The Challenge of Reigning-in Hedge Funds through Regulation and the Need to Improve Disclosure Requirements

Master's Thesis, 2005

137 Pages, Grade: A- (German: Sehr Gut 1,3)



1.1 Statement of Problem
1.2 Aims of the research
1.3 Importance of the study
1.4 Research methodology
1.5 Scope and limitations of the study
1.6 Brief overview of the study
1.7 Abbreviations and acronyms

2.1 The origin of hedge funds
2.2 The Investment process
2.2.1 Qualification requirements for US hedge funds
2.2.2 Investor restrictions for US hedge funds
2.2.3 Hedge fund structures
2.2.4 Investment strategies and styles
2.2.5 Advantages and benefits of hedge funds
2.3 Summary

3.1 Introduction
3.2 Criticism of hedge funds
3.3 Transparency
3.3.1 Standards and requirements
3.3.2 Investor due diligence
3.3.3 Investment mandate adherence
3.4 Benchmarking and performance measurement
3.4.1 Valuation of Assets
3.4.2 Return Calculation
3.4.3 Dispersion of returns
3.5 Risk Management
3.5.1 Efficient Frontier
3.5.2 Mean-Variance
3.5.3 The Sharpe Ratio
3.5.4 Value at Risk (VaR)
3.5.5 Correlation and the effect of ‘herding’
3.6 Management fees
3.7 Index Surveys
3.7.1 Survivorship Bias
3.7.2 Selection Bias
3.7.3 Instant History Bias
3.8 Fund of Funds
3.9 Summary

4.1 Current regulation
4.1.1 USA
4.1.2 UK
4.1.3 Other countries Hong Kong Ireland
4.1.4 South Africa
4.2 Proposed regulatory changes
4.2.1 USA
4.2.2 UK
4.2.3 Other countries Hong Kong Ireland
4.2.4 South Africa
4.3 Summary

5.1 The plan and procedures of the study
5.2 Empirical Research
5.3 Summary

6.1 Summary of findings and conclusions
6.2 Recommendations
6.3 Suggestions for further research

Annexure 1: The CSFB/Tremont Hedge Fund Index values for June 2004
Annexure 2: The Hurst Index
Annexure 3: Nedcor Hedge Fund Review
Annexure 4: BJM Equity Fund
Annexure 5 : Survey questionnaire



I owe to many a debt of gratitude for the help I received in preparing this paper.

I am grateful to Professor J.H. van Rooyen for trusting me to write on a topic on which I had limited previous knowledge; for providing me with constant support, guidance and by being consistently available (despite a demanding schedule) to discuss my thoughts and questions at length to my satisfaction. Thank you!

I am also grateful to Ms Eigelaar-Meets and Professor D. Nel for their assistance in the formulation of my questionnaire and survey data analysis without whose input a core feature of this work would not have been possible.

I am especially grateful to all the professionals who took time out of very congested schedules to respond to my queries and to participate in my survey. A special mention goes to Mr Waron Mann and Mr Steven Becker (Abante Capital); Mr Edgar Loxton (Allan Gray); Mr Jan Mouton and Mr Paul Roos (PSG Capital); and Ms Lizelle Steyn, Mr Matthew de Wet and Mr Nic Andrew (Nedcor Retail Investments) for granting me personal interviews and sharing their industry insights with me.

Finally, I would like to thank my family, friends and Reggie for their emotional, spiritual and financial support and for endorsing my decision to return to study further and follow my passion which spawned this work.


This study aims to look at the definition of the group of alternative investments commonly known as ‘hedge funds’, in order to better understand why regulatory bodies the world over are vehemently working on introducing new legislation and guidelines as a means of maintaining market security and integrity in order to ensure adequate investor protection. This study posits that the two most viable options available to regulatory bodies to ensure effective implementation of these changes are (i) to either further restrict access to hedge funds and thereby curb their ‘retailization’ and/or (ii) to introduce rigorous levels of disclosure on the part of hedge funds and their intermediaries.

It is the objective of this study to establish that for either of these options to be attained, tangible improvement in both the quantity and quality of information disclosure from hedge funds and their intermediaries about their positions, strategies and exposures in a manner that would enable them to continue to provide the market efficiency-enhancing services that they currently offer. After introducing all the key issues that have motivated this resolve, the study looks at the current regulatory environment and the challenges facing regulators such as the varying degrees of banking freedom offered by different states and jurisdictions. Proposed changes to current legislation are also considered across several jurisdictions. The results from the local market field study set the platform for recommendations to be investigated in future studies in order to provide guidelines for the supervision of the hedge fund industry.


Hierdie studie het ten doel om die definisie van die groep alternatiewe beleggings wat algemeen as ‘skansfondse’ bekend staan, te ondersoek ten einde beter te begryp waarom regulerende liggame wêreldwyd hulle vurig beywer vir die instelling van nuwe wetgewing en riglyne om marksekuriteit en -integriteit te handhaaf ten einde beleggers voldoende te beskerm.

Na die bespreking van die sleutelkwessie, stel die studie ondersoek in na die huidige regulerende omgewing en die uitdagings wat reguleerders in die gesig staar, soos die wisselende grade van bankvryheid wat verskillende state en jurisdiksies bied. Voorgenome veranderinge aan huidige wetgewing vir verskeie jurisdiksies word ook oorweeg.

Die studie toon deur opname in die mark dat die twee mees lewensvatbare opsies tot beskikking van regulerende liggame om te verseker dat hierdie veranderinge doeltreffend geïmplementeer word, is (i) om toegang tot skansfondse verder te beperk en sodoende die ‘verkleinhandeling’ (‘ retailization ’) daarvan te kniehalter en/of (ii) om streng vlakke van openbaarmaking vir skansfondse en hulle tussengangers, in te stel. Die studie toon dat enigeen van hierdie opsies tasbare verbetering meebring in sowel die kwantiteit as die kwaliteit van die openbaarmaking van inligting deur skansfondse en hulle tussengangers aangaande hulle posisies, strategieë en blootstelling, en op ’n wyse dat hulle in staat gestel word dat hulle huidige dienste vir verbeterde markdoeltreffendheid, voortgesit word.


Figure 1: Performance of the CSFB/Tremont Index relative to other leading indicators

Figure 2: Risk Management is a puzzle

Figure 3: The Efficient Frontier

Figure 4: The current South African regulatory structure


Table 1: The World Bank’s long term investment policy asset mix

Table 2: Correlation of hedge fund performance with the size of the fees charged

Table 3: Hedge Funds vs. Fund of Funds investment requirements

Table 4: Comparison of current vs. proposed thresholds in the USA

Table 5: Q 2.1. Cross-tabulation of assets under management in South Africa

Table 6: Q 7.1. Cross-tabulation of whether quality should be improved per firm type

Table 7: Q 7.2.1. Communication more relevant to the investment decision of private investors

Table 8: Q 7.2.2. Communication more understandable to private investors

Table 9: Q. 7.2.3. Comparability of hedge funds from the point of view of private investors


Graph 1: Q 2.1 Assets under management in South Africa

Graph 2: Q2.2 Assets under management: Abroad

Graph 3: Q 3.1 Length of hedge fund investing/advising in South Africa

Graph 4: Q 3.2 Length of hedge fund investing/advising: Abroad

Graph 5: Q 7.2.1 Communication more relevant to the investment decision of private investors

Graph 6: Q 7.2.2 Communication more understandable to private investors

Graph 7: Q 7.2.3 Comparability of hedge funds from the point of view of private investors

Graph 8: Q 9 Factors preferred by the respondents for inclusion in a standard prospectus

Graph 9: Q 10 Setting of minimum hedge fund thresholds to make them more exclusive

Graph 10: Q 11 Setting of minimum FOF thresholds to make them more exclusive

Graph 11: Q 13 Restrictions on educating private investors

Graph 12: Q 15 Accommodation of differences in styles and strategies within a single benchmark

Graph 13: Q 19 Introduction of standardised risk measures

Graph 14: Q22. Fee structures should be improved in terms of aligning manager and investor objectives

Graph 15: Q 24 Mandatory participation in independent survey

Graph 16: Q 25 Retailization of hedge funds in the South African market

Graph 17: Q 26. Are management skill levels different between hedge fund and fund of fund managers

Graph 18: Q 29.1 Stricter regulation to safeguard the industry

Graph 19: Q 29.3 SRU operating costs to be met by hedge fund operators

Chapter 1 Introduction

“ It is a riddle wrapped in a mystery inside an enigma” - Sir Winston Churchill

This provocative quote by Mr Churchill, when deliberating on the seemingly unpredictable nature of the then Russian government, may appear prophetic to those who have taken a mild look at the group of alternative investment vehicles known as ‘hedge funds’.

Caldwell (1995) proposes that hedge funds are generally recognised as having been introduced to the world by journalist-turned-investment guru, Alfred Winslow Jones. A.W. Jones’ investment creation combined the concepts of short-selling and leverage into a single-purpose financial instrument. Short-selling involves borrowing a security and selling it to another party in anticipation that the market price of the security will fall before the debt is due enabling the initial buyer to repurchase it - at a lower price- in the market. Thus, the initial buyer (i.e. investor) can ‘return’ the security to the initial lender and earn a profit from the resultant price differential. Leverage is the process of investing with borrowed money as a means of amplifying potential gains.

Jones identified two sources of risk and sought to mitigate these by going long on the stocks he considered “undervalued” and short on the stocks he considered “overvalued”. By establishing a portfolio consisting of stocks that would be rewarded in part when the market went up with those that would also be rewarded when the market went down; the fund was thus considered to be hedged as losses from one position would be used to offset against profits of the other position. And so was born the term ‘hedge fund’. It may thus come somewhat as a shock to learn that most hedge funds today do not necessarily hedge at all - deliberately, so! Hedge funds are one of the largest growing investment vehicles amongst private investors, and endowment funds. Even the World Bank is heavily invested in them. Data from Managed Account Reports Inc. (Mar/Hedge) estimated that in 1998 US$110 billion was invested in hedge funds. Figures quoted from Hedge Fund Review (HFR) puts the current asset under management for the year ending December 2003 at US$817 billion. estimates that total assets invested in hedge funds will exceed US$1 trillion by the end of December 2004. This forecast, however, still pales in comparison to the US$25-plus trillion that is currently estimated to be invested in mutual funds, pension funds and insurance companies.

According to the Investment Company Institute, the funds are “ highly regulated financial entities that comply with federal laws and regulations. In particular, the Securities and Exchange Commission (SEC) regulates [them] under the Investment Company Act of 1940, ...which imposes restrictions not only on [the] funds but also on their investment advisers, principal underwriters, directors, officers and employees ” .

However, the aforementioned attributes only apply to the mutual funds, pension funds and insurance companies, to the exclusion of hedge funds. Consequently, hedge funds are not bound by most of the aforementioned regulatory authorities because they fall beyond the reach of most regulatory platforms.

Hedge funds are an alternative investment group of assets that, in terms of classification, fall into a grey area. As with lifestyles and artistic genres, alternative investments define the exclusion of all that is in the mainstream. The term hedge fund is commonly, but erroneously, used to define the entire class of alternative investment vehicles, when in fact they are a subset, albeit a pre-eminent one as a result of the ability to attract seemingly ever increasing investor funds (see Kunene, 2002:8). Hedge funds find private equity and venture capitalists as neighbours under this banner. Gregoriou and Rouah (2003), in referring to earlier work by Bing (2000) and Brown et al. (1997), aptly noted that the current problem with hedge funds is that there is a dearth of academic literature available defining their operations as “most of the literature and analysis of hedge funds has focused on assessing their performance”.

Despite the billions of dollars entrusted to them, great uncertainty regarding hedge funds still persists. Even amongst academics and leading hedge fund managers, there is still no clear definition for the term ‘hedge funds’, and that is just the tip of the iceberg. The recurring issue is that research on hedge funds has been inhibited as a result of the lack of disclosure by industry participants. Subsequently, the present size of the hedge fund universe can at best only be estimated as significant numbers of hedge funds elect not to participate in statistical surveys conducted by index providers such as TASS and Mar/Hedge

1.1 Statement of Problem

Previously hedge funds restricted participation by sustaining prohibitively high minimum entrance requirements and by strictly adhering to private placement policies which ensured that they remained accessible exclusively to wealthy and sophisticated investors. Historically hedge funds have seemingly operated beyond the reach of most regulatory authorities, and thus their increasing proliferation into investment portfolios has motivated regulatory authorities to review policies and guidelines in an attempt to improve the standard of disclosure requirements and transparency offered by hedge fund operators.

1.2 Aims of the research

This study aims to shed light on the historical and current issues relevant to the hedge fund industry, and to identify some of the difficulties facing regulatory authorities in their attempts to regulate the industry. This study recognises that for regulatory mechanisms to be successfully implemented and enforced, a compromise is required to be struck between the views and concerns of stakeholders on the buy-side advocating for their entitlement to full and relevant disclosure to ensure investor protection and market integrity; with those on the sell-side, protesting the autonomy and sanctity of their standing partnership agreements and the need to safeguard their investment positions against those who would seek to profit from this knowledge.

1.3 Importance of the study

This paper’s contribution comes at a crucial time for South Africa, given the growing interest in, and exposure to, hedge funds. South African investment industry stakeholders and the neighbouring regional economies that have historically emulated South African banking philosophies, standards and policies would also benefit from the suggestions proposed at the conclusion of this study. Existing uncertainty regarding the regulation of hedge funds presents a knowledge gap which all capital market centres must address in a consultative manner in order that compromise can be reached between the regulatory authorities and the hedge fund industry. It would be relatively facile for hedge funds to mutate into an entity even further from the reach of regulatory bodies.

Alan Greenspan assented to this school of thought when he said:

“[M]ost hedge funds are only a short step away from cyberspace. Any direct US regulations restricting their flexibility will doubtless induce the more aggressive funds to emigrate from under our jurisdiction….If the funds move abroad, our oversight will diminish”.

The lack of transparency, dispersion of investment returns, liquidity and incentive structures are all cited by Meyer (2004) as the main reasons why regulators have decided to legally reign-in hedge funds. Various regulatory and legislative bodies (e.g. SEC, FSA, SRP, BIS and IOSCO) are working on the revisions and additions to existing legislations in an attempt to cater for this shortfall. What is still under deliberation and study is the extent to which regulation can be introduced (see Lacey, 2003; DiBiasio; 2002 and Champarnaud; 2000) and how it can be efficiently and effectively enforced across the globe. The current legislation governing hedge funds is readily accessible (CME, 2004) although regulatory authorities acknowledge that it does not adequately provide for investor protection (FSA, 2004).

From the published research of the leading academic scholars in the field of alternative investments and works by investment experts which has predominantly looked at the risk management and performance measurement tools and policies, it is apparent that there is need for more research to be undertaken in the area of hedge fund disclosure requirements.

1.4 Research methodology

A survey of role players in the South African industry will be carried out. Initially attempts will be made to establish written correspondence with the Securities Regulation Panel (SRP), the Financial Services Board (FSB), the Alternative Investment Managers Association (AIMA) and local (i.e. South African, mainly in Cape Town area) hedge fund experts. After a detailed study of issues raised in academic literature sources, a questionnaire will be drafted to highlight the most pertinent issues regarding the local industry’s regulation and disclosure requirements. Interviews will be conducted wherever possible, in person, otherwise telephonically. Correspondence will be executed via electronic mail transmissions.

A sample of managers to be interviewed will be drawn from the following companies: Sanlam Investment Managers, Allan Gray, Nedcor Retail Bank, Coronation, African Harvest and Momentum Asset Management; which due to the concentration of the asset management industry in Cape Town, may be representative of the local industry. All the hedge fund managers participating in the Nedcor Hedge Fund Review will be invited to participate, as well as other that are not currently participating in this survey but have a presence in the market.

Pilot study

Initial interviews to several local investment companies should provide the feasibility basis to determine the scope of the investigation, to improve the study formulation and to provide feedback on the suitability and relevance of the survey questionnaire content. The pilot will also serve to establish whether the principal mode of investigation, i.e. interviews, will be feasible within the envisaged time frame.

Treatment of data

A qualitative analysis of the questionnaire responses will be carried out using SPSS and the results will be presented in either a summarised tabular form or in charts, or both. The comments will be incorporated into the study’s conclusion, and where applicable, recommendations.

1.5 Scope and limitations of the study

Of the numerous issues concerning hedge funds, most notably the use of leverage, the level of fees and the disclosure requirements, the latter that will be the main focus of this study The scope of the study will be restricted to hypothetical analyses and the field research will be limited to personal interviews and a questionnaire which will be distributed to as many stakeholders as can be reached within the available timeframe. The breadth of the on-site research will also be, as far as is possible, limited to the Cape Town area. Some of the limitations to this study include:

- Time constraints will limit the ability to carry out a broad-based study (Jan 2004 - July 2004). Several weeks (two or three) will be set aside for on-site interviews at various firms and authorities on the subject matter.
- Finances will also be a constraint as this study is privately funded.
- Participation of market players in the study is not guaranteed as their willingness, or lack thereof, will have to be established on a case-by-case basis.
- Hedge funds and asset management firms that currently offer hedge funds will be the prime targets of the survey, and thus for example the major banking groups through whose private wealth management divisions large hedge fund assets are held and invested will be under under-represented.

1.6 Brief overview of the study

The study will attempt to highlight the major issues surrounding the regulation of hedge funds, from their history to the current proposals to improve disclosure and transparency. Further, it endeavours to shed new light on the options for improving regulation of the industry.

Chapter 1: Introduction

The problem statement and aims of the study are stated with emphasis on the relevance and importance of the study to the field.

Chapter 2: Definition and description of hedge funds

An overview of the hedge fund industry from its inception in the USA is given, as well as an analysis of the industry environment in terms of regulation and structures. A brief review of some of the most commonly used hedge fund strategies and styles is given and the advantages of hedge funds as both an additional and a stand-alone investment tool are reviewed.

Chapter 3: Reporting standards and requirements

The vilification of hedge funds as investment vehicles is introduced and some of the issues are discussed with emphasis on those issues that influence or are influenced by disclosure requirements or lack thereof. The selected issues for discussion include transparency; risk management; compensation fees; index surveys and fund of hedge funds.

Chapter 4: Regulation and supervision of hedge funds

The current and proposed regulatory structures and their limitations of the US, UK, Hong Kong, Ireland and South Africa are investigated and reviewed.

Chapter 5: Empirical research

The empirical research is executed by means of a questionnaire survey to role players in the local industry. The results are analysed and summarised.

Chapter 6: Conclusions and recommendations

Recommendations are made to the South African industry in particular and the industry in general.

1.7 Abbreviations and acronyms

illustration not visible in this excerpt

Chapter 2 Definition and description of hedge funds

“ Human history becomes more and more a race between education and catastrophe ” - H.G. Wells

Hedge funds, like black holes in space, are probably best defined by all the attributes that cannot be ascribed to them, and this paradoxically, is part of their attraction.

2.1 The origin of hedge funds

In attempting to add clarity to the definition of hedge funds Bookstabber (1991) notes that:

“In terms of leverage, hedge funds are the entire universe except those funds that are restricted to leverage no greater than 1. In terms of positions, they are the entire universe except those funds that are restricted to long only. In terms of securities, hedge funds are the entire universe except those funds that are restricted to a somewhat arbitrary and generally evolving set of traditional assets”.

To better understand these attempts at defining hedge funds, it is important to analyse the origin of hedge funds. Alfred W, Jones’ initial application of the term “hedge fund” was appropriate given the strict adherence to the equally long/short strategies employed by his investment structure. However, a plethora of investing strategies that have since evolved now cover such a broad spectrum as to negate the continued practical relevance of the use of the term.

So convinced was Jones of the viability of his hedging strategy that he pioneered two concepts that have remained hallmarks of the industry to this day. Firstly, he introduced a compensation fee of 20% of the fund’s realised profit for his managers. Secondly, most probably to allay the fears of investors, he personally invested significantly into the funds, thereby ensuring that his fortunes were irrevocably tied to those of his investors. It was not until “The Jones Nobody Keeps Up With” article (Loomis, 1966) appeared in Forbes magazine that hedge funds were introduced to the public on a broad scale. The article described how Jones’ funds had attained net of fee returns that were substantially higher than those of the best performing mutual funds. Subsequently several hedge funds sprouted as other investment managers sought to emulate Jones’ success. According to Caldwell (1995) the SEC found that of 215 investment partnerships in a survey for the year ending 1968… 140 of these were hedge funds, with the majority having been formed that year.

The bear markets of 1969-70 and 1973-74 dampened the growth of the hedge fund industry, but they again made headlines in 1986 when an article in Institutional Investor highlighted the staggering compounded annual return of 43% (net of expenses and fees) earned by Julian Robertson’s Tiger Fund during its first six months of operation. In the aftermath of this article, Wall Street experienced a spate of resignations as high profile traders and investment bankers cashed in their bonuses and severance packages, and established their own hedge funds. Originally touted as the investment tool that could earn absolute returns irrespective of the direction of the market, the underperformance of the industry in the late 1990’s served to highlight the fallacy of this notion. Numerous highly publicised blow-ups, most notably the near-collapse of Long-Term Capital Management (LTCM) endorsed the reputation that hedge funds were “risky investments”. Regulators feared that LTCM’s excessive use of leverage and exposure to the fixed-income markets threatened to destabilise global markets when it failed to make payments for the pursuant margin calls.

The Federal Reserve, fearing systematic failure, facilitated a $3.625 billion creditor-rescue from a consortium of major US and European banks and in so doing, staved a situation that Chairman Greenspan suggested "... could have potentially impaired the economies of many nations, including our own." This rescue invoked U.S. President Clinton to establish a committee to investigate hedge funds with a view to introducing legislation to curb their apparent threat to global systematic risk. The President’s Working Group on Financial Markets, (The Working Group) in presenting their report defined hedge funds as follows:

“Although it is not statutory defined, the term [hedge fund] encompasses any pooled investment vehicle that is privately organized, administered by professional investment managers and not widely available to the public. The primary investors in hedge funds are wealthy individuals and institutional investors. In addition, hedge fund managers frequently have a stake in the funds they manage”.

Some of the often-quoted reasons why the task of assigning a universally accepted definition for hedge funds is problematic include that hedge funds are rarely similar in nature, and that they often follow investment strategies that are also adopted by other investment funds and financial market participants.

One of the most comprehensive definitions of hedge funds was given in an International Organisation of Securities Commission (IOSCO, 2003) report. It states that hedge funds have at least some of the following characteristics:

- Borrowing and leverage restrictions, which are typically included in collective investment scheme regulation are not applied, and many (but not all) hedge funds use high levels of leverage (BIS, 2004)1 ;
- Significant performance fees (often in the form of a percentage of profits) are paid to the manager in addition to an annual management fee;
- Investors are typically permitted to redeem their interest only periodically e.g. quarterly or semi-annually;
- Derivatives are used, often for speculative purposes, and there is an ability to short sell securities;
- More diverse risks or complex underlying products are involved.

The Dictionary of Finance and Investment Terms (Downes et al., 1998) makes a distinction between the definitions of a U.S. on-shore and an off-shore hedge fund, defining the former as “a private investment partnership” and the latter as “an investment corporation”.

2.2 The Investment process

In the U.S.A., hedge funds are restricted from accepting as partners, investors that do not qualify as “accredited investors”.

2.2.1 Qualification requirements for US hedge funds

To qualify as an accredited investor, (2004) stipulates that one needs to meet one of the following criteria2:

- Individual, or combined with spouse, net-worth in excess of $1 million.
- Individual income, excluding any income attributable to spouse, of more than $200,000 in the previous two years, with reasonable expectation to do the same in current calendar year.
- Individual and spouses joint income of more than $300,000 in the previous two years with reasonable expectation to do the same current calendar year.

2.2.2 Investor restrictions for US hedge funds

100 “accredited investors” or an unlimited number of “qualified purchasers” may invest in a single hedge fund. An investor may be a “qualified purchaser” if;

- the investor owns $5 million or more in investments, including investments held jointly with a spouse;
- in the case of a family-held business, it owns $5 million or more in investments;
- in the case of business that has discretionary authority over investments of $25 million or more; or
- in the case of a trust sponsored by qualified purchasers.

As the use of hedge funds has expanded across the world and into varied financial market systems, their adoption in terms of legislation has been extensively based on that prevailing in the U.S.A. Yet, in the U.S.A., hedge funds have exploited and benefited from the exemptions that have been granted in various investment-related statutes, most notably the Investment Companies Act of 1940 and the Securities Act of 1933. This study will revisit these and other statutes. Nonetheless, it would seem as though regulators had set significant financial hurdles to ensure that hedge funds were only accessible to wealthy investors.

2.2.3 Hedge fund structures

Despite following varying investment strategies with differing investment focuses, hedge fund structures are influenced by similar factors. Barker and Hui (2003) listed the following as the key determinants of a hedge fund’s structure: tax, regulations, investors, marketing, employees and investment issues.

- Tax - the choice of domicile may be influenced by favourable tax rates and other concessions.
- Regulation - the fund may choose to be established in a jurisdiction with a level of regulation that best supports their investment and operating strategies.
- Investors - the domicile of prospective investors and their probable tax concerns and financial objectives will determine the fund’s focus.
- Marketing - the fund’s ability to market and attract new clients will depend on the applicable jurisdictions.
- Employees - the requirement of active fund management and the traditionally high levels of discretionary assets under management require the recruitment of highly trained and qualified staff.
- Investment - the geographical region or financial sector focus of the fund will impact where the fund will be based, as there will be a need to cater for time-zone influences etc.

Hedge fund activities are generally front-office operations and tend to outsource the middle and back-office functions to intermediaries such as large investment and commercial banks.

2.2.4 Investment strategies and styles

A.W. Jones’ original ‘long/short’ strategy has now been replaced by a myriad assortment that encompasses most investment theories. Eichengreen and Mathieson (1999) identified three main classes of hedge funds as being macro funds, global funds and relative value funds, although they acknowledged that even further diversity lay within each of these classes. Eichengreen et al. (1998), noted 7 categories; whilst Gregoriou and Rouah (2003) noted 8 categories; and Billingsley and Chance (1996) (as cited in Fung and Hsieh. (1999)) noted 11 categories. A summary of some of the more common categories reported in the CSFB Tremont Hedge Fund Index is given in Annexure 1.

Murguia (2004); Gregoriou and Rouah (2003); and Agarwal and Naik (1999); all contend that there is general agreement in academic circles confirming that hedge funds can be categorized into two distinct groups; “directional” and “non-directional”.

As a result of significant overlap between the categories, there has been a move away from this focus of classification. A more recent development has been the move towards categorising hedge funds based on the investment style followed by the fund. Brown and Goetzmann (2001) suggest that hedge funds are “better defined in terms of their freedom from the constraints imposed by the Investment Company Act of 1940 than they are by the particular style of investment”, although their paper concludes that appropriate style analysis and style management are critical to success for investors. The TASS and CSFB/Tremont databases used by Credit Suisse First Boston/Tremont Index LLC to track more than 3000 funds state on their website that funds are separated into ten primary subcategories based on their investment styles.

The investment style adopted by the fund is usually determined by the general partner of the hedge fund and is generally well-detailed in the hedge fund prospectus. In spite of this, hedge funds prospectuses have a reputation, maybe unfairly, of being unintelligible as a result of the extensive use of verbiage and industry jargon that some critics say, leave even seasoned investors clueless as to the funds’ focus even after having read one.

2.2.5 Advantages and benefits of hedge funds

Despite Warren Buffett’s assertion during the 2004 annual general meeting for Berkshire Hathaway investors in May 2004, that hedge funds were a Wall Street “fad” and warning that people who were not already invested and seeking to invest now in hedge funds were “going to be disappointed” (CNN, 2004), commentators do acknowledge distinct advantages and benefits of being invested in hedge funds. Some of the benefits include:

- Easier and cheaper diversification of investments assets across asset classes, sector and national boundaries.
- Outsourcing the arduous and technical task of researching investment opportunities to skilled professional.
- Allows for the reallocation of risk and resources for investors
- Access to limited and closed hedge funds with attractive track records
- Low correlation to other more traditional asset classes such as equities and bonds and real estate.
- Use of leverage to amplify real returns
- Investments strategy flexibility

Waron Mann of Cape Town-based Abante Capital - a hedge fund manager which specialises in statistical arbitrage - states that due to the complex nature of some of the models necessary to execute the investment strategy their operation is staffed by experienced dealers and technical experts with Masters and PhD degree qualifications in Mathematics, Statistics and Physics (Mann, W., Personal Communication. 16 June 2004).

illustration not visible in this excerpt

Figure 1: Performance of the CSFB/Tremont Index relative to other leading indicators.


Whereas LTCM reportedly had a leverage ratio of 300:1; that is, US$300 borrowed for every US$1 of investor capital, the average U.S. onshore and offshore hedge fund has a ratio of 1,6: 1 (Lacey, 2003). Van hedge funds, according to, consider ratios above 2:1 as “high” and those below as “low” leverage. Hedge funds also enjoy unparalleled freedom from regulatory authorities in as far as selecting their investment strategies thereby enabling them to short and use leverage as well as investing in illiquid assets.

2.3 Summary

From a single investment strategy, the hedge fund industry has grown to include classes and sub-classes of strategies making the duty of ascribing an inclusive definition difficult, although (hopefully) not impossible. The adoption of a style-based classification system has facilitated this task although austere challenges remain. Of the many issues raised against hedge funds, most notably the use of leverage, the level of fees and the disclosure requirements, it is solely the latter that will be the main focus of this study.

Chapter 3 Reporting standards and requirements

“ Someone ’ s sitting in the shade today because someone planted a tree a long time ago ”

- Warren Buffett

This chapter will attempt to highlight the main issues concerning disclosure standards in the hedge fund industry.

3.1 Introduction

Hedge funds have traditionally been secretive operations and varying views have been tabled to both defend and denounce this characteristic. With a significant number of hedge fund operators having honed their trading skills on proprietary desks where corporate governance statutes and “Chinese Wall” policies which ensure separation of duties and information between various arms of the same bank are sacrosanct, it does not come as a total surprise that the element of secrecy became part of the hedge fund doctrine. The digital revolution has enabled financial market systems to respond in “near real-time” to economic and socio-political developments. Increased market efficiency and continuous trading across the three major time zones has reduced the window period within which to effect a short-term trading strategy, (e.g. to arbitrage) to minutes before the opportunity is exploited by other market participants.

The high-risk reputation accorded to hedge funds has, it would seem, for long romantically appealed to those investors who otherwise found the articulate world of financial investing both cumbersome and a slow route to financial prosperity. Subsequent to the several highly publicised hedge fund disasters such as John Meriwether’s LTCM, David Askin’s Granite Capital and Victor Niederhoffer’s Global Systems, it would seem that preventative action could have been taken by regulatory authorities had they had access to comprehensive information detailing the extent of the respective funds’ exposure in various instruments and markets.

3.2 Criticism of hedge funds

To further endear themselves to critics, hedge funds have also been cited for their alleged role in fuelling, if not orchestrating, the run on the British Pound in 1992 (Soros,1995:22) and the fall of the Asian Tigers following a runs on the Baht (Thailand) and the Rinngit (Malaysia). The collapse of the latter led the then Prime Minister Mahatir Mohamad to complain that “all these countries have spent 40 years trying to build up their economies and a moron like [George] Soros comes along with a lot of money to speculate and ruin things”.

Research by Eichengreen and Mathieson (1999), in attempting to answer the question, whether hedge funds trading in currency markets had acquired the distinctive role as lead steers in the herding by investors in these markets or whether they are in fact more (or less) likely to join in a generalised move by other market participants against a weakening currency concluded that hedge funds tended to take positions as contrarians, “leaning against the wind, often serving as stabilising spectators”. Aside from shorting, hedge funds are also renowned for taking long positions in securities (or currencies) that had depreciated, thereby introducing liquidity to an illiquid market. Fung and Hsieh (2000) found no evidence of hedge funds using positive feedback trading strategies as well as little evidence suggesting that hedge funds systematically caused markets to deviate from economic fundamentals.

Data from financial institutions can also confirm that hedge funds are primarily purchasers of new securities (i.e. warrants, initial public offerings and mortgage backed securities’), both in the primary market and the secondary market, thereby providing greater risk management and capital raising opportunities for corporations which enables them to have lower costs of capital. It is further argued, that by taking advantage of relative pricing inefficiencies in different markets, hedge funds also serve to improve market efficiency through rationalisation of security and currency prices. This view is partially contested by Rankin (1999:159) who asserts that:

“The real issue facing small countries is not the liquidity of their markets, but [rather] the potential to be overwhelmed by the flow of funds originating from the large economies”.

The turn of the millennium has seen hedge funds making significant in-roads into investment portfolios. Lacklustre equity growth figures and volatile markets have enticed previously conservative investors (Gregoriou and Rouah., 2003) to seek out alternative investments as they try to improve portfolio diversity and ostensibly achieve higher investment returns. This renewed drive has resulted in increased asset allocations to hedge funds (Mills, 2003)3 as well as the retailing of fund of funds (FOFs) to lower income investors.

3.3 Transparency

Filimonov and Sogoloff (2001) aptly refer to transparency as a “double-edge sword”.

- Firstly because hedge funds sometimes take such large positions in illiquid markets or securities going through corporate transactions, that publication of their positions could increase the risk of exiting these positions. In instances, the stake held by hedge funds in illiquid markets has effectively made them the market maker for the sector.

Consequently hedge funds prescribe restrictive lock-up and withdrawal periods in order for them to better manage their extraction from such investments. These periods can range from six months to five years. The absence of active trading in these markets may at times hinder the independent valuation of the assets resulting in the hedge fund taking the onus to internally assign a valuation to the investments. Unsurprisingly, allegations of padding the values have been levelled in some instances (Neil, 2002).

- Secondly, the velocity with which some (if not most), hedge funds traditionally move into and out of positions makes quarterly or even monthly statements irrelevant other than for the historical tracking purpose. Brown et al., (1998), citing earlier work by Brown et al. (1997); and Fung and Hsieh (1997); researched on the extent to which hedge fund strategies differed from those of open-ended equity mutual fund managers. Whereas Fung and Hsieh (1997) used Sharpe’s style and showed that hedge funds actively shifted their factor exposures over a given period of time, concluded that the shifting dynamism rendered traditional performance measurement difficult, if not impossible. The approached used by Brown et al., differed in that they grouped managers based on an algorithm that gave prominence to realised performance as opposed to professed mandates.

- Thirdly, for hedge funds holding swaps or esoteric mortgage instruments, merely providing a full listing without indicating how the positions held correspondingly offset each other would not be useful when trying to determine the fund’s overall strategy or risk exposure.

- Fourthly, disclosure before a desired equity level is acquired in a targeted stock would inevitably attract the attention of other participants leading to an increase in the offering price. Myers and Shackelford (2001) define ‘copycat funds’ as being funds that simply mirror the investment positions held by other hedge funds without bothering to undertake any independent research of their own and thereby making significant financial savings on personnel and research costs. Based on a limited sample of high expense funds, the study concluded that after expenses “copycat funds earn statistically indistinguishable, and possible higher returns than the underlying actively managed funds” giving credence to the insistence by some hedge funds on the need for continued secrecy.

3.3.1 Standards and requirements

By not having more than 35 non-accredited investors and not engaging in solicitation (i.e. marketing through means other than word-of-mouth), US hedge funds qualify for exemptions from most registration and disclosure requirements under the provision of Rule 506 in Regulation D of the US Securities Act of 1933. To compound the problem of supervision, by not having more than 15 clients and by adhering to the non-solicitation guidelines, a hedge fund manager may be exempted from registration as an investment manager, as per the US Investment Advisers Act of 1930. It thus comes as small wonder that, in order to preserve their exemption statuses, most hedge funds are closed to new members, with replacement of a liquidating investor done by private placement at the discretion of the hedge fund manager or general partner.

Baily et al. (2000) suggest that rather than trying to limit hedge fund activities, regulators should focus on improving the quality of information provided to investors by improving disclosure, financial transparency and investor protection.

3.3.2 Investor due diligence

Eccleston (2003) duly notes that the NASD requires a heightened responsibility investors to thoroughly investigate, as well as substantial due diligence to perform on the part of fund managers in executing their fiduciary duties prior to recommending a hedge fund investment to clients. For private investors, this onus falls squarely on their shoulders. Current US legislation recognises that hedge funds are restricted to ‘sophisticated and/or wealthy investors’ - which for regulatory purposes refers to one and the same group of individuals. Subsequently they are not deemed to require additional protection beyond that of being free from systematic risk.

The hedge fund prospectus is regarded as the main communication tool between the fund and prospective investors. Lux (2002) dismisses the practicality of assessing a fund based on the information contained in most of these documents. Disparagingly he alleges that:

“Secretive and far from pristine, the industry has long been notorious for providing scant information (if any at all).”

Lavinio (1999:42) concurs stating that the information tends to be submerged in an intricate and “obscure dialect of legalese” as well as sometimes being so blandly generic as to be more prescribed than informative.

The dual responsibility for due diligence by both parties to a transaction is highlighted in an unpublished thesis paper by Kunene (2002:15) who cites Morgan Stanley UK Group v Puglisi Cosentino (High Court, London), a 1998 case in which the high net-worth investor with experience investing in straight forward swap contracts who failed to repurchase a foreign exchange structured note after it had lost 70% of its value when the contract fell due. The court ruled that the transaction in question was beyond his comprehension and he could not therefore be considered an expert investor, thereby saddling the bank with the onus of ascertaining a client’s effective level of comprehension.

3.3.3 Investment mandate adherence

Acknowledging hedge funds’ need for flexibility in order to exploit market pricing inefficiencies, investors acquiescing to the prospectus’ terms can at best hope that the hedge fund will respect the investment mandate by adhering to the investment philosophy therein contained. Barring the aforementioned vagueness and legal verbiage that allegedly characterises a significant number of prospectuses, investors should comfortably expect to have legal recourse should the hedge fund manager deviate from the mandated parameters.

Fung and Hsieh (1997) suggest that some hedge fund managers, when faced with large capital withdrawals on the back of poor performance - sometimes to the extent where the fixed management fee from the remaining assets fails to even cover the fund’s operating expenses - may opt to place a single large bet in the hope of attaining the high-water mark target. Even so, they contend that the “betting the farm approach” is somewhat mitigated by exogenous offsetting costs to the fund manager, such as reputational costs.

3.4 Benchmarking and performance measurement

The selective assignment of benchmarks by hedge funds has long riled critics who proclaim that benchmarking errors nullify the objectives of performance assessment. Fung and Hsieh (2002) however propose that fund of hedge funds (FOFs) should be used as a benchmark for hedge funds as this would minimise the measurement biases experienced, and thus produce a “cleaner estimate” than more traditional approaches. However, the simple adoption of indices and peer group analyses seems borne to carry significant latent inaccuracies. Firstly, because even hedge funds following similar investment styles produce differing results because of different investment strategies and focuses; and secondly because the accuracy, and subsequent relevancy, of said indices has been questioned. This study will return to this issue at a later stage.

3.4.1 Valuation of Assets

The most traditional evaluation method of the investment performance for active fund management has been the simple comparison with earnings achieved by following a passive (i.e. buy-and-hold) investment strategy in a similar opportunity set. Liang (2001) advocates that, after adjusting for varying market exposures, hedge funds have tended to exhibit a significant amount of alpha, that is, excess returns. The uniqueness of the hedge funds makes application of the measure difficult. The net asset value (NAV) is thus considered to be the standard reference for performance measurement of hedge funds. The three most commonly used methods to determine the NAV are:

- Marked-to-spot - this refers to the replacement cost of the asset. However, when dealing with derivatives where both time value and volatility impact on the value of the underlying asset, it is found that the quoted market price is seldom equal to the replacement cost.
- Marked-to-model - this refers to where the theoretical price of the asset is determined by a mathematical model capturing the spot price, as well as the time value and volatility factors. This method may produce a value significantly different from the market-related price.
- Marked-to-market - this refers to a process where the prevailing market price is tracked, and is thus thought to be the most accurate of the three methods. Nonetheless, it encounters difficulties when assessing illiquid and other non-actively traded securities. In such instances the investment manager or the broker-dealer determine the value subjectively (Rigby and Wiggins, 2003)

3.4.2 Return Calculation

It is well documented in financial literature (see Harrison, 2003) that as much as 80% of a fund’s investment return can be attributed to the asset allocation decision as opposed to stock selection. David White, the Chief Investment Officer of the Rockefeller Foundation claims the reverse to be true for hedge fund managers (Cheever and Keary, 2000). Murguia (2004) cautions that reliance on simple return data and traditional evaluation measures may lead to “inaccurate conclusions and inappropriate risk exposure”. Aside from the impact of statistical biases on the accuracy of hedge fund returns, the ‘issue of article’ is also a major concern. The issue of article is best demonstrated by the “Axe problem” (Lavinio, 1999). Essentially; suppose an investor acquires an axe in 2004 and after three years replaces the handle. If, 2 years later the blade is also replaced, how accurate would it be to claim that we were still assessing the same axe acquired in 2004? The impact of this conundrum is exacerbated by the mobility of invest mangers and the changes in investment strategies and focus followed by the hedge funds as they indelibly alter the characteristics of the hedge fund and thereby making effective return calculation difficult.

3.4.3 Dispersion of returns

“ The dispersion of investment returns makes the use of the term “ hedge funds ” confusing ” -Glenn Meyer

According to research published by the University of Massachusetts-affiliated CISDM hedge fund returns are mean reverting (CISDM, 2003). That is, funds with high returns (as well as alphas and/or Sharpe ratios) in a period often have lower returns (and alphas and/or Sharpe ratios) in the next period.

Given the general acceptance that past performance is not necessarily indicative of future results the question of persistence undeniably persists. As previously mentioned, hedge funds have at times been marketed as sources of absolute returns, irregardless of the direction of the market. Research by Agarwal and Naik, (2000) established that there is greater persistency shown by losing [U.S. onshore] hedge funds continuing to be losers, than by winning hedge funds continuing to outperform. An investigation by Brown et al. (1999) into the U.S. offshore hedge funds found no evidence of positive performance persistency. Agarwal and Naik (2000) found that performance persistence amongst hedge funds decreases with the length of the measurement interval and this seemed to be unaffected by whether the followed a directional or an arbitrage based strategy.

In citing previous studies by Fung and Hsieh (2002a, 2001), Murguia (2004) contends that the hedge fund return characteristics are largely influenced by three factors, namely:

- Location factors - payoffs from asset class positions
- Trading factors - payoffs from option-like payoffs
- Leverage factors - payoffs due to the degree of leverage

Murguia supports the view held in earlier studies by Schneeweis and Spurgin (1998), which suggest that the use of passive multi-factor models coupled with exchange-traded options on stocks, bonds, currencies and commodities can simulate the returns achieved by managed futures hedge funds, not only at lesser cost, but also through providing greater transparency to investors.

3.5 Risk Management

“ Risk varies inversely with knowledge “ - Irving Fisher

The management of risk is of great importance to all investment managers, more so for hedge funds given their propensity to use leverage which serves to magnify the potential return by accepting higher risk. The white paper on sound practices issued by the Managed Funds Association (MFA) (2003) lists four types of risk; namely Market Risk, Credit Risk, Liquidity Risk and Operational Risk. Operational risk, which refers to data entry errors, fraud, system failures and errors in valuation or risk measurement models, is not as well documented as the other forms of risk (Koh et al., 2002) and will be the focus of this section of the study. Each piece of the puzzle needs to be addressed (

Figure 2: Risk Management is a puzzle.

illustration not visible in this excerpt

As mentioned above, there are many facets of risk management involved with hedge funds, and solely for the purpose of brevity, this study will merely introduce the key issues namely; the impact of the addition of hedge funds to a existing portfolio’s efficient frontier, the mean-variance and normal distribution of return debate, the suitability of the Sharpe Ratio, Value at Risk and other ‘traditional’ performance evaluation tools, as well as the issue of herding and its effect on asset correlations.

The complexity and the often dynamic trading strategies adopted by hedge funds, make traditional performance evaluation inapplicable (Kazemi et al., 2003) by complicating the determination of the risk. Contrasting earlier work by Liang (1999); Schneeweis and Spurgin (1998); and Fung and Hsieh (1997) on the use of multi-factor models to the singlefactor model studies by Brown et al., (1999); Ackermann et al.; Kazemi et al. (2003) concluded that the major drawback was that the unconditional approaches assumed that hedge fund risk measures were constant over time.

3.5.1 Efficient Frontier

Consequently, the potential ability of hedge fund portfolios to lift the Efficient Frontier is also argued. Agarwal and Naik (1999); using a broad asset class factor model determined that combining hedge funds with passive indexing provided significantly better risk-return tradeoffs than passive investment in the different asset classes alone. Their study showed that out-performance of the benchmark ranged between 6% and 15%, although the associated risk per month ranged from 0.9% to 4.2%.

A study by Amin and Kat (2003) used a continuous-time version of Dybvig's payoff distribution pricing evaluation model which does not require any assumptions with regard to the return distribution of the funds to be evaluated, and applied it to the monthly returns of 77 hedge funds and 13 hedge fund indices from May 1990 to April 2000. Their study concluded that although stand-alone hedge funds could not provide a superior risk-return profile, a 10% to 20% allocation, in conjunction with an equity portfolio, achieved the best results. on the other hand, recommends that an allocation of between 20% and 50% of an investment portfolio should be in hedge funds.

Harding et al., (2003) cite Schneeweis et al., (2002) and extend the concept further by advocating for the inclusion of an allocation to managed futures in mixed portfolios containing other hedge fund investment in order to not only reduce the portfolio’s standard deviation and increase the attainable returns, but also to achieve a superior risk profile.

illustration not visible in this excerpt

Figure 3: The Efficient Frontier.


Baeb (2003) states that all the Ivy League universities are reported to have an average of 19.9% allocation of their endowments in hedge funds. According to Bloomberg, Yale University’s US$ 10.7 billion endowment fund’s hedge fund allocation has earned the fund a 17 % per annum gain over the last 10 years. The US$17 billion Harvard University endowment declined by 0,5 % for the year-ending 30 June 2004, despite averaging 15.2 % in the 10 year period to 20 June 2003. The target return for these institutions is commonly accepted as being around 5 %; equal to their approximate annual spending, with the additional accommodation for inflation.

Dow Jones News Wire reported that the world’s largest pension fund, the California Public Employees Retirement Plan (CALPERS) approved the increase allocation from 1% to between 2% and 4% of its US$130 billion on 16 June 2003 (www.blumontcapital). The US$21 billion Pennsylvania State Employees' Retirement System, (PennSERS), invested US$2.5 billion, (approximately 12% of its assets), into hedge funds. (Serwer, 2003)

The World Bank staff retirement plan has been invested in hedge funds for over 20 years, although their allocations have been of smaller magnitude than is espoused by the Ivy League institutions.

Table 1: The World Bank’s long term investment policy asset mix.

illustration not visible in this excerpt


3.5.2 Mean-Variance

Akan (2002) points out that the general adoption of Markowitz’s mean-variance as an evaluation tool contradicts the reasoning for its use, as it assumes normal distribution of individual asset returns in a portfolio over time. The debate regarding the suitability of measures using the first two moments, (i.e. mean and standard deviation) to determine risk has been extensively addressed in recent times. Given that hedge fund returns are generally accepted as not being normally distributed coupled with the general use of the Sharpe Ratio as a standard risk measurement tool often included in hedge fund prospectuses to highlight the associated level of risk has brought this matter to the fore (Akan, 2002)4.

The CISDM (2003)5 contend that “a strategy’s distribution may not be normal, even if the historical data says it is, and it may be normal even if the data says it is not”. Fung and Hsieh (1999) concluded that using a mean-variance criterion to rank hedge funds and mutual funds will produce rankings that are nearly correct.


1 The Bank for International Settlements refers to hedge funds as “Highly Leveraged Institutions”, (HLIs). [Online] Available at

2 Institutions and pension funds are subject to more complex criteria

3 MILLS, Q.D. 2003. “In 2001, the California Public Employees Retirement System (CALPERS), America ’ s largest pension fund, put $1 billion into hedge funds. It was a major stamp of approval”.

4 AKAN (2002) notes that this can be proven by calculating “the skewness, kurtosis and Jacque-Berra numbers for each hedge fund strategy”.

5 Center for International Securities and Derivative Markets

Excerpt out of 137 pages


The Challenge of Reigning-in Hedge Funds through Regulation and the Need to Improve Disclosure Requirements
Stellenbosch Universitiy
Master of Commerce- Business Management
A- (German: Sehr Gut 1,3)
Catalog Number
ISBN (eBook)
ISBN (Book)
File size
1498 KB
Challenge, Reigning-in, Hedge, Funds, Regulation, Need, Improve, Disclosure, Requirements, Master, Commerce-, Business, Management, alternative investments, hedge fund strategies
Quote paper
LL.M. Russell Mutingwende (Author), 2005, The Challenge of Reigning-in Hedge Funds through Regulation and the Need to Improve Disclosure Requirements, Munich, GRIN Verlag,


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