The success of a hedge fund relies on more than just internal structure and governance. The jurisdiction in which a hedge fund operates will also have a considerable influence on its performance. This article, based on the book Hedge Fund Governance, Regulation and Performance around the World, considers the international differences in the interplay between hedge funds and hedge fund regulations.
What are Hedge Funds and How are Hedge Funds Regulated in Different Countries?
Hedge funds have been the subject of media attention in the US and around the world pursuant to the Bernard Madoff scandal, the Lehmann Brothers (a prime broker) failure, the Galleon Group conviction and the more recent allegations against the former employees of SAC Capital Advisors. Given the pronounced growth of the hedge fund sector in recent years and the perceived inadequacy of regulations faced by hedge fund managers, this attention is probably appropriate. One concern shared by market participants is that the size of the hedge fund industry coupled with potential agency problems1, activist investment practices2 and herding behaviour exacerbates financial instability3. At the peak in the summer of 2008, industry estimates suggest the market grew above $2.5 trillion in assets4. While this amount is comparatively small compared to the size of worldwide mutual fund capital (estimated at US$24.32 trillion by the Investment Company Institute), there is significant scope for the industry to move markets. For example, in the week of August 6, 2007, hedge funds following long/short equity strategies experienced massive losses. Empirical evidence on this event shows significant and growing systematic risk in the hedge fund industry5.
Hedge funds are essentially pools of capital that are typically sourced from institutional investors and high net worth individuals. The scope of investors that may invest in a hedge fund depends on the regulatory landscape in which the fund is registered, as explained in Chapter 3 of Cumming, Dai and Johan (2013)6. Hedge funds differ from traditional investment funds in a variety of ways. Generally, private equity funds may only invest in private equity, while mutual funds in public equities. Hedge funds on the other hand most commonly trade in liquid securities but are also able to leverage their positions with use of margins and short selling. They may also invest in derivatives, currencies and commodities, on any market in any country. Hedge funds seek to provide their investors with returns that significantly exceed benchmark market index returns by taking advantage of their scope of investment freedom and in turn, charge significant fees for their expertise. As hedge funds are not prohibited from employing a variety of investment instruments in pursuing their investment strategies, fund managers compromise on the extent to which their products or funds are able to be offered to the public. Most notably, by limiting public access to funds, hedge fund managers enjoy regulatory freedom to a certain extent. For example, freedom from restrictions on leverage, short-selling, cross-holding, incentive compensation, and derivatives positions.