By: Dr. Ranjan Bhaduri, CAIA, AllAboutAlpha.com Editorial Board and Hannah Wendling, AlphaMetrix Alternative Investment Advisors.

As recently examined here on AllAboutlpha.com, hedge fund regulation is a topic that has been discussed frequently throughout the past decade, with little material change in the United States.  Triggered by the 2008 financial crisis, however, hedge fund legislation seems imminent, and with hedge fund regulation pending in legislative bodies of the United States, European Union, and elsewhere, some experts anticipate an outflow of capital to countries with less stringent regulations.  In light of this, it may be useful to examine some of the current and pending regulatory laws in the US and beyond:

One Small Paragraph

The United States is reacting to calls for greater regulation through proposed bills to more closely monitor activities of alternative investment fund managers (AIFMs). Based on the bills which have been proposed thus far, the consensus on Capitol Hill seems to be that SEC registration (to increase transparency) is the preferred method to keep private advisors in check.

Current policies were put in place in the Investment Advisers Act of 1940, nine years before A.W. Jones created the first hedge fund, and few legislative changes have occurred in the past six decades to keep pace with the evolving financial industry. Most hedge funds are exempt from regulation due to one small paragraph: Section 203(b) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(b)) states that an adviser need not register if he has fewer than 15 clients, and “client” can be interpreted to mean “fund.”

Notably, this provision, known as the “private adviser exemption” was upheld in 2006 in Goldstein v SEC, a lawsuit brought against the SEC in 2005 for its attempt to re-interpret the meaning of “clients” to mean “investors,” out of accordance with the rest of the 1940 Act. This provision in particular has been targeted by proposed legislation.

Regulatory flood gates opening

From the Oval Office is the proposed Private Fund Investment Advisers Registration Act of 2009. If enacted as proposed, it would eliminate the “private adviser exemption” and require registration with the SEC by investment advisors to private funds with $30 million or more assets under management. It contains an additional caveat which would allow the SEC to define a “client” however it wishes, effectively overruling Goldstein v SEC.

Of the bills introduced in Congress, the Senate’s Private Fund Transparency Act of 2009 (introduced by Sen. Jack Reed (D-RI)), closely mirrors the Oval Office proposal. It reflects it almost word-for-word, notably with the same elimination of the private adviser exemption and broadened power of the SEC to define terms, including “clients,” how it wishes.

A second Senate bill, the Hedge Fund Transparency Act (Sens. Levin (D-MI) and Grassley (R-IA)), focuses on private fund registration, as opposed to adviser registration. Under this proposal, any private fund with more than $50 million would be required to register with the SEC. Funds would be required to file annual disclosure statements which would be made publicly available, and which would identify investors and state the current value of assets in the fund.

The House of Representatives’ Hedge Fund Adviser Registration Act of 2009 (Reps. Capuano (D-MA) and Castle (R-DE)), is a no-frills proposed amendment to the 1940 Act. It deletes the private advisor exemption from the Investment Advisors Act of 1940, Section 203(b).

Most recently, three legislative discussion drafts were introduced in the House (Rep. Paul Kanjorski (D-PA), with similar regulatory aims, though exempting venture capital firms from its scope.

A flight to Switzerland…

Europe is facing similar legislative pressure. The Directive on Alternative Investment Fund Managers is an EU-wide bill which would, if enacted, tighten regulations on managers with assets greater than 100 million Euro. It has a similar emphasis on transparency, containing registration requirements, detailed reporting, and capital minimums for AIFMs. Proponents of the bill point to the 2008 financial crisis and argue that increased regulation is necessary: that hedge funds have become so entwined in the financial fabric of our society they could pose a systemic risk to the global economy.

However, the Directive is receiving strong resistance. The tougher rules which could result have led managers and industry experts to predict a move to Switzerland, which is not an EU member state, offering softer rules and lower taxes. There is a particular focus on potential flight from London, based on the combination of stringent regulation from the Directive and an unappealing proposal to implement 50% income tax.

…with stops in Jersey and Monaco.

An alternative would be Jersey, the British Crown Dependency, which would not be subject to the EU Directive and which offers regulatory exemptions to funds with solely institutional or professional investors. In addition, Jersey is a low tax location, where the maximum personal income tax rate does not exceed 20%.

The difficulty with relocating to avoid EU regulation, however, is that the Directive contains provisions which would inhibit outside funds from accessing the European market. One solution is EU microstates:  Monaco, for example, may become particularly attractive by virtue of being a French protectorate, and so will not be shut out by the EU directive but still has the benefit of 0% income tax.

Regulatory “Competition”

Alternatively, managers may look to move funds to Asia, and may benefit from the ongoing competition between Asian nations to attract new funds. Regulatory standards vary between countries, but many are offering incentives to lure new managers following the 2008 financial crisis. Asian countries were hit particularly hard—assets managed in Hong Kong shrank from $90 billion in early 2008 to $55 billion today.

The landscape is changing in Taiwan, in which historically tight regulation from the Financial Supervisory Commission is gradually being supplanted in a bid to expand the country’s regional presence. As of October 12^th, for instance, Taiwan will now allow the trading of both stock futures and stock index futures.

In Japan, funds are required to register with the Financial Services Agency, the Japanese equivalent of the SEC. Under a 2008 amendment to the Financial Instruments and Exchange Law, however, the reporting requirements are much reduced for funds which are limited to professional QEP investors.

In China, massive overhaul of investment fund regulations is currently underway, intended to see the China Securities Regulatory Commission’s power expanded to include supervisory oversight of China’s private funds.

Elsewhere in Asia, regulation in Singapore is governed by the Monetary Authority of Singapore, under which managers can be exempt from regulation if they have 30 or fewer clients, all of whom are financially sophisticated. In addition, managers are not required to maintain a physical presence in Singapore, and can instead offer their funds through private banks.

Some managers have estimated operations’ costs in Singapore at one-third the level of London. In contrast, in Hong Kong lawmakers prohibited exemption from licensing when the Securities and Futures Ordinance came into force in April 2003. Since that time, all hedge fund managers engaging in regulated activities must be licensed by the Hong Kong Securities and Futures Commission.

Few places to hide

Whether we will see new legislation cause a migration of managers to less-regulated countries is still uncertain, but it is clear that in regions all over the world, the hedge fund industry is moving toward increased transparency.

By: Steve Wallace, AllAboutAlpha.com Editorial Board

I remember being introduced to SRI (Socially Responsible Investing) when I started my career at a financial planning practice in Australia.  That was well before the turn of the century and the subsequent ascendancy of SRI (and its cousin Environmental, Social and Governance policies or ESG) as an investment criterion.

Over the ensuing years SRI and ESG investment products have come in and out of favour.  The main reason for this on-again off-again relationship between these funds and their investors has been performance – or more specifically, the difficulty in attributing that portion of a company’s performance which results specifically from its ESG policy.

That issue remains today, but so much attention has been lavished on climate change and environmental sustainability that these topics may have finally become part of the mainstream investing consciousness.

Private equity managers, by virtue of their in-depth analysis of company strategy, are particularly well positioned to determine whether ESG is a secular or a cycle trend.  So what do private equity investors think of the integration of ESG criteria into private equity decision making?  This is a question posed in a recent report by the Novethic Research Centre based on a survey of French private equity managers.

According to the survey, less than a tenth of private equity firms were involved with “environment funds” per se…

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Today, we bring you another installment of our “Summer of 1,000 posts” (more…)

This week we’ll be looking back through our archives to cull posts on the topic of CAPM/Alpha Theory…

How Hollywood, lotteries and mutual funds show that all risk is relative
Since the birth of the CAPM, empirical evidence has been uncooperative – showing that high risk investments produce lower returns, not higher ones.  Now one author looks beyond equity markets and finds even more evidence against the vaunted CAPM.

Real Estate Alpha
A lot of research has been conducted on real estate mutual funds.  But precious little has ever been conducted on the alpha produced by institutional funds that invest in commercial real estate – until now…

Crowds may not be so “wise” after all
A new book, an industry survey, and media reports have propelled the age-old topic of market efficiency into the spotlight this month.

Study hints that alpha may be finite (at least in the short term)
Is it a coincidence that hedge fund returns are exploding right after the biggest culling in the industry’s history?

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This week marks the publishing of our 1,000th post at AllAboutAlpha.com.  We’ve seen a lot over the past 3 years.  And despite its recent travails, the hedge fund industry remains approximately the same size now as it was back when we thought WordPress was a new type of laser printer and that blogs – like Pet Rocks and Cabbage Patch Kids before them – were another sign of the End of Times.

To celebrate this milestone, we thought we would highlight some popular posts in each topic area covered by AllAboutAlpha.com.  So throughout the summer, we’ll be pouring through the archives so you don’t have to.

(If you are a paying subscriber or a member of the CAIA Association and can’t remember your password, just hit “forgot password” at the right and we’ll have one of our army of overworked interns send you an email.)

This week, we’ll start with one of our favorite topics at AAA – CAPM/Alpha Theory.

Real Estate Alpha
A lot of research has been conducted on real estate mutual funds.  But precious little has ever been conducted on the alpha produced by institutional funds that invest in commercial real estate – until now…

Crowds may not be so “wise” after all
A new book, an industry survey, and media reports have propelled the age-old topic of market efficiency into the spotlight this month.

Study hints that alpha may be finite (at least in the short term)
Is it a coincidence that hedge fund returns are exploding right after the biggest culling in the industry’s history?

More…

A few days ago, we reflected in the rationality of closed-end hedge fund pricing.  And with markets swooning – then recovering this year, the topic of overall market rationality (or lack thereof) is firmly back on the front pages.   It seems the “wisdom of crowds” is being called into question these days.

The academics who brought us the Efficient Market Hypothesis (EMH) were recently  questioned for the website of one of their clients (Dimensional Fund Advisers).  In response to an op-ed in the Wall Street Journal by alpha-generator extraordinaire George Soros, Eugene Fama and Kenneth French argue that hedge fund managers are unqualified to comment objectively on efficient markets since they represent “a threat to their existence.”

Here’s an excerpt of what Soros had to say:

“Up until the crash of 2008, the prevailing view — called the efficient market hypothesis — was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don’t deal with the current reality, but with the future — a matter of anticipation, not knowledge.”

But Fama and French don’t buy it.  They argue that markets make “mistakes”, but they still efficient price all available information.  If their March 2009 paper on “luck vs. skill” in mutual fund management is any indication, then they’d probably also argue that Soros’ returns are a statistical aberration that is bound to crop up every now and then by chance.

Meanwhile, author Justin Fox writes a summary of his new book “The Myth of the Rational Market” (Amazon, book review) for Time Magazine this week.  Says Fox:

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Several recent studies have indicated that the ban on short selling some stocks implemented last fall had a negligible, if not a negative, impact on markets.  Not only did the bans fail to halt the downward slide in stock markets, but they also led to an increase in bid-ask spreads – a sure sign that market liquidity (and thus efficiency) declined.

But one of the ongoing challenges these studies have faced was to determine how much of the post-ban slide in markets was the result of the continuing (and even accelerating) market mayhem and how much might have actually been caused by the bans themselves.  In fact, a new analysis by Abraham Lioui of French research centre Edhec-Risk says that these studies “are unable to disentangle the impact of the ongoing crisis in the financial markets from the impact of the ban on short selling.”

Lioui proposes another approach to “disentangling” the effects of the financial crisis and the effects of the short-bans themselves.  They come to the “odd” conclusion (their description) that equity indices seem to have responded more “strongly and systematically” to the short bans than did the so-called “off-limits” stocks themselves (those where shorting was actually banned).

We summarize Lioui’s conclusion below:

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In just about every action movie and TV show these days there is at least one scene where the hero asks one of his or her techies to “sharpen” a satellite image.  Suddenly, what looked like a fuzzy bunch of pixelated squares takes on the form of someone’s face, a car, or some kind of mobile rocket launcher.   We’re not graphic imaging specialists.  But to us, it looks kind of outlandish that someone could take a very small amount of information (a few pixels) and divine the underlying image in fantastic detail.

But in a way, that’s exactly what Daniel Li & Michael Markov (of quantitative investment software vendor Markov Processes) and Russ Wermers of the University of Maryland have done in a paper released last month called “Monitoring Daily Hedge Fund Performance When Only Monthly Data is Available.”  Their trick is to leverage another kind of technology: hedge fund replication.

As we have reported extensively, “linear factor replication” aims to predict the performance of hedge funds based on a multiple regression of their historical returns on a number of variables such as equities, Fama/French factors, and several more “exotic” risk factors.

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French business school spin-off Edhec Risk and Asset Management Research Centre is in the business of education.  So it may come as no surprise that a recent white paper by the organization concludes that we all need more education on modern portfolio construction techniques.

While the report ostensibly covers the results of a survey of investment professionals, it does contain a certain element of brow-beating (“practitioners rely mostly on the assumption of a normal distribution…skewness and kurtosis is thus ignored…advanced techniques are not widely used…shortcomings in the area of portfolio construction…“).

However, Edhec makes several valid points about the resistance to measuring higher moments (skew & kurtosis, co-skew & co-kurtosis – see related AAA post) and relative returns vs. absolute returns.  Says the report:

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A couple of months ago, the U.S. Congress summonsed some of the world’s hedge fund titans to Capitol Hill.  Sensing that these managers – all of whom made over US$1 billion in 2007 – might be biased in favor of their industry, Congress also asked several noted academics to brief them on various aspects of the hedge fund business beforehand.  We interviewed one of the academics called to Hill that day, Houman Shadab of George Mason University, immediately after his testimony (see post).

Shadab is a senior research fellow in the Regulatory Studies Program at the Mercatus Center at George Mason  His work focuses primarily on financial regulation, in particular such areas as hedge funds, corporate governance, and derivatives.  He regularly publishes in journals such as the Berkeley Business Law Journal and the New York University Journal of Legislation and Public Policy and is a frequent commentator in the media.

We are pleased to invite Houman Shadab to this particular media outlet with this exclusive look at the convergence of private equity and hedge funds (a topic he covers in greater detail in this recent paper) .

Coming Together After The Crisis: The global convergence of private equity and hedge funds

Special to AllAboutAlpha.com by: Houman Shadab, George Mason University

Two of the most significant types of alternative investment funds worldwide are hedge funds and private equity funds. For years, these two alternative investment strategies have been converging.  Although the financial crisis may slow this convergence, the trend will ultimately continue and strengthen – albeit with some important variations across countries.

In part because private equity funds and hedge funds both seek returns that are uncorrelated with overall markets, there is a natural synergy between the funds that has already helped fuel their convergence. Indeed, institutional investors often view their allocations to each type of fund as relatively interchangeable components of their overall allocation to alternative investments.

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No one will likely be shocked to hear that investors weren’t overjoyed with hedge fund transparency even before the Madoff affair.  This is the headline finding of a survey conducted last fall and released on Friday by French research institute Edhec-Risk Asset Management Research Centre.  But the 72-page study based on the survey of European institutional investors also reveals some more interesting findings.

Hedge fund investors say operational risk reporting is relatively unimportant…

While a wide gap exists between the importance placed on operational risk reporting by hedge fund managers and investors, investors actually value other types of reporting much more than they do operational risk reporting.

The chart below from the report shows that investors are totally unimpressed with current operational reporting.  But note that they also value “operational risk” reporting less than all but one other form of reporting (that being reporting on the manager’s “qualitative outlook”):

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Most hedge fund conferences are rather staid affairs, taking place in exclusive hotels or converted castles.  In fact, one recent event was held at a hotel described by organizers as “A luxury Mayfair hotel of great repute, it embodies the highest of traditional values…”

But what do you do when your event becomes so popular it outgrows any of these traditional venues?  You move into London’s cavernous Excel Centre near London’s storied Canary Wharf.

That’s what French university-affiliated research centre Edhec has done this week for its annual “Alternative Investment Days“.   Billed as “bringing academic insights to alternative investments”, it’s a cross between the Detroit Auto Show and an academic symposium that has attracted nearly 800 hedge funds, investors and service providers this year.  AllAboutAlpha.com is a media partner of the event and we are on location in the Docklands this week to tell you what’s going on.

Edhec’s Jean-Rene Giraud kicked off the proceedings this morning with a spirited defense of the hedge fund sector.  Giraud emphasized that Edhec has never been afraid to criticize the hedge fund industry or to call it out on some of its claims.  But in an ironic twist, he says that he now feels compelled to defend the industry against what he sees as unfair attacks by those seeking a scapegoat for the current financial crisis.

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AllAboutAlpha.com contributor Timothy Laing reports today from The Dolder Grand hotel, over looking Zurich on this week’s Hedge Funds World Zurich conference…

“How many of you think the Sharpe Ratio is bull****?”

With characteristic bluster, author Nassim Nicholas Taleb addressed the audience of hedge funds, investors and service providers assembled before him earlier this week in Zurich (Hedge Funds World Zurich). Overall, it’s safe to say that Taleb doesn’t like quants.  He says he prefers to keep things “as simple as possible“, to plan, and to wait patiently for an unlikely, yet inevitable turn of events (i.e. the storied “Black Swan”).  But unfortunately, this is not a typical strategy in the financial markets.  Prop desk traders do not get paid to wait; pension funds cannot go 90% cash and 10% options; and hedge funds managers do not get paid to “keep things simple”.

Taleb is an options trader – or to be more precise, an options buyer.  Since the investing public often has a tough time with the concept of short selling, Taleb’s strategy might seem complex – but it’s not.

Essentially, he buys cheap insurance on all sorts of things (many, many, things) pays monthly premiums and – like a hunter – waits for Black Swans. He firmly believes that Black Swans are more plentiful than option sellers realize. Thus, he figures that the playing field is tilted in his favor. In the meantime, he ends up providing liquidity to capital markets.

Naturally, he also had a lot to say on the subject of risk management/measurement – arguing that “stress testing is useless since it tests the past and not the possible” and that “the 1,000 year flood cannot be seen in 100 years of data”. In addition to his critique of Sharpe, he went on to fire well aimed shots at VaR, portfolio theory, and the people who use these tools. He says simply that classic statistical tools do not apply to financial markets.

Taleb is a commensurate salesman. He and his colleagues know that most people do not have the ability to execute his strategies on their own, and that Wall Street’s bonus system keeps the competition out of their trades.  His stories are full of the kinds of colourful anecdotes that experienced traders love to relate.  He likes to shock his audience and is no stranger to the colourful language synonymous with successful traders. He is clearly one of the smartest guys in the room. If only Enron or LTCM had hired Taleb, history may have unfolded differently.

But at a major hedge funds conference, especially one in Switzerland, you expect to meet smart people like Taleb.   Gerlof de Vrij, Head of Global Tactical Asset Allocation at Dutch government pension fund APG Investments, is another one these.

de Vrij told the audience that “we are experiencing a flight to simplicity“.  He doesn’t think much of structured products or hedge fund replication, and believes that while you may be able to replicate the details you cannot replicate “the intelligence”. During a panel discussion on Wednesday, he accused many hedge fund managers of being too beta-oriented (i.e. long-only “closet-indexers”), and said that investors with appropriate capacity and infrastructure could simply trade many of these strategies themselves. Taleb would probably agree.

There was considerable discussion surrounding fees, lock ups, and gates at this year’s event. The common feeling was that lock ups and gates should be strategy dependent. Lock-ups for a managed futures fund would be a tough sell, for example. But a distressed fund could more easily make an argument for such a provision.

At the same time, many felt that fees should better reflect the new manager/investor relationship.  Kerrin Rosenberg, CEO of Cardano UK, suggested that “1 & 10″ might be a fair fee for an investor who agreed to a two year lock up, but “2 & 20″ was more suitable for an investor requiring immediate liquidity (or, as Rosenberg put it, an investor “who may panic at the wrong time”). He also made the point that the management fee should only serve to cover fixed costs and is therefore too high for most large funds (who require much less to keep the lights on).

At conferences like this, it’s often difficult to maintain audience attention during sessions on hedge fund regulation. Patrice Berge-Vincent of the French regulator, Autorité des marchés financiers, gave it a good college try.  However, in this blogger’s opinion, Gerlof de Vrij’s “flight to simplicity” seems to have bypassed Paris’ Charles de Gaulle airport.   Indeed, it often seems that regulators are embracing greater complexity, just as investors are demanding more simplicity.

The recent market calamities may have placed an elephant in the room here in Zurich. Many wondered how – or even if – risk management models should hereinafter reflect what has recently occurred. Michael Brandenberger, CEO of Complementa Investment Controlling, was asked how he would adjust risk management systems in light of recent events. His answer sums it all up:

“What happened to HFs over the past few months was not statistically possible so it is going to be difficult to adjust risk management models to reflect what has happened.”

You could hear Taleb smiling.

Timothy Laing, CFA, CAIA is Head of Business Development at Plenum Investments in Zurich.  The opinions expressed in this guest contribution are those of the author and not necessarily those of AllAboutAlpha.com.

Newly-released government UFO files aren’t the only controversies pitting skeptics against “believers” these days…

Hedge fund replication is back in the news today with the publication of the results from a survey on the topic conducted last winter by French research institute Edhec Risk and Asset Management Research Centre.  While the results are somewhat dated, they are a good recap of the concept as a lead-up to Edhec’s annual alternative investment conference in London in a couple of weeks (Edhec’s “Alternative Investment Days“).  The bottom line: polarization between those who believe there may be some value in the exercise and those who ridicule it as a hoax.

Regular readers may recall our own poll on this topic (conducted in partnership with conference producer Terrapinn) conducted around the same time (winter 2008).  We were curious to see if our findings lined up with those of Edhec and were encouraged to see that both surveys seemed to have yielded roughly the same results – with a few notable exceptions.  Edhec’s sample was about the same size as ours with slightly more asset managers and fewer end investors.  While we did not ask about geography, Edhec notes that its sample was predominantly European.  As we wrote in the commentary for our recent 130/30 survey, respondents to surveys like this are likely to be skewed toward those with an existing interest in the topic.  As a result, caution should be used in extrapolating the results (of both surveys).

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In an Alpha magazine article published today, Clifford Asness (founder of AQR Capital) and colleague Adam Berger launch a spirited defense of quant funds – saying they are not “black boxes” or reincarnations of the HAL 9000 from the movie 2001: A Space Odyssey.  The article is full of other colorful analogies that have become Asness’ trademark and it’s well worth the read (here – available without a login right now).

In “We’re Not Dead Yet” Asness writes:

“It’s not hard to see why people might think quant strategies are dead.  Recent performance, fears of overcrowding and the current market environment could easily lead one to question the viability of these strategies…we don’t think these concerns hold water.”

Asness and Berger base much of their argument on the belief that investors are irrational and that there are “fundamental, deep-seated, flaws in the way most investors make decisions.“  These result in trading opportunities (such as momentum and value a la Fama & French) which are likely to endure well into the future – regardless of the short term health of the hedge fund industry.

As the duo puts it:

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