Hedge funds law

Hedge funds law
Hedge funds law
Author	Meenakshi Iyer
ASSN	38975
Published on	18 July 2019
Co-Assn	47997
Editor	Faiyaz Khalid
Last Updates	06/03/2019

A hedge fund is an investment fund that pools capital from warranted investors or institutional investors and invests in a diversified range of assets, often with complex portfolio-construction and risk management proficiency. In simple words, Hedge funds are considered as feasible substitute to the subsisting forms of investment on the financial markets. However, it is not available to every individual investor. Because comparatively, the funds are more of consequence for people and institutions that have a notable amount of assets that they want to be managed and increased gradually. Managers customarily pool co-jointly the assets of their clients to create a consolidated fund, and then they make their trades and investments using that fund alone.

DEFINITION

According to Gerald T. Lins, Thomas P. Lemke, Kathryn L. Hoenig & Patricia Schoor Rube in their book “Hedge Funds and Other Private Funds: Regulation and Compliance.” define hedge funds as “an investment fund that pools capital from accredited investors or institutional investors and invests in a variety of assets, often with complex portfolio-construction and risk management techniques.” In the words of Stuart A. McCrary (2002). "Chapter 1: Introduction to Hedge Funds". How to Create and Manage a Hedge Fund: A Professional's Guide,it is administered by a professional investment management firm, and often structured as a limited partnership, limited liability company, or similar vehicle. Hedge funds are generally distinct from mutual funds, as their use of leverage is not capped by regulators, and distinct from private equity funds, as the majority of hedge funds invest in relatively liquid assets. The word "hedge", meaning a line of bushes around the perimeter of a field, has long been used as a metaphor for placing limits on risk.Early hedge funds sought to hedge specific investments against general market fluctuations by shorting the market, hence the name. Nowadays, however, many different investment strategies are used, many of which do not "hedge risk". According to the Economic Times, “Hedge fund is a private investment partnership and funds pool that uses varied and complex proprietary strategies and invests or trades in complex products, including listed and unlisted derivatives. Put simply, a hedge fund is a pool of money that takes both short and long positions, buys and sells equities, initiates arbitrage, and trades bonds, currencies, convertible securities, commodities and derivative products to generate returns at reduced risk. As the name suggests, the fund tries to hedge risks to investor’s capital against market volatility by employing alternative investment approaches.”

INTRODUCTION

The investment world now comprehends that politics and the related matters of the business climate in India since the dramatic victory of the Bharatiya Janata Party in 2014. What is less well known is that the unconventional investment funds have been amidst the recepients of the comprehensive change. This story started two years before the BJP victory, that is, in 2012, when the Securities and Exchange Board of India (SEBI) disseminated its “alternative investment funds (AIF) regulations”, governing hedge, real estate, and private equity funds registered in that country. The Securities and Exchange Board of India (SEBI) issued the SEBI (Alternative Investment Funds) Regulations 2012 (AIF Regulations) on 21 May 2012 with a perspective of regulating the non-retail asset management component on a complete basis. The AIF Regulations established three categories of AIFs to register and synchronise the emergence of variegated types of alternative investment funds. Under the AIF Regulations, hedge funds are categorised as Category III AIFs employing complex or manifold trading plans or strategies. Before the AIF Regulations, there were no fixed or determined regulations supervising onshore hedge funds. There was an expeditious rise in the hedge funds market in 2017 and as of 30 June 2017, Category III AIFs had assembled commitments worth INR150.6 billion, more than twice the commitments encountered with up until June 2016. SEBI has radically loosened up the regulatory regime for AIFs to allure further investments. As of June 2017, recognising the need of an expanded institutional participation in commodity derivatives markets in India to generate the coveted liquidity and depth for systemised price discovery and price risk management, SEBI issued a circular allowing Category III AIFs to participate in the commodity derivatives markets subject to conditions such as broad basing of the portfolio and reporting norms. SEBI also introduced an online system that can be used to apply for registration and for adhering with the reporting and filing obligations. All applicants seeking registration must apply online. Existing AIFs must also file their compliance reports on the SEBI portal after activating their online accounts. . A Hedge fund being a private investment company is not subject to the full range of restrictions on investment activities and disclosure obligations imposed by federal securities. Hedge funds take part in financial innovation by pursuing novel investment strategies that lower market risk and may increase returns attributable to managerial skill. Despite the funds’ unique costs and risk properties, their historical performance suggests that the ultimate result of Hedge fund innovation is to help investors reduce economic losses during market downturns.

SOURCES

In the year 1949, World War 2 had just ended and the world was in an amalgamate celebration. Alfred Winslow Jones, a sociologist, was operating on an endeavour for Fortune Magazine scrutinizing fundamental and technical research on prognosticating the stock market. The article reported on a contemporary class of stock market timers, in addition to eccentric or nonconformist methods of investing, all to attain substantial or positive returns and call the market. Jones was very fascinated by these trading methods because they aroused his curiosity and therefore he became thoroughly engrossed with his own conceptualization or notion of an investment fund. Preceding the release of the fortune study, Jones configured and structured an investment fund with himself as general partner. The fund was intended to be a market-neutral strategy, through which the long term and crucial stances in undervalued equities would be counter balanced by short positions in others.

This ‘hedged’ position would enable capital to be leveraged, as well as validating gigantic wagers to be made with limited resources. A further genius characteristic was possessing an incentive fee amounting to 20% of any realized profits or gains with no fixed fees. Partnerships, if assembled or organized accurately would be not liable to the control of the Investment Company Act of 1940. This exemption permits managers to exploit fully techniques, such as leverages and short selling which generally binds other mutual funds and investment in 1966 which branded the market-neutral strategy that Jones designed as a “Hedge Fund.” and thereafter hedge funds went on gaining popularity also giving rise to the laws related to it.

SCOPE

With the alerting of the SEBI (Mutual Fund) Regulations 1993, the asset management business underneath private sector took its foundation in India. In the same year, SEBI, also notified Regulations and Rules governing Portfolio Manager who were consistent to contract or make a disposition with clients, give suggestions to clients or take the responsibility of management of portfolio of securities or funds of the customer. But, however there are no details or particulars about any hedge funds based in India. Further, on account of restricted convertibility, offshore Hedge Funds are yet to provide their products to Indian investors within India. Recently, RBI through liberalized remittance scheme, permitted resident individuals to remit up to US $ 25000 per year for any capital or current account transaction. The liberalized scheme will permit Indian individual investors to explore and oversee the possibility of investing in offshore financial products. But, considering that the existing limit is very nominal, Indian market are not that attractive to hedge fund product marketing. As long as there is a restriction on capital account convertibility, foreign hedge funds, by nature of their minimum investment limit being $100,000 or higher, do not seem to be excited or much involved in accessing investment from Indian investors in India.

NATURE

A hedge fund is normally an investment pool subscribed or contributed by a limited or minimum number of partners (investors) and which is operated by a professional manager with specific goals in mind which are majorly to maximize returns and minimize risk. And, because of their nature, hedge funds are generally only open to qualified investors, but not exclusively - institutions, investors with connections to the manager, or even the managers themselves also regularly invest in it. Hedge funds normally have a very wide and diverse range of securities that they are invested in, and while not all of them are required to be registered, large hedge fund managers and a few other exceptions must compulsorily register. When the investment structure is created, it is usually structured in two ways: As either a limited partnership (LP) or a limited liability company (LLC).

The former is a structure in which the partners are only liable for the amount of money they personally invest, while the latter is a corporate structure where investors cannot be held individually responsible for the company's liabilities. Notwithstanding of the structure, the hedge fund is run by a manager who invests the money into different assets to achieve the fund's goals. various kinds of hedge funds have different goals. But a common goal for almost all hedge funds is that they aim at market direction neutrality – which means they try to make money despite the market fluctuating up or down. So, hedge fund managers often act more like traders than managers. Hedge funds got their name from investors in funds holding both long and short stocks, to ensure that they made money despite market fluctuations (called "hedging"). But now, hedge funds have many different kinds of structures with different assets and securities. The rudimentary framework of a hedge fund is an investment or partnership pool where a fund manager invests in different securities and equities that match up with the fund's goals. However, one of the biggest seperaters about hedge funds is that they are mostly always only available to "accredited investors" - or investors who have a certain amount of capital. In order to be considered an "accredited investor," one must meet the requirements of at least one of the following: Have a personal annual income of $200,000 or more for yourself only that is individually but if you are married, the combined income has to be $300,000 or more per year, you must have a personal net worth of over $1 million this could be either just of yourself that is individually or may be combined with your spouse, must be a higher-up like an executive or a director involved in the hedge fund, or must have either an employee benefit plan or trust fund worth at least $5 million which has been done before investing in hedge funds. As per government regulations, hedge fund managers can only accept 35 non-accredited investors to any given firm or partnership, and they are often reserved for people the manager knows like his friends or family.

The basic structure of a hedge fund rests on the following basic components:

• They are generally only available to qualified or "accredited" investors who meet the above mentioned requirements.

• They have a wide spread of investments ranging from stocks, bonds and mutual funds, but can also invest in real estate, food, currency, art, or whatever the fund's goals can encompass.

• They frequently leverage other funds like borrowed money to attempt to increase returns which may increase risk but also results in increased returns.

KINDS/ TYPES OF

Most hedge funds are entrepreneurial organizations that make use of proprietary or well-guarded strategies. While the hedge fund universe is wide as well as diverse and often funds can fit into multiple categories, funds are typically classified as either equity-focused or fixed-income. Beyond this very basic definition, funds can be classified down into any number of sub-categories, depending on their investment strategies. Some common fund types include:

a) Long-Short Funds: A long/short fund is a type of mutual fund that takes long and short positions in investments generally from a certain and fixed market segment. These funds mostly use a wide variety of alternative investing techniques such as leverage, derivatives and short positions. Long/short funds are also referred to as enhanced funds or 130/30 funds. They take both long and short positions in securities hoping that by using superior stock picking strategies they will outperform the general market.

b) Market-Neutral Funds: A market neutral fund is a fund which seeks a profit in either upward or downward trending environments, typically through the use of a combination of long and short positions. These funds have a potential to serve to lessen the market risk as they attempt to generate positive returns in all types of market environments. They are a sub-type of a long-short fund, however fund managers attempted to hedge against general market movements from where it derived its name.

c) Event-Driven Funds: An event driven strategy is a kind of investment strategy that seeks to take advantage of temporary stock mispricing that generally occurs before or after a corporate event takes place. The strategy is mostly used by private equity or hedge funds due to the large amount of expertise that is necessary in analyzing corporate events to execute the strategy successfully. The corporate event in question can include restructurings, mergers/acquisitions, bankruptcy, spin-offs, takeovers, and other events related to it. An event driven strategy typically exploits the tendency of a company's stock price to suffer during a period of change. It tried to capture gains from market events, such as mergers, natural disasters or political turmoil.

d) Macro Funds: this method involved taking directional bets on the market as a whole, either long or short, based upon research and/or the fund's philosophy.

BRANCHES

Hedge funds were once used to lessen market un-stability by buying overvalued stocks and quickly selling them off. These small private partnerships can help earn one high returns, but – unlike mutual funds or the stock market they are mostly unregulated which means that investors of such funds will have to do more research and know their funds well. Here are nine types of hedge funds that one needs to know

Long-short funds

Fund managers hold both long as well as short positions by buying securities that they hope will perform and short selling the ones that they think will underperform. This is one of the more relaxed and balanced strategies in managing a fund. As correlation to overall markets is low, so are the risks.

Event-driven funds

This type of fund attempts to gain from events that make an impact on market prices such as corporate actions, political developments, natural disasters, etc. As the market responds to news of such events, event-driven funds take advantage of the resulting price inefficiencies to maximise returns.

Macro funds

Macro funds can invest in a wide range of securities ranging from bonds, commodities, currencies, to stocks whose prices fluctuate depending on the macro economic developments. As this type of fund tends to make bets based on such events which are purely based on research thus the associated risks are generally high.

Distressed securities funds

Securities of companies that are in distress can be a bargain, but they are also really very risky as the company may have accumulated a large debt or may face potential bankruptcy. These securities can be bonds, common stock, trade claims, bank debt, etc. Based on the fact that these companies are in distress and are not able to settle their financial debts, securities can be bought with large discounts. However if the company files for bankruptcy then the securities held by these funds will be worthless.

Emerging-market funds

These funds are pretty self-explanatory in which they invest in securities of emerging markets, which are the markets of developing countries with generally low to medium per capita income. Since the growth rate in these countries can be relatively volatile, these funds tend to be riskier but returns can be relatively higher too.

Long-only funds

In contrast to long-short funds, long-only funds take only long positions and they solely focused on stocks with a view to gain from an increase in prices which is particularly similar to traditional mutual funds. The only disadvantage to long-only funds is that they can be pretty risky if they are exposed to a prolonged bearish market.

Short-only funds

These funds are the opposite of long-only funds in that they look for potentially bearish market conditions so as to benefit from short selling stocks when prices fall. Similar to long-only funds, this strategy is risky as bets are on the market going only one way.

Fixed-income arbitrage funds

There are a variety of convertible arbitrage funds, but this type of fund takes advantage of price differences between securities except that it solely focused on the fixed-income market. This included securities such as bonds, treasuries, and credit default swaps.

Merger arbitrage funds

This type of fund buys and sells stocks of companies that are generally undergoing a merger, which basically causes the target company’s stock price to increase and the acquiring company’s to decline. However, the target company’s stock typically still trades below the offer price as it is very uncertain as to whether the merger will actually occur or not.

HISTORY

During the US bull market of the 1920s, there were many private investment opportunities available to wealthy investors. Of that time, the most popularly known today is the Graham-Newman Partnership, which was founded by Benjamin Graham and his long-time business partner Jerry Newman. This was cited by Warren Buffett in a 2006, in a letter to the Museum of American Finance as an early hedge fund, and based on other comments from Buffett, Janet Tavakoli considers Graham's investment firm the first form of hedge fund. The sociologist Alfred W. Jones is credited for coining and coming up with the phrase "hedged fund" and is also attributed with laying the groundwork for the first hedge fund in the year, 1949. Jones referred to his fund as being "hedged", a term that was then commonly used on Wall Street to describe the management of investment risk due to changes in the financial markets.

In the 1970s, hedge funds were exclusive in a single strategy with almost all fund managers following the long/short equity model. Many hedge funds had stopped during the recession of 1969–70 and the 1973–1974 stock market crash due to huge losses. They received re-invigorated attention in the late 1980s.]During the 1990s, the number of hedge funds present in the market increased substantially, maybe because of the 1990s stock market rise, the aligned-interest compensation structure, that is common financial interests and the promise of above high returns are the likely causes. Over the next decade, hedge fund strategies expanded to include a wide variety of investment options such as credit arbitrage, distressed debt, fixed income, quantitative, and multi-strategy. Institutional investors of US, such as pension and endowment funds began assigning greater portions of their portfolios to hedge funds. During the first decade of the 21st century hedge funds gained a lot of recognition and popularity worldwide, and by 2008 the worldwide hedge fund industry held US$1.93 trillion in assets under management. However, the 2008 financial crisis caused many hedge funds to curtail investor withdrawals, thus resulting in the decline of their popularity and AUM totals. AUM totals rebounded in April 2011 and were estimated to be at almost $2 trillion. As of February 2011, 61% of worldwide investment in hedge funds came mostly from institutional sources. In June 2011, the hedge fund management firms with the greatest AUM were Bridgewater Associates (US$58.9 billion), Man Group (US$39.2 billion, Brevan Howard (US$31 billion), and Och Ziff (US$29.4 billion). At the end of that year, the 241 largest hedge fund firms in the United States accumalAtively held $1.335 trillion. In April 2012, the hedge fund industry reached a new and record high of US$2.13 trillion total assets under management. In the middle of the 2010s, the hedge fund industry went through a general decline in the "old guard" fund managers. Dan Loeb called it a "hedge fund killing field" because of the classic long/short falling out of favour due to the unprecedented easing by central banks. The US equity market correlation became unsustainable to short sellers. In July 2017, hedge funds recorded their eighth consecutive monthly gain in returns with assets under management rising to a record new of $3.1 trillion. In 1949, Alfred Winslow Jones conceived and executed an investment strategy that would forever brand him as “the father of the hedge fund industry.” While working for Fortune Magazine and analysing financial strategies, he decided to launch his own fund and raised a total of $100,000, in which $40,000 was his own money. Jones employed two strategies which are still used heavily by hedge fund managers even today: Leverage and short-selling. To avoid requirements set in place by the Investment Act of 1940, Jones restricted the number of investors to 99 and set up the fund as a limited partnership. Even though Jones accumulated sizable returns in his first few years heading the fund, his strategy did not become conventional until the late 60’s. When George Soros and Warren Buffet embraced Jones’ strategy and set in motion their own funds, hedge funds were instantaneously being pursued after by an erudite group of investors. What caught the attention of the investors was how these hedge funds had little inter relation to the market. They were “hedged” against any downtown or collapsed in the economy. While the S & P was lagging, Jones’ investors continued to make money on a per annum basis. He decided to charge his clients a 20% performance fee, which is still used today by hedge fund managers. Hedge funds still reap the benefit of limited regulations and are not required to make periodic reports with the SEC under the Securities and Exchange Act of 1934. Because of this, hedge funds have more restricted transparency than mutual funds. While there have been recent attempts by the SEC to tighten up hedge fund regulation, they still have the advantage of freedom and secrecy that other investment vehicles do not. The SEC warns, “You should also be aware that, while the SEC may conduct examinations of any hedge fund manager that is registered as an investment adviser under the Investment Advisers Act, the SEC and other securities regulators generally have limited ability to check routinely on hedge fund activities.”The one thing that they do have control over, however, is who may invest in these hedge funds. The SEC decrees that only accredited investors or qualified clients may take part in hedge funds, because of the higher risk involved.

However, the usual hedge fund investor is thought to be well educated and well prepared when it comes to funds, and risks are usually communicated by the hedge fund manager. Also, in order to keep hedge funds “private” and in compliance with the Securities Act of 1933, soliciting or marketing is strictly limited and minimised. While hedge funds may have a website, only approved, and qualified investors can access the site after their net worth is ascertained. Today, there are over 10,000 hedge funds in existence with close to $3 trillion in assets under management. While some of them still use the staple strategy of leverage and short-selling, hedge funds today use and employ hundreds of different strategies, and not all of them are “hedged,” as Jones’ was.

IN DIFFERENT COUNTRIES

Hedge funds must adhere to the national, federal, and state regulatory laws in their respective locations. The U.S. regulations and restrictions that apply to hedge funds are different from those that apply to its mutual funds. Mutual funds, unlike hedge funds and other private funds, are subject to the Investment Company Act of 1940, which is a very detailed regulatory regime. According to a report by the International Organization of Securities Commissions, the most common form of regulation is considered with restrictions on financial advisers and hedge fund managers in an effort to regulate client fraud. On the other hand, U.S. hedge funds are excused from many of the standard registration and reporting requirements because they only accept accredited investors. In 2010, regulations were executed in the US and European Union which established additional hedge fund reporting requirements. These included the U.S.'s Dodd-Frank Wall Street Reform Act and European Alternative Investment Fund Managers Directive. In 2007 in an effort to get involved in self-regulation, 14 leading hedge fund managers developed a voluntary set of international standards in best practice and known as the Hedge Fund Standards they were designed to create a "framework of transparency, integrity and good governance" in the hedge fund industry..

United States

Hedge funds within the US are susceptible to regulatory, reporting, and record-keeping requirements. Many hedge funds also come under the jurisdiction of the Commodity Futures Trading Commission, and are prone to rules and provisions of the 1922 Commodity Exchange Act, which prohibits and restricts fraud and manipulation. The Securities Act of 1933 required companies to file a registration statement with the SEC in accordance with its private placement rules before offering their securities to the public. The Securities Exchange Act of 1934 required a fund with more than 499 investors to be registered with the SEC. The Investment Advisers Act of 1940 which accomodated anti-fraud provisions that regulated hedge fund managers and advisers, created restrictions on the number and types of investors, and prohibited public offerings. The Act also excused hedge funds from mandatory registration with the SEC while selling to qualified investors with a minimum of US$5 million in investment assets. Companies and institutional investors with at least US$25 million in investment assets also qualified. The SEC stated that it was embracing a "risk-based approach" to monitor hedge funds as a part of its evolving regulatory regime for the proliferating industry. The new rule was contentious, with two Commissioners differing in opinions, and was later challenged in court by a hedge fund manager. In June 2006, the U.S. Court of Appeals for the District of Columbia overruled the regulation and sent it back to the agency to be reviewed.

In reply to the court decision, in 2007 the SEC adopted Rule 206(4)-8, which unlike the prior-challenged rule, "does not impose additional filing, reporting or disclosure obligations" but does prominently increase "the risk of enforcement action" for negligent or fraudulent activity. Hedge fund managers with at least US$100 million in assets under management are mandatorily required to file publicly, quarterly reports which discloses ownership of registered equity securities and are susceptible to public disclosure if they own more than 5% of the class of any registered equity security. Registered advisers must compulsorily report their business practices and disciplinary history to the SEC and to their investors. They are required to have written compliance policies, a chief compliance officer, and their records and practices may be examined and analysed by the SEC. The U.S.'s Dodd-Frank Wall Street Reform Act was passed in July 2010 and requires SEC registration of advisers who manage private funds with more than US$150 million in assets. Registered managers must file Form ADV with the SEC, as well as information regarding their assets under management and trading positions. Previously, advisers with fewer than 15 clients were exempt, although many hedge fund advisers voluntarily, themselves registered with the SEC to satisfy institutional investors. Under Dodd-Frank, investment advisers with less than US$100 million in assets under management became prone to state regulation. This brought about an increase in the number of hedge funds which were under state supervision. Overseas advisers who managed more than US$25 million were also required to register with the SEC. The Act requires hedge funds to provide information about their trades and portfolios to regulators including the newly created Financial Stability Oversight Council. In this regard, most hedge funds and other private funds, including private equity funds, must file with the SEC. Under the "Volcker Rule," regulators are also required to execute regulations for banks, their affiliates, and holding companies to restrict their relationships with hedge funds and to prohibit these organizations from proprietary trading, and to limit their investment in, and sponsorship of, hedge funds.

Europe

Within the European Union (EU), hedge funds are fundamentally regulated through their managers. In the United Kingdom, where 80% of Europe's hedge funds are based, hedge fund managers are required to be authorised and regulated by the Financial Conduct Authority (FCA). Each country has its own specific restrictions on hedge fund activities, including controls on use of derivatives in Portugal, and limits on leverage in France. In the EU, managers are susceptible to the EU's Directive on Alternative Investment Fund Managers (AIFMD). According to the EU, the aim of the directive is to provide greater monitoring and control of alternative investment funds. AIFMD requires all EU hedge fund managers to compulsorily register with national regulatory authorities and to disclose more information, on a more frequent basis for transparency. It also directs hedge fund managers to hold larger amounts of capital. AIFMD also introduced a "passport" for hedge funds authorised in one EU country to operate throughout the EU. The scope of AIFMD is wide and encompasses managers located within the EU as well as non-EU managers that market their funds to European investors. An aspect of AIFMD which challenges established practices in the hedge funds sector is the potential restriction of remuneration through bonus deferrals and claw back provisions.

Other

Some hedge funds are established in offshore centres such as the Cayman Islands, Dublin, Luxembourg, the British Virgin Islands, and Bermuda, which have different and varied regulations concerning non-accredited investors, client confidentiality, and fund manager independence. In South Africa, investment fund managers must be approved by, and register with, the Financial Services Board (FSB).