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7 January 2022 Issue Brief

Hedge Fund Investing & Regulation

The term hedge fund is something of a misnomer: While some funds may employ strategies that are “hedged” in the traditional sense to mitigate or reduce risk, others may not hedge exposures or employ hedging techniques.

By simple definition, hedge funds are pooled investment vehicles that can invest in a wide variety of products, including derivatives, foreign exchange, and publicly traded securities.

Highly publicized reports of both disastrous and wildly successful hedge funds don’t always make it readily apparent how volatile a given hedge fund strategy may be.

  • Most hedge funds are not widely available to the public directly;
  • Hedge funds are extremely diverse in structure, employing a great variety of investment strategies;
  • Hedge funds may concentrate their investments, employ leverage, or engage in other strategies that may offer potential for higher returns but may also pose additional volatility or risk;
  • Hedge fund regulation varies widely around the world; in several key jurisdictions (including the United States) such funds are relatively lightly regulated.

The Asset Manager Code provides a set of globally applicable ethical and professional standards for firms managing assets, including hedge funds. 

The global hedge fund industry ended 2016 with approximately $3 trillion in global assets under management, up from approximately $2.9 trillion in the prior year, according to data released by Hedge Fund Research Inc. The industry saw about $70 billion in outflows in 2016. 

Investing in Hedge Funds

Investment in hedge funds is most suited to sophisticated and/or institutional investors who typically have sufficient means, expertise, and capacity to obtain a full appreciation of the risks. These types of investors are best placed to make their own determinations regarding the suitability of hedge funds. It is likely that many hedge funds are not suitable investments for small or retail investors, who typically lack the means to fully understand the nature and risks of investment in hedge funds. Hedge funds that are marketed to retail investors should provide a high degree of product transparency to protect investors’ interests.

Funds of Hedge Funds

Funds of hedge funds provide a cost-effective means by which investors can gain exposure to the underlying performance of hedge funds. Robust due diligence on the part of the investment manager in selecting which funds to invest is a key component in protecting investors' interests in these products. Funds of hedge fund managers should also put in place policies and procedures to manage the liquidity risk of the fund so that fund investors do not suffer undue difficulty when redeeming their units.

Hedge Fund Transparency

Hedge fund investors and regulators require disclosures that detail key information on the funds managed. Transparency enables investors to properly evaluate their holdings in the fund, and enables supervisors to monitor for the build-up of risks.

Hedge Fund Verification

Periodic review of hedge fund disclosures by independent service providers verifies that the fund in question is adhering to accepted standards of presentation and performance calculation. This provides fund investors with assurance that the information on which they base their decisions is accurate and reliable.

Hedge Valuation

Hedge fund assets and liabilities should be valued according to generally accepted valuation policies and procedures. Hedge fund managers should provide full transparency to investors over the use of any valuation models.

Hedge Fund Regulations and Requirements

A consistent, global approach to hedge fund manager registration requirements and an industry-standard set of self-regulatory best practices form the foundation of an effective regulatory framework for hedge funds. Prudential oversight of regulated financial counterparties, such as prime brokers and banks, provides supervisory authorities with the information they need to monitor the build-up of risks at the level of the funds. Coordination, cooperation, and sharing of information between regulators further strengthen the effectiveness of the supervisory framework.

Hedge funds are subject to the same trading reporting and record-keeping requirements as other investors in publicly traded securities. They are also subject to a number of additional restrictions and regulations, including a limit on the number and type of investors that each fund may have. 

Specifically, hedge funds are restricted under Regulation D under the Securities Act of 1933 to raising capital only in non-public offerings and only from “accredited investors,” or individuals with a minimum net worth of $1,000,000 or a minimum income of $200,000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year.

Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, however, the SEC was given authority to adjust the net worth and income standards for individuals as it deems appropriate.  For banks and corporate entities, they must have a minimum of $5,000,000 in total assets.  Many investors in larger hedge funds must also meet heightened “qualified purchaser” standards under the Investment Company Act of 1940, which generally requires individuals to have $5,000,000 in investments and requires companies and pension plans to have $25,000,000 in investments.   

Hedge funds are also prohibited by the Investment Company Act of 1940 from making public offerings and are subject to the anti-fraud provisions included in the Securities Act of 1933 and Securities Exchange Act of 1934.

Many hedge funds operating in the U.S. are also regulated by the Commodity Futures Trading Commission (CFTC), including advisers registered as Commodity Pool Operators (CPO) and Commodity Trading Advisors (CTA).  Hedge funds investing in markets governed by the CFTC are also be regulated by the body and subject to the requirements set forth in the Commodity Exchange Act.

CFA Institute Viewpoint

Hedge fund managers should meet the registration requirements of the appropriate securities regulator in the markets in which they operate. Equal treatment prevents abuse of regulation and its intent, and provides greater transparency, oversight, and investor protection. Registration enables regulators to regularly review − and more fully understand − the activities of the fund manager. Notification does not interfere with the operations of other collective investment structures and managers who must register with the regulator, but does alert regulatory authorities that a hedge fund manager is operating within their jurisdiction.

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