Hedge funds are investment vehicles that handle over $5.2 trillion of investment capital from the data gathered during Q3 2024. They offer a diverse approach to investing that aims to get the most out of the capital, leading to numerous risks. That is why regulation is essential. How hedge funds are regulated is one of the prime questions for every new and seasoned investor, and we will get to it.
In the United States, hedge funds are regulated through the Investment Advisers Act of 1940 and a series of anti-fraud and insider trading laws. On top of that, larger hedge funds have an obligation of periodical reporting. In the European Union, the framework is based on the Alternative Investment Fund Managers Directive (AIFMD).
The regulatory framework differs depending on the jurisdiction, and in this article, we will cover all the important markets. By the end of the article, you will know the basics of hedge fund operations, why regulatory measures are crucial, and what the regulatory bodies aim to accomplish through them. Stay with us, because this piece of due diligence can save you a lot of capital and nerves.
Key Takeaways
- Hedge funds are loosely regulated in comparison to pension funds, exchange traded funds, index funds, and funds of funds. The logic behind it is that hedge fund investors must be accredited, while funds have limited disclosure requirements.
- Due to several high-profile financial scandals caused by hedge funds, including the Bernie Madoff Ponzi scheme and several other insider trading cases, hedge funds are now under tighter scrutiny than they were before.
- The goals of regulations are to provide security to investors, which comes from increased transparency and reporting demands, coupled with regulatory bodies keeping an eye on risks and leverage used by funds.
What Are Hedge Funds
In the diverse investment vehicle market, hedge funds take a special place. They offer a unique array of investment strategies that aim to outperform the indexes. In contrast to a majority of investors that first look to generate gains similar to an index like the S&P 500 or Russell 2000, hedge funds will push their strategies to the max, hoping to generate enough alpha to beat the indexes in the process. Often they rely on using leverage, investing in debt, or operating in a risky M&A market.
All these strategies come with significant risks, which is to be expected. Getting higher gains in a relatively short period is not easy, and every hedge fund manager knows what risks are involved.
When there are risks and high potential gains in the play, often people tend to be greedy and sometimes to use methods that may seem shady to a larger audience. And that is just one of the reasons why regulations are necessary in this line of work.
Goals of Regulatory Measures
As we mentioned, hedge funds often use innovative and unique approaches to achieve top-of-the-line gains. Regulatory measures are enacted to ensure that there is a good mix between allowing innovation into the investing landscape and transparency, fairness, and stability.
Regulations first-hand protect investors by combating investor fraud and unethical practices. These are not possible to root out, but with these measures, they are pushed to the boundaries and possible to avoid with detailed due diligence.
Due to the high risk often involved with hedge fund strategies, regulations are placed to monitor and control risk levels. If implemented correctly, they can limit excessive leverage that hedge funds sometimes use to maximize gains. Also, in the past, hedge fund operations caused market disruptions and excessive volatility. Specific regulations were put in place to prevent those from happening.
When talking about regulations, we cannot forget the ever-battling against bad practices, including insider trading, market manipulation, and front-running. Several measures are aimed at leveling the field for all participants in the market.
Through regulatory changes, hedge funds are obliged to increase their transparency and accountability. Now more than in the past, they are required to present their results, plans, and strategies to investors.
Also, regulations are enacted to promote better ethical practices. Hedge fund managers are encouraged to develop long-term, strong bonds with investors, which has a positive impact on both sides in the process.
Regulatory Frameworks
United States
In the United States, the Securities and Exchange Commission is the primary regulatory body overseeing hedge fund operations. All hedge fund managers that have more than $100 million in assets under management must register with the SEC. Also, the SEC is responsible for overseeing the status of accredited investors, who are the main clients of hedge funds.
Besides the SEC, there is the Commodity Futures Trading Commission, which oversees funds that trade with commodity futures, options, or swaps. Of course, there is the IRS, which must check all tax compliance by the hedge funds and their investors.
Primary laws and regulations that are dealing with hedge fund operations are:
- Securities Exchange Act of 1934
- Investment Advisers Act of 1940
- Dodd-Frank Wall Street Reform and Consumer Protection Act 2010
While the Securities Exchange Act of 1934 regulates secondary trading of securities and has demanded specific disclosures from hedge funds, the real deal is behind the Investment Advisers Act of 1940. It regulates hedge fund operations in detail. Not only did it set the rule that hedge funds with over $100 million in AUM must be registered with the SEC, but it also mandated fiduciary duties, compliance programs, and Form ADV filings.
The Dodd-Frank Act came after the global financial crisis in 2008, in which hedge funds had their take. Not only did it mandate hedge funds with over $150 million to be registered with the SEC as financial advisors, but also large private funds were required to file a Form PF in which they would disclose data on leverage, counterparty risk, and investment strategies.
European Union
Shortly after the great economic crisis, the European Union in 2011 founded the Alternative Investment Fund Managers Directive (AIFMD). With it, the EU established a complex network for regulations of hedge funds. Key goals were to raise transparency, risk management, investor protection, and financial stability.
Its jurisdiction is imposed on hedge funds with over 100 million euros in AUM or 500 million heavy funds that are unleveraged or closed-ended. Through it, the EU demanded that hedge fund managers have a specific level of personal capital invested to ensure the stability of the fund.
Also, it touches on the topics of risk management systems, rules for liquidity management, and limits of leverage to lower investment risk.
United Kingdom
The United Kingdom has three primary regulatory bodies involved in hedge fund regulations - the Financial Conduct Authority (FCA), the Bank of England (BoE), and the Prudential Regulation Authority (PRA).
FCA is the primary regulatory body, and hedge funds must be authorized by it. FCA sets the bar high, demanding that hedge fund managers follow principles for business like integrity and fair treatment of clients.
BoE and PRA are monitoring systematic risk in the financial markets and also are overseeing hedge funds that have a high level of leverage due to risks that come with it.
Offshore Jurisdictions
Many hedge funds have some elements of their operations positioned in offshore tax havens due to obvious upsides. That is why these locations must be regulated. Well-known locations like the Cayman Islands and Bermuda have their regulators - the Cayman Islands Monetary Authority and the Bermuda Monetary Authority.
These offshore jurisdictions are popular due to their loose regulations and almost non-existent capital or corporate tax on gains. Often they are under fire due to the potential to be a money laundering breeding ground.
While it is difficult to deal with numerous tax havens, understanding the risks that come with them is one step in the right direction. Investors can get access to global markets and large returns, but the lack of investor protection is sometimes not worth the risks.
Regulatory Challenges
Regulations are often looked at as one-sided, but it is essential to know the right measure because otherwise, hedge fund operations can be thwarted. Regulatory bodies need to keep in mind that hedge funds benefit from lighter-placed regulations in comparison to retail investment vehicles.
This includes the question of reporting requirements. Mandatory reporting of positions and leverage can help in monitoring risk, but going overboard could not only bring more harm than good but also take away some upsides of hedge fund operations.
Through the regulatory landscape, hedge funds should be encouraged to change their business approach to be more transparent, avoiding the approach of multi-tier overwatch.
What to Expect in the Future
With the investment landscape dynamically changing and adapting to new assets and strategies, it needs to be followed by the timely implementation of new regulations. Besides the impact of new digital assets, regulations also need to be focused on systematic risk mitigation, increased transparency and disclosure, and expansion of regulatory oversight.
While hedge funds are facing more scrutiny, especially after the global financial crisis, there are always chances that their levels can rise even higher. Demands on reporting requirements regarding used leverage and liquidity may increase. On top of this, the stress testing for extreme market conditions can become mandatory, at least for larger funds.
There is a constant discussion about the transparency levels and what and when the investors should know. Hedge funds do not universally use the 2 and 20 fee structure, so the funds will be more pressed to show this info in detail. This can be accompanied by further information about investment risks and performances that the fund generated.
We mentioned that funds that have a larger AUM than $100 and $150 million fall into a specific bracket regarding their reporting requirements and regulatory oversight. In the future, we may witness smaller funds being put under more scrutiny than in the past.
Hedge funds often operate in different jurisdictions, meaning that some of their operations are held either in offshore paradises or just in other countries. The future may bring closer collaboration aiming to monitor and regulate these funds.
