The long and short of it

The DFSA was the first regulator to introduce a code of practice for hedge funds. 
The long and short of it
By Daniel Stanton
Wed 09 Apr 2008 04:00 AM

The Dubai Financial Services Authority (DFSA) was the first regulator to introduce a code of practice for hedge funds. Daniel Stanton finds out what it hopes to achieve.

Hedge funds have often been regarded as one of the more secretive and high risk asset classes - not to mention somewhat averse to regulation.

History shows that some level of regulation is required.

However, regulators and the industry seem to have come to the understanding that there should be more transparency in hedge funds, even if it is voluntary, in order to put investors' minds at rest.

In the US, the President's Working Group has been discussing ways to oversee the industry, and in Europe, the Hedge Fund Working Group (HFWG), led by Sir Andrew Large, has been developing a voluntary code of conduct.

These two jurisdictions have been at the forefront of many regulatory changes that have later been applied internationally, so it may come as a surprise that the first hedge fund code was developed and introduced in Dubai.

The Dubai Financial Services Authority (DFSA), which regulates companies based in Dubai International Financial Centre (DIFC), introduced its code in January 2008, the first to be introduced by a regulator.

Prior to implementation, it showed the draft code to the Financial Services Authority in the UK, which provided some comments, and the HFWG sent someone to Dubai to discuss the code's development.

"We certainly didn't set out to try to tell the rest of the world how to regulate hedge funds," says Ian Johnston, managing director, policy and legal services, DFSA.

"We were doing this for our own market, for the DIFC as a centre, but it has attracted a lot of interest among the regulatory community, and, frankly, among the business community."

"We've been pleased by that because it has been generally very positive responses that we've been getting."

The code was not intended to create publicity for the DIFC, but it seems to have drawn attention to the centre as a base for hedge funds - around 85 hedge fund players have licence applications in the pipeline.

The development of the hedge fund code came about following the DFSA's introduction of its collective investment law and rules, which are binding.

"The collective investment law looks at things like what sort of strategy you use, making sure you have adequate resources, the right amount of capital - all of those normal regulatory requirements that you would have for any operation running a collective investment scheme," says Johnston.

"Then we said, there are specific risks relating to hedge funds which we wish to address, and so the hedge fund code was developed."

The code is not compulsory, but the DFSA may ask firms about compliance.

"It sits there as a code of practice which we think is best practice," says Johnston. "One way of thinking of it is if you were to adopt the code and comply with it, then that would be strong evidence that you've complied with your legal obligations under the law and the rules, but we do recognise that it's not the only way to comply with the law."

Some funds have even asked the DFSA whether they can advertise their compliance with the code, as a way of showing potential investors that they follow best practices.

The DFSA does monitor compliance with firms' legal obligations, and will hold the operator of the fund accountable for its activities, whether or not they use outsourced services.

"One principle in the code is that firms need to have access to - if they don't have them themselves - the right skills and resources," says Johnston.

"So we would expect to see that they have outsourcing agreements in place, that they've done due diligence on whoever they're using - do them on their prime brokers for example - and that those agreements give them and the regulator access to the records."
Many of the necessary records will be electronic, making it easier for the regulator to access them.

The code also addresses valuation of assets, taking an approach in line with IOSCO recommendations.

"That's about the integrity, accuracy and timeliness of the pricing," says Johnston.

"We do say that where possible, the valuation function should be independent. If not independent legally - sometimes the only people who can value an asset might well be in your own organisation - at least functionally independent, so you haven't got a trader, for example, valuing the assets they are trading."

Some people argue that the nature of hedge funds - highly leveraged and fast-moving - not only makes them extremely difficult to regulate, but reduces the need for regulation, since hedge funds that over-stretch themselves will often be made to pay the price by market forces.

Johnston does not agree. "Obviously there are market disciplines forced onto all kinds of market participants, but I think history shows that some level of regulation is required to encourage good practice and good behaviour, and where there are breaches, to hold people accountable for them," he says.

"There are funds that can operate at a higher level where they're not dealing with retail investors and they have greater freedom in their offerings. But to say that the market alone can discipline them and hold them accountable is not quite right."

Hedge funds seemed (at time of press) to have suffered less than Wall Street institutions from the US sub-prime meltdown, Peloton notwithstanding, prompting some industry observers to question whether their business model, which usually sees the fund manager taking a substantial stake themselves, makes them less likely than investment banks to suffer huge losses. There could be more bad news to emerge, however, Johnston believes.

"It has surprised people that there have been greater losses in the banking sphere than in hedge funds," says Johnston.

"I was talking to a major hedge fund operator recently who said, without having any fears about their own fund, that all the dice might not have stopped rolling yet and there might be some other things to come out. I think it's too early to say there has been a major failure in one part of the system and that other parts are relatively unscathed."

If best practice frameworks like the DFSA's hedge fund code become popular in other markets, it could soon become harder for hedge funds to hide their bad news.

Hedge fund index performanceData from the MSCI Global Capital Markets Yearbook gives some indication of which geographical areas and strategies gave best returns for hedge fund investors last year.

"Year-to-date through November 30 the MSCI Hedge Fund Composite Index gained 9.3% while the MSCI World Equity Index rose 10.5% and the 3M US Treasury Index rose 4.1%," the report reads. All indices in the report are currency hedged into US dollars.

"All process groups within the MSCI Hedge Fund Composite Index had positive returns during the period. The MSCI Security Selection Index was the top performing process group index for the year, gaining 11.5% year-to-date through November after a 13.2% gain in 2006.

"The MSCI Relative Value Index ended the eleven-month period as the lowest performing process group index with a gain of only 5.9%.

"Geographically, funds in the MSCI Hedge Fund Composite Index focused on global markets performed the best by gaining 17.8%. Funds focused on Japan fared the worst, losing 0.3%."

Hedge funds focused on emerging markets have out performed those focused on developed markets in the past three-year and five-year periods.

"Within developed markets, funds focusing on North America have performed the best in the one-year and five-year periods while funds focusing on Europe have had the strongest performance over the past three-year period ending November 30, 2007," says MSCI.

In terms of investment process, the report states: "Distressed Securities funds in the MSCI Hedge Fund Composite Index were the leading performer by investment process over the past five-year period. Short Bias funds under performed all other categories and had negative returns, while all the other hedge fund investment process indices were up over the past one-, three- and five-year periods."

Size matters when it comes to hedge funds, according to the performance of MSCI's hedge fund indices, with funds with more than US$100m under management outperforming smaller funds.

"Specifically, the MSCI Core Hedge Fund Composite Index advanced 9.4% year-to-date through November and 10.4% on a three-year basis, compared with 9.3% and 9.7% for the MSCI Small Hedge Fund Composite Index," the report notes.

"Over the past five-year period, the MSCI Small Hedge Fund Composite Index and MSCI Core Hedge Fund Composite Index had similar returns of 10.2% respectively."

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