This article provides an examination of the regulatory framework that has been implemented in the US since the global financial crisis. It also discusses the important role alternative investments like hedge funds play in this new, tightly regulated, post-crisis economy.
While special attention will be given to the Dodd-Frank Act, it is important to note that other jurisdictions have similarly adopted robust regulatory regimes for alternative investment and private fund managers, including the European Union’s adoption of revisions to the Markets in Financial Instruments Directive (MiFID), the Alternative Investment Fund Managers Directive (AIFMD) and the European Market Infrastructure Regulation (EMIR).
Combined, these new laws and regulations reach every corner of our global economy. Large banks now face new risk retention rules for securitization, capital rules and new mortgage requirements. This has, in many cases, contracted bank lending. Alternative investments have started to fill that vacuum in the US, EU, and most recently, in Asia.
The emergence of alternatives in capital markets highlights the important and expanding role private funds play in the global economy. This paper explores how funds operate in this new role, focusing on the tools used by fund managers to manage risk, provide reliable returns over time and offer portfolio diversification. Importantly, the paper also explains how funds do this without posing systemic risk to the broader financial system or investors.
With approximately $3 trillion dollars in global assets under management, the hedge fund industry is relatively small in size when compared to the size and scale of the overall financial system. The industry is also significantly less concentrated than other parts of the financial services industry and its transparency is at an all-time high.
Hedge funds have become part of the financially regulated mainstream. In the US, Europe and beyond, regulators now have extensive oversight of hedge fund managers and an array of information about their activities. In the US, large managers must register with the Securities and Exchange Commission and the Commodity Futures Trading Commission. They also file extensive reports about their portfolios and counterparty exposures with those agencies. Small fund managers are subject to state registration, examination and reporting requirements.
The market activities of every US-based hedge fund are subject to US securities and commodities laws. In addition, hedge funds execute trades and obtain other services from prime brokers (banks), which are also subject to extensive regulation that indirectly affects hedge fund activities.
The Dodd-Frank Act, combined withfinancial regulations in the EU, has changed the way our financial and capital markets function. These reforms have brought forth a new economy that is more regulated, more transparent and increasingly reliant on alternative investment vehicles like hedge funds to provide capital to businesses and liquidity to markets.
This report examines the role hedge funds play in a post-crisis global economy. The following key takeaways provide a more detailed understanding of the hedge fund industry and its investors, as well as clarify several common misunderstandings.
i. Relative size: Hedge funds’ approximately $3 trillion in AUM represents a fraction of broader markets.
ii. Less concentration: The hedge fund industry is far less concentrated than other parts of the financial services industry, making it unlikely that the closing of any one fund would cause a systemic risk. Only a few hedge fund firms have more than a 1% market share of the industry’s total AUM.
iii. Diverse investment strategies: Hedge funds pursue a tremendous diversity of investment strategies and invest in a wide range of asset classes that are often not correlated to the broader markets or each other.
iv. Less leverage: Data shows that hedge funds are less leveraged than many other types of financial institutions.
The investor makeup of the hedge fund industry has evolved in recent years. In the 1980s, institutions of higher learning began partnering with funds as a way to help fund scholarships, cutting-edge research and infrastructure upgrades. This institutional partnership expanded in the 1990s and early-2000s to include public and private pension funds. Now, philanthropic foundations also partner with hedge funds to help achieve their missions.
Today approximately 65% of all hedge fund assets under management come from these institutional investors.
Globally, the hedge fund industry has approximately $3 trillion in assets under management. Nearly two-thirds of this capital belongs to more than 4,800 institutional investors who depend on hedge funds as a tool to diversify their portfolio, protect against market fluctuations, and provide risk-adjusted returns over time. In fact, 80% of investors believe their portfolio risk would increase if hedge funds were removed from their portfolios, according to one independent survey. Preqin, a leading research firm, found that institutional investor satisfaction withhedge funds is high. Those surveyed even indicated that they plan to maintain or increase existing allocations.
While hedge funds have grown in popularity, they represent a relatively small part of the asset management industry. For example, the hedge fund industry is less than a tenth of the size of the global mutual fund industry, which managed more than $31 trillion at the end of the 2014 fiscal year. In addition, there are five US bank holding companies that each individually have assets equal to 50% or more of the entire US hedge fund industry’s AUM.
The hedge fund industry is also not concentrated by any measure. Only a few firms have more than a 1% market share of the industry’s total AUM, and every firm is well below 10%. In fact, it takes 100 firms together to reach approximately 50% of the total AUM managed by the industry.
Amidst changes in size and industry makeup, several facets about hedge funds remain the same – including limits on who can invest in them and how they are structured.
US regulations generally limit investment in hedge funds to “accredited investors” or “qualified purchasers.” The former is defined as individuals with a net worth of at least $1 million, not including the individual’s primary residence, or income of at least $200,000 in the last two years and institutions with more than $5 million in assets. The latter refers to individuals with at least $5 million in investments or institutions with at least $25 million in investments.
Hedge funds are generally structured as partnerships, limited liability companies, or similar entities where investors hold a percentage of shares in the fund along with the manager who also invests in the fund. Since managers are invested in their fund, he or she has a significant amount of money at stake with every investment decision. This is often referred to as “skin-in-the game.”
The role of alternatives in capital markets
Since the financial crisis, government regulations have brought hedge funds into the financial mainstream. Increasingly, pension funds, college endowments, and non-profit foundations use hedge funds as tools to fulfill their fiduciary obligations or help meet their financial goals.
Endowments, to a large degree, led the way for institutional investors to begin making hedge fund allocations. Public pension funds, on the other hand, are relatively new investors in the hedge fund asset class, but now account for four of the top five hedge fund investors in North America. A state-run university endowment plan completes that list.
US-based endowments, foundations and private sector pension plans also account for the majority of the global top five list of hedge fund investors in their respective categories.
A plurality of investment officers at these institutions look to hedge funds to provide risk-adjusted returns over time. Nearly 40% report, depending on their hedge fund allocations, to dampen market volatility and provide returns uncorrelated to equity markets.
Institutional investors, however, are not the only entities that use hedge funds as a tool to meet their financial objectives. Since banks have seen their lending limits constrained through new capital and liquidity requirements under the Dodd-Frank Act and Basel III requirements, many small and medium-sized businesses are turning to hedge funds to provide alternative lending options. This type of financing specifically helps small and medium-sized enterprises get off the ground by efficiently and effectively allocating capital, providing businesses access to financing, creating jobs and broadening the tax base.
The private debt industry globally has an estimated $154 billion in committed capital ready to be invested, according to one research group, and has a total AUM of $500 billion. This type of investing increased 23% from 2013 to 2014 in Europe alone.
The alternative investments industry has become considerably more transparent to regulators since the financial crisis. Title IV of the Dodd-Frank Act specifically addresses the regulation of hedge fund advisers and other private fund managers. As a result, hedge funds provide detailed information directly to the SEC and CFTC. That information is also available to FSOC and the Office of Financial Research (OFR), both created by the Dodd-Frank Act.
The Dodd-Frank Act created multiple thresholds for adviser registration and regulatory examinations at the national and state levels. The most significant threshold for private fund advisers is $150 million in AUM, which requires the adviser to register with the SEC. Advisers with less than $100 million in AUM generally are required to register with state regulatory agencies. Many advisers to private funds also must register with the CFTC as commodity trading advisors (CTAs) or commodity pool operators (CPOs).
All SEC-registered advisers report firm-specific information to the SEC with annual Form ADV filings. The first part of the ADV form collects information on ownership, clients, employees, business practices, and affiliations. Managers report information like fee structures, types of services offered, and potential conflicts of interest on the second part of the form. The completed forms, which 95% of investors report they plan to review, are available on the Investment Adviser Public Disclosure website.
The SEC also requires the filing of Form PF, which requires advisers with at least $1.5 billion in hedge fund AUM to comply with substantial SEC regulatory reporting requirements. The CFTC requires CPOs and CTAs to submit Form CPO-PQR and Form CTA-PR to the National Futures Association (NFA).
For large firms, these forms are required on a quarterly basis. Taken together, the forms help regulators monitor fund holdings and strategies in order to evaluate the use of leverage and review asset/liability and liquidity matching.
The Dodd-Frank Act gives FSOC and OFR access to all reports and information filed with or provided to the SEC in order to assess systemic risk. Moreover, the Dodd-Frank Act gives the Director of the OFR subpoena power to obtain from any bank or non-bank institution, including hedge funds, any data needed to carry out the functions of the office. With access to unlimited information and data, regulators have the authority to analyze the entire hedge fund industry and all aspects of a particular hedge fund’s investment activities, including market and counterparty exposure.
Lastly, small fund managers are subject to state registration, examination, and reporting requirements. The market activities of every US-based hedge fund are subject to US securities and commodities laws.
Improved risk management
Hedge funds rely on investor contributions and borrowed funds to create their overall portfolio. Managers work to match investor contributions and borrowed funds, to the liquidity of the assets and overall investment portfolio. This is intended to ensure that market volatility does not put the fund or its investors at risk.
The industry has developed practices to manage liquidity risks. One of those practices is generally using secured borrowings instead of relying on unsecured, short-term financing. With secured borrowing, funds pledge collateral of cash or securities that are marked-to-market on a daily basis. The U.K.Financial Conduct Authority’s Hedge Fund Survey released in 2014 and the SEC staff’s 2013 Form PF report confirmed these practices.
Many of the largest hedge funds invest primarily in highly liquid, exchange-traded equities, debt, futures, and other instruments. For these funds, monthly or quarterly redemption does not pose significant liquidity risk. Private funds that invest primarily in fairly illiquid assets (for example, high-yield bonds and senior debt securities) manage their liquidity risk by, among other things, utilizing contractual redemption restrictions and other management tools available to them.
Funds conduct regular liquidity stress tests to verify their portfolios can meet investor obligations as well as to respond to financing obligations and market conditions.
Another unique aspect of hedge funds is that they are not subject to mandatory redemption requirements under any statute or regulation. Their organizational documents generally impose certain limits on investors’ ability to redeem their interests. This gives managers the ability to ensure that liquidity of the fund’s portfolio is consistent with their funds’ redemption obligations.
As noted earlier, hedge funds utilize borrowed funds to complement investor assets. This practice has led some to reach the false assumption that hedge funds are highly leveraged. Funds are, in fact, often much less leveraged than other financial institutions. One study examining leverage ratios between December 2004 and October 2009, a period encompassing the height of the economic crisis, found the average leverage ratio was 2.1x. This compares to average ratios of approximately 13x for the US banking industry and 11.8x for the insurance industry over the same timeframe.
All funds have unique leverage ratios to achieve their investment strategies and some use greater leverage than others, but funds typically engage in collateralized financing that requires daily margining. This means that if a fund closes or experiences significant losses, its creditors are protected because they have legal rights to seize fund assets. It also is important to realize that funds can use leverage as a tool to mitigate risks to the overall portfolio.
These safeguards are ultimately tested multiple times each year when funds close for reasons ranging from extended poor performance, the retirement or departure of senior personnel, or a changed market environment. In each case, the fund’s portfolio is wound down by the manager, sometimes gradually over many months and less frequently in a “liquidation” by the prime brokers or other market participants that hold the fund’s collateral. But, compared to other types of financial institutions, hedge fund managers generally operate straightforward businesses with limited exposure to other financial institutions. Because of their simple legal structure, hedge funds are easily wound down and liquidated under existing bankruptcy laws, limiting losses to the fund’s investors and generally not creditors or counterparties.
This happened during the financial crisis without any government intervention. FSOC has even recognized that “asset management firms and investment vehicles have closed without presenting a threat to financial stability.”
Threats to fund sustainability are not limited to market factors. Managers must also deal with operational risks the same as other businesses. These risks include human error, natural disasters, counterparty failure and the increasing threat of cyberattack. SEC rules require each manager to adopt business continuity plans to address risks that could impact the manager’s ability to manage clients’ money. Successful fund managers are constantly evaluating and adopting procedures to address vulnerabilities.
Investors themselves, however, are perhaps the most important risk management factor for hedge fund managers. Pursuant to federal securities laws, hedge fund allocations are available only to large institutions and high-net worth investors. These professionals have long-term investment horizons and do not view their hedge fund investments as temporary placements requiring immediate access. These investors typically invest in hedge funds to diversify portfolio risk and to minimize exposure to market fluctuations – and they pay close attention to fund managers’ risk management and operational practices.
Investors and third-party consultants spend considerable time before investing. This due diligence process typically takes months to complete. Detailed diligence questionnaires, in-person interviews, and third-party background and reference checks are all used to examine business operations and risk practices often before any decision to invest in a hedge fund is made.
Investors and consultants continue to focus on these issues as part of ongoing due diligence, even after an initial investment is completed.
This paper has examined the role alternative investments play broadly in our new economy and has specifically focused on the regulatory changes brought about in response to the financial crisis. Now, seven years removed from the crisis and five years into the Dodd-Frank Act, economic recovery is beginning to take hold in the US.
Looking back, it is important to note that while funds have, at times, liquidated their assets and wound down for various reasons, no hedge fund has required a taxpayer bailout and the industry has never required a government program such as the Troubled Asset Relief Program or similar government backstop.
The hedge fund industry instead advocated for and embraced broad market reforms and is vastly different than it was in 2007 when the financial crisis began.
Significant regulatory changes have been implemented and market practices have fundamentally changed the way funds invest and manage risk. Hedge funds are more transparent than ever before. Managers have accepted increased regulatory oversight through registration and reporting requirements.
Fund managers have responded to investor demands and government regulations by developing extensive operational risk management processes and controls, including systems that are designed to address cybersecurity risks and ensure continuity of business operations, and are also more sensitive to risks associated with the activities of counterparties.
While hedge funds did not pose a risk to financial stability when the financial crisis hit and do not pose such risk today, the end result of the regulations the industry has implemented have made our markets – and hedge funds – safer and more resilient.
In fact, funds have adapted by helping provide capital to businesses and local communities as new regulations have limited banks’ lending capabilities.
MFA supports policymakers’ efforts to collect the information necessary to provide effective, smart oversight of markets and will continue to work with regulators to implement policies that address systemic risk holistically.
The US financial markets do not operate in a vacuum. As economies function on a global scale, policymakers and regulators must pay careful attention to the impact implementing or changing regulations will have globally. This new, global economy requires harmonization among regulatory regimes, especially those governing US and EU financial markets.
1. HFR, “Global Hedge Fund Industry Report, First Quarter 2015,” Estimated Annual Growth of Assets /Net Asset Flow, April 2015
2. Preqin, “2015 Preqin Global Hedge Fund Report,” Investors & Gatekeepers, February 2015
3. Preqin, “Special Report: The Real Value of Hedge Fund Investments,” June 2014
4. Investment Company Institute, worldwide Mutual Fund Assets and Flows, Third Quarter 2014, December 2014
5. National Information Center, Holding Companies with Assets Greater than
$10 Billion, Federal Financial Institutions Examination Council, March 2015
6. Preqin, “2015 Global Hedge Fund Report,” Investors & Gatekeepers, February 2015
7. Preqin, “2015 Global Hedge Fund Report,” Investors & Gatekeepers, February 2015
8. Department of the Treasury Office of the Comptroller of the Currency, 12 CFT Parts 32, 159 and 160, Docket ID OCC-2012-0007, RIN 1557-AD59, Lending Limits, June 2013
9. Preqin, “2015 Global Private Debt Report,” March 2015
10. Deutsche Bank Global Prime Finance, Third Annual Operational Due Diligence Survey, Summer 2014
11. NFA was founded in 1982 as a self-regulatory organization for the US derivatives industry with mandatory membership.
12. H.R. 4173, Sec. 153 (f)
13. MFA, Sound Practices for Hedge Fund Managers, 2009
14. Office of Financial Research, Annual Report, 2013
15. Andrew And, el al., Hedge Fund Leverage, National Bureau of Economic Research, “Working Paper No. 16801,” 2011
16. Sebnem Kalemli-Ozcan et al., Leverage Across Firms, Banks and Countries, National Bureau of Economic Research, “Working Paper 17354,” 2011
17. Federal Insurance Office, “Annual Report on the Insurance Industry,” June 2013
18. FSOC Notice Seeking Comment on Asset Management Products and Activities, Docket No. FSOC-2014-0001
19. Deutsche Bank Global Prime Finance, “Third Annual Operational Due Diligence Survey,” Summer 2014