UK: Hedge Funds And The Definition Challenge - Part 2

Introduction

This article was published originally in the Commercial Law Practitioner and it is the copyright of Thomson Round Hall

Part 1 of this two-part series addressed the history of hedge funds and how they have evolved over time due to significant economic events. Based on these developments, existing explanations of the term "hedge fund" from a select number of international jurisdictions were assessed to determine how adequately regulators and legislators have captured the essence of what hedge funds are in the wake of significant economic events. Key principles were drawn from this analysis which will be applied to a prospective definition of the term "hedge fund" in this concluding series.

Part 2 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.¹ 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 categorised 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".

Hedge fund characteristics

In analysing hedge funds and what constitutes a hedge fund, irrespective of what name is given to the investment vehicle, I propose a list of attributes that support a presumption that the investment vehicle in question is appropriately categorised as a hedge fund.² These characteristics are:

1. Collective investment scheme

A hedge fund can be either an open or closed-ended investment pool of more than one investor known as a collective investment scheme. The elements of a collective investment scheme change from jurisdiction to jurisdiction but the main accepted characteristic is that there are several investors in the private investment pool.

2. Short selling

A hedge fund that believes security prices will fall can borrow same from a broker and sell at the current market price. Then when the price decreases the securities can be bought back and returned to the lender thus yielding a profit to the hedge fund.

3. Leverage

A hedge fund can magnify its profits by borrowing to fund the purchase of securities that it believes will increase in value.

4. Absolute returns

A hedge fund can use short selling, leveraging, futures, derivatives, options and other alternative methods to make positive returns regardless of market conditions. This is known as absolute return. This is in contrast to traditional funds which only try to beat the market index in a rising or falling market which is known as relative return.

5. Complexity of products

A hedge fund can invest in much more complex products than mutual funds, such as collateralised bond and debt obligations.

6. Illiquid instruments

A hedge fund often invests into securities which are not quickly or easily converted into cash. Often this happens by way of a "side-pocket" where all illiquid securities are segregated.

7. Non-transparent instruments

A hedge fund often invests in instruments which can be classified as non-transparent. In the recent sub-prime debacle it was difficult for collateralised debt obligation ("CDO") and bond-holders whose bonds were related to the sub-prime mortgage market to have seen through the instrument that they bought to the risk attached to the instrument at the securitisation and rating stages. It is not and will not always be the case that complex repackaged debt or equity products will be that transparent.

8. Highly risky instruments

A hedge fund can invest in instruments such as highly complex derivatives and tailor made over-the-counter ("OTC") products.

9. Instruments with the ability to cause loss to the fund in excess of their market value

A hedge fund can invest in highly complex products that have the risk potential to cause losses to the fund in excess of their market value.

10. Measure of performance

A hedge fund will self impose an absolute return which it expects to deliver to investors instead of measuring its performance against a market index.

11. Fees and remuneration

A hedge fund charges a management fee but has an added performance fee which is a percentage of the profit made by the fund. This is charged because hedge funds have an absolute value objective meaning they seek to make positive returns even in slow or declining markets. Industry norm is a fee structure known as 2 and 20 — 2 per cent management fee and 20 per cent performance fee.

12. Resilience to a falling market

Hedge funds are able to utilise certain short selling strategies to protect from the risk of a falling market and thus can even produce positive returns in a period of economic downturn.

13. Future performance

A hedge fund's future performances can be very predictable depending on the strategy being followed and tends to be market neutral to avoid the risks associated with rising and falling markets.

14. Capacity

A hedge fund will limit its maximum size in order to operate at an optimum efficiency level. The maximum capacity of a hedge fund can differ from fund to fund as the strategies and markets used vary and the leverage, risk and liquidity variables change.

15. Investor access

A hedge fund may be lightly regulated but there is a general restriction of unsuitable investors by way of placing a minimum investment amount on the investment vehicle. This, however, may vary from jurisdiction to jurisdiction. Also, there may only be certain times when an investor can subscribe to a fund and a notice period may apply.

16. Market focus

A hedge fund will usually focus on a niche market and follow a specific strategy of using long and short positions.

17. Frequency of valuation

A hedge fund will usually calculate and publish an official net asset value once a month whereas a traditional fund may do this as frequently as on a daily basis.

18. Liquidity

A hedge fund may impose lock-up periods so that subscription money in the fund is not redeemable within a certain pre-agreed time. As well as there being only certain times in the year when holdings may be redeemed, depending on the funds dealing cycle and net asset value calculation dates, there may also only be certain dates when an investor may subscribe to the fund's shares.

While a single characteristic in isolation is not a conclusive indication of the existence of a hedge fund the conclusion of such becomes more certain with each additional characteristic. Therefore as part of any comprehensive definition of the term "hedge fund" there must be a reference to the majority of these characteristics in one form or another³ because traditional funds can often display the majority of these characteristics, but in isolation.

The one characteristic most associated with the hedge fund industry is that of the fee structure. The hedge fund industry norm has become known as "2 and 20". This signifies the level of management and performance fees charged by the hedge fund manager. The hedge fund manager will usually charge a management fee to the fund of 2 per cent of assets under management and 20 per cent of the profits of the hedge fund as a performance fee. For this reason, such a structure I propose is an independent key defining characteristic of a hedge fund. However, it is worth remembering that even the fee structure is being adopted by other areas of asset management.

Trading strategies as a characteristic

The above characteristics provide a basis upon which strategies may be followed and in line with Sir Andrew Large's concluding remark in the recent UK Hedge Fund Working Group ("HFWG") consultation jurisdictions, such as Luxembourg, are choosing to regulate hedge funds by identifying them by the strategy that they follow. Hedge fund strategies fall into a number of categories including:

1. Convertible bond arbitrage

This occurs where a fund manager identifies a discrepancy in the value of a convertible bond and the underlying share. This strategy is engaged in by the fund manager purchasing the shares and selling short the bonds, or vice versa.

2. Distressed debt / securities

This occurs where a fund manager identifies undervalued shares in the market due to market over-reaction to company announcements of financial difficulty or even bankruptcy. This strategy is engaged in by the fund manager purchasing shares or debt in those companies.

3. Equity long/short

This occurs where a fund manager believes that a share value will either increase or decrease in the future. This strategy is engaged in by purchasing shares that are believed to increase in value while selling short shares that are believed to decrease in value.

4. Fixed income

This occurs where a fund manager identifies discrepancies in the pricing of related classes of bonds, which are fixed income securities. This strategy is engaged in by purchasing bonds that are believed to be underpriced while selling short bonds that are believed to be overpriced.

5. Fund of hedge fund

This is a strategy of relying on the individual expertise of other fund managers. This strategy is engaged in by investing in other hedge funds, who then invest in the open market. It does provide a layer of diversification as risk is spread between a number of hedge fund managers and this is why in most jurisdictions, such as Ireland, retail investment into hedge funds is only allowable through fund of hedge fund vehicles.

6. Global macro

This occurs where a fund manager buys both long and sells short securities in various countries based on predicted monetary, fiscal, economic and political policy.

7. Managed futures

This occurs where a fund manager both buys long and sells short-listed financial and commodity futures or currency in the global market. This strategy is engaged in by purchasing futures that are believed to be underpriced while selling short futures that are believed to be overpriced.

8. Equity market neutral

This is a strategy of remaining neutral to market movements by buying long and selling short the exact same amount of a security thereby always maintaining the requisite level of securities to cover your short positions.

9. Merger arbitrage

This is a strategy of investing in companies that are subject to actual or expected merger or takeover. This strategy is based on the concept that there will be a spread between the current market price of the company's shares and the anticipated price of the company's shares once the merger or takeover is completed.

10. 130/30 or other variation

120/20, 140/40 or any other variation thereof. This is a quasi-alternative strategy that traditional funds are now starting to employ. This is a strategy where a 100 per cent long portfolio of shares is combined with a select short selling strategy. Of the long portfolio, 30 per cent is then sold short (the portion which the fund manager believes will underperform the market), the proceeds of which are used to buy long a further 30 per cent (the portion which is believed to outperform the market). Therefore, while the net exposure to the market remains 100 per cent due to the 30 per cent extra long covering the 30 per cent short, the strategy nevertheless aims to achieve higher returns than a 100 per cent long only portfolio.

11. Activism

Activism is the strategy of purchasing voting shares in a company for the specific purpose of influencing the policies and management of the company.

What every one of these strategies has in common is that they are based on the principles of leverage and short selling to magnify returns, a combination of which has been at the heart of debacles such as Long Term Capital Management ("LTCM"). Parry identified this as a problem when she states:

However, there is now many acknowledged benefits to the market from hedge fund investing, such as providing liquidity and stability to the market as per a recent Financial Stability Forum ("FSF") report when it was stated that:

Therefore, we have to include the elements of leverage and short selling into our definition of hedge funds along with strategy elements as another key principle. Again, as in the case of hedge fund characteristics above strategies are not necessarily definitive in the assessment of whether a fund is a hedge fund or not. As we have seen with 130/30 strategies, traditional funds are now employing short selling which had previously been viewed as a strictly alternative technique. However, one major difference between characteristics and strategies is that a fund may have several characteristics but will only pursue one strategy. The exception to this rule, however, is a fund of hedge fund strategy whereby a hedge fund manager allocates his assets under management to several underlying hedge fund managers instead of investing in the open market himself. This means that he can invest in hedge funds that follow different strategies and this is one technique that a hedge fund can use to diversify and reduce risk.⁶ As strategy is crucial to a fund we must therefore encapsulate this importance into a key principle in order to comprehensively define the term "hedge fund".

Principles v Rules

In ensuring that a "level playing field" is established upon which hedge funds can be regulated, limits need to be clearly set out as to what constitutes a hedge fund and what does not. Chorafas⁷ refers to this concept in his analysis of hedge funds when he quotes Winston Churchill as saying, "the difference between genius and stupidity is that genius has limits." Harmonisation of divergent rules and definitions has been a key to the EU's creation of an internal market over the last number of decades and continues today.⁸ However, it being clear that a definition for the term "hedge fund" would be required to introduce regulation what is important to my analysis at this stage is whether or not such a definition should take the form of a "principles-based" approach or a "rules-based" approach.

The advantages and disadvantages of principles-based regulation and rules-based regulation does not form part of my analysis as each has its desirable and undesirable effects on a regulator and firms or products that are regulated. Principles-based and rules-based regulations are suited to different circumstances and when different regulatory objectives are being pursued. What is important to my analysis is to determine if defining the term "hedge fund" is an appropriate situation to adopt a principles-based over a rules-based approach. Tiner states:

Therefore, we can see that there is a place for both rules and principles and the challenge for hedge fund regulation will be to get the balance right between instances where rules or principles are applied. In deciding which approach is most appropriate there must be an assessment of whether the measure introduced constitutes a means or an ends. This may not be an easy task. In regulatory terms, harmonisation is an example of an outcome that is easily justified. Creating uniformity amongst divergent rules is an outcome and therefore suitably attained through the use of principles. However, prudential risks or a specific issue such as investor protection is not readily identifiable as an outcome in itself and therefore may form part of a higher economic or political outcome. Therefore such prudential risks are more suitably addressed under a rules-based approach. On first reflection the current issue of defining the term "hedge fund" is not easily identifiable as a means or an outcome. However, defining the term "hedge fund" is in essence about harmonisation as there are numerous and inconsistently defined hedge fund vehicles across EU jurisdictions. Therefore, defining the term "hedge fund" is suitably categorised as an outcome and the most appropriate way to define this term is therefore through a principles-based approach.

Separating regulatory measures between principles and rules is the key to better regulation. Whittaker¹⁰ looks at the concept of better regulation from the FSA perspective as a pioneering regulator of the principles-based approach. The most interesting argument that he makes is that of predictability when he states:

A principles-based approach is therefore only appropriate if it concerns specific outcomes and the principles themselves work in a predictable way. The challenge is therefore getting a set of clear principles that could be applied as a definition.

Although this is a challenge, taking a conceptual or "principles-based" approach to defining terms is not a new concept—at least in the US. As recently as 2004 there have been recommendations to the Securities and Exchange Commission ("SEC") to adopt such an approach to complex products such as asset-backed securities.¹² This has also been the accountancy industry case in the US where terms such as "diluted EPS" were deemed to be more appropriately defined conceptually or on a principles-based approach.¹³ The conclusion of the authors of this report was a recommendation to the Financial Accounting Standards Board ("FASB")¹⁴ that a principle-based definition would have the advantage of clearing up the confusion over what constitutes diluted EPS and bring significant improvement in processes and user understanding of the accounting principle. I argue that similarly trying to get European or international agreement on a legal definition for the term "hedge fund" would be an extremely difficult task. However, a conceptual or principles-based definition could quite conceivably be the best alternative in order to create the level playing field, flexibility, legal certainty and stable foundation upon which to build a hedge fund regulatory regime going forward which is sensitive to commercial realities. As the UK HFWG said, a hedge fund is easy to recognise but hard to define.¹⁵ This approach would take those easily identifiable characteristics and strategies and make them the key principles upon which a vehicle is deemed as a hedge fund or not for regulatory purposes.

By having a principle-based definition the main benefit from Member State to Member State is that they can keep the different legal structures that they employ as investment vehicles. The principles-based definition will concentrate on substance rather than form and therefore a conceptual foundation can be laid whereupon a fluid and adaptable hedge fund regulatory regime can be built. This would then be compatible with the new flexible principles-based approach currently being developed by both the UK HFWG and the US President's Working Group that are currently undertaking the establishment of best practice standards for hedge fund managers.

A proposed principles-based hedge fund definition

Having explained where hedge funds originated and how hedge fund investment techniques evolved, how they are characterised, what strategies they follow, and why a definition of the term "hedge fund" is essential, it is now time to propose the key principles that will form my definition. Although one principle on its own is inconclusive evidence of the existence of a hedge fund I propose that the presence of 50 per cent or more of the following key principles represents conclusive evidence that an investment vehicle is in fact accurately categorised as a hedge fund. The following are the eight key principles I propose as defining a fund as a hedge fund:

1. The fund operates as a collective investment scheme and maintains a minimum investment requirement

The minimum investment requirement is one method by which jurisdictions ensure that only suitable investors are allowed access to hedge funds. Retail or institutional/qualified investor funds can have different minimum investment levels but the fact that a minimum initial investment, or, minimum holding applies does signify that the fund is a hedge fund.¹⁶ Also, there must be multiple investors so that the hedge fund qualifies as a collective investment scheme.

2. A fee structure exists that includes a management and performance element

The fee structure of a hedge fund is always in the form of a management fee and a performance fee. The management fee charged for managing the fund is usually in the region of 1.5 to 2 per cent and the performance fee charged on profit the fund makes is usually 15 to 20 per cent. Traditional funds do not typically use this fee structure and therefore its existence is compelling evidence that the fund is a hedge fund.

3. A net asset valuation of the fund occurs no more frequently than once a month and this determines the fund's liquidity

A traditional fund may value the assets of the fund on a daily basis in order to facilitate investor subscriptions and redemptions on a daily basis. Only if an official net asset value is struck can it be possible to put a price on a fund's shares or units in order for them to be bought and sold. However, hedge funds do not offer the same liquidity terms as traditional funds, partly because the portfolio of assets is not valued on as frequently a basis. Hedge funds usually strike an official net asset value once a month or once a quarter and notice periods to redeem or subscribe may be a further 45 days before that, so liquidity and valuation no more frequently than once a month is evidence that the fund is a hedge fund.

4. The fund strategies employed are based on leveraging and/or short selling and seek to make an absolute return¹⁷

All hedge fund strategies are based on the concept of leverage and/or short selling with a view to making absolute returns. Traditional funds can use leverage and short selling but do so in pursuance of relative returns. Therefore if a fund seeks absolute returns and does so based on a strategy of leverage and/or short selling then that is evidence that the fund is a hedge fund.

5. The fund has the ability to invest in non-marketable, hard to value, illiquid securities

In pursuing an absolute return objective, and because liquidity terms do not allow for investors to redeem out every day, hedge funds often invest in non-marketable, hard-to-value, illiquid securities. These securities would not be allowed as part of a traditional fund where retail investors are protected from such volatile instruments because of their inherent risk and illiquid status. As part of a hedge fund strategy these securities are often segregated from the main portfolio of assets in what is known as a "side-pocket". The holding of such securities or creation of such "side-pockets" is evidence that the fund is a hedge fund.

6. The fund has the ability to invest in complex and non-transparent instruments that may cause loss to the fund in excess of their market value

In a traditional long-only fund equities are purchased. The more subscription money received the greater the equity positions become. If an equity price falls the lowest it can go is to zero. However, hedge funds often invest in a large array of complex derivative products which are not completely transparent and these positions have the ability to cause losses to the fund far beyond their initial or market value.¹⁸ Investing in such instruments is evidence that the fund is a hedge fund.

7. The fund is seeking to benefit from an exempt regulatory status

Collective investment schemes are not always regulated and in the case of hedge funds they often benefit from an exempt regulatory status. Therefore the fact that a fund applies for an exempt status is evidence that the fund may be a hedge fund

8. The fund operates based on a maximum capacity premise

A traditional long-only fund will keep accepting subscriptions due to its strategy of building long positions. However, there is a capacity issue associated with hedge funds because of the finite number of opportunities in the market to engage in arbitrage or short selling. Therefore, a unique characteristic to hedge funds is when they reach a certain size they "soft close" in order to keep the fund operating at an optimum efficiency and profitability level. Therefore the existence of such a limit is evidence that the fund is a hedge fund.

Conclusion

The heterogeneity of hedge funds is one of the main reasons why a common definition has been so difficult. This problem is only further compounded by people's misperceptions and misunderstandings about hedge funds, issues largely perpetuated by such debacles as LTCM, Amaranth, the US sub-prime mortgage default and the collapse of Northern Rock. It is because of these debacles that hedge funds have been labeled as risky, volatile and overly aggressive. However, too much attention has been paid to the perceived risks that hedge funds pose and not enough attention paid to rather fundamental issues, such as their definition and creating necessary lines of clarity.

On a policy level it is impossible for European or national regulations, national codes or notices, sound practices or best practices to make any difference if we don't clearly define who is going to be bound by them. Could it be foreseeable that a fund would try to evade such regulatory measures by claiming it was or was not a hedge fund because no clear definition existed? Could a hedge fund avoid monitoring on the grounds that it used alternative strategies but was not a hedge fund? Of course it could and that is at the root of the necessity for regulation of hedge funds to be founded upon a common clear understanding and acknowledgment of what a hedge fund actually is.¹⁹

I propose that a definition of the term "hedge fund" could be built upon the principles-based regulatory concept currently being pioneered in the UK and at EU level. If EU Member States could agree and adopt key principles, the presence of which evidenced the existence and operation of a hedge fund, then it may circumvent the difficulty posed by each Member State having a different statutory definition for domestic investment vehicles.²⁰ A principles-based approach would allow for flexibility to be maintained as Member States would be allowed to specify the detail that applies under each principle. Each jurisdiction could keep their respective minimum investment limits, legal structures, fund restrictions, and registration categories. What the principles would do would be to say if a minimum investment level exists, if an exempt category of regulation exists, if certain types of strategies and securities are invested in, or, if certain restrictions apply to the fund such as capacity, liquidity and monthly valuation then the fund is appropriately classified as a hedge fund. What I propose is to create a principles-based definition of the term "hedge fund" that will respect the many different national categorisations and statutory definitions amongst Member States and link them through their commercially accepted commonalities.

Cullen has said that:

It is without doubt that one of the dimensions of hedge fund regulation that needs to be addressed is to whom it will apply. To set these necessary boundary lines that create legal certainty the term "hedge fund" must be defined.

To view Part 1 of this article click here.

Footnotes

1 UK Hedge Fund Working Group, Hedge Fund Standards Consultation Paper - Part 1, p.33 states: "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).

2 However, the mere existence of these characteristics is not conclusive evidence that the investment vehicle is a hedge fund. Each characteristic on its own can be used as part of a traditional fund. However, the more of these characteristics present the more likely the investment vehicle is to be a hedge fund. However, I do not propose that a principle-based definition of the term "hedge fund" contain every single characteristic listed. Rather, I shall propose a definition based on what I call "key" principles.

3 Certain hedge fund strategies will contain a mix of hedge fund characteristics and therefore one key principle could cover several characteristics and strategies.

4 Helen Parry, "Hedge funds, hot markets and high net worth individuals: A case for greater protection" J.I.B.L. 2001, 16(10), 255–264.

5 Financial Stability Forum Ongoing and Recent Work Relevant to Sound Financial Systems, September 14, 2007, p.39. http://www.fsforum.org/publications/OngoingNote140907forwebsite.pdf.

6 This is also the reason why retail investment into hedge funds in many jurisdictions is by way of fund of hedge fund only because it provides a layering of diversification. This point will be discussed in a later chapter on investor protection but it is only necessary to mention the fact at this stage.

7 Chorafas, Dimitris M., Alternative Investments and the Mismanagement of Risk (2003). In this text the risks associated with hedge funds are analysed and categorised as credit risk, market risk, operational risk, legal risk and technology risk.

8 The Lamfalussy Process is evidence of the desire at European level to create a more integrated and internal market through harmonisation, convergence and co-operation. Within the framework of this process the European Commission has engaged the issue of hedge funds through both Green Papers and White Papers. Green Paper on the enhancement of the EU framework for investment funds (Brussels, July 12, 2005, COM(2005) 314 final), led to the creation of two Expert Groups, one of which addressed the area of alternative investments. The recommendations of this Expert Group were then reflected in the following White Paper on Enhancing the Single Market Framework for Investment Funds (Brussels, November 15, 2006 COM(2006) 686 final). This White Paper's broad support to the recommendations of the Expert Group was given and certain issues such as reviewing the possibility of creating a European private placement regime, reviewing current investment policies and creating a framework for the growth of the retail hedge fund market were incorporated into its list of actions for 2007/2008.

9 John Tiner, former FSA Chief Executive, gave a speech at the APCIMS Annual Conference in Barcelona on October 13, 2006, entitled "Principles-based regulation; the EU context".

10 A.M. Whittaker, "Better regulation – principles vs. rules", J.I.B.L.R. 2006, 21(5), 233–237.

11 See above at p.237.

12 See the Financial Services Roundtable recommendation to the SEC dated July 12, 2004. Proposal, File No. S7-21-04.

13 A. Bruce Caster, Raymond J. Elson, and Leonard G. Weld, "Is Diluted EPS Becoming More Art Than Fact", The CPA Journal, September 2006. This article concentrates on the problems associated with defining the exact meaning and process of calculating diluted earnings per share.

14 The Financial Accounting Standards Board is a non-profit making private organisation that operates within the US to enhance and develop generally accepted accounting principles (GAAP).

15 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 contrast the US President's Working Group defined hedge funds after the LTCM debacle in 1998 as a pooled investment vehicle that is privately organised, administered by a professional investment firm, and not widely available to the public. However, with the debate on hedge funds moving toward retailisation it may be necessary for the President's Working Group to re-evaluate its criteria for its hedge fund definition.

16 For example, in France ARIA Funds have a minimum investment requirement of €125,000 and €250,000 for contractual funds. In Ireland, PIFs have a €125,000 level and QIFs a €250,000 required minimum investment. In Luxembourg, SIFs have a €125,000 minimum investment requirement. Spain has a €50,000 requirement for their single manager funds. This key principle would allow for each jurisdiction to keep their minimum investment limit. It is the existence of a limit, not necessarily the amount, which is the most important aspect.

17 Often we see that the legal structures used by hedge funds are also used by traditional long-only funds. The legal structure of an investment vehicle is therefore not definitive evidence of whether the fund is a hedge fund or not. We must conclude therefore that it is the substance, or the strategy, that takes precedence over the legal structure in determining if a fund is a hedge fund or not.

18 If a security is believed to be about to fall in value a hedge fund will short sell the security. This means that the security will be borrowed and sold at today's price in the hopes that tomorrow it will have fallen in price. Therefore, it will be bought back at the lower price and returned to the lender. However, when a security is short sold and the price starts to increase the propensity for loss becomes infinite as the price can keep rising and therefore closing the short position can be more expensive then the sale price of the initial security. This is ability is reflected in the recent South African definition of a hedge fund.

19 Hedge fund characteristics can be displayed by private equity funds, managed accounts, traditional funds and this is why hedge funds need to be clarified and distinguished from products that just use strategies similar to those of hedge funds.

20 Hedge fund investment vehicles are known differently throughout the EU depending on the Member State and each has its own restrictions, such as minimum subscription etc. – SICAVs, non-UCITS, etc. These would all fit into a common category of hedge fund. However, it must be remembered that not all SIFs, QIFs, PIFs, etc are hedge funds. However, all hedge funds are SIFs, QIFs, PIFs etc.

21 Iain Cullen, "The Future of Hedge Fund Regulation", AIMA Journal, September 2005.

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