Ltd. Key Locations: Dublin, Chicago, Singapore T: +353 1 878 0807 F: +353 1 878 0827 Web: www.customhousegroup.com

Mr Butler has over 35 experiences in the financial services industry and worked as a Stock Broker and Stock Jobber (specialising in South African mining stocks), before becoming a Commodity Broker and Market Maker in Metal Options on the London Metal Exchange. In 1983 Mr Butler helped set up McDonnell & Co., the Bermuda fund management company and issuer of the McD range funds. He sold his interest in that company and moved to Dublin in 1989 when he established Custom House. Mr Butler is a director of several fund companies listed in the Irish Stock Exchange and is Deputy Chairman of the Alternative Investment Management Association (AIMA).

Key Services: Fund Administration Shareholder Services/Transfer Agent Fund Formation Advice on Stock Exchange listing Corporate Secretarial Services Irish Paying Agent

Key Contacts: Dermot S. L. Butler, Chairman [email protected] David P. M. Blair, Managing Director [email protected] T: +353 1 878 0807

SECURITIES LENDING MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 75

Service Provider - PROFILES

James Lasry

Company Brief: Hassans International Law Firm, with over 55 lawyers is by far the largest law firm in Gibraltar. Hassans was established in the 1930s , and has earned a reputation for high-standards, integrity and client service. Renowned for excellence as lawyers dealing with tax advice, litigation, offshore finance and corporate practices including financial transactions, banking, insurance, property and conveyance advice, offshore trusts and company formations. James Lasry, partner in the Tax and Overseas Property Department, Hassans.
Mr Lasry is a highly regarded practitioner who has been instrumental in setting up the majority of Gibraltar’s funds, including the first Experienced Investor Fund and the first Protected Cell Company Fund. Prior to joining Hassans in 1999, Mr Lasry was at the Ministry of Industry & Trade where he gave legal opinions on international trade and consumer protection, as well as advice on international R&D contracts to the Chief Scientist. He also served as counsel to the Israeli delegation in trade accord negotiations with the Czech and Slovak republics. On joining Hassans, Mr Lasry has focused his expertise on funds, trusts, corporate law and financial services, advising the Government of Gibraltar on the regulatory and tax treatment of investment funds. He also assisted in drafting the Financial Services (Experienced Investor Funds) Regulations 2005. A member of the Society of Trust Practitioners, Mr Lasry advised a sub-

stantial trust in a case involving litigation in Paris, New York and Buenos Aires that also featured in reports in the New Yorker magazine, the New York Law Journal and on CBS News.

Key Services: Property Corporate and Commercial: Gaming Private Client and Tax residence advice Trust advice Joint Venture Mergers and Acquisitions. Capital Duty Restructuring Litigation Commercial Trust and asset tracing Dispute Resolution Criminal Matrimonial Admiralty and Shipping Judicial Review Banking Insurance Investment Services, Funds Securitisation Structured Finance Private Equity E – Money Institutions, Derivatives Tax and Overseas Property Telecom & Deregulating Industries Drafting of Legislation Maritime and Transport
the ideal location for setting up a European holding company or possibly even setting up a company to do business elsewhere in Europe.

Key Locations: If you are considering structuring an investment in Europe, Gibraltar is the ideal location through which to do so. It is a recognised international finance centre with an attractive tax regime, yet it is a part of the European Union having acceded with the United Kingdom. It therefore enjoys the stability and support of being within the EU whilst still retaining the advantages of being an international finance centre. This makes it

57/63 Line Wall Road PO Box 199 GIBRALTAR Tel (350) 79000 Fax (350) 71966 e-mail: [email protected] www.gibraltarlaw.com

76 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2007

Hedge Fund Services Market Guide

Felix Oegerli

Company Brief: IFBS offers the financial industry a wide range of consulting services, individual software development and standard software solutions. IFBS has offices in Zurich and New York. Felix Oegerli, CEO, IFBS Oegerli is Chief Executive Officer and founder of IFBS AG, an IT- application solutions and consulting firm specializing in Securities Lending, Repo and Collateral Management, with offices in Zurich and New York. Prior to launching IFBS in 1999, he held a number of business leadership roles at UBS in Zurich, New York, and London for over 20 years in different functions. Between 1990 and 1999 he was responsible for the creation and expansion of the Securities Lending, Repo and Prime Brokerage business at UBS Zurich, was deputy global head of Securities Lending and Repo, global head of Prime Brokerage and head of global product management Collateral Trading and Management. Oegerli holds a degree as Swiss federal certified banking Key Locations:
IFBS AG 45 Rockefeller Plaza 20th floor New York, NY 10111 USA IFBS AG, Buckhauserstrasse 11, CH-8048 Zurich, Switzerland T: +41 (0)44 218 14 14 F: +41 (0)44 218 14 18 [email protected]

expert, and is a frequent conference speaker and industry expert on Securities Lending, Repo and Collateral Trading and Management. Key Services & Products: Consulting for financial institutions focused on the “securities value chain” including securities lending, repo and collateral management Individual software development based on the IFBS Java framework On the product side IFBS offers FINACE®, a modular and fully integrated solution in the area of securities lending, repo and collateral management.

Key Contacts: Felix Oegerli, CEO, IFBS
T: +41 (0)44 218 14 14 F +41 44 218 14 18

Tom Ricciardi, Managing Director Americas T: +1 212 332 7144 F: +1 212 332 7145 www.ifbs.com / [email protected]
SECURITIES LENDING MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 77

Service Provider - PROFILES

Lionel deMercado

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 professionals are able to offer customized hands-on support and guidance in the areas of trade execution, margin 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 securities lenders can guarantee both low borrowing costs and excellent access to difficult-to-borrow securities. The Toronto-Dominion Bank and its subsidiaries are collectively known as TD Bank Financial Group (TDBFG). TD Bank Financial Key Locations: Ernst and Young Tower 222 Bay Street, 7th Floor Toronto, Ontario M5K 1A2 www.tdsecurities.com

Group offers a full range of financial products and services to more than 14 million customers worldwide. As of July 31, 2006, TD Bank Financial Group had CDN $385.8 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. Lionel deMercado, Managing Director and Global Head Equity Finance, TD Securities.
Mr deMercado joined the company in June 2001 with a mandate to expand its Equity Finance operations and develop the Prime Brokerage business. Mr deMercado worked for a large Canadian financial institution where he held several senior positions including Managing Director Equity Finance and Vice President Operations.

Key Services: - Trade Execution - Margin Financing - Securities Lending - Settlement and Clearance - Custody - Technology Key Contacts: Lionel deMercado, Managing Director (1) 416 308 7321 [email protected] Vicki Juretic, VP, Sr. Relationship Manager (1) 416 308 1560 [email protected] Peter Boffo, Marketing Manager (1) 416 983 1356 [email protected]

78 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2007

Hedge Fund Services Market Guide

Telekurs Financial provides a wide range of display and feed products for different purposes. They are accompanied by several local products and services.
Richard Newbury

Company Brief: Telekurs Financial is a company in the Telekurs Group, which operates in the fields of financial information, payment transactions and IT services. As a leader in its field, Telekurs Financial specializes in the procurement, processing and distribution of international financial information for investment advisory services, portfolio management, financial analysis and securities administration. A global network of local financial market specialists procures real-time stock exchange information at source from the leading financial centres. Containing over 2.7 million financial instruments, the database of structured, encoded securities information maintained by Telekurs Financial and its ten representative offices abroad is unparalleled throughout the world in terms of both depth and data coverage. As the official numbering agency for Switzerland and the Principality of Liechtenstein, Telekurs Financial is responsible for allocating Swiss security (Valor) numbers. It is a founding member of the Association of National Numbering Agencies (ANNA) and leads the way in introducing standards aimed at simplifying trading and securities administration.

Key Services: Telekurs iD: new Web-based (Java applet) display product generation giving users access to Telekurs Financial's entire range of data and functions. A number of packages geared to the needs of different banking departments are offered. Valordata Browser, a user-friendly search engine providing access to descriptive data, corporate actions and valuation prices, is integrated into this product. Telekurs iD html: The HTML version can be used by companies who have limited bandwidth for transmitting financial information or whose corporate policy does not permit the use of the Java applet. Telekurs iD mobile: Telekurs iD mobile offers easy access to current prices for all securities in the Telekurs Financial database for mobile devices (currently BlackBerry). The mobile version works together with Telekurs iD in the client’s office. Personal user lists can be maintained on the move. Valordata Browser: As a convenient search engine, the Valordata Browser rapidly and easily finds the instruments that meet a special combination of search criteria, even with complex questioning, and in just a few seconds. Intraday Pricing Service: Snapshot service which enables the valuation of portfolios several times daily. The timing of snapshots is tailored to each client’s requirements. It is flexible and can be easily changed. The requirements for timing of snaps may vary significantly: intraday snaps, market close times or traditional EOD after the integration of all market corrections. Valordata Feed (VDF): structured and encoded descriptive and corporate events data; ratings and reference data for instruments and institutions, corporate actions, cash flows, valuation prices; the data feeds are supplied several times a day.

Key Locations: Telekurs (UK) Ltd 15 Appold Street London EC2A 2NE Tel: +44 (0) 20 7550 5000 Fax: +44 (0) 20 7550 5001 Email: [email protected] Contact us at: www.telekurs.co.uk
SECURITIES LENDING MARKET GUIDE 2007 INVESTOR SERVICES JOURNAL 79

Service Provider - PROFILES

Don McClean

Company Brief: Fund Services, based in the Cayman Islands, Ireland and Canada 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. With the dedication and experience of a professional team of over 150 and state-of-the-art web reporting, accounting and shareholder systems, UBS is well positioned to provide clients with a first class service. Don McClean, Head of Fund Services, Ireland, UBS.
Mr McClean has specific responsibility for the development and management of the business and is a member of the Fund Services Management Board. He has 17 years of investment industry experience, is a graduate of the University College Dublin and a Fellow of the ACCA. Prior to joining UBS he spent nine years at Fortis, culminating in the role of Director of Operations Europe and has previously worked at Rudolf Wolf Fund Management Ireland, Strachans Management Services and Coopers and Lybrand Jersey.

Key Services & Products: With specialist expertise in both single manager and fund of hedge fund administration, services can be provided for both onshore and offshore funds. Capabilities also extend to services for investment funds through our teams in Luxembourg, Switzerland and the UK.

Key Locations / Contacts: Cayman Islands: Darren Stainrod, tel. +1-345-914 1076 Ireland: Don McClean, tel. +353-1-436 3636 Canada: Pearse Griffith, tel. +1-416-971 4702

Website: www.ubs.com/fundservices

80 INVESTOR SERVICES JOURNAL SECURITIES LENDING MARKET GUIDE 2007

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

You & Us

INVESTOR SERVICES JOURNAL

HEDGE FUND SERVICES MARKET GUIDE 2007

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