Shaping the Regulatory Framework so Hedge Funds can Achieve Scale

How do hedge fund demand, regulation, structures and scale interact and fuel each other in Europe and Asia? Everywhere funds-of-hedge-funds are gaining momentum. In Europe there is emphasis on hedge funds (and funds-of-hedge-funds) domiciled domestically or in pan-European centres. Offshore domiciles are increasing regulation to compete. Asia has experienced dramatic activity in both hedge fund demand and supply, but lack of scale has been a frustration there and elsewhere. Differing regulatory requirements mitigate against scale, and more investor and distributor education is needed, but who will bear the cost of lobbying and education efforts?

Most hedge fund regulation relies on restricting the sale of interests in hedge funds to limited numbers of qualified, knowledgeable investors. This premise must be re-examined in light of the effectiveness of many hedge funds in providing diversification and return in hostile stock market conditions, which has led to demand for hedge funds from a much broader range of investors, both institutional and retail. With investor and distributor education, this demand could be even greater. While regulators in Europe and Asia are waking up to this increased demand, they also want to ensure they “get it right” with this complex, technical and diverse product, which has suffered from a lack of both transparency and accountability. Increasingly, regulators are looking at allowing more closely-regulated domestically-domiciled hedge funds or, with even more frequency, domestically-domiciled funds-of-hedge-funds. In the hope that hedge funds may eventually follow the same distribution patterns that have arisen for UCITS, there are also signs of pan-European hedge fund domiciles building in Dublin and Luxembourg. Meanwhile, many traditional offshore hedge fund domiciles are battling to hold onto their market share by creating greater investor confidence through increased regulation.

While these steps are to be welcomed, the hedge fund industry must not lose sight of their key long-term goal of achieving scale – only 23% of single-manager hedge funds are over $100 million, and the median fund age is 5.5 years1. To do this requires a flexible and stable regulatory environment, with rules that apply over a large target market so that the industry can build hedge funds, and hedge fund management companies, to the necessary scale to survive and thrive. This is particularly true given the increased costs incurred with the institutionalisation of the hedge fund business to comply with regulatory, fiscal and risk management requirements. These costs have an impact on performance, and particularly of smaller funds where the costs cannot be spread over a large asset base. In studying the dynamics and interactions between demand, regulation, fund structure and scale, we focus first on developments in Europe, and then look at the approaches being taken in the dynamic Asian hedge fund markets.

The European view

Changing demand

The hedge fund family is far from uniform, with numerous strategies, each corresponding to a specific risk/return profile. Increasingly, funds-of-hedge-funds have been the entry to retail distribution in Europe for alternative investment products. Now investors can feel more comfortable with having professionals striving to achieve a portfolio of hedge funds with optimal risk return characteristics and whilst undertaking the due diligence on individual managers and their strategies. In return investors pay an extra layer of fees. Funds-of-hedge-funds have been extremely popular with a wide range of promoters, including even French supermarket retailers.

Private banks, the original users of hedge funds for their high-net-worth clients, are now looking for alternatives to long-only portfolios for their mass affluent clients and are keen to use hedge funds. Some private banking institutions are proposing allocation models with up to 60% in hedge funds for the most aggressive risk profiles. However, many private bankers are using the fund-of-hedge-funds route, which allows them to achieve risk diversification without shouldering the burden of hedge fund selection, and minimises liquidity issues, which have been a disincentive to investing in hedge funds (although this may involve three layers of fees for the investor).

Pension funds are increasingly important investors in hedge funds as our related article discusses for a UK pension fund. Some intriguing insights are contained in JP Morgan Fleming’s European Alternative Investment Strategies 2003. In France, 80% of pension funds invest in hedge funds, but the proportions are a low 0.7% (nevertheless, this is not negligible given the size of assets, but appears to be a “test the water” stance). In Italy, these percentages are 50% and 0.9%, respectively, and in Germany 31% and 5% respectively.

Some institutional investors will have investment constraints, such as only investing in EU-domiciled products or those listed on certain stock exchanges; thus, their ability to invest in hedge funds will depend on availability of products meeting those restrictions. Whether the crucial dimension is domicile or listing varies. A French institutional investor may invest in a Cayman-domiciled fund if listed in Europe. A German investor may look at the hedge fund domicile (which must be in a country approved by the Financial Action Task Force for anti-money laundering) rather than the listing authority.

The demand may be there, but it is certainly not a case of one hedge fund product fits all. Barriers to distribution are significant, and include cultural differences such as attitudes to savings and risk, tax disparities, differences in interpretation of common EU rules by national regulators, and disparities in national legislation on consumer protection, in addition to actual hedge fund regulation and fiscal treatment.

Regulation on the move

Regulation occurs at three levels: regulating the hedge fund manager, regulating the hedge fund product, and regulating the distribution of hedge fund product to investors. Until recently, outside of the US, hedge funds were almost always “offshore”, creating a maze of potentially different regulatory jurisdictions on each of these levels. However, this did not always happen in practice because hedge funds were largely unregulated, or lightly regulated, as long as distribution was restricted to sophisticated investors, often high-net-worth clients of private banks. Now this is changing, and new prospects are opening up for hedge funds, this market expansion could create a compliance burden which, depending on systems
implications, can be a major resource drain for hedge fund managers.

There is no doubt that demand is currently constrained by regulations in relation to whom hedge funds can be sold. While many regulators might have preferred that hedge funds remained obscure, national regulators in most EU member states are working to accommodate some sort of local hedge fund product. European countries, such as Switzerland, France, Germany and Italy have, or are developing, regulations on hedge funds or funds-of-hedge-funds.

But the table below shows that certain countries are still reluctant to open hedge funds, even domestically domiciled hedge funds, to retail investors.

  Can domestically domiciled hedge funds have local retail distribution?
  Single-manager Fund-of-hedge-funds
France No Yes (min sub €10,000)
Germany Yes, but only on a private placement basis Yes
Ireland No Yes (min sub €12,500 unless full capital protection)Yes (min sub €12,500 unless full capital protection)
Italy No No
Luxembourg Yes Yes
The Netherlands Yes Yes
Switzerland Yes Yes
United Kingdom No No

Only Luxembourg, Switzerland and the Netherlands authorise the public distribution of local and foreign hedge funds to their citizens. Germany authorises it on a private placement basis only. Retail distribution is otherwise prevented or limited to funds-of-hedge-funds; but even then, minimum subscription requirements are often imposed.

In the EU substantial progress has been made in the cross-border distribution of investment funds through the UCITS Directive. Unfortunately, the Product Directive of the UCITS III Directive expands the list of allowable investments, but seemingly precludes the establishment of short positions, making hedge funds impossible under the UCITS III Directive. So as hedge funds and funds-of-hedge-funds are non-UCITS, the setting up of local funds-of-hedge-funds is, for European countries such as France and Italy, the best way to publicly distribute alternative products. And while ‘local’ means the country in which the fund is to be distributed, there is increased use of pan-European domiciles, such as Dublin and Luxembourg, which have some flexibility, but offer higher comfort levels for European regulators and investors located in countries where foreign funds-of-hedge-funds are accepted (The Netherlands, Switzerland and now Germany).

France is a good illustration of the regulator’s reluctance to open the hedge fund market to retail distribution. The French regulator has recently created a new type of fund with simplified investment restrictions and leverage, which would permit implementation of an alternative investment strategy, while being subject to the general UCITS regime. This includes designation of a management company, an authorised custodian and an auditor (commissaire aux comptes), with the UCITS under the control of the AMF (the French regulator that succeeded the COB). This is progress, but contractual UCITS may be sold to qualified investors only and the door remains firmly closed to retail investors. For the German situation, see “Germany loosens its hedge funds straightjacket” on page 39.

In many countries where hedge fund access is limited, investment is possible via wrapper instruments, such as structured notes issued by banks or insurance companies, with performance tied to that of the underlying hedge fund. While there are moves to broaden access to hedge funds, accompanied by the removal of some tax and regulatory barriers, single-manager hedge funds are likely to remain available to only the high-net-worth clients of some private banks.

Regulation of managers and products

Fund managers are generally allowed to manage hedge fund products under the same regulatory regime that applies to conventional fund managers (with Germany and Italy important exceptions). Minimum capital requirements vary from country to country (and this must be closely followed as the Capital Adequacy Directive 3 becomes effective). It is ironic that in some countries managers can only manage offshore hedge fund product, while in others, only domestically-domiciled hedge fund product.

Of European single-manager hedge funds, almost 70% are managed from London, despite the difficulty of domiciling either single manager or fund-of-hedge-funds products in the UK. This shows that the necessary ingredients for a hedge fund industry to thrive are not necessarily domestic demand, but asset management infrastructure and a light regulatory regime which facilitates dealing with cross-border suppliers and clients. More recently hedge fund managers have been established in other European countries including France, Ireland, Italy and Sweden, serving both domestic and offshore clients.

As to specific hedge fund products, most hedge fund products are domiciled ‘offshore’ in the jurisdictions of the Caribbean, Bermuda and the European offshore centres (notably the Channel Islands). Generally offshore regulation is lighter, with no minimum investment requirements, meaning the products are open to all investors, subject to the rules of the country where the product is actually sold. However, offshore centres are tightening their regimes to comply with anti-money laundering controls and to compete with the anticipated future demand for domestically-domiciled hedge funds in Europe and Asia.

In practice, the choice of the fund domicile is driven by the target clients’ place of residency and the associated tax and regulatory barriers. Establishing a local product for distribution in a specific country may be the most appropriate solution, but in Europe a “third way” is gaining prominence, with the development of pan-European centres, such as Luxembourg or Dublin, when the distribution is anticipated to be in more than one country.

Dublin has long been established as a centre for administration of alternative investment funds, which to date have mostly been domiciled in the Caribbean or Bermuda. Most of the major global alternative investment administrators have significant Dublin operations, administering assets in excess of $200 billion. In addition, the majority of Dublin-administered hedge funds are listed on the Irish Stock Exchange, which has served as a natural attraction for hedge fund promoters to Ireland. In recent months Dublin has experienced an increase in the number of hedge funds seeking domicile there, following regulations that allow having put in place the full menu of necessary products, ranging from professional funds to retail funds-of-hedge-funds.

However, Luxembourg has also taken the necessary measures to further develop hedge fund business and is now seen as an alternative to Dublin. A new Circular CSSF 2002/80 authorises the creation of regulated hedge funds, and funds-of-hedge-funds, for both institutional and retail investors, and sets investment constraints that are flexible enough to allow fund managers to implement various investment strategies specific to the hedge
fund industry.

An intriguing development at EU level was a recent report (16 October 2003) by the Committee on Economic and Monetary Affairs of the European Parliament on the future of hedge funds and derivatives, which suggests distribution of hedge funds is not left with the national regulators in Europe. In the coming years, Europe could allow a lighter regulatory regime for encouraging hedge funds to be set up in Europe rather than offshore. But once again, these products would only be available to high-net-worth individuals not to retail investors. Not specifically related to hedge funds, but the increased prominence of the Committee of European Securities Regulators to coordinate detailed decision rule-making based on the principles set down by the EU Commission could speed up harmonisation moves. A significant concern of European regulators is data protection, which may affect the ability of hedge fund managers to transit personal data (requiring individual investor’s consent). While many countries are deemed to have legislation in place which provides adequate protection, the United States is among those that do not.

The Asian view

The growth in Asian-based hedge fund managers has been both demand-driven and supply-driven. The loss of confidence in long-only equity fund managers certainly led many of the regions high-net-worth investors to seek out established alternative funds with a proven positive track record in absolute returns. Institutions have also taken measures to allocate assets to these types of products. Expectations of what types of returns can be realistically achieved within certain risk and volatility parameters have had to be adjusted. On the supply side, many former traders from high reward investment banks have taken the leap towards setting up their own boutique fund houses.

The number of hedge funds managed in Asia now exceeds 360, with growing numbers of boutique managers now up and running in Hong Kong, Singapore and Tokyo. More than half of the funds are pursuing long/short Asian equity strategies, but most trading strategies can be found in Asia. Some of the funds have been quite modest in size at the point of launch; however, there are numerous examples of hedge funds that have grown their assets under management very significantly following a period of positive performance and, thus, benefited from the advantages of scale.

For a number of Asian-managed hedge funds, returns have, in fact, been good in the past two years, in some cases spectacular! At a recent Asia Hedge Funds Awards Dinner, held in Hong Kong, a number of the ‘Oscar’ inners were reporting gains of over 100% for the period under measurement. There is certainly enthusiasm for the product and there is also some momentum. Offshore jurisdictions have also been quick to tap into growing product demand and recently the Cayman Islands Monetary Authority issued The Retail Mutual Funds (Japan) Regulations, 2003 with a view to promoting the Cayman Islands as a preferred offshore jurisdiction for Japanese hedge funds.

In Asia, most hedge funds are generally established offshore and are distributed on a private placement basis. However, in 2002, regulatory authorities in Asia started to recognise the potential benefits to investors of diversification associated with this type of product when first the Monetary Authority of Singapore, and then the Hong Kong Securities and Futures Commission, introduced rules surrounding the authorisation of such investment products for sale to the public. Some of the basic restrictions are detailed overleaf.

Hong Kong

In Hong Kong, restrictions deal with manager qualifications (experience and financial strength), calculation of fees, fund liquidity and redemption, the anticipated retail client base and investor communication.

A hurdle for Hong Kong hedge fund managers, particularly star managers wishing to set up from scratch, is the requirement that the corporate hedge fund manager must have a minimum of US$100 million in assets under management pursuing hedge funds strategies. To date, there are eight authorised hedge funds in Hong Kong, all of them managed by larger firms, most of whom have previously been long-only fund managers. The corporate hedge fund manager must have at least two investment executives, each with five years’ general experience in hedge funds strategies, including at least two years’ experience in the same strategy as that of the fund. There must be appropriate internal controls and risk management systems (although no independent third-party verification is required at this stage).

With regard to the mechanics of the fund, the SFC specifies that performance fees can be paid no more frequently than yearly subject to meeting their relevant high water mark. There must be at least one regular dealing day per month, and redemption payment proceeds must be paid within 90 calendar days of redemption requests.

To restrict the investor base appropriately, minimum subscriptions for hedge funds are US$50,000 and US$10,000 for funds-of-hedge-funds. An authorised hedge fund must report quarterly within one month of the quarter-end and 60 days of the quarter end in the case of a funds-of-hedge-funds. Among disclosures, that must be included are performance commentary, changes in key personnel, level of leverage, connected persons transactions and interest, and details of illiquid holdings.

Hong Kong hedge fund managers are in a chicken-and-egg situation. There are currently few participants in the market and, thus, investor education is proving a large burden. However, more hedge fund managers and wider choice is crucial to building investor confidence. The SFC has stepped forward, launching various investor education initiatives.


Singapore relaxed rules allowing single-manager hedge funds to be marketed to the retail public in June 2001. However, the high minimum subscription amount of S$100,000 (US$58,000) required for each investor at that time dampened enthusiasm for hedge funds, as evidenced by the first retail hedge fund product launch which raised less than US$5 million. Over the following year, with feedback and lobbying from the industry, the rules were then broadened to include different forms of hedge funds, for example funds-of-hedge-funds as well as capital-protected/guaranteed products, both as single-manager hedge funds and funds-of-hedge funds, which were deemed to be lower risk. The minimum investments for these types of funds are S$20,000 (US$12,000) for funds-of-hedge-funds, with the minimum subscription amount waived (subject to certain criteria being met) for capital protected/guaranteed single-manager hedge funds and funds-of-hedge-funds. Since then, there have been several capital protected/guaranteed funds-of-hedge-funds launched in the Singapore retail market, but the anticipated “in-pouring” of subscriptions has not materialised, due in part to the need for increased retail investor education as well as increasing the understanding of distributors when selling such products. Some have also commented that the minimum of S$20,000 is still considered high. At present the total subscriptions into retail hedge funds in Singapore are only slightly in excess of US$25 million.

To offer either single-manager hedge funds or funds-of-hedge-funds, the manager must meet certain criteria for the number of experienced professionals. They must institute proper risk management and monitoring procedures and internal controls as well as providing minimum dealing days and meeting the specified redemption terms.

There has nevertheless been significant activity in the hedge fund business to cater for high-net-worth individuals in Singapore, led by a large number of talented professional managers who have struck out on their own to offer alternative investments, either to institutions or wealthy individuals. In addition, a number of offshore hedge fund products have also been registered as restricted schemes in Singapore, and largely offered through private banks to their clients. This re-enforces the findings of the PricewaterhouseCoopers Asia Pacific Private Banking Wealth Management 2002/3 Survey, that private banks expect alternative investments including funds-of-hedge-funds to take a much larger share of their clients’ overall asset allocation.

Since then a number of hedge funds have successfully applied for authorisation in both Singapore and Hong Kong, although perhaps it is fair to say that the amounts of money raised have been disappointing in most cases. This probably illustrates that there are still some concerns on the part of the distributing banks in selling this type of product to their retail customers. The education, of both end-investors and intermediaries, is an ongoing process and it will take some time to see real scale emerging in Asia's hedge funds. However, the developments of the past two years have been very healthy and must be seen as a good start. A brief synopsis of where hedge fund products are open to retail investors is as follows:

  Can hedge funds have local retail distribution?
  Single-manager Fund-of-hedge-funds
Australia Yes, if registered1 Yes, if registered1
Hong Kong Yes, (min sub US$50,000)2 Yes, (min sub US$10,000)2
Japan Yes, if registered3 Yes, if registered3
Korea No No
Singapore Yes, (min sub S$100,000)4 Yes, (min sub S$20,000)4
Taiwan No No
1Australia: must be registered under the Managed Investment Act and comply with applicable investement rules 2 HK: minimum subscription waived if capital 100% guaranteed 3Japan: must be registered under the Law for Investment Trusts and Investment Companies and the Securities and Exchange Law 4 Singapore: minimum subscription waived if capital (less front-end charges) 100% guaranteed or protected

Moving forward on structure and scale

There are a number of steps hedge funds can take to make their funds more welcoming to regulators and investors. Many of these are discussed in other articles in this publication, e.g. in the articles on operational risk controls and on transparency.

Of particular importance to regulators and investors (particularly smaller investors) are:

  • To be a regulated entity, i.e. properly supervised by local regulatory authorities. Unregulated schemes are indeed restricted investments for certain categories of institutional investors, such as insurance companies, pension funds and even for some private bankers.
  • To appoint a depositary bank acting as a trustee of the investors’ interests.
  • To appoint an auditor, and regularly issue financial statements.
  • To provide minimum information necessary for monitoring the fund’s management.

However, the tricky question of scale in the hedge fund industry needs to be examined more closely, as the hedge fund industry is at a crossroads.

Click here to enlarge the image

As the chart above showing size distribution of global hedge funds illustrates, almost half the industry is struggling for survival with fund sizes under $25 million. Indeed, this is understated by survivor bias, in that those funds which went out of business are not included in the data. Those very large funds, which do have scale, and are most in demand with funds-of-hedge-funds, are aware that their investment strategy may suffer if they get too large, and are restricting access to their funds (giving some funds-of-hedge-funds a major raison-d’etre).

In an under-resourced industry, who will be fighting for the biggest possible playing field, by lobbying with regulators to allow hedge funds and encouraging standardisation in investor qualification criteria (if it is necessary at all)? The large funds, which already have all the assets they want? The small funds which are barely surviving? Or will funds-of-hedge-funds step in to ensure there is a continuing supply of hedge funds in which to invest? Will today’s pre-occupations prevent the industry from achieving the potential it could in ten years’ time, one that the US industry has already achieved by doing all it can to influence regulators now that they are overcoming past prejudices against hedge funds? Similarly, who has the resources to do the investor and distributor education that’s needed?


There is an extraordinary chain of events in Europe and Asia that is moving hedge funds into mainstream investment. Both retail and institutional investors are seeking access to hedge funds for return and diversification. Regulators are wrestling with this complex asset class, and have made significant progress, but there is much further to go in the quest for a stable, flexible, open regulatory (and fiscal) environment. Given the alternative is sometimes private placements of foreign unregulated hedge funds, and accusations of discrimination against small investors, regulators are increasingly looking at domestically domiciled funds-of-hedge-funds. There is still some way to go for hedge funds to qualify as UCITS and benefit from a European passport for pan-European retail distribution which would be a good step toward improving scale. How far the regulators are willing to go may depend on the hedge fund industry’s willingness to adapt to the “quality” and transparency requirements that investors need. And, critically in the longer term, it will be the ability to achieve hedge funds with scale, which depends on both the regulatory environment and investor access and demand, that will determine whether hedge funds transform the investment management industry.

Contact Details
Marie-Anne Kong, Partner
Telephone: +852 2289 2707

Didier Prime, Partner
Telephone: +352 49 48 48 21 27