Why the AIFMD boosts the case for hedge funds

The intention of the directive is to ensure high standards of practice are met by alternative investment managers across governance, managing conflicts, disclosures, and having adequate systems and procedures in place. Overall it aims to further prevent market abuses and irresponsible risk-taking.

The case

Historically, some institutional investors, including pension funds, have been restricted from allocating to offshore hedge funds for regulatory or internal risk control reasons.

The directive opens up the ability to create the same offshore hedge fund strategy in an onshore format. Significantly, it also means managers authorised in accordance with the directive would have implemented some of the highest standards in investor regulation.

As such, the AIFMD should reduce concerns of the lack of transparency of certain funds as it ensures there is a standard for reporting and providing information to investors.

This regulated framework will bring greater protection and security for investors such as pension funds, while providing access to the full range of hedge fund strategies.

While the directive has been in place since July 2013, there will be a lag until we see a large number of funds available in an onshore format.

One reason is a transitional period that has been offered to alternative managers and of course it will also take time for others to be fully compliant.

Many managers will likely move to adhere to AIFMD requirements over time, which will in turn provide investors with onshore access to strategies they could not previously allocate to.

Those managers not regulated by the directive will be considered out-of-scope and will have to work on a reverse inquiry basis with strict rules of interpretation.

For its part, the hedge fund industry largely expects that once there is an equivalent onshore vehicle ready for investment, the investor base will move in that direction.

The cost

One area where investors, either using or considering allocating to hedge funds, have raised concern relates to the cost of AIFMD compliance.

Typically there are two types of cost: one that comes from setting up an operational infrastructure, and another from potentially higher fee requirements of third-party service providers.

Key hedge fund risks such as fraud, style drift, lack of portfolio transparency and reputational risk are still possible

For the first, an operational infrastructure cost denotes that a manager will have to invest in their back-office operations and headcount, assuming the manager does not have this in place already.

For smaller hedge funds this is certainly a risk, but since the financial crisis of 2008, there are a large number of hedge funds that have become more institutional in the framework they have established.

Even if this cost was to arise, investors should make sure it is borne by the management company and not the fund.

This would ensure there is no cost to the investor, just the manager. For the second potential cost, ie the service provider cost, this is passed through to investors but, even so, this can be mitigated as the larger and more established managers are usually able to lower their service provider fees due to economies of scale.

For hedge funds themselves, the challenges of fully implementing AIFMD are actually quite considerable. As a result, many managers will choose to use platforms such as managed account providers to help comply with the directive.

In such a case, the managed account provider will be the alternative investment fund manager and delegate the trading of the portfolio to a trading adviser – the hedge fund manager – as well as appointing service providers to operate the account.

In this way, hedge funds will outsource a lot of the burden that comes from dealing with the directive while their managed account vehicle can be broadly marketed to professional clients such as pension funds.

One final point to note, however, is that investors may feel that greater protection in the form of an onshore AIFM will provide them with mitigated risks when allocating to hedge funds. This is not necessarily the case.

Key hedge fund risks such as fraud, style drift, lack of portfolio transparency and reputational risk are still possible under the new regime.

Investors therefore need to carefully consider how to access hedge fund strategies. Due to the additional layer of due diligence and risk management managed account platforms can provide, they offer a particularly attractive solution to address these issues. 

Cyrus Amaria is a senior product specialist for managed account development at Lyxor Asset Management