2.1.1 The Buy Side

Buy side refers to the institutions and entities that buy large quantities of securities for the portfolios they manage. Buy side entities include asset owners and asset managers. The buy side contrasts with the sell side (detailed in section 2.1.2), which focuses on distributing securities to the public. Examples of buy-side institutions follow, with an emphasis on the perspective of alternative investing.

PLAN SPONSORS: A plan sponsor is a designated party, such as a company or an employer, that establishes a health care or retirement plan (pension) that has special legal or taxation status, such as a 401(k) retirement plan in the United States for employees. Plan sponsors are companies or other collectives that establish the health care and retirement plans for the benefit of the organization's employees or members. Plan sponsors are responsible for determining membership parameters and investment choices and, in some cases, providing contribution payments in the form of cash or stock (or both). In many cases, one individual, the plan trustee, is designated with overall responsibility for managing the plan's assets, whereas the plan administrator is charged with overseeing the plan's day-to-day operations. Both the trustee and the administrator are identified in the plan's summary plan description.

FOUNDATIONS AND ENDOWMENTS: A foundation is a not-for-profit organization that donates funds and support to other organizations for its own charitable purposes. An endowment is a fund bestowed on an individual or institution (e.g., a museum, university, hospital, or foundation) to be used by that entity for specific purposes and with principal preservation in mind.

FAMILY OFFICE AND PRIVATE WEALTH: Family office and private wealth institutions are private management advisory firms that serve ultra high-net-worth investors. A family office is a group of investors joined by familial or other ties who manage their personal investments as a single entity, usually hiring professionals to manage money for members of the office.

SOVEREIGN WEALTH FUNDS: Sovereign wealth funds are state-owned investment funds held by that state's central bank for the purpose of future generations and/or to stabilize the state currency. These funds may emanate from budgetary and trade surpluses, perhaps through exportation of natural resources and raw materials such as oil, copper, or diamonds. Because of the high volatility of resource prices, unpredictability of extraction, and exhaustibility of resources, sovereign wealth funds are accumulated to help provide financial stability and future opportunities for citizens and governments.

PRIVATE LIMITED PARTNERSHIPS: Private limited partnerships are a form of business organization that potentially offers the benefit of limited liability to the organization's limited partners (similar to that enjoyed by shareholders of corporations) but not to its general partner. For tax purposes, limited partnerships tend to flow taxable revenue and expenses directly through to their partners rather than being taxed at the partnership level.

PRIVATE INVESTMENT POOLS: Hedge funds, funds of funds, private equity funds, managed futures funds, commodity trading advisers (CTAs), and the like are private investment pools that focus on serving as intermediaries between investors and alternative investments. Most U.S. funds are structured as limited partnerships and offer incentive-based compensation schemes to their managers. These limited partnerships are usually managed by the general partner, while most of the invested funds are provided by the limited partners. Exhibit 2.1 illustrates the basic structure used for most private alternative investment vehicles. The general partner manages the assets in the fund. Hedge funds tend to use sophisticated trading strategies, funds of funds invest in other funds, private equity funds tend to invest in stock of nonpublic companies, and managed futures funds and CTAs are asset managers who, instead of focusing on traditional stock and bond investments, focus on currency or commodity futures markets.

SEPARATELY MANAGED ACCOUNTS: Separately managed accounts (SMAs) are individual investment accounts offered by a brokerage firm and managed by independent investment management firms. The relationship between an investment adviser and a client to which it provides advice is typically documented by a written investment management agreement. SMAs can be thought of as being similar to pooled investment arrangements, such as mutual funds, in that a customer pays a fee to a money manager for managing the customer's investment, but SMAs tend to be differentiated from funds in five major ways:

1. A fund investor owns shares of a company (the fund) that in turn owns other investments, whereas an SMA investor actually owns the invested assets as the owner on record.
2. A fund invests for the common purposes of multiple investors, whereas an SMA may have objectives tailored to suit the specific needs of its only investor, such as tax efficiency.
3. A fund is often opaque to its investors to promote confidentiality; an SMA offers transparency to its investor.
4. Fund investors may suffer adverse consequences from other investors' redemptions (withdrawals) and subscriptions (deposits), but an SMA provides protection from these liquidity issues for its only investor.
5. Whereas the fund structure may allow investors to have limited liability, the SMA format may allow losses to be greater than the capital contribution when leverage or derivatives are used.

From an investor's perspective, the advantages of the first four distinctions typically outweigh the disadvantages of the last distinction. However, fund managers prefer the simplicity and convenience of pooled arrangements (funds).

MUTUAL FUNDS (’40 ACT FUNDS): Mutual funds, or ’40 Act funds, are registered investment pools offering their shareholders pro rata claims on the fund's portfolio of assets. In the United States, mutual funds that offer their shares for sale to the public are known as ’40 Act funds due to the regulations that permit their offering by registered investment advisers: the U.S. Investment Company Act of 1940. In recent years, ’40 Act funds have increasingly offered alternative asset exposures through these retail fund structures. A general discussion is provided in section 2.4, along with more specific discussions throughout Parts 2 through 5.

MASTER LIMITED PARTNERSHIPS: Master limited partnerships (MLPs) are publicly traded investment pools that are structured as limited partnerships and that offer their owners pro rata claims. Like equities, MLP units are traded on major stock exchanges, but they have legal and tax structures similar to those of private limited partnerships.

2.1.2 The Sell Side

In contrast to buy-side institutions, sell-side institutions, such as large dealer banks, act as agents for investors when they trade securities. Sell-side institutions make their research available to their clients and are more focused on facilitating transactions than on managing money.

LARGE DEALER BANKS: Large dealer banks are major financial institutions, such as Goldman Sachs, Deutsche Bank, and the Barclays Group, that deal in securities and derivatives. Although based on the same economic principles as typical retail banks, large dealer banks are much bigger and more complex. The macroeconomic impact of a large dealer bank failure may be more widespread because of the central role this type of bank plays in the economic system at large. Generally, most large dealer banks act as intermediaries in the markets for securities, repurchase agreements, securities lending, and over-the-counter (OTC) derivatives. In addition, large dealer banks are often engaged in proprietary trading and brokering hedge funds.

Large dealer banks also have large asset management divisions that cater to the investment management needs of institutional and wealthy individual clients. This involves custody of securities, cash management, brokerage, and investment in alternative investment vehicles, such as hedge funds and private equity partnerships that are then managed by the same banks. Some of these types of banks operate internal hedge funds and take on private equity partnerships as part of their business management service. In this role, the bank acts as a general partner with limited-partner clients.

The role of dealer banks in the primary market is to intermediate between issuers and investors, to provide liquidity, and to act as underwriters of investments. In secondary securities markets, large dealer banks trade with one another and with brokers/dealers directly over the computer or the phone, as well as play an intermediating role of facilitating trades.

Large dealer banks also engage in proprietary trading. Proprietary trading occurs when a firm trades securities with its own money in order to make a profit. Large dealer banks serve as counterparties to OTC derivatives such as options, forwards, and swaps that require the participation of a counterparty dealer who meets customer demand by taking the opposite side of a desired position. Dealers may accept the risk or use a matched book dealer operation, in which the dealer lays off the derivative risk by taking an offsetting position.

As part of their business management activities, large dealer banks are active as prime brokers that offer professional services specifically to hedge funds and other large institutional customers. (Prime brokers are discussed in more detail in section 2.1.3.) Several large dealer banks have ventured into off-balance-sheet financing methods, a practice that involves a form of accounting in which large expenditures are kept off the company's balance sheet through various classification methods. Companies use off-balance-sheet financing to keep their debt-to-equity and leverage ratios low.

In addition to their special role in the financial system, large dealer banks share many of the same responsibilities as conventional commercial banks, including deposit taking and lending to corporations and consumers.

BROKERS: Also on the sell side are retail brokers that receive commissions for executing transactions and that have research departments that make investment recommendations. Advantages of using brokers include their expertise in the trading process, their access to other traders and exchanges, and their ability to facilitate clearance and settlement. Because brokers play the role of middlemen in the trading process, traders can use broker services when they want to remain anonymous to other traders. Typically, traders can manage their order exposure by breaking up large trades and distributing them to different brokers or by asking a single broker in charge of the entire trade to expose only parts of the order, so that the full size remains unknown to other traders. Brokers also often represent limit orders for clients (i.e., orders placed with a brokerage to buy or sell shares at a specified price or better). In this event, brokers monitor the markets on behalf of their clients and make decisions based on client limit and stop orders when the markets change.

The brokerage firm's proprietary trading operations involve the firm's own account, called the house account. Other sources of broker revenue include soft commissions, payments for order flow, interest on margin loans, short interest rebates (on short sales), underwriting fees when the firm helps clients sell securities, and mergers and acquisitions (M&A) fees. The major cost of running a brokerage firm is labor: the brokers and other employees who provide the firm's services to clients.

Brokerage firms and other firms with major investment activities organize their activities into three major operations: (1) front office, (2) back office, and (3) middle office. Front office operations involve investment decision-making and, in the case of brokerage firms, contact with clients. Back office operations play a supportive role in the maintenance of accounts and information systems used to transmit important market and trader information in all trading transactions, as well as in the clearance and settlement of the trades. Middle office operations form the interface between the front office and the back office, with a focus on risk management.

2.1.3 Outside Service Providers

Other major participants in the world of alternative investments are outside service providers, such as prime brokers, accountants, attorneys, and fund administrators. Alternative investment funds rely on outside service providers for their successful creation and operation. Details regarding outside service providers are provided in Chapter 31, and their roles are briefly discussed here.

PRIME BROKERS: Prime brokers allow an investment manager to carry out trades in multiple financial instruments at multiple broker-dealers while keeping all cash and securities at a single firm. The prime broker has the following primary functions: clearing and financing trades for its client, providing research, arranging financing, and producing portfolio accounting. Prime brokers offer a range of services, which are discussed in more detail in Chapter 31, on due diligence.

ACCOUNTANTS AND AUDITORS: The accounting firm providing services to a hedge fund or to another alternative investment fund should include an experienced auditor and tax adviser. During the creation of the fund or investment vehicle, the accounting firm provides services largely parallel to those of an attorney: reviewing legal documents to ensure that accounting methods and allocations are appropriate and feasible, and that relevant tax issues have been addressed. The accountant helps prepare partnership returns and the necessary forms for the investors in the fund to report their shares of partnership income, deductions, gains, and losses (e.g., Schedule K-1 in the United States). The adviser also provides tax-related advice to the fund throughout the year and may be called on as a consultant on structuring and compensation issues for the principals of the general partner. The auditor performs a year-end audit of the fund, including the review of security pricing, and presents the results of this audit to the fund and its investors. Accountants usually cooperate with the prime broker and fund administrator to gather the necessary information for audits and tax returns.

ATTORNEYS: An attorney helps determine the best legal structure for a fund's unique investment strategies, objectives, and desired investors. The attorney takes care of filing any documents required by the government (federal or other levels) and creates the legal documents necessary for establishing and managing a hedge fund or another alternative investment, including (1) private-placement memoranda (a.k.a. offering documents), which are formal descriptions of an investment opportunity that comply with federal securities regulations; (2) a partnership agreement, which is a formal written contract creating a partnership; (3) a subscription agreement, which is an application submitted by an investor who desires to join a limited partnership; and (4) a management company operating agreement, which is an agreement between members related to a limited liability company and the conduct of its business as it pertains to the law. The attorney can offer guidance on marketing a hedge fund or another alternative investment in full compliance with all legal requirements, as well as on operational issues, such as personal trading. For example, in the United States, an attorney can provide advice regarding Securities and Exchange Commission (SEC) rules governing the use of testimonials, performance statistics, and prior performance statistics.

FUND ADMINISTRATORS: Many hedge funds and other alternative investment funds now engage a fund administrator to be responsible for bookkeeping, third-party information gathering, and securities valuation functions for all of their funds, both onshore and offshore. The fund administrator maintains a general ledger account, marks the fund's books, maintains its records, carries out monthly accounting, supplies its monthly profit and loss (P&L) statements, calculates its returns, verifies asset existence, independently calculates fees, and provides an unbiased, third-party resource for price confirmation on security positions. The same administrator also produces a monthly capital account statement for investors, and apportions fund income or loss among them. The administrator takes over the duties of day-to-day accounting and bookkeeping so that managers can focus on maximizing the portfolio's returns. The administrator can also be an important source of information for the auditor and tax adviser in completing required audits andtax returns.

HEDGE FUND INFRASTRUCTURE: Hedge funds can require a complicated infrastructure and extensive technological systems. The infrastructure may have three main components: (1) platforms, (2) software, and (3) data providers. Financial platforms are systems that provide access to financial markets, portfolio management systems, accounting and reporting systems, and risk management systems. Financial software may consist of prepackaged software programs and computer languages tailored to the needs of financial organizations. Some funds use open-source software, and others pay licensing fees for proprietary software. For a hedge fund, most of the raw material that goes into its strategy development and ongoing investment process is in the form of data. Financial data providers supply funds primarily with raw financial market data, including security prices, trading information, and indices. The amount of data is dictated by the investment style. Nonetheless, most hedge fund managers are required to keep abreast of market developments and macroeconomic news.

Due to legal implications, directly marketing alternative investment vehicles can be problematic. One method of indirectly marketing private funds is to report a fund's performance to an index provider, especially if the fund's performance is attractive. Index providers compile indices of prices that assist fund managers in evaluating performance.

CONSULTANTS: Consultants may be hired by pensions, endowments, or high-net-worth individuals to provide a number of roles and services that center on advice, analysis, and investment recommendations. Clients rely on consultants to offer unbiased analysis of money managers’ investment performance, as well as advice on how to best allocate funds. Clients expect their consultants to help them lay out the parameters of their investment objectives by setting out a plan for allocating assets within the framework of their objectives and risk tolerance. Consultants work closely with their clients to monitor the performance of investments while continuing to play an advisory role in a client's choice of other service providers.

Consultants are increasingly being used to serve the role of chief investment officer in small organizations. The role of an outsourced chief investment officer (OCIO) ranges from performing all of the decision-making duties of an in-house chief investment officer to a reduced role of assisting staff with a subset of decisions.

Consultants have traditionally been compensated for their services in one or both of the following ways: fees from their clients, or compensation packages from the money managers for whom they generate business. This latter form of payment presents a conflict of interest on the part of consultants because it can detract from the ability to offer independent advice to clients. Further, the compensation that consultants receive from money managers is undisclosed and can be quite substantial. Some consultants waive their regular consulting fee, giving the impression that their services are free.

Consultants' integrity and expertise are vital parts of the consultant-client relationship because many clients rely on their consultants to set out the best investment plan for their purposes and hire the best money managers to oversee those investments.

A third compensation approach has emerged in which consultants use their expertise in manager selection and risk management to serve as fund-of-funds managers to their clients. This arrangement avoids explicit hourly fees to the investors for the consulting advice, and offers the potential that the consultants will act with substantial objectivity in the selection of managers.

DEPOSITORIES AND CUSTODIANS: Depositories and custodians are very similar entities that are responsible for holding their clients' cash and securities and settling clients' trades, both of which maintain the integrity of clients' assets while ensuring that trades are settled quickly. The Depository Trust Company (DTC) is the principal holding body of securities for traders all over the world and is part of the Depository Trust and Clearing Corporation (DTCC), which provides clearing, settlement, and information services. The National Securities Clearing Corporation is the DTCC's second major subsidiary in the United States. The DTCC also created the Fixed Income Clearing Corporation (FICC). The European Central Counterparty Limited (EuroCCP) is the major depository for clients in European trading markets, and offers European clients the same clearing and settlement services as those offered by the DTCC to American traders.

BANKS: A commercial bank focuses on the business of accepting deposits and making loans, with modest investment-related services. An investment bank focuses on providing sophisticated investment services, including underwriting and raising capital, as well as other activities such as brokerage services, mergers, and acquisitions.

Hedge funds may enlist the services of a commercial bank to facilitate the flow of both investment- and non-investment-related capital. In addition, hedge funds may use their commercial bank for loans, credit enhancement, and/or lines of credit. In the United States, the commercial banking and investment banking functions tend to be separated by regulation. Germany uses universal banking, which means that German banks can engage in both commercial and investment banking. Also unlike the United States, a large portion of German firms is privately funded and has two governance bodies: the Vorstand, or management board, and the Aufsichtsrat, or supervisory board.

Although the Japanese financial system seems superficially similar to the American system, banks are much more influential in Japan than they are in the United States, and cross-ownership is far more common. Japanese banks can hold common stock, and Japanese corporations can hold stock in other Japanese firms. A keiretsu is a group of firms in different industries bound together by cross-ownership of their common stock and by customer-supplier relationships. The 10 largest Japanese banks (known as city banks) are responsible for funding approximately one-third of all investments in the country. As in Germany, large banks play an active role in monitoring the decisions of the borrowing firm's management and have significant power to seize collateral, as both trustee and direct lender.

In the United Kingdom, there are two main types of banks: clearing banks, which are similar to American commercial banks, and merchant banks, similar to American investment banks. As in the United States, UK banks are not strongly involved in the firms with which they do business, and substantial stock ownership by banks is prohibited.

2.2.1 Primary Capital Markets

New issues are sold in primary capital markets and distributed by an underwriter, who is responsible for the organization, risk bearing (during placement), and distribution (or sale) of newly issued securities. Investment banks serve as underwriters for the placement of traditional investments. For example, investment banks place new equity issues that originate either as new and additional shares in existing securities (secondary issues) or as first-time issues of shares not previously traded (initial public offerings, or IPOs).

In the modern global economy, firms often arrange to have their shares traded in foreign markets and denominated in the currency of the foreign market. For example, a German firm could list its stock on a U.S. exchange as an American depositary receipt (ADR) or a global depositary receipt (GDR). Foreign issuers must comply with all the rules that apply to domestic firms, as well as any additional regulations that apply to foreign issuers.

Another source of securities issued in primary capital markets is securitization. Securitization involves bundling assets, especially unlisted assets, and issuing claims on the bundled assets. The securities are registered and sold in the public market. Securitization can allow firms to divest illiquid assets such as accounts receivable to lay off risk and obtain cash. Various types of unlisted but liquid assets are also securitized, including various fixed-income securities such as mortgages. Exchange-traded funds are emerging as a major source of securitization, in which new securities are created, generally with underlying portfolios of listed securities.

Participants in alternative investments often create securities that are not subsequently listed. An example is when deal creators issue structured products, some of which are private (see Part 5). Private equity firms often use primary markets as exit strategies for their underlying investments. Large private equity firms hold substantial controlling positions in the companies. A goal of these private equity firms is to develop these companies to the point that they can be sold to the public through IPOs.

2.2.2 Secondary Capital Market

After their initial offerings, many securities are traded in secondary capital markets, which provide greater liquidity and a continuous flow of price information. In major markets, limit orders by market participants are maintained to buy securities (bid orders at bid prices) and to sell securities (offer orders at ask prices). The price difference between the highest bid price (the best bid price) and the lowest offer (the best ask price) is the bid-ask spread. Market making is a practice whereby an investment bank or another market participant deals securities by regularly offering to buy securities and sell securities. The market maker seeks to receive the bid-ask spread through regularly selling at the ask price and buying at the bid price. The bid-ask spread compensates investment banks for providing liquidity to the market. Market participants that wish to have transactions executed without delay may place market orders, which cause immediate execution at the best available price. Participants that place market orders are market takers, which buy at ask prices and sell at bid prices, generally paying the bid-ask spread for taking liquidity.

The primary listing markets in the United States are the New York Stock Exchange (NYSE) and the NASDAQ. The NYSE has physically centralized trading, while the NASDAQ uses computer networks between dealers. The largest markets outside the United States include the Tokyo Stock Exchange (Japan), the Euronext (several locations), the London Stock Exchange (United Kingdom), and the Hong Kong Stock Exchange (China).

2.2.3 Third and Fourth Private Markets

Third markets are regional exchanges where stocks listed in primary secondary markets can also be traded. In the United States, third markets allow brokers and dealers to set up trades away from an exchange by listing their prices on the NASDAQ Intermarket. Third markets represent a segment of the OTC market where nonmember investment firms can make markets in and trade securities without going through the exchange.

Fourth markets are electronic exchanges that allow traders to quickly buy and sell exchange-listed stocks via the electronic communications systems offered by these markets. Because of the anonymity of traders within these electronic networks, registered broker-dealers provide sponsorship for these systems so that traders have an alternative system to physical exchanges to buy and sell stocks. These alternative trading systems are computerized trading systems that do not formally list stocks but include electronic communication networks serving retail brokers and small institutional traders, as well as electronic crossing systems that match large buy and sell orders. This system is also called the fourth market system. These private financial markets are non-regulated markets that are neither exchanges nor OTC.

Much of the high-frequency trading takes place in the fourth market. The advantages of private markets may include lower transaction costs, ease of completing a transaction directly between a buyer and a seller (which may or may not involve a broker), and the ability to expedite the consummation of a transaction. Conversely, the disadvantages may include the existence of asymmetrical information (between the participants), lack of transparency, and lack of regulatory protections.

2.3.1 Five Primary Forms of Hedge Fund Regulation

Regulations of hedge funds take four primary forms:

1. Requirements regarding establishing a hedge fund, including registration, licensing, minimum capital, and waiting periods
2. Registrations or restrictions on investment advisers and hedge fund managers
3. Restrictions on distribution and marketing of hedge funds, including which marketing channels may be used (e.g., banks), whether advertising is permitted, and to whom funds may be sold
4. Restrictions on operation of a hedge fund, including leverage, liquidity, risk, reporting, and location of outside service providers
5. Requirements regarding ongoing reporting

Hedge funds may also be subject to varying levels of taxation and to special taxes, fees, or licensing costs. Understanding regulations is a crucial aspect of alternative investing. The rest of this section provides an overview of global regulatory matters. The first part focuses on U.S. regulations, for which there is much detail due to the extensive history of alternative investing in the United States. The second part briefly discusses regulatory matters of other jurisdictions, including Europe.

2.3.2 U.S. Hedge Fund Regulations

The U.S. regulation of hedge fund registrations may be divided into two areas. The first area is regulation of securities issued to the public (the primary market), and the second is regulation of advisers to investment pools. Offers to sell securities are regulated by the U.S. Securities Act of 1933 (the Securities Act), and investment advisers are regulated by the U.S. Investment Company Act of 1940 (the ’40 Act).

In the United States, hedge funds may be unregistered, but the hedge fund manager must register as an investment adviser with the SEC. The only exemption from investment adviser registration is based on size. A manager that is too small for required SEC registration must register with its state regulator.

Hedge funds and other alternative investment pools typically avoid registration through exemptions, such as sections 3(c)1 and 3(c)7 of the ’40 Act. Both sections delineate conditions under which registration may be waived based on the perceived financial sophistication of the investors and the number of accredited investors or qualified purchasers.

The effects of using these exemptions regarding private securities include tight restriction of each fund's marketing efforts so that the fund is not viewed as offering securities to the public. Hedge funds offered to U.S. taxable investors are most commonly established as limited partnerships or limited liability companies organized in the state of Delaware. The favorable characteristics of these entity types include limited liability protection for the fund investors and pass-through of gains and losses for U.S. federal income tax purposes. Hedge funds offered to U.S. tax-exempt investors and non-U.S. investors are most commonly established as exempt companies organized offshore.

Under U.S. law, investment advisers owe a fiduciary duty to the clients they advise. The practical consequence is that advisers have an obligation to act in the best interests of the client, disclose to the client all facts that the client might consider relevant, employ a reasonable degree of care in the provision of their advice, and avoid misleading clients through either misstatements or omissions of relevant facts. In addition, the Investment Advisers Act of 1940 sets out a series of antifraud provisions to which all investment advisers operating in the United States or serving U.S. clients are subject.

Trading practices, including soft dollar arrangements, must be disclosed to clients. A soft dollar arrangement generally refers to an agreement or an understanding by which an investment adviser receives research services from a broker-dealer in exchange for a fee (such as a commission) paid out of the fund or client account. In effect, the investment adviser can receive research services, such as those provided by computerized financial information systems, by using the broker-dealer to execute the trades of its clients. Because the adviser is receiving research services in addition to brokerage services, the total commission paid by the client through the investment adviser may exceed the rates charged by other broker-dealers who simply execute trades. The practice of paying up from the lowest possible commission in exchange for research or brokerage services is protected by a specific safe harbor under U.S. law.

Federal Reserve Board leverage rules include the Regulation T margin rule, which currently requires a deposit of at least 50% of the purchase cost or short sale proceeds of a trade (margin). An alternative investment manager, such as a hedge fund, can increase its leveraging capabilities by working around the strict requirements of Regulation T as well as NYSE, NASD, and U.S. Financial Industry Regulatory Authority (FINRA) requirements that limit leverage. This kind of maneuvering creates much of the complexity of hedge fund leveraging. Some relief from it is available to broker-dealers. By registering themselves as broker-dealers, some hedge funds have taken advantage of this rule to increase leverage to 5:1 or even higher. Another method for avoiding margin requirements is for a hedge fund to use a joint back office account. Parent broker-dealers decide what constitutes a prudent margin for an affiliate, often 5% or less, and carry those positions on the parent's own balance sheet. Offshore broker-dealers are exempt from these regulations, even when they are offshore subsidiaries of U.S. broker-dealers. More complicated transactions can be designed to evade initial and maintenance margin rules. For example, derivative positions can be substituted for actual shares, as in a total return swap that creates synthetic ownership of securities. These transactions do not appear on a balance sheet, which can be advantageous as well. Another method of effecting leverage is by carrying out a repurchase (repo) transaction. A repo occurs when a trader borrows money backed by a security. The repo rate is the interest charged on this loan.

Finally, a recent and increasing area of regulation deals with money-laundering and terrorism-related restrictions. These laws generally expand the scope of government surveillance on banks and other financial institutions, and place greater restrictions and new penalties on institutions that fail to comply with the prohibitions and reporting rules for accounts dealing with foreign concerns or suspicious transactions.

2.3.3 Non-U.S. Hedge Fund Regulations

Regulation of hedge funds in Europe centers on the concept of Undertakings for Collective Investment in Transferable Securities (UCITS). UCITS are carefully regulated European fund vehicles that allow retail access and marketing of hedge-fund-like investment pools. The concept of UCITS came into force in 1985 and was intended to create a pan-European regulated fund vehicle that could be offered to retail investors across the European Union (EU). In effect, a UCITS fund is a hedge-fund-like investment pool that conforms to European regulations such that the product can be sold throughout the various members of the EU. Because UCITS were intended for retail investors, they were subject to very strict investment restrictions and diversification requirements. Since 1985, additional directives have been made (UCITS II, UCITS III, and UCITS IV). The regulatory requirements for a UCITS include meeting minimum size requirements (net asset value) based on the fund's age; being authorized by the Commission de Surveillance du Secteur Financier (CSSF); being annually audited; and meeting standards involving the promoters and other parties related to the UCITS creation, distribution, and management. A UCITS must be authorized by the regulator in its home EU country. Unless the UCITS is self-managed, the external manager also needs to be approved. Authorization of a UCITS is refused if it does not comply with the numerous conditions set out in the most recent UCITS directive or if the directors are not deemed sufficiently experienced or reputable. A full prospectus must be prepared and approved by the regulator, as must a key investor information document: a summary of key terms of the prospectus, which is typically provided to retail investors. UCITS and their managers are subject to various requirements related to valuation of assets, appointment of depositaries, and conduct of business.

The Markets in Financial Instruments Directive (MiFID) is an EU law that establishes uniform regulation for investment managers in the European Economic Area (the EU plus Iceland, Norway, and Liechtenstein). The MiFID is one of the primary pieces of European legislation dealing with regulation of investment services, including management services. In the wake of the financial crisis that began in 2007, regulation of hedge funds began to increase throughout the world, and Europe was no exception. The MiFID II is a revision directed toward extending the reach of MiFID to cover gaps in the 2007 document as well as address emerging issues, such as lack of transparency in trading occurring in dark pools. A dark pool refers to non-exchange trading by large market participants that is hidden from the view of most market participants.

In July 2011, the Alternative Investment Fund Managers Directive (AIFMD) came into force. This directive applies to alternative investment fund managers (AIFMs) that are located in the EU or, if located outside the EU, manage either EU funds or market funds (whether EU or non-EU) in the EU. An AIFM includes any legal or natural person whose regular business is to manage one or more alternative investment funds (AIFs). An AIF is any collective investment that invests in accordance with a specified policy, except UCITS. This captures hedge funds, private equity funds, infrastructure funds, real estate funds, and non-UCITS retail funds, whether open ended or close ended and whether listed or not.

Hedge fund activity in Europe varies between nations. The FCA (Financial Conduct Authority) and the Prudential Regulatory Authority are the primary regulators of investments in the United Kingdom, which is the European center for hedge fund management, with perhaps 80% of Europe's hedge fund assets.¹ However, the FCA has not generally regulated hedge funds themselves as much as the investment advisers and related entities (e.g., banks) that provide outside services to hedge funds. The FCA most closely oversees the 40 largest hedge fund managers, but it also oversees smaller fund managers using visits and reviews.² Hedge fund managers “are required to maintain minimum capital resources to ensure that, if necessary, they can wind up in an orderly manner” through the Capital Requirement Directive.³

France's Autorités des Marchés Financiers (AMF) regulates hedge funds, including net equity requirements.⁴ France has streamlined procedures that allow three types of hedge funds (funds of hedge funds, unleveraged funds, and leveraged hedge funds) known as ARIA funds (Agréé à Règles d’Investissement Allégées). Germany regulates hedge funds rather closely, with restrictions on funds of hedge funds, redemptions, subscriptions, disclosures, and custody. The Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) is the primary regulator. German regulations differentiate between single hedge funds and funds of hedge funds.⁵ For example, funds of hedge funds may be distributed publicly or privately. However, single hedge funds may be distributed only privately and only by a licensed financial institution.⁶ Switzerland, a major world banking center, plays a relatively modest role in single hedge fund management under the authority of the Swiss Financial Market Supervisory Authority (FINMA). However, “Swiss funds of hedge funds account for one third of the assets invested in funds of hedge funds worldwide” and are generally not afforded special regulatory oversight.⁷

During the financial crisis that began in 2007, some policy makers in Europe saw short selling as exacerbating turbulent market conditions. In particular, short selling was thought to have contributed to the sharp falls in value of stocks in financial sector companies. As a reaction to this, restrictions on short selling and disclosure of short positions have been imposed in various EU countries. More permanently, European regulators have been considering the creation of a specific regulatory regime for short selling.

Hedge fund activity and hedge fund regulation vary tremendously outside of the United States and the EU. For example, the Australian Securities and Investment Commission (ASIC) does not regulate hedge funds differently from other managed funds.⁸ Domestic hedge funds in Australia are usually organized as unit trusts, and foreign hedge funds are foreign investment funds (FIFs). Taxation is a relatively important and complex issue in Australian hedge fund ownership. Brazil's Securities Commission (CVM) regulates funds through a classification system and controls eligible investors, valuation standards, and reports.⁹

In Canada, most hedge funds are distributed as principal protected notes (PPNs), which can provide retail access to hedge funds. The Canadian Securities Administrators (CAS) regulates registration of advisers, registration of dealers who sell securities, accreditation standards of investors, disclosure requirements, and compliance reviews.¹⁰ Japanese hedge fund regulations are relatively loose under the Financial Services Agency (FSA), while Singapore's regulation and taxation regimes have been loosened in recent years by the Monetary Authority of Singapore (MAS).¹¹

South Africa's Financial Services Board introduced specific regulations for hedge funds in 2008, including requirements for fund managers to register, although hedge funds may not be marketed to retail investors, and hedge fund products are not regulated. Taxation treatment of hedge funds has been unclear in South Africa.¹² The United Arab Emirates (UAE) is part of the GCC (Gulf Cooperation Council), which also includes Bahrain, Kuwait, Oman, Qatar, and the Kingdom of Saudi Arabia. The GCC seeks cooperation and agreement among its member states to harmonize regulation and taxation. Two authorities within the UAE allow establishment of hedge funds: the UAE Central Bank (onshore) and the more often used Dubai Financial Services Authority (DFSA). Regulations include requirements for risk assessment and audits, as well as restrictions on marketing. Taxes, however, are generally zero.¹³

Many relatively small nations or jurisdictions play important roles in hedge fund regulation by providing tax-neutral locations in which funds may be quickly and inexpensively formed. Examples of popular locations for hedge fund domiciles are Bermuda, the Cayman Islands, and the Isle of Man.

2.4.1 The Spectrum of Liquid Alternatives Products

Liquid alternatives span a spectrum of alternative assets and strategies, with more innovations expected to emerge. A popular investment vehicle in the United States that illustrates liquid alternatives well is real estate investment trusts (REITs). REITs hold real estate as their underlying assets and are generally owned through publicly traded shares. The underlying assets of many large REITs are large private real estate properties, such as office buildings, retail properties, health care facilities, and apartment complexes. Large real estate properties are often owned by institutions directly or through limited partnerships. REITs offer retail access of similar properties to large and small investors alike. Even though the underlying real estate properties are illiquid, the shares in the REITs offer investors high levels of liquidity. Many REITs also hold liquid real estate assets, such as mortgage securities. REITs are further discussed in Chapter 14.

Real estate in general and REITs in particular have been popular in the United States for so long that some experts may not view REITs as liquid alternatives. Many discussions of liquid alternatives focus on more recent innovations that provide liquid investment vehicles for small investors to obtain exposure to classic alternative investment strategies, such as hedge fund strategies. Specifically, these new liquid alternatives include the offering of hedge fund and managed futures strategies through liquid mutual funds, such as ’40 Act funds in the United States and UCITS in the EU.

Liquid alternatives tend to have substantial fee structure differences, which are discussed later in this section. Liquid alternatives differ with the extent to which their investment strategies match the investment strategies of privately placed alternative investments. In this regard, there are five distinct types of liquid alternative funds:

1. UNCONSTRAINED CLONES: These liquid funds follow virtually the same strategy as private placement products with underlying liquid assets, such as some hedge funds or managed futures funds.
2. CONSTRAINED CLONES: These liquid funds implement a similar strategy as private placement products but are limited in risk exposure by leverage, concentration, or liquidity constraints.
3. LIQUIDITY-BASED REPLICATION PRODUCTS: These liquid funds are designed to mimic illiquid private placement investments, using liquid securities as proxies.
4. SKILL-BASED REPLICATION PRODUCTS: These liquid funds are designed to mimic a highly skilled private placement strategy using a simplified and more mechanical strategy.
5. ABSOLUTE RETURN OR DIVERSIFIED PRODUCTS: These liquid funds are designed to offer absolute returns and/or diversifying returns not directly related to opportunities historically available in private placements and potentially inconsistent with alternative strategies as typically deployed.

The last category refers to products being touted as liquid alternatives that are long-only mixes of traditional investment strategies that offer returns that have exhibited relatively low correlation with the overall market. These products lack the innovation, leverage, short positions, illiquidity, and skill-based active trading that have been the hallmark of alternative investment for decades. They tend to be offered by institutions with expertise in traditional investments that are responding to investor preferences for investment products that offer diversification relative to traditional equity and bond markets.

2.4.2 Growth and Growth Factors in Liquid Alternatives

Prior to the financial crisis of 2007–09, global assets under management in liquid alternatives totaled less than $100 billion. The performance success of some alternative investment strategies during the financial crisis, such as managed futures and global macro funds, led retail investors to welcome the opportunity to diversify into those strategies and other alternative investment strategies as retail products became widely available.

By 2015, liquid alternatives had soared to over half a trillion dollars in global AUM, and this number is expected to rise by an annual rate of approximately 20%. This growth can also be seen by the proportion of assets in U.S. mutual funds that is devoted to liquid alternative vehicles. That proportion, which soared by 2015 to a few percentage points, will eventually reach double-digit levels if growth rate projections are realized.

Projections of continued rapid growth are based on two primary factors. First, retail investors are projected to continue to diversify into alternative strategies to lessen their percentage exposure to traditional stock and bond strategies if traditional asset markets continue to offer historically low interest rates and high equity valuations. Second, the shift of retirement assets from a focus on defined benefit plans to defined contribution plans means that retail access to alternative investments will increase. Rather than obtaining alternative asset exposure through investment by institutions managing defined benefit plans, investors may increasingly obtain alternative asset exposure directly through retail products inside their defined contribution plans. If these two trends persist, the meteoric growth in liquid alternatives may parallel the growth in exchange-traded funds that began in the 1990s.

2.4.3 Three Constraints against Achieving Alternative Investment Benefits through Liquid Products

Some alternative investment strategies appear unable to be implemented through liquid retail structures, such as U.S. mutual funds. First, the sophisticated hedge fund strategies discussed in Part 3 often require substantial use of leverage, which is restricted within U.S. mutual funds by regulation. Specifically, there is a 300% asset coverage rule that requires a mutual fund to have assets totaling at least three times the total borrowings of the fund, thus limiting borrowing to 33% of assets. UCITS restrictions are even tighter. Second, there are regulatory constraints on concentration (i.e., lack of diversification). Third, there are illiquidity constraints (e.g., no more than 15% of a mutual fund can be invested in illiquid assets) that prevent substantial inclusion of private equity in U.S. open-end mutual funds.

These regulatory issues are a primary reason why such alternative investments are organized through private placements. It should be noted that to qualify as a private placement vehicle, funds are severely limited as to the number of investors permitted. The severe limits on the number of investors lead fund managers to require large initial investment sizes, which steer the products away from small retail investors and toward large institutional investors. Thus, it is due to regulations regarding public products that many hedge fund and most private equity strategies cannot be directly and exactly implemented through open-end mutual funds.

Other hedge fund strategies appear quite tractable for delivery through retail products. For example, the returns of managed futures funds and hedge funds holding other liquid underlying assets can easily be delivered through retail products as long as the strategies do not require high leverage or concentration. Chapter 21 discusses the creative ways that multialternative mutual funds can be structured so as to facilitate the delivery of a large subset of hedge fund strategies through retail products.

A highly researched and debated approach to delivering hedge-fund-like strategies without necessarily using sophisticated management teams or illiquid securities is hedge fund replication. Hedge fund replication is the attempt to mimic the returns of an illiquid or highly sophisticated hedge fund strategy using liquid assets and simplified trading rules.

Another method of delivering alternative investment strategies through retail vehicles is the use of a closed-end mutual fund structure. Closed-end mutual fund structures provide investors with relatively liquid access to the returns of underlying assets even when the underlying assets are illiquid.

The field of liquid alternatives is rapidly changing and evolving. It is especially difficult to forecast the changes and innovations that will occur given the highly regulated nature of retail investment vehicles and the constantly shifting regulatory regimes.

2.4.4 Four Factors Determining Performance of Liquid Alternatives Compared to Private Placements

Liquid alternatives are relatively new products with limited historical return data. Accordingly, there is especially high uncertainty with regard to the extent to which liquid alternatives will generate return enhancement or diversification benefits comparable to the results achieved in the past for institutional investors in private placements.

Returns from private placement vehicles and liquid alternatives may differ primarily due to four important factors, two of which relate to investment flexibility and two of which relate to fees:

1. The permissible investment strategies differ. Private placements often enjoy important flexibility with regard to leverage (including the magnitude of short positions) and concentration (lack of diversification).
2. Similarly, private placements may be able to generate higher returns due to their investment flexibility to hold more illiquid assets, thereby potentially receiving higher liquidity premiums.
3. Fees differ between liquid alternatives and private placements. Liquid alternatives tend to have lower fees because most do not have incentive fees, especially asymmetric incentive fees wherein managers benefit from sharing upside profits but are limited in their exposure to downside losses.
4. Managerial skill may differ. The higher potential fees from the asymmetric incentive fees of private placements may attract managers with greater skill. Some liquid alternative funds implement simplified trading rules rather than hiring sophisticated management teams.

2.4.5 Empirical Analysis of Liquid Alternative Investment Performance

The permissible investment strategies of liquid alternatives often do not match the flexible investment strategies being implemented in private placements. However, comparing the performance in those cases in which the strategies match can be an effective way to estimate the risk and return differentials between liquid alternative funds and private placements. A 2013 study by Cliffwater (discussed further in Chapter 21) compared funds and concluded that, on average, liquid alternative funds have lower risks and slightly to moderately lower average returns than limited partnership (or LP) funds that employ the same strategy.¹⁴

This brief overview of liquid alternatives lays a foundation for more detailed discussions on the underlying assets and investment strategies of the funds. Liquid alternatives are further discussed in the context of real assets in Chapters 10 and 14, hedge funds in Chapter 21, and private equity in Chapter 22.

2.5.1 Income Taxation

Throughout the major economies of the world, income is taxed. Income taxation typically includes taxation on individual and corporate income. Most income taxation is progressive. Progressive taxation places higher-percentage taxation on individuals and corporations with higher incomes. Individual income taxation includes taxation of both wage income and investment income.

Although individual wage income and corporate earnings are often fully taxed, the primary issue for investing involves the potential for reduced income tax rates on investment income. Investment income is primarily dividend income, interest income, and capital gains. Investment income from dividends, interest, and capital gains is often either taxed at reduced rates or exempt from income taxation. Although most countries tax all of these types of investment income, the tax rules of individual countries differ primarily by the extent to which dividends, interest, and capital gains are exempted, partially taxed, or fully taxed.

Most major economies, including those of Austria, Brazil, China, Finland, France, Hong Kong, Italy, Japan, the Netherlands, Poland, Sweden, the United Kingdom, and the United States, tax investment income but offer reduced rates on some or all dividends, interest, and capital gains. In the United States, for example, state and municipal bond interest is exempt from federal taxation, and most corporate dividends are taxed at a reduced rate. However, some countries have investment income tax regimes that tax dividends, interest, or capital gains rather heavily or lightly compared to other nations. For example, Canada, Denmark, and Germany tend to have high tax rates on interest income. Australia, Belgium, New Zealand, Switzerland, and Taiwan tend to have low capital gains taxes.¹⁵

Other jurisdictions have no income tax or at least no income tax on particular investment pools. These jurisdictions are attractive locations for investment pools in that investors are taxed only by their home country rather than having to pay income taxes on investment income to both their home country and the domicile of the investment fund. These countries include traditional jurisdictions used by hedge funds, such as the Cayman Islands, the British Virgin Islands, Bermuda, Ireland, Luxembourg, Guernsey, and Mauritius.¹⁶

Some investing offers deferred taxation, in which investment income taxes are not assessed until the funds are withdrawn or distributed. For example, in the United States, qualified retirement savings are generally taxed only at withdrawal. Further, the contributions are often tax-deductible in the period in which the contribution is made. Other opportunities, such as some life insurance contracts, allow tax-deferred accrual of investment income.

Taxation of interest and dividends is generally assessed in the period in which the dividends and interest are distributed. Capital gains tend to be taxed when realized. Capital gains are realized in the period when there is a sale of a security for a price higher than the investor's cost, known as the cost basis. Investments therefore often offer a potentially valuable tax advantage of allowing wealth to be accumulated and accrued through capital appreciation that is not taxed as income until the asset is sold. Further, tax rates may be lower on capital gains, especially when an investment is held for a long time.

Taxation of investment income involves complex rules in most jurisdictions. Understanding taxation can be a very important part of investment management. For example, Section 1256 contracts, which include many futures and options contracts, have potentially enormous tax advantages in the United States. including having their income treated as 60% long-term capital gain and 40% short-term capital gain regardless of holding period. Proper decision-making based on this preferential tax treatment can enhance an investor's after-tax return.

2.5.2 Other Taxes and Withholding

In most jurisdictions, real estate taxation is an important form of taxation. Often, real estate taxes are assessed by local jurisdictions to fund local services such as schools, and governmental services such as law enforcement. Australia, Singapore, Belgium, Germany, and the United Kingdom tax real estate.¹⁷ However, some jurisdictions tax wealth as a general national tax. For example, in Colombia, a wealth tax is assessed on all assets, including financial assets. Another important category of taxation is estate taxation. For wealthy individuals, estate tax rates can be very high.

Although many countries have either drastically reduced or totally eliminated transaction taxes, several European countries continue to impose some form of tax on investment transactions. The United Kingdom uses a stamp tax of 0.5% on purchases of domestic securities, and France levies a 19.6% value-added tax on commissions rather than on the transaction value. When market makers trade for their own accounts, they are usually exempted from transaction taxes. In the United States, there is a small fee assessed on securities transactions that is attributed to providing the regulatory services of the SEC.

The international convention on taxing income on foreign investments is to certify that the investor pays taxes to at least one country. Withholding taxes are therefore levied on dividend payments. Although this sometimes results in double taxation, a network of international tax treaties has been signed to prevent double taxation from occurring, so that investors receive a dividend net of withholding tax plus a tax credit from the foreign government but must pay tax on the gross dividends (minus the amount of the withholding tax credit) to the government where they reside. Although this process is potentially lengthy, it allows the investor to reclaim the withholding tax in the foreign country. Depending on the individual country's tax policies, some of the withholding can be retained by the country of origin. Some countries allow tax-free foreign investors (public pension funds) to apply for direct exemptions from tax withholding.