March 3, 2015

In this article, after giving a brief background of the Hedge Fund industry, we shall shed light on the impact of regulatory changes on the industry since the onset of the financial crisis both in Europe and the US, and the corresponding operational challenges faced by managers.

Hedge funds are investment vehicles that pool capital from several types of investors (institutional like pension funds, endowments but also private investors) to invest in securities using different types of strategies. Hedge Funds are generally distinct from mutual funds in the sense that they are not restricted to the same diversification rules and leverage constraints. They also differ from private equity funds as they invest in relatively liquid assets.

In Europe, assets under management held in Hedge Funds currently total 549 billion USD for a total of 2.4 tn$ for the industry worldwide. Some hedge funds have several billion dollars of assets under management (AUM) and overall, hedge funds represent 1.15% of the total funds and assets held by financial institutions. In Europe, the ESRB (European Systemic Risk Board) has a mission to implement macro prudential oversight of the financial system within the Union as non-regulation of the Hedge Fund industry has proven a large systemic risk for the financial system as a whole.

Hedge Fund investment strategies aim to achieve a positive return on investment regardless of markets directionality (“absolute return” or “alpha”) and magnify those returns through the use of leverage.

Historically, hedge funds could not be proposed and sold to the general public or retail investors. Therefore hedge funds were not under the same regulatory constraints and scrutiny that govern other funds like mutual funds and had a wider range of choice in terms of investment structuring, strategies and structures that they could implement. However, with the financial crisis of 2007-2008, regulations passed in the United States (Dodd-Frank) and Europe (AIFMD) to increase regulatory oversight of hedge funds, eliminate certain regulatory gaps in order to reduce global systemic risk.

Hedge Fund strategies are generally classified among four major categories: global macro, directional, event-driven and relative value (arbitrage) that correspond to different risk-return characteristics. This list is by no means exhaustive and hedge funds can approach investments through a wide range of strategies and techniques. For instance, quantitative hedge funds use advanced computational and algorithmic techniques to identify profitable investment strategies. A fund may deploy a single strategy or multiple strategies for flexibility, risk management and diversification. The offering memorandum of a Hedge Fund will describe key aspects of the fund, including its investment strategy and leverage limit.

The term “Hedge” often refers to the hedging strategy that is being used by portfolio managers to cover their exposure and limit their risk, thus the name “Hedge Fund”. However, this is not restrictive in the sense that a Hedge Fund does not necessarily use hedging and may simply follow a long-only, long-term buy-and-hold investment approach through top-down or bottom-up investment analysis.

In fact, a Hedge Fund may be structured as an umbrella to different but related investment strategies with different return targets and risk-return profiles. For instance, a structured credit leverage fund could have different target returns like LIBOR + 500 bps or LIBOR + 1000 bps or LIBOR + 1500 bps. A higher target return will correspond to a higher level of risk or use of leverage or both. In the context of measuring returns of a hedge fund, the Sharpe ratio (risk-adjusted measure of return) is a key performance indicator that measures the risk adjusted return per unit of risk. Mathematically, it will be expressed by the real return minus the risk-free rate (or any other benchmark) divided by the standard deviation (measure of volatility). This is in essence the bottom line that measures “alpha”.

It is critical to understand the Hedge Fund industry in terms of systems, models, reporting structures and processes points of view. By processes, we mean both business and operational processes. This is all the more important as Hedge Funds need to develop investment and trading strategies that can sustain the test of time. Essentially, hedge fund managers will need to revisit their strategy on an ongoing basis depending on the evolutions in terms of technology, regulation and the economic environment, both at micro and macro levels.

What allows a Hedge Fund to gain competitive advantage in the market place is its ability to seek alpha while managing its risk effectively and proactively. And for this, a Hedge Fund needs to rely on lean and efficient operations: it needs to have the right technology and architecture to be able to analyze information very quickly.

In this paradigm, lean technology will be one of the drivers of a Hedge Fund competitive advantage. A Hedge Fund will need the right type of technology to gain superior ability to organize and structure data quickly and make fast and efficient computations to support the decision making process. The Hedge Fund business is all about interpreting signals and using that interpretation to implement the right asset allocation strategy. For this, a Hedge Fund will need the right integrated framework for optimal decision making.

The Hedge Fund industry is often perceived as unregulated. It is actually not the case. In fact, since the onset of the financial crisis, major regulatory measures in the US and Europe have completely modified the industry landscape. AIFMD (Europe) and Dodd-Frank (US) have defined the basis for regulation of the Industry and have led to an unprecedented set of rules and costs for what was once a close to non-regulated industry. This has considerably impacted the costs of running a hedge fund. The average costs for implementing the most recent rules has been 700000$ for a small fund manager, 6m$ for medium-sized one and 14m$ for the largest. Hedge funds have spent 4bn$ meeting compliance costs associated with new regulations since 2008, equating to roughly a 10 percent increase in their annual operating costs. This sounds like large amounts but those investments will pay off from a competitive standpoint in the future.

In parallel to those regulatory changes and corresponding costs incurred by the funds, the industry’s investor base has changed dramatically, shifting from high-net-worth individuals to institutions such as pension funds and endowments. The industry’s new investors are more conservative in nature and more inclined to invest with managers with proven track records and compliant regulatory oversight.

In the US, with the new provisions in the Dodd-Frank reforms, the largest overhaul of US financial regulation since the 1940s, hedge funds must register with the Securities and Exchange Commission for the first time. Complying with the SEC, Dodd-Frank and AIFMD directives means that investors will feel more confident investing on those hedge funds that are up-to-speed with the new regulatory frameworks. However, for smaller hedge fund firms, the opportunity of compliance is less easily grasped. Indeed, large managers can better absorb the costs of new regulations but smaller managers may find this task more challenging. It is fair to say that the industry and investors actually need large, medium and small hedge fund managers. Often, the small boutiques are the ones that actually drive innovation. In a way, it is a balance between the “too-big-to fail” players (those with established track records and that can raise funds more easily) and the “too-small-to-succeed” ones (those that struggle to survive but that are often more innovative and cost-effective). Overall, the new regulations have heightened barriers to entry into the Industry.

This trend is actually reflected into the direction taken by money inflows. In fact, the largest hedge fund money managers have captured the biggest chunk of money inflows since the financial crisis of 2007-2008 whereas starting up a hedge fund has never been so difficult (the 2.4 tn$ in global assets of the hedge fund industry is managed by just 389 funds in a universe of more than 7000).

Hedge Funds are now strictly regulated by a range of methods worldwide.

In the US, Dodd Frank Wall Street Reform and the Consumer Protection Act of 2010 change the regulatory structure of the financial services industry. Hedge funds with more than 150 MUSD in assets are now required to register with the SEC. Most Commodity pool operators and commodity trading advisers must register with CFTC. In this regulatory environment, it is interesting to mention the Jumpstart Our Business Startups (JOBS) Act of 2012, which removes a prior ban on general solicitation and advertising by companies conducting private offerings – including hedge funds, provided the funds are only sold to sophisticated investors with net worth over 2.5MUSD.

Counterparties, such as banks and insurance companies, that are trading over-the-counter (“OTC”) derivatives with hedge funds may be deemed a “swap dealer”, “security-based swap dealer”, “major swap participant” or “major security-based swap participant” and thus would be subject to registration with, and comprehensive derivatives regulation by, the Commodity Futures Trading Commission (CFTC) for “swaps” and by the SEC for “security-based swaps”.

Among the many other requirements that will be imposed on regulated entities and how and where they must execute their swaps and security-based swaps with hedge funds and other counterparties, the new regulatory regime under Title VII of Dodd-Frank will require that most derivatives contracts formerly traded exclusively in the OTC market be subject to “central clearing”. Central clearing uses a clearing agency to act as a central counterparty to remove individual counterparty credit risk and distribute risk among the clearing agency’s participants that must satisfy the clearing agency’s capital and margin requirements. Moving most privately negotiated, bilateral contracts in the OTC market to central clearing and requiring real-time trade reporting would allow the regulators to see the volume of contracts trading in the market, to assess the asset classes in play, to monitor derivatives trading data and thus, to oversee risk exposures and reduce systemic risk in the derivatives markets. These new mandates would also give hedge funds and other investors access to timely information on price and other derivatives trading data.

European lawmakers have also undertaken regulatory changes affecting hedge funds in recent years. In 2010 the European Union (EU) approved the Directive on Alternative Investment Fund Managers (AIFMD), the first EU directive focused specifically on alternative investment fund managers. AIFMD requires hedge funds to register with national regulators and increases disclosure requirements and frequency for fund managers operating in the EU. Furthermore, the directive increases capital requirements for hedge funds and places further restrictions on leverage utilized by the funds. The AIFMD requires EU-based managers to comply with all provisions of the AIFMD, while non-EU managers marketing funds in the EU are subject to reporting requirements under an enhanced national private placement regime until they are eligible to or required to market under an EU passport in the future, at which point those non-EU managers are subject to all of the provisions in the AIFMD. EU member countries are required to adopt the AIFMD into their own national legislation since 2013. The European Securities and Markets Authority and the European Commission are developing implementing rules and guidance to give effect to the AIFMD.

There are a number of regulations in the EU that are of specific interest to hedge funds:

1) AIFMD: alternative investment fund managers directive:

As we saw, AIFMD aims at creating a comprehensive regulatory framework for European Alternative Investment Fund Managers.

2) European Market Infrastructure Regulation (EMIR)

All OTC derivative contracts considered eligible, entered into between any financial and certain non-financial counterparties, will be required to be cleared by a CCP (Central Counter Party). All OTC derivative contracts not considered eligible shall be subject to risk mitigation requirements, including the exchange of collateral or a proportionate holding of capital. Counterparties to an OTC derivatives trade (cleared or not) shall report details of that trade to a trade repository. CCPs shall be subject to registration and prudential and conduct of business regulation. Trade repositories shall be subject to conduct of business regulation

3) Short selling regulation

This regulation implies the public disclosure of short positions over a certain threshold and requires parties entering into a short sale to have borrowed the instruments, entered into an agreement to borrow them or made other arrangements to ensure they can be borrowed in time to cover the deal. It also requires notification of significant positions in CDS that relate to EU sovereign debt issuers and it provides competent authorities with temporary power to require greater transparency or impose certain restrictions on short selling and CDS transactions

4) Review of Markets in Financial Instruments Directive (MIFID II)

This directive extends the existing regulatory framework both in terms of instruments and firms covered, so that, for example, certain commodity trading firms will fall within scope of the regime. It imposes regulatory requirements on firms undertaking algorithmic trading (including HFT) and imposes position limits on the trading of commodity derivatives. It also imposes restrictions on third country firms providing services in the EU and introduces enhanced corporate governance requirements for investment firms. It introduces enhanced pre- and post-trade transparency provisions in respect of both equities and non-equities.

Conclusion:

We have seen that Hedge Funds will face many ongoing challenges to keep up to speed with the evolution of the regulatory environment and update their operating models accordingly. Fund managers will have the choice of taking either a reactive approach or a proactive approach to regulation. In a reactive approach, managers will adjust their operating models, compliance and organization structures ex-post regulatory changes. In a proactive approach, managers will try to anticipate the impact of regulatory changes on their operating model. They may thus gain a substantial competitive advantage.

As a concluding note and to open further debate, it is worth mentioning that one of the pitfalls of regulation is actually over-regulation and a lack of well-targeted and adapted regulations. It is thus interesting to look at regulation in the financial industry from the Hedge Fund angle. There is a clear need for regulation on the banking industry. However, imposing heavy regulatory burdens (that are costly from an operational and legal perspective) on a vast majority of small hedge funds, most of which too small to threaten financial stability, may not be the most optimal response to reduce systemic risk, and a more balanced and layered approach to Hedge Fund regulation might in fact be preferable.

Acknowledgements:

This article has been written with the help of several sources including Wikipedia, the Financial Times, the Handbook of Hedge Funds by Francois-Serge Lhabitant, the Managed Funds Association and Interviews with Ram Ananth from Nomura.

The article and the analysis it contains are also based on the author’s own experience of the Hedge Fund Industry as he worked as a quantitative analyst at Cambridge Place Investment Management, a leading Hedge Fund in fixed income, structured credit and asset-backed securities investing.