Compliance for Hedge Funds

Building a best practice framework

Originally published in the February 2016 issue

In just a few short years, the global alternative investment market has had to adjust from being relatively unfettered to tightly regulated. Compliance is an everyday event. Regulatory examinations and audits have become a way of life. Meanwhile, institutional investors now account for the majority of capital flowing into hedge funds, and are thus in a position to demand – and get – greater transparency from fund managers.

The industry on the whole has adapted, though not without pain. Many firms report that the cost of compliance is a quantifiable drag on profitability. Fund managers are looking for ways to reduce the administrative burden and costs while fulfilling the requirements. Increasing efficiency through technology has the potential to offset some of the cost associated with compliance, while reducing regulatory risks. And a “culture of compliance” may well turn out to be good business for many managers – the ability to demonstrate disciplined processes and a sound operational infrastructure can be a key differentiator in investor due diligence.

To understand the operational and technology implications of compliance, it’s helpful to review the key regulations in both the EU and the US, the challenges they pose, and where they stand in their evolution.

AIFMD (the Alternative Investment Fund Managers Directive)
Implemented in 2013, AIFMD applies to alternative investment fund managers in European Union countries, as well as US and other non-EU managers who market their funds to European investors. It essentially confers a “passport” that allows complying firms to market their funds to professional investors across the EU.

The primary reporting component of AIFMD is the Annex IV report, a quarterly accounting to regulators of various fund characteristics such as holdings, strategies, leverage, exposure, investor information, and other variables. Since its launch in January 2015, firms report that the Annex IV reporting process is time-consuming and complex. All of the data required does not reside in a single platform, but usually must be aggregated from multiple sources, both internal and external, then formatted to the Annex IV template.

MiFID II (the Markets in Financial Instruments Directive II)
MiFID II was originally scheduled to take effect in January 2017. Its main focus is on proving best execution, for example, suitability and appropriateness, and disclosures of costs and charges. Among its key requirements is the recording of all telephone and electronic communications associated with client orders in order to protect investors. Although the compliance deadlines will likely be extended, fund firms should be in the process of readying their systems and procedures to comply.

European Market Infrastructure Regulation (EMIR)
Mandated by both the US Dodd-Frank Act and EMIR, the clearing of over-the-counter derivatives through central counterparties (CCPs) was meant to take effect at the end of 2012. Implementation, however, has proven to be far more than a matter of flipping a switch. It is now expected to be fully phased in by September of 2016 for the largest institutions, and March 2017 for the remainder.

Under the new rules, firms that trade in OTC derivatives will be required to make larger margin commitments and will be subject to more frequent margin calls. Moreover, different CCPs will have different asset valuation methodologies and margin calculation models, which firms will need a way of tracking. Asset eligibility requirements are expected to vary among CCPs as well, and in most cases are likely to be narrower and more stringent. All of this would suggest that fund managers should be looking at technology that can help them better manage collateral.

FATCA (the Foreign Account Tax Compliance Act)
Although FATCA is a US law administered by the Internal Revenue Service, non-US financial institutions are the ones who feel its impact. It requires financial institutions outside the US to report on deposits or assets owned by US citizens or residents. Its purpose is to curtail tax evasion by US investors attempting to conceal assets and income in foreign accounts, including offshore hedge funds. Firms have had to implement processes for the purpose of conducting ongoing investor due diligence, and many have had to revamp their fund reporting and documentation procedures substantially. The US has succeeded in generating a high level of compliance among countries and institutions – in part by levelling a 30% withholding tax on institutions that fail to comply. It’s also important to note that the European Union is moving towards an EU FACTA to include all 28 nations belonging to the union.

Dodd-Frank (US)
A key component of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 is the requirement for private funds, including hedge funds and private equity funds, to register with the US Securities and Exchange Commission (SEC) as investment advisors. The upshot is that hedge funds are now subject to the same reporting requirements as traditional advisors. As of October 2015, the SEC reported approximately 4,500 private fund advisors had registered, representing some 30,000 funds.1

Private funds must also file Form PF, on which SEC-registered firms that manage private funds of $150 million or more in assets report risk exposure statistics on a consistent basis. By now, most US hedge funds should be familiar with Form PF requirements, though many may still be struggling with how to meet those requirements efficiently. The report entails aggregating data from multiple disparate sources and putting it into a standardised format following SEC guidelines. It can be a time-consuming drain on staff resources, and carries a high risk of errors when done manually. The requirement has motivated many firms to upgrade their reporting capabilities with more automation and integration, while other firms have decided to outsource much or all of the process to third-party solution providers.

Network and Information SecurityDirective (NIS)
Cybersecurity is a burning issue on both sides of the Atlantic. Enacted in December 2015, the NIS is the first cybersecurity legislation in the EU. It requires businesses in several industries, including financial, to implement safeguards and report incidents. In the US, existing SEC rules requiring firms to protect confidential client data now extend to network-borne threats. The SEC has made cybersecurity procedures and policies a focus of recent exams and is imposing fines on firms deemed to be weak in this area.

Advanced technology that improves data quality and delivers real-time information has become both a competitive and a regulatory necessity. Investors are increasingly tech-savvy and cognizant of operational risk, and take a close look at hedge fund managers’ systems in the course of due diligence. A sound technology infrastructure is also virtually imperative in determining success in regulatory examinations. The systems you use and the way you use them can give regulators greater confidence that you are exercising due diligence and have the controls in place to properly monitor your activities for compliance.

Creating a compliance infrastructure
Of course, the core role of technology in hedge fund management is to streamline operations, systematise practices, improve productivity and accuracy, and reduce costs and risks. At a higher level, technology enables hedge fund managers to manage complex fund structures, make better-informed decisions and implement sophisticated strategies. The systems that deliver these advantages, however, should have the ancillary benefits of improving compliance readiness and creating a competitive advantage in the eyes of prospective clients.

Transparency in portfolio management systems
Today’s state-of-the-art portfolio management systems play a critical role for hedge funds, delivering real-time information with a high degree of accuracy. A dynamic portfolio management system also demonstrates a strong culture of compliance. It shows clients and regulators alike that a firm has instituted best practices to price and value holdings accurately.

Numbers used to demonstrate (and promote) a track record of performance must be supportable based on industry-standard calculations. The CFA Institute’s Global Investment Performance Standards, or GIPS, are widely recognised as the standard in calculating performance. Using performance numbers that are compliant with and presented in accordance with GIPS demonstrates that a firm adheres to industry-standard measurement guidelines when measuring performance, affirming the integrity and the credibility of their numbers. That should further enhance the firm’s ability to attract institutional clients.

Order management systems for accurate and efficient trading
Improved trading system support also can strengthen a hedge fund’s compliance infrastructure. In today’s environment, trading is often seen as being at odds with compliance. For the trader, speed is of the essence. But from a compliance perspective, speed creates risk—the risk of error or violation of policy. Because trading is inherently risky, each firm needs to have a trading programme that has at least three components:

  • Risk identification;
  • A process to manage risk; and
  • Periodic assessment of risk.

To manage trade-related risks, a hedge fund manager can implement an advanced trade order management system that can handle higher volume and instrument sophistication, while simultaneously addressing the demand for flawless accounting and reporting, error correction and efficiency of execution.

Even with all the right tools in place, trading errors may still happen. The right way to fix errors is to document their cause. The ability to create a clear audit trail of a fund’s trading activity easily is of great importance from both an operational and a compliance perspective. If a firm can demonstrate that it had the policies and procedures in place to catch an error and then correct it before damage was done, it sends a powerful message.

In evaluating trading systems, hedge funds should look for such important features as connectivity to prime brokers, fund administrators and trading partners, a FIX interface for order execution, and automated P&L reporting.

Investor accounting and servicing
A less understood yet no less critical area of hedge fund accountability is investor accounting. Due to the flexibility of fund partnership structures, investor accounting can be extremely complex, tedious and error-prone. A modern investor accounting system, however, can automatically perform book and tax allocations among investors through multi-tiered fund structures and generate, for example, IRS-approved Schedule K-1s. These systems automate rate of return calculations and NAV computations, and send account statements to investors.

Using a proven investor accounting system solution underscores a firm’s commitment to the utmost in data accuracy and integrity. It also ensures equitable distribution of assets and promotes transparency to fund partners.

Research management systems: documenting due diligence
SEC regulations require firms to maintain all documents pertaining to specific investment decisions. A purpose-built investment research management solution (RMS) can help firms meet this requirement. The RMS provides a centralised repository for organising external and internal research data around specific investment theses, as well as a firm’s own records of meetings and deliberations leading to each buy and sell decision. An RMS also helps demonstrate to investors that the fund manager follows a rigorous, disciplined, and repeatable due diligence process in decision making.

Margin and finance management: optimising collateral
With centralised clearing of OTC derivatives under EMIR, paying closer attention to margin requirements to avoid excessive commitments and overcharges is clearly in a firm’s best interest. Technology is available that can help firms manage collateral more effectively and adapt more quickly to the new market realities. Effective collateral management, combined with greater operational efficiency, can also help strengthen the bottom line during times of uncertain returns. In volatile markets, better collateral management can be a competitive advantage. Under the new regulations and a more complex centralised clearing environment, it’s virtually a necessity.

Regulatory reporting technology
In addition to the built-in functionality to support compliance in your everyday systems, you can also take advantage of solutions built specifically to address complex regulatory reporting requirements. A few technology providers (including SS&C Advent) have introduced solutions to help fulfill reporting obligations, including Form PF and AIFMD Annex IV. These solutions can alleviate a tremendous administrative burden while reducing the risk of errors or omissions and ensuring that the reports adhere to the regulators’ guidelines.

The outsourcing option
Outsourcing some or all components of the technology and operational infrastructure is increasingly viewed as a way to improve efficiency, control costs, reduce risks, and achieve compliance goals. A firm may choose to outsource the hosting and maintenance of its core portfolio management system,reaping the advantages of the technology while reducing the need for in-house IT expertise. Specific operational functions – for instance, reconciliation, data management, or performance measurement – can also be outsourced to specialists. Fund managers can leverage the specialised expertise of providers that have developed best practices from working with a number of clients. It’s critical, however, to perform due diligence on technology and service providers to ensure that they are thoroughly knowledgeable on regulatory issues and that their processes meet current compliance standards.  

Regulators have pointed out the positive role hedge funds play in the capital markets. Hedge funds can contribute substantially to capital formation, market efficiency, price discovery, and liquidity. Instead of a burden, compliance may in fact create an opportunity for hedge funds. The worlds of hedge fund management and mainstream asset management are converging. Institutional money managers increasingly incorporate hedge funds into their strategies. The ability to demonstrate compliance and best practices will only increase in importance in attracting institutional money or mutual funds.

Regulation is the reality. It is here to stay and likely to become even more complex. That makes it incumbent on hedge fund firms to institute compliance practices and invest in the technology infrastructure that supports them. As competition, volume and complexity accelerate, technology that makes a firm’s operations more transparent and its data more reliable will deliver a powerful competitive advantage. And a culture of compliance, ingrained in a firm’s everyday business, may well prove to be good business.


1.SEC Chair Mary Jo White Address, 16 October 2015