"This article was published originally in the Commercial Law Practitioner and it is the copyright of Thomson Round Hall"
Introduction
Seldom is an entire industry defined by default but in the case of the "alternative investment" industry this has proven true for nearly 60 years. Alternative investments, or those investments outside what has been regarded as traditional investments,1 comprise hedge funds, private equity, venture capital, property funds and art. This dilemma of definition by default gets more complex when we see that constituent segments of the alternative investment industry, such as hedge funds, are also defined by reference to what they are not.
In Europe funds are categorised primarily as UCITS or non-UCITS. A UCITS fund is an Undertaking for Collective Investment in Transferable Securities (UCITS). This fund status is granted on compliance with restrictions and requirements contained in the UCITS Directive2 and represents an EU passport system whereby qualifying funds can be marketed and distributed cross-border. Attaining UCITS status means that after the initial authorization of the fund in the home state there are no further regulatory obligations imposed on the fund when it is marketed and distributed in other member states. However not all funds adhere to these restrictions and requirements and therefore not all funds qualify as UCITS. Those collective investment schemes which do not qualify are frequently referred to as non-UCITS. Due to the lack of restrictions and requirements that hedge funds wish to be exposed to they do not attempt to satisfy the conditions of the UCITS Directive and therefore fall into this latter category and are identified by reference to what they are not.
This lack of definitional clarity, while facilitating the commercial side of the hedge funds3 industry, is likely to provide difficulty in the now imminent regulation of the industry. Without a definition of the term "hedge fund," regulation of the industry would be uncertain as hedge fund managers and hedge funds would be unsure of their regulatory status and creative compliance to avoid regulation would be a risk. Similarly unintended regulatory consequences4 would be sure to arise in areas close to the hedge fund industry within the alternative investments umbrella. Due to the similarity of hedge funds and private equity funds there is a risk that in the absence of a definition for the term "hedge fund" prospective regulation may inadvertently have implications for private equity funds as many characteristics, practices, and strategies are shared. Another unintended regulatory consequence is that this uncertainty may encourage fund managers or funds to migrate to jurisdictions and foreign markets where such issues do not exist.
Hurst5 states that "'Hedge fund' is not a legally defined term since in general they are subject to little or no regulation." However this is not an accurate reflection on the current situation. A more accurate and complete statement is that the term "hedge fund" has no internationally accepted legal definition because each jurisdiction categorizes hedge funds differently,6 and each jurisdiction has therefore only statutorily defined the specific investment vehicles used in its own jurisdiction. In a generic sense these different vehicles across different jurisdictions are commonly and collectively referred to as hedge funds.
Hurst seems to imply that the term "hedge fund" is not defined because hedge funds are not, or very lightly, regulated products. His statement is correct in certain respects as most jurisdictions do not regulate hedge funds7 but there are jurisdictions that do regulate hedge funds and do have a statutory definition, such as South Africa.8 It is important to understand that the lack of regulation is not the reason why the term "hedge fund" has avoided legal definition. The lack of an international legal definition of the term "hedge fund" has its roots in two major issues:
1. There is no international commercial framework for the registration, marketing and distribution of hedge funds and therefore defining the term "hedge fund" has not been necessary from a commercial, regulatory, or tax perspective because they have been domiciled offshore, and
2. European legislation in the area of financial services has concentrated on regulation at service provider level and not at product level so there has been less of an historical policy emphasis on understanding products.
It is the argument of this article that although such a European or international commercial regime is only currently being debated the regulation of the industry is pushing ahead from other perspectives9 and therefore a definition of the term "hedge fund" is necessary.10 Without a working definition of this term any regulatory measures introduced may be illusory. Regulation must seek to establish legal certainty and in the absence of a definition it is impossible for any regulatory measures introduced in relation to hedge funds to be applied or enforced with any degree of certainty.
The main issue here therefore becomes: how do you create an internationally acceptable definition when there is so much jurisdictional inconsistency? The two contrasting options which are available are: (a) a prescriptive rules-based approach where a definition is built upon the harmonization of technical requirements, or (b) a higher level principles-based approach where a definition is built upon commonly accepted and recognised attributes. What this article sets out to achieve is to not only to show that such a definition can and should be developed in a principles-based form but to propose a definition in such a format.11
In supporting my proposed definition, I will address two key areas which will be broken into a two-part series. Part one of this series will address the history of hedge funds and how they have evolved over time due to significant economic events. Based on these developments this section will also address the existing explanations of the term "hedge fund" from a select number of international jurisdictions to assess how adequately regulators and legislators have captured the essence of what hedge funds are in the wake of those significant economic events. Key principles will be drawn and applied to a prospective definition of the term "hedge fund".
Part two of this series will address the characteristics of hedge funds. This is perhaps the most important issue as hedge funds are difficult to describe but easy to identify by their characteristics.12 These characteristics will be central in my principles-based definition and my argument that this approach can successfully overcome the current regulatory dilemma of defining hedge funds as regulation looms. In the absence of a clear definition regulatory measures introduced will not be built on a foundation of legal certainty and therefore of central importance to the regulation of hedge funds is their definition and the setting out of boundaries within which the regulation will apply. This section will also address trading strategies which are another way of determining if a fund is categorized as a hedge fund or a more traditional mutual fund. This strategy classification is also crucial to a principles-based definition of hedge funds and therefore I must demonstrate how each strategy of a hedge fund is classified and identified. This section will condense the many characteristics and strategies which are "distinguishing features" into key principles which represent "proposed rules" and which constitute my proposed definition of the term "hedge fund".
The concept of hedge funds and where it came from
Essential to an understanding of hedge funds is an appreciation of where they originated and how they have changed over time to what we know today as hedge funds. Hedge funds owe their beginnings to nearly two hundred years of crisis and development in the area of mutual funds. These developments frequently followed adverse economic events and fashioned new classes of investors. As investors in mutual funds altered their appetite for the nature and levels of risk to which they were exposed, financial innovation moved one step at a time from mutual funds to what became known as hedge funds. The change in investing techniques over time due to these economic events is the understanding that is needed in order to define the term "hedge fund".
In assessing how investing techniques have changed over time we must acknowledge that this evolution of a new strand of collective investing never posed a significant issue for policy makers until a hedge fund known as Long Term Capital Management (LTCM) was bailed out of nearly $5 billion of losses made as a result of the Russian default and subsequent devaluation of the ruble in late 1998, before LTCM hedge fund losses had been restricted to their wealthy investors. However, LTCM evidenced the ability of a single hedge fund to affect an entire economy's financial stability and cause widespread contagion in financial markets. Therefore we can split up the history of hedge funds into two specific eras: 1. pre-LTCM and 2. post-LTCM.
Pre-LTCM
The concept of collective investing has been formally in existence since 1822 when King William of the Netherlands set up the first investment fund, to him being the pooling of money to make investments for the common good of those who had invested their money.13 After the fund set up by King William in the Netherlands, the Scottish Life Company set up a mutual fund in Scotland, that being recognised as the second recorded mutual fund in history.14 The investment technique of pooling money was proving favourable with investors and this is the foundation of both mutual and hedge funds. By 1830 the New York Stock Exchange had been formed with a small number of listed companies and organisations were investing in these listed companies as a way of providing pensions for employees on retirement. The faculty and staff of Harvard University appreciated the wisdom in this financial concept and pooled their money together in 1893 to constitute the first unofficial mutual fund in America.15 However, in light of the 1893 run on gold and silver which caused markets to fall rather than investing in one single company they diversified their investment over a portfolio of stocks. This investment technique of diversification born of economic crisis is another foundation element of both mutual and hedge funds. Finally, on March 21, 1924 the Massachusetts Investors Trust was formed and incorporated these two concepts of collective investing and diversification. This was the first official mutual fund in America and in no small measure it owed its existence to the 1893 economic crisis where necessity forced financial innovation. Collective investment schemes were moulded even further by the 1926 Stock Market crash. The diversification of risk through a strategy of collectively investing in a portfolio of stocks was the answer to previous economic crisis but with the crash of 1926 investor demands for risk mitigation was forcing further financial innovation. A greater appreciation of risk was needed to help investors avoid losses that would undoubtedly occur should such a crash ever happen again.
Congress enacted legislation to protect investors and with the Securities Act 1933 and the Stock Exchange Act 1934 protection would be provided to investors of mutual funds by requiring those funds to register with the Securities and Exchange Commission and to provide every prospective investor with a prospectus that would allow for a more informed investment decision to be made. The Securities and Exchange Commission was pivotal in the development and eventual passing into law of the Investment Company Act 1940 which sets out the rules which were to be adhered to by all funds, and which are still recognised in the US today. However, this regulatory response to economic crisis was one of disclosure not one of risk mitigation. Risk mitigation would have to come from financial innovation. Out of this investor appetite for an alternative investment vehicle that could eliminate risk emerged the hedge fund industry. Alfred Winslow Jones is credited with pioneering the hedge fund movement when in 1949 he coupled the concepts of leveraging and short selling into an investment technique known as hedging. Although this did not eliminate risk it did hedge the risk or in other words neutralize the negative effects of price movements in the market. Leverage is the extent to which an institution or fund is borrowing money and is usually measured and restricted as a percentage of the net asset value of the fund. Short selling is a strategy which enables the hedge fund to profit from the decline in the price of a security instrument. To profit, a short seller simply borrows securities from a broker and sells them at the market rate. Then when the market price decreases the short seller buys the securities back and returns them to the broker he borrowed from. The difference between the initial price the securities were sold short at and the price they were bought back at represents the short seller's profit. The major risk inherent in short selling is that it is based on the prediction that the securities will decrease in value. For this reason, short selling can be very expensive when security prices actually rise above the initial price at which the securities are short sold. If this occurs the short sellers' liability begins to exponentially increase.16 When several short sellers find themselves in this situation a phenomenon known as a "short squeeze" occurs. This occurs as security prices increase and short sellers race to close their positions but with the increased buying of a security the price will increase and therefore losses will mount even faster.
By leveraging to buy long17 and short selling the exact same amount of securities, Jones found that he was effectively protecting himself against any adverse market movements, in essence he was hedging his bets and thus the hedge fund concept was born. By the 1960s over 14018 hedge funds existed worldwide and short selling became a recognised investment technique as opposed to a mutual fund investment technique of simply buying more and more equity.
However, the historic 1973 bear market19 caused serious doubts in investors' minds as to whether or not hedge funds were actually a good investment strategy. Hedge funds should have been able to protect themselves in turbulent economic conditions as the opportunities for profit would have been present by short selling in a falling market.20 However, hedge funds had not fully developed to the point where survival was independent of economic trends and large numbers of hedge funds closed. By the early 1980s hedge funds had nearly disappeared. However, when George Soros, Michael Steinhardt and Julian Robertson set up hedge funds, such as the world renowned Quantum Fund,21 producing annual returns in excess of 50 per cent, the interest and intrigue associated with hedge funds returned. The emphasis had shifted from hedging to complex risk management to produce absolute returns with varying risk/return profiles. By 1990 there were over 500 hedge funds operating worldwide but this has escalated to the current level of over 9,500 with nearly $2.5 trillion in assets under management.22 While originally formed as a way to prevent losses, hedge funds today employ very sophisticated risk management techniques to achieve absolute returns regardless of market conditions. Therefore, the fundamental difference over time is that the aim of a hedge fund is no longer one of loss minimization but is now one of profit maximization. It is because of financial innovation in the area of mutual funds born of economic crisis that such techniques are now possible.
However, an intriguing fact about this entire development process is that for nearly 60 years hedge funds have dominated investment innovation globally but as of yet have never been officially defined. It's almost like the anecdotal quest for an explanation of what salt tastes like; nobody knows how to define it but everybody knows when they are tasting it. However, after 60 years we can no longer say that it is too hard to explain and define hedge funds. Although this is a task much easier said than done we must find a way to define this term and establish the boundaries within which future regulatory measures will operate.
Post-LTCM
Although many hedge funds failed pre-LTCM it was not until the Russian default of 1998 that a hedge fund failure linked to an economic crisis threatened the financial stability of an entire economy.23 LTCM was a hedge fund formed in 1994 by John Meriwether and several high profile traders, including two Nobel Prize winners: Myron Scholes and Robert Merton. LTCM had a global trading strategy concentrating on arbitrage and dynamic hedging. With annual returns of 20–40 per cent based on complex financial models LTCM began in 1997 to return capital to investors. The principals of LTCM decided to maintain the funds trading activities and positions on a reduced capital base by increasing the fund's leverage to 25/1. Although LTCM reduced its capital base to $4.8 billion in 1998, it maintained over 60,000 positions in its trading book and with its leverage, maintained over $50 billion in long positions and a further $50 billion in short positions. It also held futures contracts worth $500 billion, SWAPs contracts worth $750 billion and OTC derivative contracts worth $150 billion. However, LTCM's financial models were flawed because they were not designed to take into account the possibility of multiple markets simultaneously experiencing economic downturn. Once the Russian ruble was devalued in late 1998 many markets around the world simultaneously experienced a "flight to quality" as investors sought to avoid risk and invest in liquid products. As a result, in less than 4 months LTCM lost over $4.6 billion in capital and it took until 2000 for the 60,000 fund positions to be wound down completely. The risk to US financial stability came from the 60,000 trades that created an intricate web between all the major investment banks on Wall Street. LTCM, through its myriad of trades with Wall Street investment banks, had the potential to cause widespread contagion within financial systems and essentially cripple the US economy by leaving bankrupt many of those investment banks. However, in an extremely rare occasion the Federal Reserve orchestrated a rescue and, as mentioned above, LTCM was finally wound down in 2000. This is why the term "hedge fund" has become synonymous with that of financial stability. Along with LTCM such debacles as that of Amaranth,24 and more recently in the summer of 2007 with the sub-prime mortgage crisis that has caused turmoil in world financial markets, financial stability has increased political temperature for regulating hedge funds.
However, hedge funds have not caused these many economic events but are merely investors in the market for risky products, as many proprietary trading desks of large investment banks are. The association of high risk or financial instability with hedge funds is a misperception as hedge funds employ strategies that are often market neutral meaning the fund has been constructed in a way that it will benefit in either a rising or falling market. Also, hedge funds bring liquidity to markets in recessionary periods and therefore represent a stabilizing mechanism. In fact, in relation to hedge funds there have been many misperceptions that have been fostered by the broader financial industry.25 Hedge funds have been misunderstood26 at very fundamental levels with a lingering misperception that hedge funds' aim is to hedge. The term "hedge fund" is a misnomer as an overwhelming majority of hedge funds do not hedge in the traditional sense of the word. "Hedging" actually means the taking of two positions that offset risk so that regardless of the market events or market circumstances the risk bearer is left with a no win/no loss situation. This is often used to protect the value of currency. However, the original meaning of the term "hedge fund" does not bear resemblance to the hedge funds that we have today. Today hedge funds do attempt to profit based on the balance of long and short positions and therefore the use of the term "hedge fund" is actually a misnomer. It should be understood that today a hedge fund is an unrestricted investment vehicle for sophisticated and qualifying investors and whilst they may hedge in the conventional sense of the phrase they do so with a profit motive in mind. The term "hedge fund", with its roots in 1949 with Alfred Winslow Jones, is therefore a legacy of its origins but also was never changed because the term itself has never been defined.
With a greater emphasis on risk management and profit maximization, hedge funds post-LTCM have continued to use increasingly complex financial modelling to invest in increasingly complex products which are increasingly difficult to value. In essence this is what hedge funds have now become. However, the main effect that LTCM has had on the hedge fund industry is not to change investment techniques used by hedge fund managers but to increase the political temperature for regulating the industry. Secrecy, transparency, risk monitoring, portfolio valuation, consumer protection and financial stability have all come to the fore as policy concerns.27 However, it is impossible for any of these issues to be addressed before the term "hedge fund" is actually defined.
The differing definitions of a hedge fund
An appropriate place to begin this analysis is with IOSCO and its Technical Committee which undertook a significant amount of work in understanding hedge funds.28 The 2005 Committee came to four significant conclusions29 which demonstrate how fundamental a problem exists in the hedge fund regulatory space today. Not one IOSCO member responded that a legal definition for the term "hedge fund" existed in their jurisdiction. Although each jurisdiction had its own way of identifying and categorizing hedge funds there was no universally accepted formula. What is therefore crucial is to assess how some of these jurisdictions have identified and categorized hedge funds so that we can put together a set of established characteristics and ultimately key principles that will appropriately capture all of these vehicles.
The jurisdictions which I have selected are: Ireland, because of its significance as an administration, custody and listing location for hedge funds globally; Denmark, because it comes so close to defining "hedge funds" by its definition of "hedge associations"; Luxembourg, because of its significance as an administration and custody centre for hedge funds along with Ireland; France, because it classifies funds by the strategy they follow and French funds can register as alternative funds; and South Africa, because it is the jurisdiction which has recently introduced a legal definition for the term "hedge fund".
In Ireland hedge funds are not defined but collective investment schemes are authorised as either professional investor funds30 (PIF) or qualifying investor funds31 (QIF). The minimum investment restrictions of these vehicles act as a method of controlling the investor base to ensure that only appropriate investors enter the fund. Ireland allows funds to be established as unit trusts, investment companies, investment partnerships and common contractual funds. Both UCITS and non-UCITS can be marketed to investors in this fashion however a non-UCITS fund will use one of the four legal forms but be categorized as either a PIF or a QIF pursuant to the non-UCITS Notices. The characteristics which evidence the existence of a hedge fund are not the characteristics of a unit trust or a common contractual fund but rather the restrictions that the non-UICTS Notices place on the category of PIF and QIF. However, a PIF and QIF can also be established under the UCITS regime so it is the categorization of PIF or QIF plus the strategy followed by the fund that determine its true nature. The minimum investment element which determines the investor base of the fund and the investment strategy of the fund therefore represent two of our key principles in defining "hedge fund".
In Denmark investment vehicles known as "hedge associations"32 are used. These associations operate like a corporate entity in that all investors are members and each member has a vote in electing a board of directors at the annual general meeting. Although the fund has the legal characteristics of a company it is not these characteristics that identify the fund as a hedge fund. Rather it is the activities engaged in by the hedge association that evidence its true nature. A hedge association can invest in a diverse set of instruments including shares, bonds and derivatives. However, a hedge association is not required to adhere to diversification rules but strategies and leveraging limits must be disclosed. The ability to invest in complex financial products and leverage are therefore two key principles which must also be included in our definition.
In Luxembourg hedge funds are established as Specialized Investment Funds (SIFs)33 and designated as common placement funds known as FCPs,34 as variable capital funds known as SICAVs35 or fixed capital funds known as SICAFs.36 However, these statutorily defined variable and fixed capital fund structures are not what define a fund as a hedge fund or a traditional fund, they are merely legal structures. Rather than being an issue of legal form it is an issue of substance and the fact that the fund is a collective investment scheme that employs an alternative strategy that is the definitive aspect. However, although not legally defined Luxembourg does list hedge funds as a type of collective investment scheme37 but again places the emphasis on regulating collective investment schemes that follow "alternative" investment strategies. Therefore another key principle in our definition needs to be one that makes these points clear.
In France the categorisation of hedge funds works slightly different.38 Although there is no legal definition of the term "hedge fund", collective investment schemes can follow alternative investment strategies and the regulatory framework surrounds the strategy followed. Funds can be registered as funds of alternative funds (which in essence are funds of hedge funds), "ARIA" funds which contain lighter investment restrictions, and, "ARIA EL" funds which contain similar restrictions to ARIA funds but allow more extensive use of leverage. Therefore our definition must include a key principle to reflect the light investment restrictions associated with hedge funds, most notably the lack of restriction surrounding the use of leverage.
South Africa is a jurisdiction which has brought in a statutory definition of the term "hedge fund". Section 2(a), Notice on Codes of Conduct for Administrative and Discretionary FSPs Amendments Notice, 2007 [Board Notice 89 of 2007] states:
"'Hedge fund' means a portfolio which uses any strategy or takes any position which could result in the portfolio incurring losses greater than its aggregate market value at any point in time, and which strategies or positions include but are not limited to-
(a) leverage; or
(b) net short positions."
Therefore our key principles must include the fact that hedge funds invest in short positions and financial products that can cause loss to the fund in excess of the market value of the financial products themselves.
As is evident from the above jurisdictional reviews there are varying methods used whereby collective investment schemes are identifiable as hedge funds which must form part of our principles-based definition. These range from restrictions on the investor base by way of minimum investment limits to characteristics of the investment strategy employed such as the use of leverage and short selling. However, there is diversity and debate amongst jurisdictions on the limits and practices utilised by hedge funds.39 However, the difficulties with defining the term "hedge fund" are not just about politics and appeasing Member States. The difficulties fall into two primary categories—legal/political and commercial. As can be seen from the few jurisdictions above from a legal/political perspective the difficulty is, in essence, that every Member State would have to amend several pieces of legislation to reflect the new definition of hedge funds and to get to this point an international forum would have to deliberate on the technical specifics of a mutually agreeable wording for this heretofore fluid legal concept. However, equally as problematic is the commercial difficulty element in the equation. In order for legal wording to be drafted it is incumbent upon legislators to fully understand what they are being asked to define. As far as the commercial operation of hedge funds is concerned there is somewhat of a problem here. Some of the characteristics of a hedge fund such as leveraging and investment in complex derivative products are not restricted to hedge funds. This can be seen in a comparison with more traditional investment and commercial banking. The proprietary trading desks of an investment bank often buy and sell derivatives and engage in trading patterns that could be mistaken for those of a hedge fund. Commercial banks often buy securities on margin40 and engage in leveraging much the same way as a hedge fund. Hedge fund techniques have always existed; they are not new to financial markets. What is new to financial markets is the fact that those managing funds for the investment banks in this fashion are now separating from the investment banking sector and establishing this new alternative sector of fund management. The joint legal/commercial difficulty as stated earlier is that it is easy to identify but hard to describe a hedge fund. To the untrained eye perhaps it is a futile exercise, one never undertaken before because of the aforementioned problems. However, based on a principles approach a definition could be formed without the need to agree on technical legal terminology or distinguish between commercial practices of banks and hedge funds. In Part two on hedge fund characteristics and strategies I shall show how eight suggested key principles could be used to conclusively and definitively categorise investment vehicles as either hedge funds, or not.
Conclusion
In this first of a two-part series we have seen how the history of hedge funds has evolved over time due to significant economic events which have altered investor expectations. Existing explanations of the term "hedge fund" from a select number of international jurisdictions has also shown how adequately regulators and legislators have captured the essence of what hedge funds are in the wake of those significant economic events. This has resulted in a number of key principles which will form part of a proposed comprehensive principles-based definition of the term "hedge fund" in Part two of this series.
To view Part 2 of this article click here.
Footnotes
1 "Traditional investments" is a phrase likewise not defined but as it relates to the funds industry represents what the US terms as mutual fund investing. The EU label on these funds is UCITS after the European Commission Directive which established the regime whereby mutual funds are passported throughout the EU.
2 Council Directive of 20 December 1985 on the co-ordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) (Directive 85/611/EEC) as amended.
3 Hedge funds have gained favour with investors because of the returns which they are making. These returns are based on the hedge funds ability to keep its trading strategy secret and to keep administrative and regulatory compliance costs to a minimum. As discussed later in this text, defining the term "hedge fund" would necessitate many disclosures and create an increased administrative and regulatory compliance cost to the fund which would act as a commercial discouragement to investors.
4 Traditional funds and alternative investment funds are now showing signs of convergence. Under the UCITS III rules a strategy can be engaged in known as 130/30 whereby short selling may be engaged in on a restricted basis. This short selling strategy has always been synonymous as an alternative investment strategy but has now found its way into the traditional fund space, blurring the once clear lines between the two disciplines. Also, within the area of alternative investments there has been evidence of convergence of hedge funds and private equity. This widespread blurring of lines and convergence is partly because there are no definitions for key terms used extensively throughout the industry such as non-UCITS, hedge funds, alternative investments, and private equity. Perhaps from a commercial perspective this blurring of the lines has no significant downside, however, from a legal, regulatory and tax certainty perspective going forward we need to dust off the sand from the line and clearly define each investment vehicle category. Principles-based definitions will provide the most politically palatable solution to this issue as it will allow regulators across divergent jurisdictions to keep certain controls in place which may be difficult to get agreement on if a rules-based approach is adopted, i.e. such as the minimum level of investment that is appropriate for a hedge fund. For this reason defining the term hedge funds is necessary in order to avoid unintended consequences to other related areas where common characteristics and strategies exist but do not constitute hedge funds and this is best achieved through a principles-based approach as this article shall show.
5 Thomas R. Hurst., "Hedge Funds in the 21st Century: Do the benefits outweigh potential dangers to the financial markets" (2007) 28(8) Comp. Law 228–234.
6 For example, in Portugal and Luxembourg hedge funds are referred to and defined as Specialised Investment Funds (SIFs), in Ireland hedge funds are referred to as non-UCITS (NUs) and defined as Professional Investor Funds (PIFs) and Qualifying Investor Funds (QIFs), in Switzerland hedge funds are referred to and defined as investment companies with variable or fixed capital (SICAVs or SICAFs). However, it should be noted that all SIFs, PIFs, QIFs or SICAVs are not hedge funds but all hedge funds are SIFs, QIFs, PIFs, SICAVs etc.
However, often hedge funds are also colloquially referred to as "unharmonized collective investment schemes" as they are collective investments schemes which fall outside the UCITS framework. Again this is definition by default.
7 Although it must always be remembered that hedge funds managers are nearly always located in the UK or the US and therefore are regulated even if the funds are domiciled offshore.
8 Section 2(a), Notice on Codes of Conduct for Administrative and Discretionary FSPs Amendments Notice, 2007 [Board Notice 89 of 2007] which states:
"Hedge fund" means a portfolio which uses any strategy or takes any position which could result in the portfolio incurring losses greater than its aggregate market value at any point in time, and which strategies or positions include but are not limited to-
- leverage; or
- net short positions.
9 Although regulation from the perspective of the hedge fund is only at an embryonic stage regulation from the hedge fund manager perspective is moving ahead. In October 2007, the UK Hedge Fund Working Group released its two part consultation paper recommending 15 standards of best practice for hedge fund managers that it envisages over time will become a globally accepted standard of best practice for the industry. In light of the President's Working Group appointments during September 2007 and the creation of an Asset Management Committee to create a standard of best practice in the US a quasi-regulatory global standard of best practice does seem to be on the distant horizon for hedge fund managers. Both sets of standards are scheduled to be released in early 2008.
10 In October 2007, the UK Hedge Fund Working Group released its two-part consultation paper recommending 15 standards of best practice for hedge fund managers that it envisages over time will become a globally accepted standard of best practice for the industry. In light of the President's Working Group appointments during September 2007 and the creation of an Asset Management Committee to create a standard of best practice in the US a quasi-regulatory global standard of best practice does seem to be on the distant horizon. Also, the European Commission's release of respondents' submissions to a call for evidence in relation to a European private placement regime on October 15, 2007 also gives credence to the idea that regulatory regimes within the area of hedge funds may not be far off.
11 However, it is not necessarily the case that a statutory definition is the most appropriate to achieve the desired result. This is where the debate arises as to whether a rules-based approach or a principles-based approach is more appropriate. This issue will be addressed throughout the article.
12 UK Hedge Fund Working Group, Hedge Fund Standards Consultation Paper—Part 1, p. 33: "There is no legal or regulatory definition of a hedge fund in the UK and the range of funds covered by the term is very wide. Not all use leverage. Not all engage in short selling. And a few are now even quoted and open to retail investors. As a result hedge funds are easier to recognise than to define. However, they tend to share certain characteristics and are generally susceptible to the elephant test: although hard to describe, you know a hedge fund when you see it." (October 2007).
13 Jerry W. Markham, A Financial History of the United States: Volume 1, p.322.
14 Jerry W. Markham, A Financial History of the United States: Volume 1, p.323.
15 Jerry W. Markham, A Financial History of the United States: Volume 1, p.323. See Ch.4 entitled "Investment Trusts and the Panic of 1893" for an explanation of how the 1893 run on gold and silver caused economic crisis and played a pivotal role in how ordinary pension funds that lost money in times of poor economic performance migrated towards mutual funds as a way to diversify and mitigate market risk.
16 Short selling is done through a "margin account". This margin account must maintain a certain level of deposits against the accounts trading. If your account goes below this minimum level a margin call will be made to top up your account. This means that you must either put more cash into the account or liquidate the position. Therefore, as security prices increase margin calls will be made regularly.
17 If a trader believes a security is undervalued he will increase his holding of this security in the hopes that the price will increase once the market spots the inefficiency and the price increases to the appropriate market value. On the other hand a trader that believes that a security is overvalued will short sell it at the current overvalued price and buy it back once the market inefficiency has been corrected and the price of the security has reduced. The security short sold will then be returned to the lender. Therefore "going long" or buying long is a strategy of simply buying securities. "Going short" is simply a strategy of selling borrowed securities.
18 Gregory Connor and Mason Woo, "An Introduction to Hedge Funds", London School of Economics September 2003. 140 is the total number of hedge funds according to a 1968 survey of hedge funds by the SEC.
19 The 1973 stock market crash began in January 1973 and lasted until December 1974 but has its roots in an agreement made 30 years earlier. The Bretton Woods Agreement of 1944, which provided for a system of fixed exchange rates between signatory states, facilitated the growth of capitalism in a post WWII Europe that was economically weak. Bretton Woods was seen as a significant step in the establishment of a European and global financial regulatory regime as the system was based upon the cooperation of all contracting states to the Agreement. However, with the US significance within the Bretton Woods system decreasing and the eventual removal of gold backing from the US dollar in 1971 the Bretton Woods Agreement collapsed with contracting states reverting to a floating exchange rate system. Compounded and coupled with the oil crisis of 1973 this put tremendous pressure on world economies and exchange rates, particularly the capital markets where oil equities and derivatives were being traded. The collapse of the Bretton Woods agreement gave rise to one of the greatest global financial crises.
20 Without doubt this was related to Rule 10a-1 of the Securities Exchange Act 1934 which introduced a "tick test". This test restricted short selling to situations where the price of the security was higher than the last traded price of the security, or, where there is no change since the last traded price then the one that preceded it. In essence this placed a restriction on short selling in a falling market in order to protect the security price from destabilizing. However, this rule was abolished on July 3, 2007 by the SEC when they removed the restriction on the execution prices of short sales. See Securities and Exchange Commission, , 17 CFR PARTS 240 and 242 [Release No. 34-55970; File No. S7-21-06] RIN 3235-AJ76, Regulation SHO and Rule 10a-1. It seems coincidental that no sooner did the SEC remove the rule 10a-1 restriction on short sale prices that short-selling was engaged in extensively in the current global turmoil associated with sub-prime mortgage securities. However, we can still not blame this debacle on hedge funds for their use of short selling in the falling market. The fundamental issue lies with the risk classification at the securitization stage.
21 However, as well as being known for its profit-making, it ended up as a high profile failure. This dynamic of being a super-performing hedge fund followed by a spectacular failure also occurred with LTCM and Amaranth. Debacles such as these fund failures prove that hedge funds are very much prone to significant economic events.
22 Over 7,500 single manager hedge funds and over 2,500 fund of hedge funds as per Hedge Fund Intelligence.
23 For a complete review of the LTCM debacle see Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, Report of The President's Working Group on Financial Markets, April 1999.
24 Unlike LTCM, that was rescued and subsequently wound down, Amaranth Advisors actually collapsed after it lost $6.5 billion in September 2006 on wrong-way bets on natural gas prices.
25 See research paper: Ed Easterling, Hedge Funds: Myths & Facts, Crestmont Research, April 10, 2007. http://www.crestmontresearch.com/pdfs/HF%20Myths%20Facts.pdf
26 Easterling states in his research that:
The myths typically emanate from three sources:
(1) academics that are misapplying principles of finance and markets to hedge funds or that are repeating seemingly-logical perspectives,
(2) high-profile observers from outside the hedge fund industry that lack actual knowledge, and
(3) critics of the hedge fund industry that relish in attempting to discredit it.
27 Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, Report of The President's Working Group on Financial Markets, April 1999. In the UK the FSA has also expressed similar concerns about hedge funds in DP 05/4 [http://www.fsa.gov.uk/pubs/discussion/dp05_04.pdf]. The UK HFWG and the US President's Working Group also began to look at these issues in separate consultations in late 2007.
28 IOSCO's work commenced in 1999 after the debacle of LTCM highlighted a need for hedge funds to be given significantly more attention on an international level. This initial survey was a first step to understanding the divergent regulatory frameworks which existed and still do exist amongst both EU Member States and from an international perspective also. By 2001 IOSCO had realised that not only was there a systemic issue associated with hedge funds but that investor protection was so non-existent that if retail investors managed to gain access to a hedge fund product their money would in no way benefit from protections available to retail money invested in regulated products such as UCITS. This report, Regulatory and Investor Protection Issues Arising from the Participation by Retail Investors in (Funds-of) Hedge Funds, was published in 2003 but by 2005 IOSCO convened its Standing Committee on Investment Management (SC5) to review the situation.
29 1. No legal definition of the term "hedge fund" existed in any jurisdiction 2. Hedge fund advisors were regulated in most jurisdictions. 3. Few jurisdictions had experienced "retailization" of hedge funds. 4. Incidents of fraud had been discovered in relation to hedge funds in some jurisdictions.
30 See Non-UCITS Notice 12. An investment scheme is considered "professional" when a minimum investment of €125,000 is required but slightly different rules apply when the Professional Investor Scheme is in the form of a Unit Trust and a Variable Capital Company. There are a few exceptions to this requirement but only in the cases where the investor has already invested in a sub-fund or an umbrella scheme, the investor is the Management Company, or the investor is an employee of the Management Company. IFRSA has strict guidelines on the operation of Professional Investor Schemes and requires transparency in relation to all risks and exposures to be evidenced in the prospectus. A feeder fund and a fund of hedge funds product can be established as a Professional Investor Scheme.
31 See Non-UCITS Notice 24. An investment scheme is considered "qualifying" when a minimum investment of €250,000 is required and marketed to institutions and individual investors with minimum net worth limits of €25 million and €1.25 million respectively. However, there are slightly different rules applied when the Qualifying Investor Scheme is in the form of a Unit Trust and a Variable Capital Company. As is the case of Professional Investor Schemes there are a few exceptions to this requirement but only in the cases where the investor has already invested in a sub-fund or an umbrella scheme, the investor is the Management Company, or the investor is an employee of the Management Company. Depending on the intended ultimate investor such schemes can be organized as feeder funds or as fund of hedge funds products.
32 Chapter 16a, Investment Associations and Special Purpose Associations etc Consolidated Act & Bill L55 of 31 January 2006.
33 On February 13, 2007 the previous 1991 law relating to Specialised Investment Funds in Luxembourg was amended to broaden the scope of eligible investors into SIFs. This extra flexibility, along with some amendments to the tax regime and listing process to coincide, has been advantageous to hedge funds. Circular CSSF 02/80 outlines the rules applicable to Luxembourg domiciled hedge funds and fund of hedge funds.
34 Fonds commun de placement (FCP) which is a type of contractual fund. However, this is not the most commonly used investment vehicle for hedge funds.
35 Société d'Investissement À Capital Variable (SICAVs). This is a legal structure in both France and Luxembourg but does not specifically relate to hedge funds. It is simply an open-ended variable capital fund structure. Not all SICAVs are hedge funds but hedge funds can be established as SICAVs.
36 Société d'Investissement À Capital Fixe (SICAFs). This is a legal structure in Luxembourg but again does not specifically relate to hedge funds. It is simply a closed-ended fixed capital fund structure. Not all SICAFs are hedge funds but hedge funds can be established as SICAFs.
37 Luxembourg Circular CSSF 02/80.
38 See Decree 89-623 as amended.
39 For example the EC Expert Group on Alternative Investments recommended to the European Commission in its July 2006 report on the future of hedge funds in Europe that the minimum investment limit should be harmonized at €50,000 so that inappropriate investors would not gain access to hedge funds. See Report of the Alternative Investment Expert Group, Managing, Servicing and Marketing Hedge Funds in Europe, July 2006. http://ec.europa.eu/internal_market/investment/docs/other_docs/reports/hedgefunds_en.pdf
40 Margin refers to the borrowing of money specifically for the purpose of buying securities. This practice is most commonly referred to as "buying on margin". This is done through a margin account, with a broker, which will have a minimum requirement of deposits and/or securities. When deposits or securities go below these minimum maintenance levels the broker makes a "margin call" for extra deposits or securities.
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