By Douglas Cumming, Na Dai & Sofia Johan
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.
It is said that no man is an island, and that holds true for hedge fund managers. Hedge fund investment strategies are facilitated by various external (and increasingly internal) service providers, as depicted in Exhibit 1 (next page). A hedge fund itself has no employees and no assets other than its investments. The portfolio is managed by the investment manager, a separate entity which is the actual business and has employees.
As well as the investment manager, the functions of a hedge fund are delegated to a number of other service providers. The most common service providers are administrators, registrars, prime brokers, custodians, and distributors. The administrators assist the fund managers in providing fund administrative and accounting services, including record keeping, independent valuation of investments and meeting disclosure requirements. The registrar or transfer agent may assist the fund manager in processing subscriptions and redemptions and in maintaining the register of shareholders. Prime brokers can be either securities firms or banks. Prime brokerage services include lending money, acting as counterparty to derivative contracts, lending securities for the purpose of short selling, trade execution, clearing and settlement. Many prime brokers also provide custody services. The custodian has custody over the fund assets. Finally, the distributor is responsible for marketing the fund to potential investors. Frequently, this role is taken by the investment manager. In some funds, particularly in the US, some of these service provider functions are performed internally by the investment manager, a practice that gives rise to a potential conflict of interest inherent in, for example, having the investment manager act as administrator hence both determining the NAV of the fund, and benefiting from its increase through performance fees.
The fact that hedge funds operate in conjunction with these key players in Exhibit 1 means that the most important international differences in hedge fund regulation are those that affect their relationship. In particular, international differences in hedge fund regulation on: (1) minimum capital to operate as a hedge fund, (2) permissible marketing channels, and (3) restrictions on the location of key service providers. Specific details on these differences across countries are reviewed in detail in Cumming, Dai and Johan (2013) and PriceWaterhouseCoopers (2006, 2007), and briefly summarised below.
Some jurisdictions require hedge funds to maintain a certain level of minimum capitalisation to remain in operation. Greater minimum capitalisation facilitates financial stability by mitigating the risk of fund failure and ensures that lower quality and less reputable fund managers will have difficulty establishing funds. In view of the sophisticated investor base, it is perceived that only the funds that are able to attract enough investors and pass their due diligence exercises to raise the minimum amount of capital required should be allowed to operate. Also, as the fees charged by the hedge fund managers are dependent on the capital raised, there needs to be sufficient capital to meet overhead costs of managing a fund. Minimum capitalisation also indirectly ensures that hedge funds limit their investors to high net worth individuals and institutional investors as each investor has to invest a rather substantial sum. Austria has the greatest minimum capitalisation requirement at US$6.75 million among the 48 countries. Many jurisdictions such as Bermuda, Canada, New Zealand and the US currently have no minimum capitalisation requirements.
Different countries also have different permissible distribution channels. Jurisdictions limit the hedge funds’ distribution channels to mainly private placements as it precludes them from direct access to retail investors. In their aim to limit their investor base to sophisticated investors, this limitation on their distribution channels may inadvertently enable hedge funds to be less transparent with their initial disclosures in their placement memoranda, such as their fee structure and liquidity terms as the sophisticated investors may not necessarily be playing on a level playing field. Private placements are the only permitted distribution channel in some jurisdictions, such as Italy, the Netherlands Antilles and the US.
There are additional distribution channels through which funds may gain greater access to a wider range of investors. For example, 14 of 48 countries permit distributions via wrappers. Wrapper products are typically insurance policies or structured products, purportedly used by investors for tax deferral7. Legal practitioners have noted potential conflicts of interest with respect to disclosures in the wrapper and generally wrappers are used to overcome regulatory barriers in distributions to high net worth individuals8. Distributions via banks, regulated financial institutions, fund distribution companies and investment managers may be deemed by regulators to be appropriate in view of the strict regulatory oversight over these institutions themselves. Also, it is in the interests of the hedge fund themselves to avoid the inclusion of potentially unsophisticated investors to ensure the continuity of their ability to operate rather free of regulation.
The final type of regulation we address in this section is the restriction on the use of key service providers based outside the jurisdiction. Twenty of the 48 jurisdictions impose restrictions on the location of key service providers. Restrictions on location of key service providers typically require the presence of a local agent9. It is most probably the view of the regulatory authorities that the existing regulatory oversight of the key service providers providing support services to the hedge fund will suffice. Practitioners often warn against using low quality service providers (e.g. “…beware of the potential downside of using third-tier service providers. Furthermore, it is hard to garner the confidence of investors when you do not employ a top notch support network.”) The recent failure of hedge funds affiliated with Lehman Brothers and Bear Sterns has been attributable to low quality, unreliable service providers.
Suffice it to say that the international differences in hedge fund regulation do not capture all of the nuances of the differences across countries. For additional details, see Cumming, Dai and Johan (2013) and PricewaterhouseCoopers (2006, 2007). They do, however, enable broad levels of comparison that can be used in our empirical analyses of the effect of such regulations, which are discussed below and carried out in detail in Chapters 5-9 of Cumming, Dai and Johan (2013).
What is the Impact of Hedge Fund Regulations on Hedge Funds?
In Cumming, Dai and Johan (2013) we seek to analyse the impact of hedge fund regulation of hedge funds. One argument consistently being put forward opposing more onerous regulation of hedge funds is the threat of regulatory arbitrage, or hedge funds moving from one jurisdiction to another less regulated one to avoid onerous regulatory oversight. A central issue considered in Chapter 5 of Cumming, Dai and Johan (2013) is therefore whether hedge funds that are pursuing riskier strategies are also practicing regulatory arbitrage to facilitate such strategies. The data presented in Chapter 5 suggest that funds pursuing riskier strategies or strategies with greater potential agency problems select jurisdictions with more stringent regulations. We may infer from the evidence that forum shopping by fund managers in relation to fund strategic focus is not consistent with regulatory arbitrage where funds select jurisdictions with limited regulation such that regulators have incentives to curtail regulation.
Chapter 6 in Cumming, Dai and Johan (2013) focuses on the issue of the ability of hedge funds to attract capital from their investors in response to changes in prior returns. Among other things, we show that hedge funds registered in countries which have larger minimum capitalisation requirements tend to have higher levels of inflows. This suggests minimum capitalisation enhances investor confidence. Chapter 6 also shows that hedge funds registered in countries which restrict the location of key service providers also have lower levels of inflows. This latter result is consistent with the view that locational restrictions are perceived by investors to mitigate human resource quality.
Chapter 7 in Cumming, Dai and Johan (2013) explains the different ways to measure hedge fund performance. We present data consistent with the view that restrictions on the location of key service providers and permissible distributions via wrappers are associated with lower fund alphas, lower average monthly returns, and higher fixed fees. Further, restrictions on the location of key service providers are associated with lower manipulation-proof performance measures, while wrapper distributions are associated with lower performance fees. As well, the data show standard deviations of monthly returns are lower among jurisdictions with restrictions on the location of key service providers and higher minimum capitalisation requirements.
Chapter 8 in Cumming, Dai and Johan (2013) addresses the issue of hedge fund misreporting of monthly returns to investors. We find a positive association between wrappers and misreporting, particularly for funds that do not have a lockup provision. Also, we find some evidence that misreporting is less common among funds in jurisdictions with minimum capitalisation requirements and restrictions on the location of key service providers. We show misreporting significantly affects capital allocation, and calculate the wealth transfer effects of misreporting and relate this wealth transfer to differences in hedge fund regulation.
Chapter 9 of Cumming, Dai and Johan (2013) considers whether or not hedge fund regulation affects persistence. The data show evidence of three types of regulation influencing performance persistence. First, minimum capital restrictions increase the likelihood of performance persistence. Second, restrictions on location of key service providers mitigate performance persistence. Third, distribution channels decrease the likelihood of performance persistence.
Chapter 10 of Cumming, Dai and Johan (2013) considers whether or not regulation plays a role in fund survival. Finally, we examine arguments regarding the interplay between the hedge fund industry and the stability of financial systems and consider whether hedge funds affect macro-financial outcomes in a country, or the reverse causality regarding the affect of macro-financial conditions on the stability and survival of hedge funds. Other questions are similarly considered.
The Future of Hedge Fund Regulation
In summary, hedge funds are distinct investment vehicles relative to other financial intermediaries with distinct investment strategies. The asset class is very large in terms of its size and scope, and offers investors significant possibilities for enhancing returns. But hedge funds also present specific issues of agency and other problems that arguably give rise to the importance for regulation. Hence, it is worthwhile to consider evidence-based policy making by examining worldwide data on the interplay between hedge fund regulation and hedge fund structure, governance and performance. The empirical evidence in Cumming, Dai and Johan (2013) provides guidance to students, academics, practitioners and policymakers alike as to appropriate forms of regulation with reference to existing empirical data and existing international differences in hedge fund regulation.
About the Authors
Douglas Cumming is a Professor of Finance and Entrepreneurship and Ontario Research Chair at the Schulich School of Business, York University. His work have appeared in numerous journals including Review of Financial Studies, American Law and Economics Review, Financial Management, Journal of International Business Studies, and Journal of Financial Economics.
Na Dai, is an Associate Professor of Finance at the school of business at SUNY, Albany and is also a research associate with the center for institutional investment management at SUNY. Her work has appeared in journals such as Financial Management, Journal of Corporate Finance, Journal of Empirical Finance, and European Financial Management.
Sofia Johan is an Adjunct Professor of Law and Finance at the Schulich School of Business, York University. Her work has appeared in journals such as the Journal of Financial Economics, American Law and Economics Review, Journal of International.
References
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6. Cumming, D.J., N. Dai, and S.A. Johan, 2013. Hedge Fund Governance, Regulation and Performance around the World. Oxford University Press.
7. Fink, S., 2005, “The Distribution of Hedge Funds to Mass Affluent Investors”, Alternative Investment Management Association Journal (September) at http://www.aima.org/uploads/Fink68.pdf
8. Ibid.
9. PriceWaterhouseCoopers [PWC], various years. The Regulation, Taxation and Distribution of Hedge Funds. London: PriceWaterhouseCoopers.
