Friday, April 22, 2005

 

Hedge Funds as B-Ds/Compliance Issues

A Broker-Dealer Morality Tale
John Hintze
April 25, 2005

Citadel Investment Group and Ramius Capital may be using broker-dealer affiliates to build new businesses as part of their natural growth as financial institutions. But broker-dealer affiliates can also be used to obscure business practices, including fraudulent ones, by minimizing the traditional market scrutiny of hedge funds.

To the dismay of investors and Wall Street participants, that is apparently what happened when KL Financial, a Palm Beach-based hedge fund, collapsed in early March, leaving investors with more than $100 million in losses.

KL Financial acquired a broker-dealer in 2001 that reportedly had a pre-existing correspondent clearing relationship with Spear, Leeds & Kellogg Specialists LLC, which was bought by Goldman Sachs and is now part of its execution and clearing operation.

Gary Klein, a former Securities and Exchange Commission enforcement official who is currently representing investors suing KL Financial, says the relationship with Goldman gave the broker-dealer, Shoreland Trading, "immediate credibility" on the Street. As a result, it was probably able to get financing and pursue trades that a prime broker would have frowned at.

Shoreland Trading left Goldman last summer and moved to Penson Financial Services, a clearing firm headquartered in Dallas. Sources familiar with Shoreland's relationship to Penson said the clearing firm provided leverage to Shoreland, as clearing firms typically do, although it was unclear by press time whether Penson suffered losses as a result.

Indeed, it was unclear which firm Shoreland was using to clear through shortly before its collapse. Dan Son, the president of Penson Worldwide, said Shoreland cleared through Penson through late December or very early January. Shoreland then reportedly moved to West Coast clearing firm Wedbush Morgan, although officials there declined to comment.

Sources said Goldman and Penson each viewed Shoreland as a proprietary trading broker-dealer. Both firms also provide prime brokerage services directly to hedge fund managers, and prime brokers typically employ sophisticated risk management models to monitor their customers' trading for undue risk. As a broker-dealer, however, KL Financial's Shoreland Trading used those firms' correspondent clearing functions, and correspondent clearers have long argued that they are simply trade processors and are not responsible for their correspondents' actions.

That argument especially applies to proprietary trading correspondents, which stand to lose only their principals' own capital. For correspondent clearers, proprietary traders are a source of high trading volumes and hence fees, without the requirements to service broker-dealers catering to investors.

Shoreland, however, was not truly a proprietary trader, since it had investors through its hedge fund affiliate that apparently funded its trading. In a fully disclosed clearing relationship, the clearing firm also sends statements to the broker-dealer's customers. In the case of KL Financial, its investors received statements purporting fantastic gains. But those statements came from the hedge fund and clearly had little to do with the financial results provided by the clearing firms. In fact, each clearing firm reportedly ended its relationship with Shoreland based on concerns about Shoreland's financial health and risk.

Even the Pacific Exchange, which Shoreland joined in May 2003, failed to detect the trading activity that ended up costing the hedge fund's investors more than $100 million.

"Any time you have a registered broker-dealer, you think you have additional layers of compliance. You're supposed to be sitting with a [Series 24-licensed principal who is] supervising all this, and the exchange is coming in to look at [the broker-dealer's activities]," said Klein.

Klein noted that exchanges examine registrants at least once a year-which is one reason hedge funds so adamantly opposed registration under the Investment Advisors Act of 1940. Hedge funds will have to register under that statute next February, and while the requirements are far less demanding than registering as a broker-dealer, even hedge funds without broker-dealer affiliates will face annual examinations.


Copyright 2005 Thomson Media Inc. All Rights Reserved.

http://www.thomsonmedia.com http://www.iddmagazine.com

Wednesday, April 20, 2005

 

ICI on MF/HF Differences 032005

The Differences Between Mutual Funds and Hedge Funds
Mutual funds and hedge funds differ in many ways. The areas of greatest difference between the two are: fees; leveraging practices; pricing and liquidity; degree of regulatory oversight; and investor characteristics.

U.S. mutual funds are among the most strictly regulated financial products. They are subject to numerous requirements designed to ensure that they are operated in the best interests of their shareholders. Hedge funds are private investment pools subject to far less regulatory oversight. In 2004, however, the SEC adopted new rules requiring hedge fund advisers to register with the SEC under the Investment Advisers Act of 1940.

Regulatory Requirements
Mutual Funds
Mutual funds are investment companies that must register with the U.S. Securities and Exchange Commission (SEC) and, as such, are subject to rigorous regulatory oversight. Virtually every aspect of a mutual fund's structure and operation is subject to strict regulation under four federal laws: the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940 and the Investment Advisers Act. The SEC is charged with overseeing the mutual fund industry's compliance with these regulations. The Internal Revenue Code sets additional requirements regarding a fund's portfolio diversification and its distribution of earnings, and the National Association of Securities Dealers, Inc. (NASD) oversees most mutual fund advertisements and other sales materials. In addition, mutual funds must have directors who are responsible for extensive oversight of the fund's policies and procedures. For virtually all funds, at least 75 percent of their directors and the chairman of the fund board must be independent of the fund's management.

The Investment Company Act is the cornerstone of mutual fund regulation. It regulates the structure and operation of mutual funds and requires funds to safeguard their portfolio securities, forward price their securities, and keep detailed books and records. In addition, the 1933 Act requires all prospective fund investors to receive a prospectus containing specific information about the fund's management, holdings, fees and expenses, and performance.

Hedge Funds
Hedge funds are private investment pools subject to the terms of an investment agreement entered into by the sponsor of, and investors in, the hedge fund. In response to rapid growth in the hedge fund industry, the SEC ordered a study of the hedge fund market and, in October 2004, adopted a rule requiring advisers to hedge funds - for the first time - to register under the Investment Advisers Act. The new rule will allow the SEC to inspect all hedge fund advisers and to deny the registration of any hedge fund adviser that has been convicted of a felony or has a disciplinary record.

Under the Investment Advisers Act, hedge fund advisers are now subject to many of the same requirements as mutual fund advisers, including registration with the Commission; designation of a Chief Compliance Officer; implementation of policies to prevent the misuse of nonpublic customer information and to ensure that client securities are voted in the best interests of the client; and implementation of a code of ethics. Hedge fund advisers are required to comply with all of these requirements by February 2006.

Fees
Mutual Funds
Federal law imposes a fiduciary duty on a mutual fund's investment adviser regarding the compensation it receives from the fund. In addition, mutual fund sales charges and other distribution fees are subject to specific regulatory limits under NASD rules. Mutual fund fees and expenses are disclosed in detail, as required by law, in a fee table at the front of every prospectus. They are presented in a standardized format, so that an investor can easily understand them and can compare expense ratios among different funds.

Hedge Funds
There are no limits on the fees a hedge fund adviser can charge its investors. Typically, the hedge fund manager charges an asset-based fee and a performance fee. Some have front-end sales charges, as well.

Leveraging Practices
Mutual Funds
The Investment Company Act severely restricts a mutual fund's ability to leverage or borrow against the value of securities in its portfolio. The SEC requires that funds engaging in certain investment techniques, including the use of options, futures, forward contracts and short selling, "cover" their positions. The effect of these constraints has been to strictly limit leveraging by mutual fund portfolio managers.

Hedge Funds
Leveraging and other higher-risk investment strategies are a hallmark of hedge fund management. Hedge funds were originally designed to invest in equity securities and use leverage and short selling to "hedge" the portfolio's exposure to movements of the equity markets. Today, however, advisers to hedge funds utilize a wide variety of investment strategies and techniques. Many are very active traders of securities.

Pricing and Liquidity
Mutual Funds
Mutual funds are required to value their portfolios and price their securities daily based on market quotations that are readily available at market value and others at fair value, as determined in good faith by the board of directors. In addition to providing investors with timely information regarding the value of their investments, daily pricing is designed to ensure that both new investments and redemptions are made at accurate prices. Moreover, mutual funds are required by law to allow shareholders to redeem their shares at any time.

Hedge Funds
There are no specific rules governing hedge fund pricing. Hedge fund investors may be unable to determine the value of their investment at any given time

Investor Characteristics
Mutual Funds
The only qualification for investing in a mutual fund is having the minimum investment to open an account with a fund company, which is typically around $1,000, but can be lower. After the account has been opened, there is generally no minimum additional investment required, and many fund investors contribute relatively small amounts to their mutual funds on a regular basis as part of a long-term investment strategy. More than 92 million Americans own mutual fund shares. The typical fund investor is a middle-income, middle-aged individual.

Hedge Funds
A minimum investment of $1 million or more is often required of hedge fund investors. Under the National Securities Markets Improvement Act of 1996, certain hedge funds can accept investments from any individual who holds at least $5 million in investments. This measure is intended to help limit participation in hedge funds and other types of unregulated pools to highly sophisticated individuals. Hedge funds can also accept other types of investors if they rely on other exemptions under the Investment Company Act or are operated outside the United States.

March 2005




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