What are the regulations regarding hedge funds in other countries besides the U.S.? - Healthcor Joseph Healey

Hedge funds have definitely gone global. While America is one of the “hubs” or financial centers for hedge funds and other types of investments, the international market has seen the lucrative promise of hedge funds, and jumped on board. Additionally, many Americans have seen the benefits of holding offshore hedge funds, and that brings an entirely new dimension to the subject of hedge fund regulation outside of the United States. With so many domestic individuals seeking international hedge funds because of their different laws and regulations, it can complicate matters.

Offshore hedge funds are perhaps the most popular “destination” for this type of investment. There are a few reasons for this; one is that there are no universal requirements for “accredited” investors as there is in the US. Another reason is the structure of offshore hedge funds themselves; they are structured as corporations/companies rather than limited partnerships. What this means for offshore hedge funds is that there is virtually no limit to the number of potential investors, whereas in America, there are strict regulations in place with regards to that. However, there is a “hang up” to Americans investing in offshore hedge funds – they are only legally permitted to do so if they have established offshore life insurance, or established an offshore trust. The popular offshore locations include the Cayman Islands, Dublin, Luxembourg, Bermuda, and more.

Singapore is fairly loosely regulated, especially in comparison to Hong Kong and other Asian financial centers. Smaller funds will continue to be able to operate without licensing even as their regulations and rules change. In Hong Kong, the regulatory structure of hedge funds is very similar to that of mutual funds. In India, the Securities and Exchange Board of India (SEBI) decided to place a ban on any investments made by unregulated companies/entities with participatory notes. 

The European Union is a big center for hedge funds, and they have their own set of rules and regulations. They are not too dissimilar to regulation within the United States, choosing to focus on the regulation of money managers. The FSA (Financial Services Authority) in the United Kingdom requires that fund managers register and become authorized, adhering to the FSA’s regulation. As there are many countries within the European Union, and each has their own set of regulatory laws, having cohesive legislation for the whole EU is difficult. However, with the passing of AIFMD, the EU is one step closer to being able to regulate hedge fund managers all across the board.

However, it should be noted that the Dodd-Frank Act from the US will affect overseas hedge fund investments. Any hedge funds with more than fifteen American investors, and with twenty-five million dollars or more, must register with SEC. Some international funds, especially in Asia, had already registered with the SEC prior to the act, but this act ushers in a whole new era of international hedge fund regulation.

It does seem as though there is a shift internationally to increase regulation on hedge funds, but thus far it has not been overwhelming.

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Controversies and debates about hedge funds - joe healy

Hedge funds have seen their share of debate and controversy over the years, but none so much as after the year 1998. That was when Long-Term Capital Management, a speculative hedge fund in Connecticut, failed and required bailout from other financial companies and institutions. The failure of LTCM, which had been using absolute return strategies, shook up the financial industry, and many were gravely concerned about the future of hedge funds. When information about LTCM’s practices, including evidence of tax avoidance, became public knowledge, the media, the general public, and even some of the financial sector were up in arms about ramifications to the hedge fund industry.

Some saw the collapse of Long-Term Capital Management, and their alleged illegal activities, as a sign of pending doom for many other hedge funds. The bailout, which was under the supervision of the Federal Reserve, ended up costing financial institutions over three and a half billion dollars – and it was a desperate measure to stop the rest of the financial market from experiencing difficulties. The ultimate losses of LTCM cost around four and a half billion dollars, and the hedge fund eventually went under in 2000. With such a huge scare, and such a huge bailout, there was great concern about systemic risk (the whole financial system failing). Any hedge funds who acted similarly to LTCM were considered, by some, to be at risk of failure. Multiple hedge funds requiring bailout to stave off systemic risk was a very real possibility at the time. However, LTCM was the major failure and the biggest bailout to date, and there has not been any systemic failure before or after LTCM.

The fear of systemic risk is far from the only criticism that hedge funds have seen. A major concern with critics is the fact that there is so little transparency required in hedge funds. For one, it makes it difficult to track average performance of hedge funds when so few comprehensively disclose information. For another, a lack of transparency can mean a bigger opportunity for fraud, and there have been several big cases of fraud in the last several years that critics cite as evidence that there should be more disclosure and more regulation. However, hedge funds remain private investments, and are not – in most circumstances – required to divulge information to a third party. There is also a concern of conflict of interest in cases where Americans do not use third parties to act as custodians or administrators of their funds; in some such cases of proven conflict of interest, there have been allegations of fraud and securities violations.

Hedge funds may be debated in the public realm, and may be occasionally subjected to new rules and regulations, but it remains fairly unregulated compared to other investment types. Unless hedge funds are some day no longer considered private investments, there is no sign of this changing in a major way. The SEC does investigate allegations of insider trading and other fraudulent activities when it can, but it is not as involved with hedge funds as many would prefer.

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What are the regulations regarding hedge funds in the United States? - Joseph Healy

While the average person might hear the word “unregulated” tossed around in regards to hedge funds inside of the United States, this is technically untrue. Yes, hedge funds are considered private investments, and therefore investors and hedge fund managers (either as partnerships or as a company) do not have to register with the SEC (Securities and Exchanges Commission). However, there are some exceptions to that rule, and most importantly, hedge funds cannot legally be fully unregulated.

First of all, some of the multiple exceptions to hedge funds not being required to report information to the Securities and Exchanges Commission include:

•  Even though a fund can have unlimited investors, if they number more than four hundred and ninety-nine in total, they must register their securities with the SEC, according to the Securities Exchange Act of 1934.
•  If a hedge fund wants to advertise or make public offerings, they must sell said offerings under the private offerings rule of SEC. This requires either filing a registration statement with SEC, or adversely following the private placement rules under the Securities Act of 1933.
•  If a hedge fund adviser who is registered with the SEC wishes to charge a performance or an incentive fee, all investors must meet the standards for qualification set forth by the Investment Advisers Act of 1940 Rule 205–3.

As for other regulation that hedge funds are subjected to, compliance with the SEC is only the beginning. One of the most efficient ways to keep track of hedge funds, and to try and keep a handle on potential fraud, is to make stringent rules for investors. Investors must meet a specific set of criterion (and some of this will vary depending upon state) before they can begin to invest. For example, investors who meet a qualified purchaser qualification will have five million dollars as a bare minimum in investment assets. An investment company would need a minimum of twenty-five million dollars in order to qualify. 

Even though the regulations for hedge funds are quite lax compared to some other types of investments – and keep in mind this is because hedge funds are considered private investments – they are indeed regulated. Fraud is a very real possibility in any investment scenario, and when such large sums are dealt with in hedge funds, schemes and fraud can occur and must be prevented. There have been several high profile cases of hedge fund schemes in the news over the last several years, and that has drawn both media and public attention onto the fact that hedge funds have a very unique regulatory status. In fact, there have been several attempts (mostly by the Securities and Exchanges Commission) to bring more regulation to hedge funds, including a rule change that required all hedge fund advisers to register under the Investment Advisers Act. This rule change was subsequently contested, overturned, and sent back to the SEC for review. Some are eager to regulate hedge funds, and some continue to hotly contest the practice.

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How are hedge funds structured? - Joseph Healy

No one hedge fund is structured like any other. There are a number of factors that come into play, mostly having to do with what state (or even country) the hedge fund is located in, the hedge fund manager’s practices, policies, and specific skill set, and of course the amount of money in the fund itself. Furthermore, the diversity of the investments in the hedge fund changes the structure of the hedge fund as well; a typical, well-managed portfolio has more than one type of investment at a time. In a way, hedge fund investments can be “mixed and matched” in order to achieve the best results. Investment managers can use a risk parity strategy with one investment, and on another use fixed income arbitrage, for example.

Typically, a hedge fund is comprised of an investor (either an individual or a company), and the investor enters into a partnership with the hedge fund money manager – or (when there are multiple parties) else enters into a company with the manager. Once established, the hedge fund company will make investments; this is the hands-on part of the partnership or company. The investor virtually has no role in the investment process, and is not nearly as involved in the decision making, business practices part of the hedge fund.

Other people may provide services in a hedge fund as well. These may include a distributor, who primarily markets the funds to investors; a prime broker, who do the majority of the work with lending money and securities; and an administrator, who handles the withdrawals and subscriptions of investors. This is a very basic outline of what various people within the hedge fund may do, and every hedge fund is different. A hedge fund never has any employees or assets other than the investments within the fund itself.

The taxation and regulation of hedge funds varies greatly depending on the location of the fund itself. For example, hedge funds in America are considered very loosely regulated (they typically do not have to report to SEC, for one). A lot of hedge fund companies take advantage of tax opportunities by establishing the fund in an offshore financial center, so that the investor pays taxes on the portfolio, and it doesn’t come out of the fund itself. However, despite many hedge funds being technically located offshore, a lot of investment managers are located onshore.

Legally, hedge funds are usually formed as limited partnerships, or limited liability companies. The general partner is the investment/money manager, and the limited partner(s) is the investor themselves. Hedge funds are considered private investments and are not held up to the same amount of regulation that other investments are. While hedge funds are often referred to as “unregulated,” the fact is that there is some regulation that has to take place by law – it is simply different than regulation for other types of investment. An example of how hedge fund regulation functions is that investors are heavily scrutinized and must meet certain criteria before being approved.

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Hedge fund indices - Healthcor Joe Healey

Like many other types of investments, hedge funds have indices that track the industry. There are some differences between hedge fund indices and more traditional investment indices, as hedge funds are considered private investments, and more than that, they are mostly all illiquid. This poses some issues with the reliability indices; how comprehensive, and thus satisfactory, are they, really? This is part of why several different methods of hedge fund indexing have been created over the years.

Regardless of whether or not hedge fund indices are fully satisfactory, there is no question that they exist, and that people use them. There are generally three types of hedge fund indices, and these include:

•   Non-investable indices – Using a hedge fund database from which to measure performance, non-investable indices are the oldest type of hedge fund indices used. The databases use weighted mean, medium, and mean in order to measure performance. No one database will represent all funds, which means that no one database is the same as another; every single performance result will be different. This is an issue that some have with the reliability of non-investable indices. Another issue that some have with them is that they are subject to a lot of bias. For one, database reporting is voluntary, which in some cases may lead to self-selection bias. Additionally, hedge funds may come and go (fail and succeed, if you will) annually, which changes the database selection significantly every year.
• Investable indices –the main goal of an investable index is to eradicate some of the bias and issues raised with using a non-investable index. The main method it does this is by making the index return available to all shareholders. In an investable index, the index provider/manager will select certain funds to develop something somewhat like a “fund of hedge funds” portfolio. The investments created by the index provider must be accepted by any hedge funds, in order to be properly investable.
•  Hedge fund replication – this is more of a statistical look at how hedge funds have performed, analyzing past returns in order to make models of how hedge funds will perform under various circumstances with different assets. The model(s) can be used to make an actual portfolio of assets, and thus makes the index investable. Of the three types of hedge fund indices mentioned here, hedge fund replication is probably the newest. One of the pitfalls that goes along with this index form being so new is that there is very little history or data to support its usefulness in practice – especially when one considers the private, rarely disclosed nature of hedge funds themselves.

This is essentially the beginning of what hedge fund indices entail. They are meant to give investors – and the financial market as a whole – a view of what average returns on hedge funds are, and how they change throughout time. Even though there is some question as to the reliability of hedge fund indices, given that most of the data found within is self-disclosed and therefore very limited, they are popular and continue to grow.

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