Thesis P1final

Bachelor Thesis
Business Administration
15 ECTS
Spring Semester 2009

Hedge Funds: Performances, risks and Regulations.
An empirical study of the hedge fund industry via an international
case study comparison
Linköping’s University
Atlantis Program

Authors: Tutor:
Florian Chapelle Dr. Padmaja Pillutla
Thomas Jean
ISRN Number: LIU‐IEI‐FIL‐G—09/00391—SE

Linköping University Spring 2009

“From Aristotle to Amaranth, the funds have lured investors with dreams of heady profits and
terrified them with nightmares of risk”

Alan Rappeport, Financial Times Journalist

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Abstract
Bachelor Thesis in Business Administration, 15 ECTS
Linköping University, Spring 2009
Authors: Florian Chapelle and Thomas Jean
Tutor: Dr. Padmaja Pillutla

Title Hedge Funds: performances, risks and regulation.
Keywords Hedge funds, regulation, performance, risk, SEC, AIFM.
Background and Since August 2007, and the U.S. Subprime crisis a responsible has been
Problem Discussion pointed out: the hedge fund industry. Already the number of hedge funds
has diminished drastically; therefore, we would like to discover the
impact of regulation on the hedge fund industry.
Purpose Explain the regulatory environment surrounding hedge funds. Explained it
on both sides of the Atlantic Ocean in the United States and in Europe.
We intend to explain the consequences of regulation on risk and on
performances. And finally give recommendations that could reduce risks
and improve performances.
Methodology This thesis is based on the analysis of a case study. We used a qualitative
approach in the gathering of the empirical data, while giving it a critical
opinion.
Theories The main theories consist of the risks and performance evaluations
surrounding hedge funds and the existing and suggested regulation about
them.
Empirical Data The empirical information of four hedge funds and the related indicators
used to calculate ratios.
Conclusion Setting up a limited regulation, displaying transparency reports, but
keeping the essence of what made the success of hedge funds in the past.

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Acknowledgements

The process of creating a thesis is time taking and energy consuming. It is a route one cannot take by
himself.

We would like to first thank our tutor, Dr Padmaja Pillutla. She guided us in this process and helped
us narrow our subject.

We would like to show gratitude to the French economist, Jézabel Couppey‐Soubeyran. She guided
us in our research and provided us with precious information and guidelines.

We also want to thank all our fellow Atlantis Classmates. We are extremely grateful for their opinion
on our Initial Draft that helped improve considerably our work. Gunilla Söderberg and Dr. Emeric
Solymossy also deserve to be cited thanks to their valuable methodology advices.

We cannot forget to mention all the people without whom we would not be given this opportunity to
write a thesis: Dr. Peter Gustavsson from Linköping’s University and John Monahan from Groupe
INSEEC, the main instigators of WELD Atlantis.

And to finish our most faithful recognition goes to Mr. X, the Swiss based manager that gave us all
our empirical data; the person without whom this thesis would not have any reason to be.

We wish all our readers a very pleasant learning time,

Florian Chapelle and Thomas Jean

4

Table of Contents
1 Introduction ..................................................................................................................................... 7
1.1 History of Hedge funds ............................................................................................................ 8
1.2 Problem Discussion ................................................................................................................. 9
1.3 Purpose and Research question ............................................................................................ 10
1.4 Contraints .............................................................................................................................. 10
1.5 Disposition ............................................................................................................................. 10
2 Methodology ................................................................................................................................. 12
2.1 The General approach of our thesis ...................................................................................... 12
2.2 In‐depth methodology .......................................................................................................... 12
3 Theoretical background on hedge funds ....................................................................................... 15
3.1 The Hedge Fund: Features, Performances and Risks ............................................................ 15
3.1.1 Introduction ................................................................................................................... 15
3.1.2 Management methods .................................................................................................. 20
3.1.3 Performances and performance risk measures ............................................................ 26
3.1.4 Risks ............................................................................................................................... 29
3.1.5 Advanced mathematical theories ................................................................................. 30
3.2 Theoretical Background on Hedge Fund Regulation ............................................................. 34
3.2.2 The United States Regulatory Environment .................................................................. 35
3.2.3 The European Regulatory Environment ........................................................................ 40
3.2.4 The Hedge fund Regulation Main Point of views (Pros and Cons) ................................ 48
4 Empirics ......................................................................................................................................... 51
4.1 Basic empirical data on chosen Hedge funds ........................................................................ 52
4.1.1 Basic Comparison 1: Brookdale Intl Partners LP/Brummer & Partners Zenit ............... 52
4.1.2 Basic Comparison 2: Sunrise Cap Expanded Diversified/Transtrend DTP Enhanced Risk
55
4.1.3 Advanced empirical Data (Ratios….).............................................................................. 58
5 Analysis .......................................................................................................................................... 60
5

5.1 Analysis of group 1: Brookdale and Zenit .............................................................................. 60
5.1.1 Hedge funds administrative specificities ....................................................................... 60
5.1.2 Managers financial remuneration ................................................................................. 61
5.1.3 Performance data and liquidity and management tools .............................................. 62
5.1.4 Market risk..................................................................................................................... 63
5.2 Analysis of group 2: Sunrise Expanded and Transtrend DTP ................................................. 63
5.2.1 Hedge Funds Administrative Specificities ..................................................................... 63
5.2.2 Managers financial remuneration ................................................................................. 64
5.2.3 Performance data and liquidity and management tools .............................................. 64
5.2.4 Market Risk .................................................................................................................... 65
5.3 Operational risk ..................................................................................................................... 65
6 Conclusion ..................................................................................................................................... 66
7 Work Cited ..................................................................................................................................... 68
8 Appendix ........................................................................................................................................ 72

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1 Introduction

The summer of 2007 marked the beginning of a new era in the world of finance economics. That
summer saw the emergence of toxic assets known as subprime. The visible part of the subprime
crisis was the deprivation of thousand of average working class homes and colossal amount of losses
for the banking industry. A collateral damage may have occurred on another level: hedge funds.
How are hedge funds related with these mortgage‐backed securities? It seems that many hedge
funds had invested in those securities; consequently the industry saw un‐previous losses strike their
business. Since the industry is opaque, no one knows exactly how many hedge funds were directly
implicated with subprimes. The number that actually failed because of them is even less known. Yet
numbers are honest and clear: the Hegde Fund Research (data provider) claims the number of funds
is shrinking very fast. In January of 2008 there were 10,200 speculative funds; one year later that
number is down to only 6,800. The other concern the Hedge Fund Research points out is the total
Assets under management has diminished by one third in one year to settle at $1,400 Billion. Worse,
it predicts this number is going to fall down to $900 billion by the end of the year.
Investors in hedge funds are feeling despaired as they witness the collapse of an industry they
created to outperform the market no matter its direction. These facts are increasing the demand for
more regulation as we witnessed during the latest G20 summit in London.
Still the debate on the role of the regulation of hedge funds goes back ten years. The question on
how the regulation should be put in place is also subject to questions and arguments. The debate
lays on the many examples of failures in the industry that jeopardized the financial stability of the
system. Those events include the quasi‐bankruptcy of the fund Long Term Capital Management (see
appendix 1) in 1998 or the collapse of the Amaranth fund in 2006. As we mentioned previously,
hedge funds had a major role in the securitization process linked to the subprime crisis. Since March
2008, hedge funds were put under pressure; on one side investment banks are asking for less
leverage (glossary) and on the other institutional investors want to retrieve their initial investment.
The actual crisis in the hedge fund industry allows lifting the veil on the regulatory issues concerning
hedge funds. Indeed, those investments vehicles are characterized by the absence of strict regulation
for managers. The liberty given to hedge funds was based on the fact that investors were mainly
private and supposed to know and understands the risks taken. Lately, a trend has seen institutional
investors rush into the industry to also benefit from hedge fund advantages. They include pension
7

funds and university endowments.1 Consequently, the finger is pointed at hedge funds for many
reasons, especially in these times of crisis.

1.1 History of Hedge funds
“From Aristotle to Amaranth, the funds have lured investors with dreams of heady profits and
terrified them with nightmares of risk”. Alan Rappeport.2
It is said that the first Hedge Fund was launched by Albert Winslow Jones in 19493. He was a former
journalist of Fortune magazine when he decided to try to reduce the risk of holding securities by
short selling (see theoretical framework) other securities. The global risk of the market was then
reduced. He also wanted to increase his profits by using the leverage effect (see theoretical
framework). Only a few investors were allowed to invest in his company and he received a
performance fee of 20%. Thus, he established the basis of the hedge fund industry. In 1968, after an
article in Fortune showing the very good result of Jones’ fund, a hundred and forty hedge funds were
created for roughly two billion dollars of assets under management4.
However, the managers of hedge fund at that time used mainly, not to say only, the leverage effect
but forgot to hedge the portfolio with the sale of other securities. As a result, after two crises on the
markets in 1970 and 1974, almost all the funds went bankrupt. Then, by 1986, managers of funds
created all the strategies that funds are using nowadays; Georges Soros with the global macro
(glossary), or John Merriwether with fixed income arbitrage (glossary) for example. Almost all the
strategies were then created and we have noticed some unbelievable returns from some funds.
However, the role played by those funds during the European Exchange Rate crisis and the Asian
crisis (particularly Soros’ fund: Soros Quantum Investment Fund) was then involved in controversy5.
The debate about the hedge funds’ effect on the global economy is still open today with the
subprime crisis. Also, the fixed income arbitrage fund, Long Term Capital Management (LTCM) lost
90% of his value in two days6 (see appendix 1). This exceptional bankruptcy destabilized the whole
financial sphere that the FED (Federal Reserve) had to organize its bailout. The FED was afraid of the
collapse of the global economy due to the existence of a systemic risk (glossary).

1
Shadab, Houman B.,The Challenge of Hedge Fund Regulation. Regulation, Vol. 30, No. 1, pp. 36‐41, Spring
2007.
2
Alan Rappeport, “A Short History Of Hedge Fund”, CFO, March 27, 2007
http://www.cfo.com/article.cfm/8914091/c_9826509 accessed May 2009.
3
Ibid.
4
Ibid.
5
Ibid.
6
Ibid.
8

Then, in the years 2000, with the spread of the internet bubble, investors took a lot of positions in
hedge funds thanks to the economic climate during which the interest rates were kept low. They
invested in such funds in order to protect their portfolio from market fluctuations. As a result, we
have seen a relevant increase of the number of funds, reaching 10 200 funds in January 2008. The
crisis then arose. As a consequence, all the investors wanted to withdraw their assets at the same
time, leading a lot of funds to bankruptcy. In four months, 3 100 funds collapsed to reach the number
of 6 800 funds in January 20097.

1.2 Problem Discussion
As we mentioned, hedge funds are shaken by the actual crisis. Yet these investment vehicles are the
most advanced and perfected in the financial world. They regroup a great number of strategy and
particularities in comparison to traditional funds, such as mutual funds. It brings a lot of question to
our mind: could each crisis in the hedge fund industry have been avoided or at least weakened? Are
the effects and impacts of the Hedge funds industry on the financial world too high? Is it possible to
control those effects, in particular with regulation? But the lack of regulation is one main feature of
hedges funds, which also allowed them to observe some very high returns.
The background clearly stipulates the issue, on one side the defenders (i.e. funds’ managers) and on
the other the accusers (i.e. politicians). The hedge funds are being held in the center of the
controversy for their regulation since some investors are realizing their methods cannot
systematically beat the market because of the credit crunch. They no longer manage to obtain really
high returns, no matter the markets trends in spite of the risky investments they make.
The industry is clearly unregulated in the direct sense, and still manages to attract investors. This is
surprising since hedge funds are not required to publicly divulge their strategy and assets. Also the
use of derivatives products and leverage is widely spread out in the industry. This poses the problem
of the impact of hedge funds on the financial stability (systemic risk). Indeed, more and more hedge
funds use the same strategy on same markets; risks for the market include among others liquidity
risk, leverage, and credit risk8. The question this issue arises is: can hedge funds be held responsible
for market collapses, due to all the risks they can imply?
Investors persist in betting on hedge funds knowing the risks involved. The risk on their money is
multiplied on several levels. First, hedge funds use lock‐ups (see theoretical framework) to guaranty
a minimum activity period. Then, most hedge fund managers want to be out of reach of national

7
Couppey‐Soubeyran J., "Seul Un Gendarme financier mondial pourra prévenir les crises", interview by Marie
Charrel, Capital N°211 April 2009, p71.
8
Dierick F. and Garbaravicius T. “Hedge Funds and their Implication For Financial Stability.” European Central
Banks: Occasional Paper Series, No.34 August 2005.
9

regulators such as the Security and Exchange Commission (SEC) for the United States for instance.
The seizure of regulation on hedge funds is inexistent. How can hedge funds attract investors to bet
on unregulated products? Does showing high performance return is enough, no matter the risks
involved? The only thing we know, so far, is that this hedge fund industry is loudly criticized (to link
with risk) or admired (to link with high profits) either in the United States or in Europe. Furthermore,
their regulation appears to be a big issue. Are there any differences in the vision on risk or
performance according to which side of the Atlantic Ocean one lives?
1.3 Purpose and Research question
The purpose of this thesis is to provide insight on the hedge fund industry. The industry is accused of
being the symbol of the decadence of the actual financial sphere. Many hedge funds symbolize the
exuberance of modern capitalism and the dominance of finance in economies. The aim of this thesis
is to clarify the several issues in relation to hedge funds. This thesis intends to be normative and
provide answers to problems in one way or another. To complete this task, we came up with the
following research question:
“What are the influences of the current and suggested regulation in the United States and in the
European Union on the intrinsic proprieties of hedge funds, their performances and risks?”
1.4 Contraints
In order to achieve our goal, we need to set the playing field. First, we will focus on two markets: the
United States and Europe. We will not go in depth on regulation in specific countries of Europe but
provide a general overview. Secondly, given the size of the industry, we centered our attention on
four big hedge funds (over $500 million in assets under management) trough our qualitative analysis.
The aim is to extract the accurate data from those funds and extrapolate hypothesis, answers and
solutions. Finally, we decided to keep the study on a general basis, meaning that we will not try to
explain from a deep and complex mathematical point of view, especially concerning risks. The aim is
to give a general idea on the matter and help understand the workings of the industry.
1.5 Disposition
This part will explain how theories and findings are organized throughout this paper. How we went
from our research question to our conclusion. There are five major parts in our thesis.

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Part One: Introduction
This part provides some background information that is articulated and linked to issues. Those issues
are the ones leading to our research problem. This part also includes the purpose of our thesis and
clearly stipulates what can be expected to be found at the close of this thesis.
Part Two: Methodology
This part contains our approach to the problem, and our method for collecting the information and
data we used throughout our research
Part Three: Theoretical Framework
This part is divided in two and provides the groundwork for our entire paper. The first part includes
knowledge on hedge funds (Definition, management techniques, performance and risk ratios…). The
second part describes the already existing and suggested regulations in the United States and in
Europe, as well as self regulation knowledge.
Part Four: Empirics
This part will contain the empiric data we managed to gather in order to set up our case study. Four
funds will be presented. Information related to hedge funds’ features, performance and risk ratios
will be displayed.
Part Five: Analysis
This part is the most important. The analysis will put in perspective the relationship between the
United States and Europe about regulation. This will give our results that we extrapolated from our
case study. Those results will be in relation with the theories we initially gave in the third part. It will
include the limitations of our research.
As we started our thesis we did not have our mind set on the direction our analysis was going to
take. Only after we finished our analysis were we able to choose if the industry needed more or less
regulation. Our suggestions are given at the end of our thesis, enjoy your reading.

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2 Methodology
This study is based on case studies. We have used a qualitative method in the gathering of the
existing regulation of hedge funds. Then we linked that theoretical framework with four case studies
we were able to get our hands on. We then analyzed and interpreted all the data collected and
finally pulled the conclusions we believed were pertinent with our findings.
2.1 The General approach of our thesis
We are using a deductive approach in our thesis. By deduction we mean that we are going to try to
give new propositions on regulation based on facts. The deductive approach aims at “reach(ing)
conclusions by reasoning or inferring from general principles to particular”.9 We are going to analyze
via empirical evidences the actual hedge fund industry. Via our series of case studies we are going to
attempt to produce normative propositions to meet our problematic. Consequently we are hoping to
find strong arguments in favor or not of change in the hedge fund industry. This target is in
accordance with a deductive approach of a thesis. That approach is perfectly suited to generate new
ideas and propositions.10 Finally our broad problematic is meant to be narrowed down thanks to this
deductive approach.
The nature of our research is qualitative and exploratory. Our approach is qualitative because we are
not trying to measure something. Instead we believe that every theories and example is helping us
understand and find solutions that meet our initial aim: suggesting propositions. Additionally, our
approach is exploratory because we know the nature of the solutions we want to find. Unfortunately
we do not know the location of the data or how to get to it. Kotler et al (2006) describe exploratory
research as a “gather(ing) [of] preliminary information that will help define problems and suggest
hypotheses.”11 This approach is perfectly suited to the purpose of our thesis, analyzing and providing
solutions.
2.2 Indepth methodology
Now that we explained the nature of our research and our study, we are going to explain the
conductance of our work via the plan of a thesis. The first part is the theoretical framework, then the
empirical findings followed by the analysis and the conclusions.
We are first going to lay the base of our work. This base is going to be the theoretical framework.
The first part of the framework is going to focus on the Hedge Fund industry. The focus will be on the

9
Mauch, Jame E. and Park, Namgi. Guide to the Successful Thesis and Dissertation: A Handbook for Students
and Faculty Fifth Edition. Marcel Dekker, Inc, NY 2005
10
Ibid.
11
Kotler P., Adam S., Brown L. & Armstrong G. 2006, Principles of Marketing , 3rd edn, Prentice Hall, Frenchs
Forest, NSW Russell K. Schutt, Investigating the Social World, 5th ed, Pine Forge Press
12

measures of the performances and risks. The most important element of this first part is going to be
the description of two different strategies used by hedge funds. We chose just two because they are
the more relevant (See Appendix 1). Then in this part we are going to provide information on Risks
and Performance measures such as the Sharpe Ratio and the definition of Alpha and Omega. This
part is important because it shows the techniques used by hedge funds managers and it establishes
the essential basis to the understanding of the thesis.
Then in the second part of the theoretical framework, we set the background on hedge fund
regulation. The background analyses and describes the existing and suggested regulations of hedge
funds in the United States and in Europe. The regulatory issues will present the reporting obligations,
all the different thresholds and the legal targeted audience among others. The focus of the analysis
will be on giving rough explanation on the status of regulation in Europe and in the USA. However
since the world is flattening12, the regulation is done on several levels, not only national ones but also
internationals.
The theoretical background is going to be the base of our further analysis. Our main analysis will
consist of a comparative case study. It consists of putting side by side “two or more existing
situations” in order to “determine and explicate their likenesses and differences”.13 We are going to
compare different hedge funds on each side of the Atlantic Ocean. The hedge funds we are going to
compare have to meet strict specifications. They have to be comparable on several points. For
example the hedge funds have to be similar in size, in strategy and in age. We have to compare the
comparable. We have to keep in mind the aim of our thesis, provide normative suggestions based on
our analysis on the question of regulation. Given the qualitative approach of our thesis, our case
studies will be limited in numbers. Indeed, we intend to focus our analysis on only four hedge funds.
Of course, we are going to also base our results on findings already provided by big names of finance
and renowned institutions. However, we are hoping to provide originals solutions for more or maybe
less regulation according to our results.
The choice of the empirical examples was a determining step in our study. As we mentioned above
the funds have to be comparable. That’s why we initially established a list of global hedge funds.
Obviously, the vast majority of hedge funds are managed in the USA even though they are fiscally
located off shore (Cayman Islands, Jersey, Bermuda and others). Still as we mention in our theoretical
approach they are still submitted to regulation whether direct or indirect. Once we established that
list of funds difficulties had just begun. We had trouble getting access to all the statistical data we
wanted to analyze.

12
Friedman T. The World Is Flat: A Brief History of The Twenty‐first Century, 2005.
13
Mauch et al 2005.
13

As we are going to see, transparency is not a quality of hedge funds. Thus, finding information about
a specific hedge fund is time taking and almost impossible. Fortunately, companies gather hedge
funds information in databases. Unfortunately, those companies carry out those operations in a
lucrative purpose. The most important data vendors are Hedge Fund Research, Hedgeworld’s TASS
database, HF.net, Bloomberg and Barclay. The access to those databases is extremely expensive but
provides valuable information. The information includes administrative data, performance data,
asset data, region data and instrument data. Fortunately, very basic data is accessible upon
registration on TASS’s website. We found lots of empirical example material on this support;
unluckily it was too basic to put in relation with our problematic.
The gathering of the information of hedge fund was the most challenging point we had to cope with.
We contacted the French economist, Jézabel Couppey‐Soubeyran, she is also a teacher at the
University of Sorbonne‐Paris‐I. She is a specialist in financial regulation and has some strong positions
on the subject; she often takes part in interviews and writes for the most prestigious journals. She
introduced us to a French Journalist, Florent Berthat, he is an expert in Hedge Fund regulation at
Agefi.fr. He gave us a power point presentation he made for a seminar he directed on the subject.
Those contacts were just helpful in making us understand the functioning of this obscure world. We
still had to find our empirical data.
Luckily, we were able to contact the manager of a Swiss Investment Firm that accepted to give us the
up to date empirical data on hedge funds we were hoping for. We reached him through several
phone calls that, unfortunately, we cannot provide since we did not record them. Those different
calls dealt mainly with the relevancy of the hedge funds chosen or the explanation of the data
provided.
The manager first provided us with two lists, the first one was a list of hedge funds located in the
United States containing basic data, and the second was a list of “Offshore” (glossary) funds in the
American perspective with the same information. This manager has access to the Altvest hedge fund
database; he used advanced search options to retrieve specific information. The options are
described in the Empirical part. After comparing the two lists, we chose four funds, two in each
geographical area, with two different strategies. After that, the manager made his software calculate
the ratios and information we asked. The lists of hedge funds and the ratios are large excel
document. Therefore, we do not want to provide them in our appendix but those files are available
upon request if needed.
Our thesis is consequently composed of both primary and secondary data. The theoretical
framework will contain the existing secondary data. Then our empirical part will present the primary
data provided by the manager. All the main ideas used in the theoretical framework will not be
14

original and previously given by financial experts from around the world. On the other hand the
solutions will hopefully be primary data and unpublished previously.
As we start our thesis we are open to every possible outcome. We do not have our mind set on any
directions to give to the conclusions. The suggestions will be a result of our analysis.
3 Theoretical background on hedge funds
The theoretical framework can be considered as one of the most important part of this thesis. It will
set the foundations of our knowledge, and be the base we lean on to analyze our empirical findings
and draw up our suggestions and conclusions. The first part of our theoretical framework concerns
the hedge fund and the performance and risk measurements linked to it. While the Second part
tackles all the existing and suggested regulatory measures in the United States and the European
Union
3.1 The Hedge Fund: Features, Performances and Risks

3.1.1 Introduction

Since 2000, we have seen a very high increase of the number of hedge funds. Hedge funds are active
managers which step in with an informal way on traditional markets (shares, obligations, and change)
or exotic markets (raw material, structured or complex products). They can offer very high
performances thanks to their dynamic management and their capacity to work on new investment
products. They are what we call alternative investment vehicles. In hedge funds, the portfolio of
assets is changed often in order to get a high short term return. Moreover, thanks to their complexity
and the lack of regulation, only professionals or wealthy people tend to invest in such funds due to
the high risk involved in such investments. Regulations or steps towards regulation are established by
USA and European Union countries in order to try to control the different kinds of risk (further
explication in the following paragraphs). We will see in the second part, what those regulations are
from both sides, their implementation, which actor they are trying to protect and from which risk.
Nevertheless, we have to understand first the functioning of hedge funds and, most of all, how the
risk is calculated.

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3.1.1.1 Definition of Hedge Funds

Starting with a definition of hedge funds would be nice but since there is not a legal, accurate, and
formal definition for the term hedge fund, it is difficult to define them. There is a “huge lack of
uniformity”14. That is why, in this part, we will present the features of the hedge funds to better
understand what they are. That will allow us to have our own vision of Hedge fund at the end.
Some attempts of definitions are available though. Each time, the definitions are based on their
untraditional way to invest, and/or their characteristics, and/or their view about the high return,
and/or the risk of the investment etc.
Daniel Capocci, Ph.D, Senior Portfolio Manager at Kredietbank Luxembourg synthesizes it as follows:
“A hedge fund is a private pool of investments using a large range of financial investments,
such as the short selling, derivatives products, the leverage and arbitrage and this on
different markets. [Of course, we will explain those terms later on]. Generally, the fund
managers invest a part of their own resources and are paid according to their performances.
Those types of funds often require high minimum investments and their access is limited.
Their potential clients are private investors or institutions, but in both cases wealthy”15.

Classic investments funds, such as mutual funds (glossary), for instance, invest in stocks and bonds.
They do not use hedge strategies (will be explained) or very few. Thus, they use only long term
strategies (trade only stocks and bonds with an expected result in the long term). And they are
available to retail investors and strictly regulated as far as the type of securities they can trade in
their portfolio.

Because of the complexity of the strategies that hedge funds use and the flexibility of legal rules, only
accredited investors (institutions + HNWI: High Net Worth Individuals, meaning wealthy customers)
can invest in hedge funds. These investors are supposed to be aware of the risk of their investments.
We will see later when discussing regulation that some quotas exist.

As a summary, the term hedge fund in itself is “misleading”16. The investorswords.com dictionary
provides the following definition for hedge: “an investment made in order to reduce the risk of
adverse price movements in a security, by taking an offsetting position in a related security, such as

14
Alternative Investment Management Association “Survey of hedge fund classification practice”, 2003
15
Daniel Capocci, Introduction aux hedge funds, Paris, Economica, 2004
16
Michel Prada, “The world of hedge funds: prejudice and reality”, Financial Stability Review: Special Issue:
Hedge Funds, April 2007. Banque de France
16

an option or a short sale”. In other words, this definition says that hedge funds are making
investments in order to protect their portfolio from markets fluctuations. This could lead one to
believe that they are risk‐free investments while on the contrary they are riskier than any of the
other types of funds (mutual funds, pension funds, common funds…)
However, there are loopholes in the regulation, as we will demonstrate later. Investments can be
made in illiquid and complex assets. Investors use investment techniques to speculate on the
markets, whether they are bear or bull (glossary), such as derivative products, short selling, leverage,
in order to reach an absolute return (glossary).
The freedom of the managers is highlighted. He is free to use as many strategies as he wants in order
to make profits thanks to his views and forecast on the market.
Finally the lack of transparency of those vehicles also appears to be a problem as it deals with risk
issues.

We have seen how vague the definition of hedge funds is. A better understanding of performance
and risk of those vehicles can me made trough the understanding of their own features

3.1.1.2 Quick overview of the hedge fund Industry

The Hedge fund industry is an opaque and obscure world with limited statistics and comprehensive
set of data. Secrecy is one of the keys of Hedge funds; it’s triggered by a strong competition between
managers and funds.
A few numbers concerning Hedge funds:
‐ The number of hedge funds in the world is estimated at 6,800 according to “Hedge
Fund Research”.
‐ One year ago, the number was of 10,200 (see Chart 1).
‐ The total amount of assets under management is also decreasing (Hedge Fund
Research).
‐ The actual assets under management are approximately $1,400 billion against
$2,100 billion one year earlier.
‐ “Hedge Fund Research” predicts that that number will fall below $900 billion by the
end of 2009. These numbers are falling, because clients are withdrawing heavily due
to the global financial crisis.

17

Chart 1: Evolution of the Number of
Hedge Funds (source: HFR)
10500
10000
9500
9000
8500
8000
7500
7000
6500
6000
January 2008 June 2008 September 2008 January 2009

‐ The total amount of assets under management is estimated at less than 1% of the total
assets on markets in the world17 or only 3% of the world GDP according to Strategic
Financial Solutions18.
‐ Hedge funds are looking for high returns on high risk investments. Often hedge funds are
capable of shaking markets just by taking positions on stocks or values.

Table 1. Percentage of Hedge Funds on
the trading of American Markets (source:
Greenwich Associates)19
Stocks 30%
Credit Default Swap 60%
Collaterized Debt Obligation 33%
Emerging Markets Debt 45%
Distressed Debt 47%
Leveraged Credits 33%
High Yield Debt 25%

‐ 15% of funds managers handle two third of all the assets managed by the industry.

17
Teïletche Jérôme. Les Hedge Funds. Paris: Edition La Découverte, 2000.
18
Ibid
19
Ibid
18

These characteristics raise many issues; one of them is the systemic risk. Given the strong activities
on certain markets, are hedge funds able to shaken them? Is the concentration of assets a benefit or
a risk, are there influences on performance?
The functioning of hedge funds is so complex that it would deserve a thesis of its own. A brief
synopsis will help understand how it works.

This chart shows all the parts influencing the hedge fund’s life. The management of the fund,
sometimes located off shore, is often done by a group of managers and financial experts located on
shore. The administrator (Citco, Citi, HSBC, securities or Caceis)20 leads the operations concerning the
subscriptions and redemptions of the investors, giving as a result the value of the fund. The auditor
checks out the legacy of the accounts, and particularly those which are published. The prime broker
is often an investment bank. It helps the manager in his daily operations by providing him cash for
the leverage and by lending him securities for short selling.
We are now going to describe the two main counterparties of hedge funds: the Prime brokers and
the Investors.

20
AIMA
19

As we mentioned, counterparties include prime brokers21 who are typically big investments banks,
the three biggest prime brokers in 2007 were Morgan Stanley, Goldman Sachs and Bear Stearns,
those numbers are most likely out of date given the subprime crisis that hit the banking sphere that
year.22 Prime brokers are the main partner of hedge funds on day to day operations of funds. The
prime brokers provides the funds with the short term financing used for leverage, the lending of
securities used in the short selling, the brokerage and the custody of securities.23 Prime brokers are
subject to counterparty risk. They directly put at stake their own assets in hedge funds. The best
illustration of this issue is the LTCM (See Appendix 1) crisis where the leverage was so high24 that the
total losses required the Federal Bank of New York to organize a bailout of $3,6 billion.
The other major actors in the hedge fund industry are the Investors who are often wealthy private
investors. Their main objective is to “outperform the market”25. Other investors are pension funds
that do not have enough capital to face the increasing number of retired employees and are
attracted by the possibility of outperforming the market. All these investors put their assets at high
risk and in the case of pension funds; it can endanger the monthly benefits of the retired persons.

3.1.2 Management methods
As already said Hedge funds want to keep their freedom from regulation and also want to manage
freely with different techniques and strategies. This is one of the key elements that enable a good
understanding and help analyze the consequences towards performance and risks, in a first step, and
how regulation could influence it in a second one.
3.1.2.1 Techniques
The main techniques used by hedge funds managers are:
Short selling,
Leverage effect,
High portfolio turnover and
Limited access.

21
Hildebrand, Philipp, "Hedge Funds and Prime Brokers Dealers: steps towards a best practice proposal”.
Financial Stability Review: Special Issue: Hedge Funds, April 2007. Banque de France.
22
Teïletche, 2008.
23
Ibid.
24
Edwards, Franklin R. “Hedge Funds and the Collapse of Long‐Term Capital Management" The Journal of
Economic Perspectives, Vol. 13, No. 2 (Spring, 1999), pp. 189‐210 Published by: American Economic Association,
Stable URL: http://www.jstor.org/stable/2647125
25
Amadeo, Kimberly, "Who Invest in Hedge Funds and Why”, about.com
http://useconomy.about.com/od/themarkets/f/Hedge_Investors.htm, accessed May 2009.
20

3.1.2.1.1 Short‐selling
Hedge fund managers use short selling when they sell a security that they do not own in their
portfolio. In fact, they borrow a security to a lender (investment banks) and sell it on the appropriate
markets. Later, they must buy back the same security in order to give it back to the lender. Thus, the
prices difference is the gain (or the loss) for the managers. The fee for the loan of the security must
be subtracted from this gain (or added to the loss) 26.
Managers use it in two cases. Let‘s take examples to have a better understanding.
Foresee of a bear market: at time t, a manager borrows a security that has a value of $100. He thinks
either this security is over‐evaluated or either its price is going to decrease soon because of a new
event or information. He sells the borrowed security and therefore receives $100. If the manager was
right, the price of the security is $80 at t+1 for instance. So, he buys the security back at $80 and
gives it back to the lender. He made a capital gain of $20 if we do not take in consideration the cost
of the loan.
Hedge a long position (glossary): a manager, using a long short equity strategy (explanation in the
strategy section) wants to be covered from the market risk (glossary) on a specific industry. For
instance, within the pharmaceutical industry, he takes long positions in Merck ($100) and short
positions (glossary) in Pfizer ($100). If the market drops by 15%, he will lose $15 from the Merck long
positions but will earn $15 by short selling his Pfizer security. The market risk is thus covered.

Risk of the short selling
The main risk of using short selling is to face liquidity constraints. In fact, the less liquid the borrowed
security is, the higher the cost of the loan. Indeed, the manager has to deposit collaterals for the loan
of securities. The daily fluctuations of the borrowed securities are reported on the collaterals. As a
result, if the value of the security increases, the manager will be ask to add another collateral loan
because the first one is under a determined threshold. If he cannot, the contract is broken and the
manager has to re‐buy the security at the current market price. This price might even be higher than
the one when the manager borrowed the security. A big loss is therefore noticed, without having
been able to keep the security to the expected maturity (glossary).

Limitations
Managers of classic investments funds (not alternative) are forbidden to use this technique. The laws
authorize hedge fund managers in the USA and in Europe to use this investment tool. However, short

26
Yuille, Brigitte, “Short Selling”, investopedia.com http://www.investopedia.com/university/shortselling/
accessed May 2009
21

selling allows the creation of alpha (glossary) in a portfolio if well used. Hedge funds managers’ skills
can then be compared. Nevertheless, we understand the need of regulation around this tool due to
possible consequences of the liquidity risk. (See appendix 1 for the analysis of the LTCM bankruptcy)

3.1.2.1.1.1 The leverage effect
This tool aims at amplifying an exposition to a security or a market or investing in a strategy, while
keeping the same initial capital. For the third point, sometimes a manager cannot invest in a strategy
under a specific threshold. He, then, must borrow money if he wants to have enough capital to get
involved in that specific trade.
The leverage is measured by a ratio dividing the total capital (initial capital + borrowed capital) by
the initial capital. For instance, a manager, having an initial capital of $100 million and borrowing
$400 million, will create a leverage of 5:1. There are different ways to create leverage. Of course, the
easiest way to do so is to borrow some funds directly to a lender. But one can also create leverage by
using the short selling. Indeed, you borrow securities that you sell immediately and therefore receive
an amount of money that you can invest elsewhere.
The leverage effect offers 2 main advantages. In one hand, the extra liquidity allows the manager to
have a return higher than the cost of the extra liquidity, in the case of a loan for instance. In the
other hand, the leverage allows a multiplication of the gains. Therefore, for the investment strategies
using an arbitrage (glossary), this characteristic is pretty interesting since the gains per each security
are weak. The use of leverage will then amplify those gains.
Risk of Leverage
The leverage effect is often seen as an aggressive tool and consequently, risky. And it is.
Nevertheless, in this case the risk is systemic. It means that the counterparties (lenders, investors)
will be damaged from a non reimbursement of the loan, which may bring consequences for the
whole economy.
Limitations
This previous risk is relevant. Nevertheless, let’s take an example that shows how it can be reduced.
For instance, a manager makes a short selling of $100 million in order to hedge a $100 million market
exposition. As seen previously, there is consequently no market risk in spite of a leverage effect of
2:1. If we compare this same investment to a classic fund that is not allowed to use the short selling,
the market risk is 100%. In fact, the classic funds can lose all its $100 million investment if the market
drops. Concerning the market risk, the strategy of hedge funds using the leverage is therefore less
risky. Consequently, the probability to reimburse the loaner is high which decreases the percentage
of systemic risk.
22

3.1.2.1.2 High portfolio turnover or active trading27
This represents the frequency of assets purchased or sold made by a manager in a fund. Within the
hedge fund industry, managers use to have a high turnover in order to benefit from many arbitrage
opportunities. Nevertheless, the gains made from this high turnover have at least to cover the
transaction costs, such as commission fees to make a profit.
This features shows that hedge funds partly make benefits from the wrong estimate of certain
securities prices. The turnover is high because they constantly have to find those under or over
estimated costs and benefit from their arbitrage.

3.1.2.1.3 Special features

Limited access and lock up period
Low liquidity is also a feature of hedge funds. Indeed, subscription and redemption frequencies are
not continuous. In fact, the liquidity is even lower at the exit because reimbursements are not, most
of the time, made monthly as the subscription but quarterly or annually. It means that an investor
can invest in a fund only at a specific time. If he wants his money back, he also has to do it at a
predetermined period. He cannot access to his money immediately which highlights a lack of
liquidity.
Moreover, this lack of liquidity is even emphasized because hedge funds often have a lock up period
when an investor cannot get his money back. He is not allowed to make the demand to withdraw his
money during this period of time. Usually, this period corresponds to one year. But it can be more
depending on the manager‘s will (see appendix 1 for the analysis of the LTCM bankruptcy). There is
no regulation about the fixation of this number of years.

Management fees
The best argument of hedge fund managers is to be able to generate money no matter the markets
trends. For this reason, they take a performance fee from the investors. Those fees are deducted as
soon as the fund shows a positive absolute performance. Those fees are usually cashed once a year.
Let us see how it is interesting for us and our concern about the risk approach.

27
Investopedia.com, “Portfolio Turnover”, http://www.investopedia.com/terms/p/portfolioturnover.asp
accessed May 2009
23

Concerning the remuneration of the managers, most of the funds nowadays use the “High Water
Mark” technique. The manager do not receive a performance fee as long as the value of the fund
(NAV: net asset value) (glossary) does not reach the best NAV reached in the past. That avoids
paying the manager for a positive performance on one year whereas the overall profitability is
negative.
For instance, with a regular technique (based only on the yearly performance), a manager, making a
loss of $1 million dollars the first year and a profit of $1 million dollars the second year, would still
receive his performance fee (percentage on the performance previously fixed by managers; different
for each hedge funds) based on the positive performance on the second year (x % of $1M) whereas
the overall profitability was equal to zero. Now with the water mark, using the same figures, the
manager will not receive any performance fees, since the overall NAV of the funds has not been
increased. The performance of the second year only matches the previous loss and does not over
perform it.
It was necessary to present this remuneration technique because it influences the risk rate taken by
managers. Indeed, on the one hand, taking too risky positions and then suffering a big loss would
prevent managers from getting their performance fees. On the other hand, being paid only by
performance fees stimulates managers to take risks in order to try to receive a weighty fee. Once
again, the points of views differ concerning a strict regulation about the remuneration of managers
since the risk is not avoided in any techniques.

3.1.2.2 Strategies
Hedge funds managers say that they are able to over perform the market no matter the conditions.
Theoretically, this goes against the law of market’s efficiency and transparency, where all the
information available is included in the prices, pronounced by Fama28 in 1970. Normally, it is
impossible to always beat the market. Here are the reasons why hedge funds could eventually over
perform markets. First of all, they can invest in niche markets, requiring high level skills, where the
regulation forbids traditional funds to invest. Secondly, the lower number of constraints for hedge
fund managers can help them make better performances than managers of traditional funds. That
means that a manager working with constraints cannot express fully his talent in his performances29.

28
Eugene Fama is an American economist known for his theory on the efficient market hypothesis.
29
Clarke R., Silva H. De and Thorley S. “Portfolio constraints and the fundamental law of active management”
Financial Analyst Journal, Vol 58, p48‐66.
24

Therefore, according to the strategies, the performance return, the volatility, and the risk fluctuate a
lot from one fund to another30. A lot of strategies with different features are used within the hedge
fund industry. However, we will focus here only on the two strategies used by the funds we picked.
The strategies long short equity and managed futures are however two majors strategies, showing a
good overview of the industry.

3.1.2.2.1 Long Short Equity
This strategy consists in taking long positions in under‐estimated securities, anticipating an increase
and to take short positions in securities that the manager thinks over‐estimated, anticipating a
decrease.
This basic principle is applied in two different versions: the short selling and the pair trading. We
have already explained how the short selling works in the previous part. Both techniques have the
exact same functioning. The only difference is the risk against which one wants to cover himself. In
the short selling, the market risk is eliminated by taking a position (long or short) in a security and
taking at the same time the opposing position in the index corresponding to this industry (product
representing a whole industry such as pharmaceutical, automobile…) Then, the loss made from the
security would be covered by the gains from the industry index or vice‐versa, eliminating the market
risk. However, in the pair trading, the manager trades on the spread (prices difference) between two
securities within the same industry. By taking short positions in the first security and long positions in
the second one, the manager is still covered from the market risk since both securities belong to the
same industry. He just trades on the evolution of the two securities between them. For example,
Pfizer’s stock price is $10 and Merck’s is $12. The spread is ‐2$ (10‐12).The trader thinks that the
situation is going to be better for Pfizer because they are about to announce very good results. He
takes long positions in Pfizer and short in Merck. Later, he was right and the new prices are: Pfizer
$14 and Merck $13. The manager makes a gain of $4 and a loss of $1 (because he will have to buy
back the Merck security one dollar more expensive). The new spread is +1$ (14‐13). Thanks to his
anticipations, the manager made a gain of 3$ per securities (1‐(‐2) =3).
This strategy is very well spread because a manager can benefit from long and short positions. This
high competition reduces the gains made from arbitrage (trading on spread differences)
opportunities in the markets. Consequently, hedge funds have to increase the leverage to multiply
those little gains thanks to a bigger initial investment.

30
Magnum.com, "About Hedge Funds – Synopsis of Hedge Funds Strategies”
http://www.magnum.com/hedgefunds/strategies.asp accessed May 2009.
25

3.1.2.2.2 Managed futures
This strategy is also called CTA: commodities traders’ advisors. Managers using it make investments
only on futures contracts markets. They identify a trend and they invest accordingly by using only
derivatives products such as futures and forwards. The decision process for investing is quantitative
and not qualitative. That means that a computer with algorithms is responsible for analyzing
technically all the trends in the market concerning prices, volatility, purchase and sale signals etc.
They can also invest in both long and short positions on futures contracts according to the trends
identified.
Moreover, the initial investment for the hedge funds is not big since they only give the collateral loan
to the prime brokers. Therefore, the leverage is often weighty. Indeed, a hedge fund manager will
only invest the collateral but will receive financial product from a higher value.
Even if hedge funds are not regulated themselves, the use of this strategy implies indirect regulation.
Thus, the markets in which they invest are very liquid, and regulated giving a significant
security/confidence to investors.

3.1.2.2.3 Conclusion on strategies
We decided to choose those two strategies because investments choices rely on a qualitative
approach (thoughts, feelings of the manager) for the long short equity strategy and on a quantitative
approach (technically analyzed, neutral) for the managed futures strategy. We made this choice in
order to stay global in our analysis of the hedge funds industry, and show a broad overview in spite
of our qualitative analysis.

3.1.3 Performances and performance risk measures
In order to compare our hedge funds in our case study, we need to understand previously how the
performance and the risk are measured. That will allow us in our analysis to understand the effect of
the results of those data or ratios. This basis is essential if we want to come up with links or
hypothesis with the regulation rules.
Introduction
We have to remind that one major feature of a hedge fund is that it targets absolute performances
(glossary). As we have previously seen, hedge funds aim at protecting the capital thanks to various
26

hedge tools. Contrary to common belief, volatility is not the only parameters to measure risks31.
Indeed, due to non linear return, the risk measurement is a little bit more complicated according to
the literature. And as Goltz and Shroeder said “like any investor, the typical hedge fund investor is
risk‐averse, i.e., he has a preference for high returns, but dislikes the risk related to his investment”.32
The attempts on regulation are basically made on hedge fund transparency. Thus, knowing the
returns but also the true riskiness of the hedge fund investment is basic information for investors.

3.1.3.1 Basic statistical data

3.1.3.1.1 Returns on investments (glossary)
Lhabitant33 (2004) tells us that the most important unbiased data to show the performance are the
past returns, and that it exists several ways to calculate it. Therefore, it was important for us to get
this information in our case study. Usually, returns are provided monthly, and annually. Each month,
the NAV (net asset value) of the fund fluctuates according to this rate.
For instance, if the NAV of the fund the 01/31/2008 is equal to $100 and the manager obtains a
return of 6% during this month, the new NAV on 02/28/2008 will be $106.
The performance can therefore be analyzed through the past.
3.1.3.1.2 Alpha

The total return of a portfolio comes from two different sources: the alpha and the beta.
The alpha of a portfolio corresponds to the part of the return which is not based on the market but
only on the manager’s skills. He will use techniques such as short selling and a good portfolio
turnover to produce a high alpha34.
“A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%.
Correspondingly, a similar negative alpha would indicate an underperformance of 1%”35.

31
Pictet “Hedge Funds, Aiming for New Heights”, pictet.com 2005, p10.
32
Goltz F., and Schroeder D., “Hedge fund reporting survey”, EDHEC Risk and Management Research Centre
Publication 11/2008
33
Lhabitant F.S., “Hedge funds, quantitative insights”, John Wiley & Sons, Chichester, UK, 2004
34
Della Casa T., Rechsteiner M., and Lehmann A., “Attack of the hedge funds clones”, Man Investments, July
2008
35
Investopedia.com “Alpha” http://www.investopedia.com/terms/a/alpha.asp accessed May 2009
27

3.1.3.1.3 Beta

The beta of a portfolio represents the part of its return due to the market performance and risks. The
higher is the beta, the more the return of the portfolio will fluctuate according to the market36.
“A beta of 1 indicates that the security's price will move with the market. A beta lower than 1 means
that the security will be less volatile than the market. A beta greater than 1 indicates that the
security's price will be more volatile than the market”37.
Alpha Managers
Skills
Total
Traditional Depending
Return
Beta on the
Markets
(Chart adapted from Man Investments)
3.1.3.1.4 Performance persistence
The past returns are interesting but it is easy to understand that “investors are less concerned with
past returns than with futures returns”38. Performance pertinence becomes consequently an
important factor for investors. Among others techniques, it is measured by a simple one: the gain
frequency. This is a ratio dividing the number of positive monthly returns by the total number of
months in the analyzed period. Of course, this ratio has limitations since it does not include the
weighting of each monthly return.

3.1.3.1.5 Volatility
The volatility corresponds to the standard deviation of the returns. Basically, it represents the
dispersion of the returns. A high volatility represents high differences between the returns, leading
to either big gains or either big losses. Whereas with a low volatility, the fluctuations curve of a
sample will be flatter, leading to small gains or losses. Consequently, we understand that volatility is
an assessment of risk39. Goltz et al also highlight the importance of the maximum and minimum
returns to assess performance and risk of a hedge fund.

36
Della Casa et al. 2008
37
Investopedia.com "Beta", http://www.investopedia.com/terms/b/beta.asp accessed May 2009
38
Goltz F., et al 2008
39
Ibid.
28

All those data are simple to understand but give a necessary overview to an investor in order to
select his investment according to his hopes. Before going more in depth and explaining the more
complex ratios that allow a measure of risk and performance at the same time, we must explain what
the main risks hedge funds must face (in addition to volatility).

3.1.4 Risks
3.1.4.1 Operational risks
According to Gupta and Straatman, an absolute performance (glossary) can be made only thanks to
the manager’s skills40. Therefore, the manager‘s expertness has to be high. The first operational risk
is the skills and reputation of the manager. An investor must trust the manager of the fund. The risk
can be effective if, for instance, the manager changes his investment strategy without informing the
investors. Moreover, as we have seen in the management fees’ part, the manager can be attempted
to take very risky positions in order to earn a high fee, without telling the investors, creating a moral
hazard phenomenon (glossary).
However, like in every firm, the operational risk does not have to be reduced to the sole manager. It
can also come from the back office operations, the legal infrastructure and so on41.
In the chart below, we have the distribution of defaults consecutive to an operational issue by
location of the management company. Source: Quantification of Default Risk, January 2007.
Country Percentage of defaults
USA 79%
Canada 7%
Europe 14%

We notice in this chart the difference between the US and Europe in term of hedge fund default. Is
that just a coincidence? Or is it due to the management techniques? Or is there maybe a role played
by the differences in regulation?

3.1.4.2 Liquidity risk
The liquidity risk is emphasized by the short selling as we explained earlier. Moreover, the lack of
efficiency in few liquid markets is higher. We have to bear in mind that taking short positions is not

40
Gupta P., and Straatman J. “Skill based Investment Management: The next evolution in the asset
management strategy” August 2005.
41
Castle Hall Alternatives “The new standard of operational due diligence: Five principles to guide best
practice” April 2009.
29

the exact opposite of taking long positions. A liquidity crisis starts with a first loss from the manager.
Therefore, he has to liquidate some positions to get some cash back, because investors want to
redeem their investment. Given the substantial illiquidity of the considered market (low exchange
volume), the liquidation will bring an increase of the products prices. This phenomenon will weaken
even more the short positions taken. That’s where regulation points can be made. Indeed, a mean to
avoid a liquidity crisis would be to keep high level of cash. Nevertheless, this cash would not provide
any return… A balance has to be taken…

3.1.4.3 Market risk (or systematic risk)
This risk corresponds to a decrease of an entire class of assets at the same time, simply because of
economic changes.42 Diversification is a solution to this issue because you cannot control it. Among
other, we understand especially why the skills of a manager are important in the anticipation of this
market risk.
One can measure this risk thanks to different financial formulas that we are going to see.
3.1.5 Advanced mathematical theories
To assess the absolute performance of hedge funds is difficult since the ratio return/risk is atypical
(non linear) in the hedge fund industry. However, it can be calculated by some specific tools even if
they include some imperfections.
3.1.5.1 Sharpe’s ratio
The Sharpe’s ratio is used in order to calculate the absolute performance (risk adjusted). Actually, it is
an adjustment of the return regards to the volatility. The ratio is calculated as follow:43

42
Investorwords.com “Market Risk” http://www.investorwords.com/2987/market_risk.html accessed May
2009
43
Investopedia.com “Sharpe Ratio” http://www.investopedia.com/terms/s/sharperatio.asp accessed May 2009
30

“Intuitively, it can be interpreted as a fund's excess return per unit of risk”.44 “The greater a
portfolio's Sharpe ratio, the better its risk‐adjusted performance has been. A negative Sharpe ratio
indicates that a risk‐less asset would perform better than the security being analyzed”45.
A negative result demonstrates a lower performance of the portfolio than the risk free rate. If
between 0 and 1/2, the positions taken are too risky compared to the obtained returns. If above 1/2,
the outperformance of the portfolio is great compared to the risks taken46.

Nevertheless, as we have seen before, the volatility is not the only risk because of “the non
symmetry of the returns”47. Indeed, this hypothesis of symmetry is supposed to give the relevancy of
this formula.

Researchers are consequently trying to find other formulas where the asymmetry of the return could
be included for example although the Sharpe ratio is very famous and widespread.
Thus, they have to take into consideration at least three other parameters of distribution: the
skewness, the kurtosis and the correlation.

The Skewness measures the asymmetry of the distribution shape of the returns. A positive skewness
will induce an average of more positive returns than negative and inversely.

The Kurtosis: measures the concentration of the returns in the curve, showing a peak distribution
curve or a flatter one.
“The skewness and kurtosis of fund returns are together important in assessing downside risk: a
return distribution that is negatively skewed combined with positive (excess) kurtosis is a strong
indicator of high downside risk”48. This result demonstrate the following trend in the returns: more
negative monthly returns with high absolute value.

44
Goltz et al 2008
45
Investopedia.com “Sharpe Ratio”
46
Sharpe, William, “the Sharpe’s ratio”, The Journal Of Portfolio Management”, Fall 1994;
http://www.stanford.edu/~wfsharpe/art/sr/sr.htm accessed May 2009
47
Lo A., “The Statistics of Sharpe Ratios” Financial Analyst Journal 2002 Vol.58, n°4, p36‐50
48
Goltz et al 2008
31


Source: Ressources Naturelles Canada, www.nrcan-rncan.gc.ca
3.1.5.2 Sortino’s Ratio
The Sharpe’s ratio remains an interesting tool for investors in spite of its limitations. Moreover, it is a
basis where we can adapt the specific asymmetry of the returns. Thus, the most known ratio
including also the “bad” volatility is the Sortino’s ratio. The “bad” volatility is the one which have a
negative effect on the returns (under a threshold called MAR: minimum acceptable return, here the
risk free rate). One calculates it according to the following formula49:

49
Investopedia.com “Sortino Ratio” http://www.investopedia.com/terms/s/sortinoratio.asp accessed May
2009
32

“Sortino’s ratio demonstrates return of the fund relative to its risk. The higher the Sortino ratio, the
more effective the fund’s asset management is. The interpretation is the same as the one on the
Sharpe’s ratio”50.
We understand that the Sortino’s ratio takes the skewness into consideration by considering only the
negative returns. However, this model does not include the kurtosis and the correlation.
Nevertheless, investors still trust this risk assessment.

3.1.5.3 Omega ratio
Keating and Shadwick (2002) introduced another ratio called Omega ratio. This ratio has the
advantage to take the skewness but also the kurtosis into consideration.51
“The Omega is a relative gain‐to‐loss function. The Omega is then the quotient of the (expected)
excess return over a threshold and the expected loss below the same threshold. Hence, the higher is
the Omega the better”52. The interpretation is also the same as the ones for the Sharpe’s and
Sortino’s ratio

3.1.5.4 Ljung Box test or test of auto correlation
“The Ljung‐Box test (Ljung and Box, 1978) of autocorrelation of hedge fund returns is a practical test
for evaluating to what extent the fund contains illiquid assets. Since illiquid assets tend to exhibit
relatively constant prices, the returns of a portfolio containing illiquid assets are more likely to be
auto‐correlated”53.
The Ljung Box test is also able to recognize the phenomenon of return smoothing, even if not
deliberate. In other words, this test is able to check the accurate randomness of the returns. If failed,
this test may identify an intentional fraud. Of course, when we talk about fraud, regulation is never
far away.
Now that we have seen what the proprieties of hedge funds are, and how the performance can be
calculated, even risk adjusted we are going to see what the regulations in Europe and in the United
States are. Maybe we will find a link between those proprieties and the applied regulation.

50
Investfunds.ru “Investfunds Sortino ratio calculation methodology”
51
Keating C. and Shadwick W., “A Universal Performance Measure”, The Finance Development Centre, London,
January 2002
52
Goltz et al. 2008
53
Getmansky M., Lo A. and Makarov I., “An econometric model of serial correlation and illiquidity in hedge
fund returns”, Journal of Financial Economics 2004 Vol 74, p529‐609.

33

3.2 Theoretical Background on Hedge Fund Regulation

The main theoretical framework about regulation consists of three parts. In the first part we will
describe the existing regulatory laws on hedge funds in the United States. The second part will
describe the existing and future regulations in the European Union from the perspective of two
countries. Finally we will give the different points of view on hedge fund regulation, the pros and cons
at different level on each side of the Atlantic Ocean.
3.2.1.1 Introduction
The issue of Hedge fund regulation is a recurring topic. According to Champarnaud (2000) the Long
Term Capital Management (LTCM) (glossary) Crisis of 1998 was a trigger for financial regulators to
launch actions concerning Hedge Funds54. (As a reminder; the LTCM crisis, which occurred at the
same time as the Asian crisis, obliged the New York Federal Reserve to organize a $3.7 billion
bailout.) According to different data providers including Hedge Fund Research and Hedgefund.net,
the assets under management by Hedge Funds ranged from $1, 9 trillion and $2, 9 trillion as of 2008.
Of course the usage of leverage increases this range. However it is difficult to estimate exactly given
the obscurity of the leverage ratio used by funds. Hedge funds are accused of triggering the actual
financial crisis because of the opacity and the lack of control and hedge funds detractors blamed
them for being partially responsible for the subprime crisis. They believe that hedge funds had a
major role in the securitization (glossary) process linked to the subprime crisis. In the EU, under the
presidency of Germany, a 2007 report called for better regulation of private funds and hedge funds55.
Knowing all these facts, the main problem is the actual regulation of hedge funds.
What are the common European laws and the Federal American laws?
Who are the enforcers?
Are there loopholes in regulation?
We are going to give an overview of the different rules, both applied and suggested, between the
USA and the European Union. These rules are going to help us understand the major conflicting
debates within the hedge fund industry. We will also demonstrate how and to which extent they may
influence the performances and risks of the industry.

54
Champarnaud, François. “Regulating Hedge Funds.” Revue D’économie financiére n°60 (5‐2000)
55
(Euractiv.fr. "Vers un code de conduite pour les fonds spéculatifs (July 26th 2008) Acteurs d’Europe S.A.R.L.
web site. http://www.euractiv.fr/euro‐finance/dossier/code‐conduite‐fonds‐speculatifs‐hedge‐funds‐00036,
accessed may 2009.
34

3.2.1.2 The creation of hedge funds from a regulation perspective
First we have to go back to the origins of hedge funds; these investment pools were created because
of the strict regulation imposed to protect individual investors. The targets of hedge funds were
initially wealthy and knowledgeable investors. These investors were believed to be conscious enough
to protect their own interests. However, in recent years, hedge funds have marketed themselves to a
broader range of investors, including investors who have no understanding of risk management. As a
result, when these new less savvy investors felt their investments were shaken, they demanded
more formal regulations.56
3.2.1.3 International and Domestic Regulation
The existing regulation of Hedge Funds, although weak, is done internationally and domestically. The
domestic regulation of hedge fund relies on three factors:
‐ the fund manager,
‐ the fund itself and
‐ the distribution of the fund (main marketing channels, rules on advertising, legal
advertisers…) (See Appendix 2 PriceWaterHouseCooper on Regulation and
Distribution of Hedge Funds in Europe)
In each country regulations differ; it is believed that the relatively good performances of hedge funds
are linked to the lack of regulation they are subjected to. Reviewing the domestic regulation rules on
each side of the Atlantic (USA and European Union) will allow us to see the consequences of these
rules on the risks and performances of funds that we will analyze in our case study. This background
is therefore mandatory in order to draw conclusions or hypothesis.
Our presentation will divide the European and American rules into two parts; the existing rules and
the rules that are going to be put in place in the coming months.

3.2.2 The United States Regulatory Environment

The USA has a “light” regulation policy concerning hedge funds. However, efforts are being made on
questions of registration. Acts have been voted in the United States requiring hedge funds to have a
relative transparency. We will see how it is possible to by‐pass these acts allowing the funds to
maintain their opacity since registration is only a first step towards full regulation. These acts can be
of two kinds, either on the fund itself or on the managers of the hedge fund resulting in different
consequences.

56
Crockett, Andrew. “The Evolution and Regulation of Hedge Funds”. Financial Stability Review: Special Issue:
35

3.2.2.1 Regulation of Funds

3.2.2.1.1 Securities Act of 1933 modified 1993
This act requires every securities vendor (the legal entity) to give a description of the securities, to
give information about the management of the issuer and to provide financial statements certified
by independent accountants57. In other words, the respect of this act would oblige hedge funds to
register at the SEC, and be transparent about their investment strategies and their financial data. Yet
the 1993 Act has changed the conditions of regulation of the 1933 act and sets exceptions to this. “If
the interests are not sold in a public offering” as defined by the Connecticut General Assembly, then
it does not have to be registered58. Indeed, every hedge fund stayed private (in the Securities Act
meaning) in order not to have to divulgate their strategies and track records (see glossary). If the
fund is not registered, it is forbidden from doing public advertising and therefore cannot reach a
broad range of investors.
The disclosure of strategic and financial information would prevent them to benefit from their
competitive advantages. The performance of the fund could be diminished and the risk (market risk,
glossary) increased. The best funds would be imitated or copied and the market would not regulate
itself. Also the risk for investors could increase because funds could bet against each others’
strategies leading to potential big losses. On the contrary, if the fund is registered and divulgates
information to the SEC, it can also reduce risks by warning the managers in case of too hazardous
positions59. The motivation to follow this act is controversial even within hedge fund managers.
3.2.2.1.2 Investment Company Act of 1940
This act mentions that funds that have more than 100 accredited investors must register with the
SEC. For clarification, according to the Staff Report to the United States Securities and Exchange
Commission: “accredited investors include individuals with a minimum annual income of $200,000
($300,000 with spouse) or $1 million in net worth and most institutions with $5 million in assets”60.
As a result, hedge funds often market their services to less than one hundred investors in order to
stay away from registration as an investment company at the SEC61. The registration at the SEC,
because of the Investment Company Act of 1940, brought exactly the same issue relative to

57
Investopedia.com “Securities Act of 1933”
58
Coleman, Soncia , "Hedge Funds", Connecticut General Assembly, http://www.cga.ct.gov/2006/rpt/2006‐r‐
0154.htm accessed May 2009
59
McCarthy, Callum, "Transparency Requirements and Hedge Funds” ”. Financial Stability Review: Special Issue:
Hedge Funds, April 2007. Banque de France.
60
Staff Report to the United States Securities and Exchange Commission. “Implication of the Growth of Hedge
Funds”, September 2003, p x
61
Teïletche 2009.
36

performances and risks as discussed in the previous paragraph with the Securities Act of 1933 and
1993. However, because funds do not wish to fulfill the obligations of this act, it causes auto‐
regulation of the size of the funds.
Now that we saw the specific regulations for the funds themselves we are going to see the particular
regulations that concern the managers of the funds.

3.2.2.2 Regulation of Hedge Funds Managers

The nature of the hedge fund business leads to “misrepresentation and fraud”62. This reveals the
problematic of the registration of hedge funds advisors. From 2000 to 2005, the SEC estimated that
fraudulent actions by Hedge Funds valued $1 billion. The actions include “the gross overstatement of
hedge fund performance, the payment of unnecessary and undisclosed commissions, and the
misappropriation of clients by hedge funds.”63 Furthermore, since most hedge funds are
international, it can be subject to money laundering.
It is the role of the managers to insure the nature of the investors and consequently protect the fund
from the risk brought by those fraudulent behaviors.

3.2.2.2.1 Investment Advisors act of 1940

The registration under this act of certain hedge fund advisers is designed to provide “the protections
to investors in hedge funds, and to enhance the commissions ability to protect our nation’s [United
States] securities market”64. Indeed this act requires hedge funds managers to disclose “advice,
counsel, publications, writings, analyses, and reports” and “their contracts, subscription agreements,
and other arrangements with clients”65. In other words, in this act it is the manager that registers
himself and not the fund. However, the aim remains the same as the acts we described earlier. The
effects concerning risks and the performances are the same even if the targets are different. As in
the previous acts, there is a loophole allowing hedge funds managers not to register. This loophole is
for managers that supervise fewer than 15 hedge funds in 12 months; they are hence not required to

62
Dierick, Frank and Garbaravicius, Tomas. “Hedge Funds and Their Implication for Financial Stability.”
European Central Bank: Occasional Paper Series, No.34 August 2005.
63
Ibid.
64
United States Securities and Exchange Commission, 17 CFR Part 275 and 279.
65
Cornell University Law School, "US CODE : Title 15/80b‐1"
37

register.66 Consequently those managers are “not subject to any reporting or standardized disclosure
requirements or subject to commission examination”67. This allows managers to keep their strategies
secret and therefore their competitive advantages, influencing the performances of the funds. This
secrecy also hides the risks to investors.
3.2.2.2.2 The 2009 proposed bill on Investment Advisors Act of 1940 (not yet amended)

By “removing the current exemption for advisers with fewer than 15 clients”68, this bill is aimed at
closing “a loophole that allows some hedge fund managers to avoid registering with federal
securities regulators”69. “It is a step in the right direction towards future hedge fund regulation”70,
according to the House Financial Services Capital Markets Subcommittee chairman Paul Kanjorski. It
seems that the United States, nowadays, want to strengthen the regulation of hedge funds but
through “a narrowly tailored regulatory treatment"71. Even the Hedge fund industry agrees that it
“would be an effective way to achieve this result”72, according to Managed Funds Association chief
executive Richard Baker. However, it definitely exists in their minds a need for this regulation to be
"customized to treat small firms differently from big ones."73 Of course, there is debate because
some people think this bill does not manage the systemic risk issue (glossary) and is not the answer
to future stronger regulations of hedge funds. "It is a one‐size fits all legislation and is not tailored for
the risk areas ‐ entities that have scale, are complex and are systemically important"74. For Guillaume
Monarcha, a Natixis economist, it is just a “solution for the United States to repatriate fiscal flows
that they have lost”.75 Obviously, hedge fund regulation remains a sensitive and controversial
subject…

3.2.2.3 Specific Strategies Regulations

66
Krug, Anita, “The Hedge Fund Transparency”, Berkley Center For Law, Business and the Economy, 2009.
67
Funds” September 2003
68
Baker, R. in “US Rep Kanjorski: Hedge Funds Should Register with SEC”, May 2009
69
Kanjorski P. in "US Rep Kanjorski : Hedge Funds Should Register with SEC” May 2009
70
Ibid.
71
Ibid.
72
Richard Baker, 2009
73
Paul Kanjorski 2009
74
Harris Brit in "US Rep Kanjorski : Hedge Funds Should Register with SEC” May 2009
75
Monarcha G., "Faut‐il euthanasier les hedges funds", L’express 02 March 2009,
http://www.lexpress.fr/actualite/economie/faut‐il‐euthanasier‐les‐hedge‐funds_744157.html, accessed May
2009.
38

To complete this set on the US regulation, hedge funds fall under the jurisdiction of different
advisors in function of the composition of the assets operated. We can give three examples taken
from Shabad essay called The Challenge of Hedge Funds Regulation. If the hedge fund has significant
holdings in a public company and if the fund has more than $100 Million invested in public
companies, then it has to report it to the SEC under the Exchange Act. If the fund deals with futures
and commodity options contracts it is under the surveillance of the CFTC (Commodity Futures
Trading Commission). And as a last example, if more than 25% of its equity assets are owned by a
“qualified employee benefit plan”, the funds falls under the jurisdiction of the ERISA (Employee
Retirement Income Security Act).76
Furthermore, in order to gain from advantageous fiscal conditions, hedge funds are often located
offshore (glossary), meaning that they are out of reach of national regulators. This is a specificity of
hedge funds as the managers are located on traditional financial markets such as New York, London
or Geneva. However our thesis is not oriented on offshore hedge funds and their regulation. We are
focusing on onshore funds.

3.2.2.4 Conclusion

As we have seen, in the United States, hedge funds can manage to be “exempt from the registration
and disclosure requirements of federal securities laws”77 mentioned above, even if the new
amendment, if included, will change the background. The funds are also not prohibited from
leveraged trading, short‐selling, or concentrated investing. To qualify for those exemptions, hedge
funds may not advertise and can only accept investments from large institutions and wealthy
individuals, according to Shadab. Therefore, Hedge funds are not obliged to publish financial
information. However, hedge funds often indicate to their clients their investment strategies and
some details about the operations.
Basically, one can say that the hedge fund philosophy is to avoid any kind of regulation and
supervisory powers of the SEC. They do this in order to benefit from more liberty in portfolio
management. This last factor is what leads to high differences in performances and risks taken in the
hedge fund industry. It is estimated that “60–70 per cent of hedge funds are exempted from SEC
regulation. In order to achieve this, hedge funds will ascertain that all relevant exemptions apply, not

76
Shadab 2007
77
Ibid.
39

only at the moment of their establishment but also during their existence in order not to be
sanctioned by the SEC.78”
Moreover, we notice that all those acts have been introduced as a response to the 1929 crisis. One
may discuss their efficiency. Is the new amendment a response to 2008 crisis? Are the United States
always functioning by repairing instead of preventing? Is an ounce of prevention worth a pound of
cure? Time will tell…
3.2.3 The European Regulatory Environment

We are going to oversee the general trends in the European Union concerning the regulation of
hedge funds and link it to performance and risk in the industry. The regulatory framework in Europe
is not harmonized between each country of the Union. We decided to focus our analysis on two
countries the Netherlands and Sweden because you will see after the analysis; they represent an
average in the regulation in Europe. Additionally those countries are often cited as example within
the EU; they quote the Nordic Model they are members of79. We are then going to analyze the
recently submitted directive on Alternative Investments to the European Union and see the
consequences it can have on performance and risks.
3.2.3.1 The Existing Relevant Regulation
In 1985, the European Union introduced UCITS (Undertakings for Collective Investment in
Transferable Securities)80. As investopedia.com explains:
“These funds can be marketed within all countries that are a part of the European Union, provided
that the fund and fund managers are registered within the domestic country. The regulation
recognizes that each country within the European Union may differ on their specific disclosure
requirements.”
Also inside the framework of this directive we can find, a directory of the assets in which UCITS fund
can work in. Also the UCITS directives give indication concerning the “diversification and liquidity of
the fund’s portfolio” 81. This small background on UCITS is important for setting the theoretical
framework on hedge fund regulation in Europe.

78
Kaal W. A. “Hedge Fund Regulation by Banking Supervision: A Comparative Institutional Analysis”, Peter Lang,
Oxford, p 74‐75
79
The Wall Street Journal, "The Stockholm Curve”, 29 September 2008,
http://online.wsj.com/article/SB122264826575484095.html accessed May 2009
80
The European Commission , The EU single Market “Investment Funds”
http://ec.europa.eu/internal_market/investment/index_en.htm, accessed May 2009.
81
Europa.eu, “Improved EU Framework for Investment Funds – Frequently Asked Questions” 16 July 2008
http://europa.eu/rapid/pressReleasesAction.do?reference=MEMO/08/510&format=HTML&aged=0&language
=EN&guiLanguage=fr accessed May 2009.
40

3.2.3.1.1 Registration
In Europe, the countries of the EU have strict rules concerning hedge funds. However, “common
features can be found in all EU Member States where regulations governing hedge funds exist. In
fact, hedge funds are always defined as “collective investment undertakings” and are therefore (…)
separate from other types of financial investments”82
First every new domestic hedge fund requires an approval time in order for it to operate. That
approval period is the time taken by the national regulator to approve the proper working of the
fund. That period varies in each country of the European Union in accordance with the respective
national law. The approval period is different for foreign funds that wish to implement in a specific
country of the Union. Indeed each state has a different perceptions of the risks incurred with hedge
funds.
To proceed with our case study, let’s focus on the registration process of hedge funds in the
Netherlands. First, hedge funds are considered exactly like any other funds and are consequently
fully regulated.83 The regulation is entrusted to the Netherlands Authority for the Financial Markets
(Autoriteit Financiële Markten, AFM) and to the Dutch Central Bank (De Nederlandsche Bank DNB).
As we mention an authorization is necessary to offer alternative investment vehicles in that country.
That authorization takes the form of a license delivered by the AFM. This license is defined by the
Financial Supervision Act (Wet toezicht beleggingsinstellingen, Wtb) implemented since 1st January
2007, that regulates the countries alternative investment vehicles.
The requirements to obtain that license are to divulgate the following information: “(...) relating to
the expertise and reliability of managers, financial guarantees and the supply of information to
investors, including a prospectus and continuous reporting”84. The exception to the Wtb (mentioned
above) licensing process is if the fund is “offered exclusively to professional parties, to less than 100
persons,”85 or if the amount offered to contract in the fund is of at least €50,00086. Additionally,
foreign hedge funds that aspire to operate in the Netherlands also require a license, which is

82
Efama and Assogestione, "Hedge Funds Regulation in Europe: A Comparative Survey” November 2005
83
Van Berkel, Sander, “Should Hedge Funds be Regulated?” Journal of Banking 2008 http://www.palgrave‐
journals.com/jbr/journal/v9/n3/full/jbr200810a.html accessed May 2009.
84
The Netherlands Authority for the Financial Markets. 'Hedge Funds: An exploratory study of conduct‐related
issues', AFM August
2005,http://www.afm.nl/marktpartijen/upl_documents/Hedge_Funds_An_exploratory_study_of_conduct_rela
ted_issues.pdf, Accessed May 2009, p49.
85
Ibid, p49.
86
Lemstra, Derk and Groenewoud Lars, “How to market hedge funds in the Netherlands”, Feb 09, 2009,
Complinet.
41

delivered by the AFM. That specific license is delivered only if the supervisory authority (AFM)
estimates that the home country supervision is satisfactory87.
As for Sweden, the regulatory authority is called The Swedish Financial Supervisory Authority (SFSA).
The SFSA qualifies hedge funds as “special funds” and consequently they are more regulated than
traditional funds88. The conditions for distributing domestic and foreign (Glossary: off‐shore) hedge
funds in Sweden are the same as in the Netherlands. For example, the SFSA also needs to deliver a
license, it is delivered base on an analysis of requirements. Those requirements include among
others that “the foreign hedge fund is subject to adequate home state supervision”89. The
implementation process of a hedge fund is between two months for foreign and six month for
domestic.90

3.2.3.1.2 Financial Minimum Requirements
For Managers to operate hedge funds, minimum capital requirements are obliged throughout the
countries of the Union. The level of capital requirements varies in function of the country. In the
Netherlands the minimum capital is €226,890 (approximately 500,000 former Dutch Guilder). This
amount varies in Sweden. The minimum requirement is €125,000 plus the equivalent to three
months of expenditure and if the Assets under management is above €250 million the managers has
to guaranty 0,02% of the excess capital.91
The objective of those capital requirements is to provide guaranties against default of managers.
Since this capital is brought by the managers themselves it is a tool of auto‐regulation, and prevents
the risks of bad managing since their own capital is at stake.
3.2.3.1.3 Trading strategies
They are no uniform regulation concerning the different types of trading strategies that hedge funds
in each country can use. They can range from respecting strictly the list cited in the UCITS directives
like in France or allowing hedge funds to invest in every kind of assets like in Italy.92 This amplitude in
regulation within Europe has consequences on both performance and risk.
In the case of Sweden, Hedge Funds are allowed to deviate from the list defined by the UCITS if they
ask the permission at the SFSA. The Swedish FSA then determines whether the risks taken are

87
PriceWaterHouseCoopers, “The Regulation and Distribution of Hedge Funds in Europe: Changes and
Challenges” June 2005.
88
Anderlind, P., Dotevall, B., Eidolf, E., Holm, M., & Sommer lou, P. Hedgefonder – En Dyr Investering?
Högskolan I Halmstad, 14 May 2008.
89
PriceWaterHouseCoopers, 2005
90
ibid
91
ibid
92
ibid
42

sufficiently spread to allow the usage of more securities. Additionally, Sweden does not use
quantitative restrictions on investments. They applied the principles of risk spreading (glossary). This
means that the Swedish FSA is in charge of checking that the Swedish Hedge Funds are holding
diversified portfolios. Furthermore Swedish hedge funds are required to report on a regular basis all
the risks in the fund.93
In the Netherlands, the situation is easier. There are no restrictions yet in the usage of leverage,
trading strategies and the use of derivatives.94
3.2.3.1.4 Conclusion
We can see that hedge funds are strictly regulated in Europe; specific rules apply in each country
they are authorized to work in. The purpose of these regulations is to prevent the different types of
risks. Giving consequences on performance is too soon in our analysis to describe; however, those
regulations are time consuming and require capital investment. We can therefore speculate that
there have consequences on performance.
3.2.3.2 The AIFM Directive

3.2.3.2.1 Introduction to the AIFM Directive
The latest G20 summit in London came up with an agreement in principle for further hedge fund
regulation and registration95 in a context of financial crisis. However, as we have already mentioned,
in the United States the Hedge Fund Transparency Act was presented in January 2009. As for Europe,
the European Union has been working since 2006 on a new regulatory scheme for the industry.96
The directive the EU has been working on was presented on April 30th 2009 to the Council and to the
European Parliament. It is called the Alternative Investment Fund Manager Directive.
This draft directive provides a regulatory frame for Manager of Alternative investment vehicles
(AIFM) such as Hedge Funds, private equity fund, commodity funds, real estate funds and others.

93
Deputy Governor Lars Nyberg, “Are Hedge Funds Dangerous?” Speech 24 November 2006
94
issues', AFM August 2005,
http://www.afm.nl/marktpartijen/upl_documents/Hedge_Funds_An_exploratory_study_of_conduct_related_i
ssues.pdf, Accessed May 2009, p49.
95
Bodescot, Anne, “Contrôler les Hedges Funds”, lefigaro.fr, 3rd April 2009,
http://www.lefigaro.fr/economie/2009/04/03/04001‐20090403ARTFIG00274‐controler‐les‐hedge‐funds‐.php
accessed May 2009.
96
Directive on Alternative Investments Fund Managers (AIFMs): Frequently Asked Questions, 29th April 2009
43

This directive comes as there is a “perceived lack of supervision of investment activities”97, as
McDermott Will & Emery law firm states in its publication concerning the directive. This publication is
going to be the base of our analysis on this matter.
This draft is an attempt to meet both the expectations of countries like France and Germany that
want strong regulation and countries like the United Kingdom that have the same perception as the
United States on the matter (more regulation can be harmful for investment companies). That is the
reason why the draft is seen as a compromise.
This directive represents the key requirements; nothing prevents countries to put in action stricter

measures. France and Germany are expected to do so around 2011/2012. Let’s now overview the
main suggestion of this draft
3.2.3.2.2 The Suggestions of the AIFM Draft
The directive stipulates that every AIFM that is based in the European Union that has more than €100
million of assets under management is to register with the national financial authority. For funds that
do not use leverage and have lock up (glossary) periods of at least five years, the thresholds for
registration is €500 million. The national financial authority needs to approve the fund and subject it
to perpetual obligations. The EU Commission estimates that, with those regulatory limits, 30% of
hedge managers and 90% of the total assets under management in the EU will be covered.98 This
directive also applies for the managers that meet those requirements even if the fund is domiciled
outside the borders of the EU.
Concerning authorization, the directive mentions that AIFM will have to earn an authorization from
the financial regulator of the EU country it is based in. To get the authorization the Manager is to
divulgate consistent information. This data are
• The information on the anticipated activity of the fund
• The Characteristics of the fund (such as the identities of the members)
• The control mechanisms
• The measure taken for the estimation and the safe keeping of the assets under management

97
McDermot Will & Emery, “ Draft AIFM Directive Constrict Hedge Fund“, May 5 2009 McDermot Will & Emery
Publications http://www.mwe.com/index.cfm/fuseaction/publications.nldetail/object_id/c930b434‐6928‐
4d0d‐8eab‐7555b3bff632.cfm, accessed May 2009
98
Debevoise & Plimpton LLP, Regulation of EU Private Equity and Hedge Fund Managers Ahead, But not Any
Time Soon”, May 1st 2009
44

• The method of reporting.
The directive plans to set up a European “passport” for managers that have been authorized. This
passport would allow the marketing of the alternative products in all the countries of the EU but only
to “professional investors”. However a notification to the host country’s regulatory authority is
required to proceed to such marketing.
In order to keep their authorization the managers will have to constantly show that they meet the
authorization standards, they include many factors that are linked to risk: management risk, solvency
risk, operational risk and others.
Simply Managers have other threshold and condition to respect in order to keep their authorization.
They have to prove that their risk of liquidity is adequate compared with their investment strategies.
In case of difficulties AIFM must have “redemption policies” adequate with the liquidity of their
positions. They have to avoid all conflicts of interest at all levels (Managers, Employees, and
Investors). In case they realize such a condition is taking place in their firm they must take measures
to avoid it and report them (the measures) to the authority.
By the new rules, AIFMs will have to cope with minimum capital requirements. The managers will
have to keep safe €125,000 when they have less than €250 million assets under management. If the
assets under management is above that threshold the manager will have to add to the initial amount
0,02% of the amount over. (This point is already applied in Sweden)
Concerning the protection of investors, this new directive will impose several new requirements to
managers. This is an exhaustive list of the new imposed information managers have to disclose:
• The Fund’s objectives
• The fund’s investment strategy and the type of assets it invests in
• The different investment techniques the fund may employ
• The reason for using leverage, and the granter of the leverage (if leverage is used)
• Annual reports to investors that contains the account of assets and liabilities, income and
expenditure
• The different preferential treatments it may give to investors in comparison of others.
Furthermore, AIFM will under those new rules report to the regulatory bodies of the markets the
fund trades on. They will have to disclose to them the main trading instruments and main exposures.
45

Special arrangements are taken for AIFMs whose strategies imply using high levels of leverage (when
the leverage is higher than the equity capital of the fund). Particular reports have to be published
stating the total amount of leverage used. Plans are already in process to introduce limits on
leverage in function of the nature of investments.
Another new rule concerns the controlling of more than 30% of the voting right of a non‐listed
company. The Fund has to disclose that information to the shareholders of that specific company and
explain them the underlying risk of such a position. This applies only for companies employing less
than 250 persons, with annual turnover of less than €50 million and/or the bottom line of the
balance sheet must not exceed €43 million.
This regulation will authorize the marketing of AIF located from outside the EU starting in 2014. Only
if the fund receives an authorization from the competent authority and if that specific country has
mutual agreements with the UE. Those agreements are among other to respect the OECD Model Tax
Convention and that it accepts in his turn the marketing of EU Funds in its count. Those points have
already been applied in the Netherlands and Sweden; the new directive would take them to another
level.
3.2.3.2.3 Reactions
This directive is still in a draft stage. The reactions to it have been multiple. Some want more
regulation other think it is too restrictive. Those rules are to be applied starting in 2011 or 2012, but
complaints might retard that adoption process. We are now going to describe the different critics of
this directive.
Reactions to this draft have been significant. The most virulent have spawned from the United
Kingdom. Since 80% of the European hedge fund industry is based in London, the City fears for its
future.99 Florence Lombard, the executive director of AIMA (Alternative Investment Management
Association see Glossary) states in the Telegraph “This directive is not a proportionate regulatory
response to any of the identified causes of the current crisis.” And she added that, “It is
extraordinary that at a time of economic crisis the Commission is contemplating putting jobs at risk
and hitting investors and thus investment.”

99
Armistead, Louise, “European Commission unveils tough hedge fund directive”, telegraph.co.uk 29 April 2009
http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5242982/European‐Commission‐unveils‐
tough‐hedge‐fund‐directive.html, accessed May 2009
46

Another point of concern is the price of implementation for the industry. This point is also rising from
Great Britain. Kinetic Partners, an auditing and consultancy firm that operate within the investment
sector, estimate the cost of implementing the AIFM directive at approximately £3,0 billion. As the
private equity wire (privateequitywire.co.uk) mentions that this cost is an estimate for the entire
industry. For each typical manager, this represents several million of pounds each year in addition to
the initial investment to understand the directive.100 The found of Kinetic Partners also claims that
this directive would be “disastrous for the UK industry” and would have “no apparent benefit”.
Critics also mention that this goes in the wrong direction; indeed they quote the Turner Review (see
glossary) on hedge fund. This review claims the hedge fund industry has had no major influence on
the ongoing crisis; therefore it should not be the one being punished.
Reactions came all the way from the United States where the Managed Funds Association (MFA)
indicated that it was worried “about certain aspects of the directive, including those that could
potentially establish minimum capital requirements for managers. We would also urge that any
reporting of information include appropriate confidentiality of certain information for fund
managers."101
On the other side of the barrier, the president of the European Socialist Group, Poul Nyrup
Rasmussen, said the directive "has more holes than a Swiss cheese" has it is reported in Business
Week102. Finally the French Finance Minister accused the directives as being too soft and said that
accepting offshore hedge funds inside the UE is like letting enter “Trojan Horse(s)”103.
3.2.3.2.4 Conclusion
The reactions to this directive have been mostly hostile. They imply that these rules are useless. The
idea behind this directive was to reduce risks. Both counter parts have strong arguments on whether
this directive will be efficient or not. On one side some believe that the directive will decrease the
performances and on the other some believe risk is not managed enough. The directive wanted to
please a maximum number of members of the industry. However, like Gilles Bourgoin says at the
Ecole de Commerce Européenne at Lyon, “it is by wanting to please the most that you please no

100
Private Equity Wire, “EU Directive will Cost UK Hedge Fund Industry GBP3bn, says Kinetic Partners”, 06 May
2009, http://www.privateequitywire.co.uk/articles/detail.jsp?content_id=328717, accessed May 2009.
101
Hedge Funds Review, “Furry over European hedge fund directive”, 29 April 2009,
http://www.hedgefundsreview.com/public/showPage.html?page=854946 accessed May 2009.
102
Willis, Andrew, "Battle Heats Up on Hedge Fund Rules”, Business Week, 30 April 2009,
http://www.businessweek.com/globalbiz/content/apr2009/gb20090430_048575.htm accessed May 2009.
103
Laurent, Lionel, "Hedge Funds fight EU Regs”Forbes.com 29 April 2009.
http://www.forbes.com/2009/04/29/hedge‐funds‐europe‐markets‐econ‐lagarde.html?feed=rss_markets
accessed may 2009.
47

one”, the reaction seems to coincide with that affirmation. This shows us perfectly an essential
characteristic of the hedge fund industry: its complexity. As for right now in our study we are not
able to give our point of view on these matters.

3.2.4 The Hedge fund Regulation Main Point of views (Pros and Cons)
The regulation of hedge funds is one the most controversial topic within the financial investment
industry. Many points of views are completely opposed depending on the function of the
commentator. In this part we are opposing the point of views on both side of the Atlantic Ocean; we
are focusing on different actors: hedge funds managers themselves, financial institutions such as
banks and public institutions, political personalities and journalist that have an influence.
3.2.4.1 The American Point of Views
The November 14th 2008 e24.fr article “Sur la Sellette, les Hedges Fund se Défendent” (On the Hot
Seat, Hedge Funds are Defending Themselves) gives different point of views on the subject of
regulation. On November 13th, 2008 the House of Representatives held auditions of some of the
biggest hedge fund managers of the United States. Among those people were George Soros, founder
of Soros Fund Management, James Simons of Renaissance Capital, Philip Falcone of Harbinger Capital
Partners, John Paulson of John Paulson & Co and Kenneth Griffin of Citadel Investment Group. Those
managers took advantage of that opportunity to underline the role of hedge funds that bring
liquidity to the markets, reminding to everyone that banks were not able to do so at that time (eg:
Lehman Brothers had just gone bankrupt)
During that audition many managers called for more regulation:
• John Paulson called for more regulation, reminding that his firm was one the first
one to register with the SEC in 2004.
• Philip Falcone asked for more transparency since he believes it is in the interest of
nobody that those institutions fall and create “domino effects” (e.g.: systemic risk)
• James Simmons, claimed that investors controlled the leverage much better than the
banks, but still agreed that more regulation or at least more transparency was
needed.
During that audition, Kenneth Griffin was the only one to believe that more regulation is unneeded.
Indeed he believes that hedge funds are regulated via Banks and since banks are regulated hedge
funds also are. He added that even if institutions are regulated it does not guaranty their survival. He
took the example of Fannie Mae and the insurance company AIG that both almost went under.

48

The banks which are the main lenders of assets to hedge funds also have a point of view on the
subject. Lloyd Blankfein the CEO of Goldman Sachs stated that every investments pool that rely on
the good functioning of the financial system and that is big enough to constitute a burden during a
crisis, should in a way be subject to regulation. This scope includes many hedge funds.104

Points of views on regulation of hedge funds are also given on different levels.
As soon as 2005, the Washington Post columnist, Steven Pearlstein, ask for hedge funds to be
“required to send audited, quarterly statements to investors and the SEC” because of the
involvement of college endowment, insurance companies, pension funds and mutual funds in the
industry. He then claims that the reach of hedge fund has gone past the sole wealthy investors. It is
the main reason he gives to encourage more regulation.105

The Treasury Secretary Timothy Geithner (and former President of the Federal Reserve of New York)
claims: “Today, the consequences of (hedge funds') failure is greater. They need to be subject to a
higher set of standards."106 This statement goes in the same direction has the ones presented before.
The fear of systemic risk is the main motivator for the pro regulation actors in the industry.
3.2.4.2 The European Points of View
As we mentioned in the previous parts, the regulatory framework for European countries is not
uniform. Certain countries apply more regulation than others (see appendix 3). The new IAFM
directive had the aim to set better standards within the Union. Yet, it has not been fully accepted by
the industry. We explained the different point of views on the subject in the previous part 3.2.3.2.3.
The continental European Political point of view on hedge fund regulation is best presented by the
position of the French President and the German Chancellor, Nicolas Sarkozy and Angela Merkel.
They took advantage of the G20 summit that took place in London to call in a same voice for
regulation of hedge funds. The reason for asking for regulation is based on the strength of those two
economies in the world. There credo is simple and they are just saying hedge fund should be
“regulated and controlled”107.

104
E24.fr, “Blankfein veut plus de régulation”, 8 April 2009,
http://www.e24.fr/finance/banque/article78810.ece/Blankfein‐veut‐plus‐de‐regulation.html, accessed May
2009.
105
Pearlstein, Steve, “Hedge Funds get Tangled in Bad‐Business Cycle”, The Washington Post 19 October 2005.
106
Gogoi Pallavi and Hagenbaugh, Barbara, "Geithner seeks more hedge fund regulations”, USA Today, 27
March 2009
107
Telegraph.co.uk, "G20 summit: Nicolas Sarkozy and Angela Merkel Tough Market Regulation”,
Telegrap.co.uk 2 April 2009, http://www.telegraph.co.uk/finance/financetopics/g20‐summit/5090442/G20‐
summit‐Nicolas‐Sarkozy‐and‐Angela‐Merkel‐demand‐tough‐market‐regulations.html accessed May 2009
49

Michel Prada the head of the French Financial Authority AMF, suggested as soon as 2006 that
regulation had to focus on the Operators (managers, agents, prime brokers or distributor) instead of
funds themselves because of the fast financial innovation they contribute to.108

3.2.4.3 Conclusion

Consequently the voices of actors are heading in different directions. There seems to be a general
consensus on the need for regulation. But no one can agree on the nature it should take. The main
reasons for calling for regulation would be to reduce systemic risk in the New World and to protect
investors on the Old Continent. The impact on risk and performance are of course big but are not
evaluated since no study have been made.

108
Michel Prada"Discours de Clôture de Michel Prada sur la problématique des hedges funds – Conférence
organisée par Premier Cercle en association avec The Wall Street Journal" 14 December 2006, http://www.amf‐
france.org/documents/general/7603_1.pdf, accessed May 2009.

50

4 Empirics
All the data compared are between January 1st 1996 and March 31st 2009.In order to get those
precious information we contacted a Swiss based investment company manager. He accepted to
help us with our study. He provided us a list of US based funds and non‐US based funds he retrieved
from the ALTVEST Database. The options he placed on his quests are the following:
Option Default
From Date 31/07/1996
To Date 31/03/2009
Frequency Monthly
Currency USD
Auxiliar Currency N/A
Risk Free Rate (Glossary) 0,040315097
Risk Free Index (Glossary) Libor 3 M USD
Data Source OAS DSR
Interest Rate Index (Target Currency) Libor 3 M USD
Other options were available, but were not used. All the funds we chose have more than $500
million assets under management. This is considered as big. This means that the differences above
that point are not significant. The Risk Free Rate is the Libor 3 month in US Dollars, at the time of the
analysis that rate was 4,031%.All the comparison of the ratios presented in this empirical part are
based on this rate. This part will seem as a simple list and be a burden for the reader. We want to
remind everyone that this part is the link between the Theoretical Framework and our Analysis that
leads to the conclusion.
One the main characteristics of hedge funds are there secrecy and opacity. This opacity was an
advantage in the past as statistic showed a perpetual increase in the number of funds in the past
decade. Now in times of crisis, hedge funds new statistics show that the number of hedge funds is
decreasing (see graph 1). This raises the questions of performances of hedge funds especially in time
of crisis. Then the other point we are picking out is the effect of regulation on performance.
Overview of the hedge funds we are going to use in our analysis. The two strategies we chose to
analysis are the L/S equity and the Managed Futures. We chose a fund from the United States of
America and a fund from Europe in each of these strategies. For each fund we are going to present
briefly the manager of the fund and then give a brief overview of the fund itself (strategy, assets
under management, yearly returns, location…). For the ease of the reader we have grouped the
funds in pair, we have coupled the funds per location and strategy. It was important for us to choose
funds that were comparable. They had to be comparable principally in terms of size and strategy.
Additionally, the comparative tool we are going to use in our analysis is MSCI World Equity Index. It is
commercialized by MSCI Barra. It defines it as:
51

“A free float‐adjusted market capitalization weighted index that is designed to measure the equity
market performance of developed markets. As of June 2007 the MSCI World Index consisted of the
following 23 developed market country indices: Australia, Austria, Belgium, Canada, Denmark,
Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand,
Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United
States.”109

4.1 Basic empirical data on chosen Hedge funds

4.1.1 Basic Comparison 1: Brookdale Intl Partners LP/Brummer & Partners Zenit
4.1.1.1 Brookdale International Partners LP
This fund is managed by Weiss Asset Management (WAM). WAM is based in Boston Massachusetts
and it was founded in 1991 by Andrew Weiss110. The date of inception of the Brookdale International
Partner fund was November 1st 1994. The assets under management are as of March 31st 2009 of
$639 million. The subscription period is monthly while the redemption period is Quarterly. The
minimum initial investment in this fund is $5,0 million. The management fees are of 1% plus a 25%
fee on performance based on the high watermark. The annual compound return since 1996 has been
15,89%. The strategy employed by this fund is the Long/Short equity. The major key indicators of that
funds are the following: since the beginning of its existence this fund has had a total return of 548%,
since January 1st 1996 and the average volatility has been of 14,04%. The largest drawdown of the
fund has been of ‐18,7% and its recovery period of 7months. The correlation with the MSCI World
Equity Index is of 0,39. The gain frequency of Brookdale since 1996 is 71,05%. Concerning more
recent financial information the return for 2008 has been of 1,19% and its correlation with MSCI
World Equity Index is of 0,52. The average volatility of 2008 has been 4,22%.
4.1.1.2 Brummer& Partners Zenit
This fund was created by Brummer & Partners a Stockholm (Sweden) based hedge fund manager.
The company was founded in the summer of 1996111 with the launch of this fund Zenit. To be precise
that fund was launched on July 31st 1996. The latest statistics concerning the assets under
management show that they are approximately of $851 million. The redemption period are given on

109
MSCI Barra, “Index Definitions”, MSCI Barra website,
http://www.mscibarra.com/products/indices/equity/definitions.jsp, accessed May 2009
110
Weiss Asset Management, Company Web site
111
52

a quarterly basis while the subscription can be done monthly. The minimum initial investment in this
fund is $500,000. The management fees are of 20% of the performance with no high watermark plus
a 1% fix management fee. The average annual compound return since inception has been of 18,93%.
The strategy employed by Zenit is the Long/Short equity. The major key indicators of that fund are
the following: since its launch the total return inception has been around 800% (799,7%), the annual
volatility since inception (middle of 1996) has been 13,36%. The largest drawdown of Zenit has been ‐
16,57% . The recovery period of that largest drawdown period has been 7 months. The correlation
with the MSCI World Equity Index is of ‐0,065, since its inception. The gain frequency of Zenit has
been since 1996 of 67,7%. Now we are going to tackle the more recent data, the total return for 2008
has been negative 9,5% and its correlation with the MCSI Index has been of 0,09. The average
volatility for the 2008 year as been 8,10%.
Let’s summarize all those information for Brookdale International Partners LP and for Brummer &
Partners Zenit in a comparative Table
Brookdale International Brummer & Partners MSCI World Equity
Partners LP Zenit Index
Country United States Sweden N/A
Inception Year 1994 1996 N/A
Strategy Long/Short Equity Long/Short Equity N/A
Assets Under $639 million $851 million N/A
Management (March
2009)
Minimum Investment $5,0 million $500,000 N/A
Requirements
Management Fees 1% plus 25 performance 1% plus 20% of N/A
HWM Performance
Subscription Period Monthly Monthly N/A
Redemption Period Quarterly Quarterly N/A
Average Annual Return 15,89% 18,93% 0,55%
(since 1996)
Total Return (since 548% 799,9% 7,15%
1996)
Annual Volatility (since 14,04% 13,36% 15,96%
1996)
Correlation with MSCI 0,39 ‐0,065 1,00
Largest Drawdown ‐18,7% ‐16,57% ‐55,37%
Gain Frequency (1996) 71,05% 67,7% 57,24%
2008 Compound Return 1,19% ‐9,5% ‐42,08%
2008 Volatility 4,22% 8,10% 23,63%
2008 MSCI Correlation 0,52 0,09 1

53

To better understand the general tendency of those funds over the last thirteen years we drew
charts based on performance at the end of each month. The results are shown in Graph 2.
Graph 2: Comparison Brookdale/Zenit
July 1996 with MSCI World Eq as of March 2009
(Base 100)
1 200,00
1 000,00
800,00
600,00
400,00
200,00
0,00
01‐janv.‐97
01‐janv.‐98
01‐janv.‐99
01‐janv.‐00
01‐janv.‐01
01‐janv.‐02
01‐janv.‐03
01‐janv.‐04
01‐janv.‐05
01‐janv.‐06
01‐janv.‐07
01‐janv.‐08
01‐janv.‐09
01‐juil.‐96
01‐juil.‐97
01‐juil.‐98
01‐juil.‐99
01‐juil.‐00
01‐juil.‐01
01‐juil.‐02
01‐juil.‐03
01‐juil.‐04
01‐juil.‐05
01‐juil.‐06
01‐juil.‐07
01‐juil.‐08
MSCI WORLD EQ. (USD) MSCI WORLD EQ. (USD)
Brookdale International P (USD >< USD) Brookdale International P (USD >< USD)
Brummer & Partners Zenit (USD) Brummer & Partners Zenit (USD)

Then to put the analysis back in the context of the financial crisis we drew a chart of the evolution
specifically over the year 2008 still in comparison with the MSCI World Equity Index. Those results
are presented in the chart 3.
54

Chart 3: Comparison Brookdale/Zenit
Year 2008 with MSCI World Equity
(base 100)
110,00
100,00
90,00
80,00
70,00
60,00
50,00
40,00
Brookdale Internationale Brummer & Partners Zenit
MSCI World Eq

4.1.2 Basic Comparison 2: Sunrise Cap Expanded Diversified/Transtrend DTP Enhanced
Risk
The two other funds that we are going to analyze are Transtrend DTP Enhanced Risk and Sunrise
Expanded Diversified.
4.1.2.1 Sunrise Capital Expanded Diversified
The fund is managed by Sunrise Capital Partners. That firm is located in Solana Beach California. It is
the oldest hedge fund of our analysis; it was launched in February 1989. As of March 2009 the
estimated assets under management of the firm were $784 million. The subscription and redemption
periods are not disclosed. The minimum initial capital for subscription is $5,0 million. The
management fees are 2% plus 20% on performance with no high watermark. The average annual
compound return since 1996 has been 12,17%. The Strategy employed by Sunrise Capital on this
fund is managed futures. The total return since inception of this fund has been 328%. The annual
volatility since this date has been 14,04%. The largest drawdown has been 19,32% and the recovery
period for that drawdown has been 5 months. The correlation with the MSCI World Equity Index is ‐
0,21. The gain frequency of Sunrise Capital on that hedge fund since 1996 has been 58,5%.
Concerning more recent empirical data we can outline that the total return for 2008 has 29,8% and
the annual volatility for that year has been 17,3%. And the correlation with the MCSI Equity index in
2008 has been ‐0,62
55

4.1.2.2 Transtrend DTP Enhanced Risk
The launcher of this fund is Transtrend B.V (B.V stands for Besloten Vennootschap,: Duthch for
Limited Company); the firm is based in Rotterdam Netherlands. The firm operates mainly in future
and forward contracts. That strategy is based on “in‐depth analysis of price behavior by a team of
academics, notably mathematicians and econometricians, since 1987”112. The Transtrend DTP
Enhanced Risk fund was launched on March 1st 1995. As of March 2009, the assets under
management were $4 468 million. The subscription period is not disclosed but the redemption
period is monthly. The minimum initial capital upon subscription is $10 million. The management
fees are of 3% management fees, and a 25% on performance with a high watermark. The average
annual compound return since 1996 of this fund is 18,11%. The strategy employed is Managed
Futures. The total return since the inception of the fund has been of 724,6%. The annual volatility
since inception date is of 14,38%. The largest drawdown has been of ‐9,4% and it took the fund three
months to recover. The correlation with the MSCI World Equity Index is of ‐0,11. The gain frequency
of this hedge fund has been 65,13%. Concerning more recent data, the compound return for 2008,
are of 29,3%. The volatility for 2008 as been of 9,78%. And the correlation with the MSCI World
Equity Index in 2008 is of ‐0,4
We can now summarize all this empirical data for Sunrise Capital Expanded Diversified and
Transtrend DTP Enhanced Risk in the following chart:
Sunrise Capital Transtrend DTP MSCI World Equity
Expanded Diversified Enhanced Risk Index
Country United States Netherlands N/A
Inception Year 1989 1995 N/A
Strategy Managed Futures Managed Futures N/A
Assets Under $784 million $4 468 million N/A
Management (March
2009)
Minimum Investment $5,0 million $10,0 million N/A
Requirements
Management Fees 2% plus 20% 3% plus 25% N/A
performance performance HWM
Subscription Period N/A N/A N/A
Redemption Period N/A Monthly N/A
Average Annual Return 12,17% 18,11% 0,55%
(since 1996)
Total Return (since 328% 724,6% 7,15%
1996)

112
Transtrend, Company Website, "Systematic Investment Strategies"
http://www.transtrend.com/START.HTM, accessed May 2009.
56

Annual Volatility (since 14,04% 14,38% 15,96%

1996)
Correlation with MSCI ‐0,19 ‐0,11 1,00
Largest Drawdown ‐19,32% ‐9,40% ‐55,37%
Gain Frequency (1996) 58,50% 65,13% 57,24%
2008 Compound Return 29,8% 29,3% ‐42,08%
2008 Volatility 17,30% 9,78% 23,63%
2008 MSCI Correlation ‐0,62 ‐0,49 1

Just like for the precedent comparison, we drew charts of the evolution of the performances over the
last thirteen years in comparison with MSCI world Equity index. The results are in graph 4
Graph 4: Comparison Transtrend/Sunrise
July 1996 with MSCI World Eq as of March 2009
900,00
800,00
700,00
600,00
500,00
400,00
300,00
200,00
100,00
0,00
07/01/96
01/01/97
07/01/97
01/01/98
07/01/98
01/01/99
07/01/99
01/01/00
07/01/00
01/01/01
07/01/01
01/01/02
07/01/02
01/01/03
07/01/03
01/01/04
07/01/04
01/01/05
07/01/05
01/01/06
07/01/06
01/01/07
07/01/07
01/01/08
07/01/08
01/01/09
MSCI WORLD EQ. (USD) Transtrend DTP ‐ Enhanced (USD)
Sunrise Expanded Diversif (USD >< USD)

Just like before we put back in the context of the financial crisis the evolution of the two hedge funds
in 2008
57

Graph 5: Comparison Sunrise/Transtrend Year
2008 with MSCI World Equity
140,00
130,00
120,00
110,00
100,00
90,00
80,00
70,00
60,00
50,00
40,00
Transtrend DTP Enhanced Sunrise Expanded Diversified MSCI Index World EQ.

4.1.3 Advanced empirical Data (Ratios….)
Now that we have set the background on each hedge fund’s strategy we are going to give the more
advanced information for each hedge fund. Those data are going to serve in our analysis and allow us
to compare performance strategy and risk. The presentation of our advanced empirics is going to be
the same as the previous part: compare the two hedge funds that have the same strategy in back to
back. The presentation of those empirical is closely related to our theoretical framework and the part
that explains the role of each of the indicators described.

4.1.3.1 Advanced Comparison 1: Brookdale International Partners LP/Brummer &

Partners Zenit

2008 Advanced Brookdale International Brummer & Partners MSCI World Equity
Empirical Data Partners Zenit Index
Sharpe Ratio ‐0,41 ‐1,54 ‐1,91
Average Alpha 0,50% ‐0,68% 0,00%
Average Beta 0,09% 0,03% 1,0
58

Sortino ‐0,32 ‐1,30 ‐1,32

Omega 1,24 0,34 0,15
Kurtosis ‐0,60 1,09 0,60
Skewness ‐0,55 0,06 ‐0,84
Ljung Box Test Passed Passed

4.1.3.2 Advanced Comparison 2: Sunrise Capital Expanded Diversified/Transtrend DTP

Enhanced Risk
2008 Advanced Sunrise Capital TRanstrend DTP MSCI World Equity
Empirical Data Expanded Diversified Enhanced Risk Index
Sharpe Ratio 2,23 2,68 ‐1,91
Average Alpha 0,41% 1,33% 0,00%
Average Beta ‐0,45% ‐0,21% 1,0
Sortino 2,23 3,48 ‐1,32
Omega 3,50 7,24 0,15
Kurtosis 0,19 ‐0,61 0,60
Skewness 0,73 0,06 ‐0,84
Ljung Box Text Pass Pass
59

5 Analysis
The presentation of our analysis is going to be as follow. For every group of hedge funds we
presented in the empirical part, we are going to link the findings to each points of the theoretical
framework. Consequently, we are going to have a series of comparison points based on figures and
facts. According to those results, we will try to draw some conclusions and suggest some
improvements as far as our knowledge allows us to do.
The analysis of each of our groups is going to be subdivided in four parts:
• Hedge funds administrative specificities
• Managers financial remuneration
• Performance data and Liquidity risk and management tools
• Market risk
In additional we are going to analyze a fifth part in jointly for the two cases since the stakes are
common
• Operational risk
In both cases, we chose hedge funds that use the same strategy and with approximately the same
amount of assets under management to avoid bias due to conflicting information. That legitimizes
the purpose of our comparison, which is to outline the possible differences between the United
States and Europe on hedge funds’ regulation.
5.1 Analysis of group 1: Brookdale and Zenit
To ease the understanding of the analysis, we will call this two funds respectively Brookdale and
Zenit.
5.1.1 Hedge funds administrative specificities
This point will deal with the restrictive access clauses for accredited investors, such as minimum
investment requirements, subscription and redemption periods, lock up periods.
In both funds, the minimum investment requirements are relatively high (Brookdale $5 million and
Zenit: $500,000). This means that there exist entry barriers to these funds. Therefore, the access is
limited to only really high net worth individuals. Those individuals need to be able to afford such a
depravation of cash. Here, it would have been interesting to compare the lock up period, which adds
weights to this depravation of liquidity. Unfortunately, we did not manage to get this data.
Concerning the subscription and redemption period, those funds apply respectively monthly and
quarterly policies.
60

All those administrative points are not regulated by any authority neither in the US nor in Europe.
Each fund fixes them by themselves. It seems that both funds are targeting very wealthy investors
due to the amount of their minimum investments. For Brookdale, that might be because they want
to have a sufficient amount to invest but with a minimum of investors to avoid being under the
Investment advisors act of 1940. Both the US and Europe do not require a minimum initial
investment. However, funds themselves put a minimum threshold, limiting the access to the funds
and protecting the small investors by this process of auto‐regulation.
In spite of this known auto regulation, Europe wants to strengthen that position. Indeed, the AIFM
draft would set a European standard concerning the capital requirements of the managers
themselves. Zenit is already under this regulation since it is from Sweden. Moreover, that draft
indulges on managers’ divulgation requirements.
Consequently, even if the regulation will set high standards to protect investors, this might not have
the expected results since small investors have an indirect access to hedge funds in both regions
through the investments made by their pension funds for instance.

5.1.2 Managers financial remuneration
In this case, the two funds employ two slightly different approaches. The American uses a 25%
performance fee above the high watermark while the European takes 20% of the performances
regardless of the past performances.
This point is highly discussed, on one hand the high watermark can create a moral hazard the
investor will believe in the confidence of the managers and consequently invest blindly in the fund.
The offside to this is that the manager in order to earn his fee will take high risks. In addition the
manager will have to create every year positive returns, thus the risk taken will increase yearly. A
single failure could be a disaster and result in high losses and even the collapse of the fund.
On the other hand, the managers not using the high watermark usually take almost similar
management fees based on performance. Indeed those managers are covered in case of a bad
performance one year if they manage a good one the following year. They are insured of getting
there fee even if the absolute has not increase over the two years.
In other industries, the trend is to limit the remuneration of the upper management. It would not be
shocking to apply that regulation to hedge funds’ managers. Especially because regulation on that
specific point would not reduce their advantage: their opacity. If regulation is applied, we think that
the high watermark would fit better the interest of investors. Indeed usually managers with high
watermark rather have lower positive returns each year instead of high volatile unguaranteed annual
61

returns, which would prevent them from being remunerated. Of course that measure could apply as
well in the United States and in Europe.
5.1.3 Performance data and liquidity and management tools
In this part we are focusing principally on performances. We are going to analyze the returns, the
gain frequencies and the volatilities. They are as seen in the theoretical framework the basic
assessments for performances and risks. The return for Brookdale is for 2008 positive at 1,19% as
opposed to Zenit’s which is negative at ‐9,5%. Those performances can be considered as good
compared to the MSCI Index World Equity, for which the 2008 compound return was ‐42,08%. We
can outline in this situation the main advertising credo of hedge funds: their capacity to outperform
the market whatever the tendency (bull or bear). Even if those performances are low, they
remarkable given the extreme crisis the world is facing.
The results of Brookdale compared to Zenit are even more impressive given the two time lower
volatility (4,22% versus 8,10%). Those empirical data are illustrated on the Chart 3 in the empiric’s
part of this thesis. By analyzing the monthly returns of 2008, we can extrapolate the gain frequency
over the period see appendix 4. Once again Brookdale outperforms its European competitor with a
58% rates (seven positive months out of twelve against 25% for Zenit).
Brookdale largest drawdown was ‐2,25% and the best return 1,51%. Zenit largest return was 4,03%
and the largest was ‐4,76%. After this comparison the American fund has (according to this basic
data) stable results over time. The question we can ask at this point is: is the American manager
more skilled than the European one? We will give the answer to this question while studying the
alphas and the betas of each fund.
The betas of the two funds are almost similar (the difference between the two is too small to be
significant 0,06%) and very close to zero. This means that the returns can be considered as being only
related to the alphas. We notice that a significant difference separates the alphas of the two hedge
funds. The American is positive 0,50% the European is negative 0,68%. The negative alpha of Zenit
reveals bad investment choices on its behalf. The alphas being almost equal in terms of absolute
value, the performance of Brookdale is as good as the performance of Zenit is bad.
The results obtained by Brookdale imply a good usage of the tools such as short selling, leverage and
portfolio turnover. A priori Zenit did not use them as well. Unfortunately we cannot get access to the
precise data illustrating those three management techniques. The conclusions are consequently hard
to draw. It would be reductive and simplistic to say that Europe is putting in place a stronger
regulation on those techniques in order to reduce the bad usage of those tools by European
managers.
62

Here we are facing a limit of our analysis, by analyzing two funds it would be unwise to draw trends.
However, we are not able due to the lack of transparency. That’s why the two projects of law
(described in the theoretical framework) in Europe and in the United States go in the direction of
more transparency to control and supervise in the interest of investors and the entire financial
sphere. More regulation will definitely protect funds from liquidity defaults. This regulation can be
applied either by limiting the leverage rate or by imposing liquid assets (such as states bonds) within
portfolios for instance. If our reductive vision of American managers being better than Europeans
happens to be true, we understand why Americans desire to remain opaque. Their skill is their
competitive advantage in the industry.
5.1.4 Market risk
The three market risk adjusted ratios Sharpe, Sortino and Omega confirm the results obtained earlier
in our analysis. Brookdale’s ratios being all significantly higher than Zenits, those ratios are even
more significant in the confirmation of the hypothesis given earlier because they take into
consideration the asymmetric distribution of the returns. However, we are realizing that the
Brookdale hedge fund still appears better, but since Sharpe and Sortino are negative for the two
funds that shows that the risks taken are too high in comparison to the returns obtained.
That brings us to the regulations concern. Would tougher regulation allow those funds to have
positive Sharpe and Sortino ratios? In this case, our knowledge does not allow us to see how specific
regulatory measures on hedge funds or its managers could increase those ratios via a diminution of
the exposure of the market risk. The regulation of the market itself remains the only way to
positively impact on those ratios, if we except cheating.
5.2 Analysis of group 2: Sunrise Expanded and Transtrend DTP
To ease the understanding of the analysis, we will call this two funds respectively Sunrise and
Transtrend.
5.2.1 Hedge Funds Administrative Specificities
This point will deal with the restrictive access clauses for accredited investors, such as minimum
investment requirements, subscription and redemption periods and lock up periods.
In both funds, the minimum investment requirements are relatively high (Sunrise: $5 million and
Transtrend: $10 million). This means that there exist entry barriers to these funds. Therefore, the
access is limited to only really high net worth individuals. Those individuals need to be able to afford
such a deprivation of cash. Here the comparison of the lock up periods would be interesting;
unfortunately we were not able to put our hands on that data. Lock up periods add a weight to the
deprivation of the investors.
63

All those administrative points are not regulated by any authority in the United States or in the
European Union. Each fund has the liberty to choose those points. Just by the minimum investment
capital requirements those two funds are limiting their access to really wealthy investors. The
conclusions drawn in this case are the same as in the case one. The strategy employed does not have
consequences concerning administrative regulation and we do not desire to repeat ourselves.
5.2.2 Managers financial remuneration
In this case the analysis is exactly the same as in the case 1. The only difference is that the European
uses a high water mark as the American does not. The conclusion is therefore the same and our
suggestion still applies for Europe and the United States.
5.2.3 Performance data and liquidity and management tools
In this part we are focusing principally on performances. We are going to analyze the returns, the
gain frequencies and the volatilities. They are as seen in the theoretical framework the basic
assessments for performances and risks. The annual compound returns are similar for Sunrise and
Transtrend at approximately 29% in 2008. Those performances can be considered as very good
compared to the MSCI Index World Equity, for which the 2008 compound return was ‐42,08%. It is
easily understandable since they have significant negative correlations. This means that their
performances are inversely proportional to the markets’ evolutions.
The two funds both have similar interesting returns; however, Sunrise capital earned it by exposing
itself to risks more than Transtrend. The respective volatility are 17,30% versus 9,78%.
There returns are impressive this year compared to the funds in the previous case study the returns
are a lot higher and that is mainly explained by the strategy employed. Indeed, Managed Futures can
allow better results in crisis periods. That because of the nature of their investment vehicles: futures
forewards.
In this second we are also going to compare the alphas and betas of these two funds. The analysis of
those percentages provides the same empirics as in the first case but this time the European fund
shows more skills than the American.
The betas are negative. Sunrise with a ‐0,45% beta in a bear market benefits from more profits than
Transtrend. Indeed, a negative beta shows that the funds reacts in an inversely proportionally
manner to the market. The market being especially negative, the negative beta provides positive
returns. We have to understand that this fact is linked to the managed future strategy.
Yet, concerning the Alphas, Transtrend shows better managerial skills with a 1,33% alpha. As
opposed to the 0,41% alpha of Sunrise.
The simplistic hypothesis formulated during the study of group one is being disproved in this
example. The European manager shows better skills than the American. Some trends on the quality
64

of each country seem unrealistic, however maybe some countries are better in one strategy then
others. This hypothesis remains highly reductive like the first one because of the qualitative nature of
this study (instead of a quantitative one).
The managed future technique seems well used by both sides, yet, the bear market is favorable for
this strategy. Again it is difficult to take side for or against regulation of short selling, leverage or
portfolio composition, since we do not have examples of every market trends and of many hedge
funds strategy.
5.2.4 Market Risk
All the market adjusted ratios in this second case study are radically positive. This means that the risk
expositions of those funds are very acceptable compared with the obtained returns. The ratios in this
situation are very suitable for investors. The ratios of the European fund still follow the trends we
had previously exposed earlier. This means that Transtrend show more qualities in its ability to
generate risk adjusted performances.
In those kinds of situations the question of regulation is hardly thinkable since every ratio is positive
and the returns are high. Furthermore we can come back to the statement we gave earlier no
regulatory measures on hedge funds or its managers could have an influence on these ratios. When
every indicator is green, the need for regulation is not elevated. Once again our qualitative analysis in
itself is a limit to our ability to come up with suggestions linked with the result of our empirical data.
5.3 Operational risk
In the two cases, the fund passed the Ljund Box test; this demonstrates the total randomness of the
returns. Our knowledge is not sufficient to extrapolate real measures. Yet, the interesting feature of
this test is its faculty to recognize the phenomenon of smoothing returns. Indeed, we were saying
that it was hard to influence on the Risk adjusted ratios such as the Sharpe Ratio by regulatory
measures. It is common knowledge in the hedge fund industry that those ratios can be modified
artificially by “smoothing” the returns. The smoothing returns will reduce volatility used at the
denominator of the Sharpe Ratio, subsequently increasing that ratio and lying to the investors. In
both geographical areas fraud is always independently regulated by federal laws not linked
specifically with hedge funds. Fraud is always hard to discover in the hedge fund industry due to the
lack of transparency

65

6 Conclusion

The hedge fund industry is complex, secretive and opaque. When we started our thesis, we had very
high hopes we would be able to explain thoroughly this fascinating industry. Unfortunately, we
rapidly faced the reality of the world. This was without counting on our perseverance in achieving the
goals we had set for ourselves. We led many battles against the hazards of writing and researching.
At the beginning of our study, we had outlined many problems of this industry. Those problems
mainly concerned regulatory issues. Especially in these times of crisis, many financial experts claimed
as we have already mentioned that hedge funds are the underlying factor that led to the subprime
crisis. Saying that they are the sole responsible would be a mistake. However, they did have a role in
it. Their extensive use of leverage creates systemic risks that can lead to unstable markets. A stricter
regulatory control of that leverage issue could diminish those kinds of risks. That regulatory issue
could take several forms, such as stricter reporting and analyze of those reports by competent
financial authorities. That idea is interesting and the European Union is already taking steps toward
that direction with the brand new IAFM directive. That directive has been fierce fully accused of
creating disadvantages for the European Hedge Fund industry. We wanted to see for ourselves what
the actual state was of play of the industry. The most important part was that needed a comparative
counterpart to legitimize our study, we obviously chose the United State of America’s Hedge Fund
Industry.
We rapidly faced the limits of our case study analysis. Indeed, we went for a qualitative study, thus
focusing on solely two comparisons. The first comparison showed a tendency of superior
performance on the Western side of the Atlantic Ocean while its European competitor was left
behind and showed signs of struggle since the beginning of the financial crisis. As we did the second
comparison, the opposite trend emerged.
We were not able to extrapolate a general trend of those situations, given the qualitative study. A
quantitative study would have been more appropriate in our case to really extrapolate trends within
the industry. The risk‐adjusted performances analysis also showed conflicting results.
On some points hedge fund applied the same policies such as for the entry barriers they raised, in
order to prevent small investors to put at stake their entire savings. Hedge Funds did not forget that
they are highly risky investments and only well aware investors are to invest in them. That is a
process of auto‐regulation that all the hedge funds of our study apply. Yet, the new IAFM directive in
Europe would strengthen and make uniform the capital requirements for hedge fund managers that
want to set up new funds. That would decrease the risk taking from managers as they put their own
money at stake.
66

The other part we believed could be improved was the spreading of the high watermark for the
performance based remuneration of managers. We estimate that reduce risk taking from managers
that would rather benefit from small profits rather than none at all.
The risk taken by certain hedge funds subjected that they had high risk of illiquidity. The surprise was
that those risks were taken on both side of the Atlantic Ocean. But as we say before we cannot
pretend to suggest regulatory measures based on such a simplistic analysis.
The major risk for hedge funds is the risk of liquidity; it is that one that creates the systemic risk. In
bull markets, that risk is less likely to be a threat. It is in bear markets such as the one we are facing
actually that the liquidity risk is the higher. Already certain countries in Europe apply rules of risk
spreading. Those rules could be spread across the entire international regulatory framework.
The conclusion is that more regulation would indeed reduce risk; however too much regulation
would kill the sole purpose of hedge funds: outperform the market no matter the tendencies. As well
many studies have showed and outlined the role of those investments in the regulation of markets
liquidity.
To conclude on this subject about hedge funds regulation, we want to talk about the regulation of
fraud. We did not tackle this subject specifically because anti fraud measures are greater that the
sole regulation of hedge funds themselves. Antifrauds are made on higher levels, however, a secret
weapon: the Ljung Box test that initially shows the correlation of the returns. But this test also has
the faculty to detect fraudulent activities. This tool could be use on greater scales; however the main
characteristic of hedge fund prevents it from happening: the lack of transparency. The fight for more
transparency is the main issue for the coming years especially after the Madoff and Kerviel Scams.
Therefore, as Shakespeare said to regulate or not to regulate, that is the question…

67

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8 Appendix
Appendix 1: Long Term Capital Management
The Long Term Capital Management was a hedge fund founded in 1994 by John Meriwether. Mister
Meriwether was a former bond trader at Salomon Brothers. When it was founded the total equity
was of $1,3 billion, among which $100 million was brought by the partners (Edwards 1999) in spite of
a 3 year lock up. The fees included a 2% management fee and a 25% fee on profits. And the minimum
entry investment was of $10 million and the lock up period of 3 years. Among the partners there
were two future Nobel Prizes laureates, Myron Scholes and Robert C. Merton and the vice chairman
of the Federal Reserve David W. Mullins.
The primary strategy of LTCM was what hedge fund professional call “market‐neutral arbitrage”. The
hedge fund had long positions in bonds that it thought were underestimated and short positions in
bonds it thought were overestimated. Basically LTCM purchased high yielding illiquid bond, the good
example are the “Danish mortgage‐backed securities, bonds issued by emerging market countries,
and “junk” corporate bonds” (Edwards 1999). And opposing LTCM then traded low‐yielding liquid
bonds (U.S. federal bonds). The problem was the difference between over price securities and the
under priced were very small, that is the reason why the hedge fund took highly leveraged positions
to increase profits.
Consequently at the start of the year 1998, the fund’s assets were of $5 billion, but had over $125
billion in borrowed equity, this is the equivalent to a leverage factor of thirty to one (Sungard). This
strategy was applied by using complex mathematical algorithm, meaning a systematic/quantitative
method.
The first years of trading of LTCM were successful and the annual returns were impressive. By 1997
the fund had $7,5 billion of assets under management. Yet LTCM in December of that year gave back
up to $ 2,7 billion to its investors. Mr. Meriwether claimed the investment opportunities had
shrunken establishing the assets under management at $ 4,8 billion. The problems started in June
1998 with losses on the arbitrage portfolio of MBS, and continued with the default on the Russian
government bonds. It caused a liquidity crisis and a violent widening of all the spreads from risky
issuers. Indeed, the worst the grade of the issuer is, the higher the expected spread must be. 42% of
the fund was lost because of these reasons. During this period, LTCM managers refused to reduce
their positions, increasing their leverage up to 55. In September 1998, the funds losses reached 92%
of the fund’s value of January 1998. At this time, the commitments were too high, it was clearly
impossible to liquidate the positions, and a risk for the whole financial system even existed. Due to
those circumstances, the US Fed had to organize LTCM bailout by collecting 3,6 billion dollars from
72

14 American investment banks to avoid its bankruptcy. Eventually, 1999 bull market allowed the
funds to earn its losses back and to organize softly its liquidation.
Edwards, Franklin R. “Hedge Funds and the Collapse of Long‐Term Capital Management"
The Journal of Economic Perspectives, Vol. 13, No. 2 (Spring, 1999), pp. 189‐210 Published by:
American Economic Association, Stable URL: http://www.jstor.org/stable/2647125

Sungard Ambit ERisk, “Case Study, LTCM Long Term Capital Management”
http://www.erisk.com/Learning/CaseStudies/Long‐TermCapitalManagemen.asp accessed May 2009.
73

Apendix 2: Channels for distribution of hedge funds by country at May 2005, source: PriceWaterCooperHouse

74

75

Appendix 3: The availability of hedge funds and funds‐of‐hedge funds to investors by country at
May 2005, source: PriceWaterCooperHouse

76

Appendix 4: Brookdale and Zenit monthly returns 2008, Source: Alvest via Mr. X.
Brookdale Zenit MCSI Index
31‐janv‐
08 1,34% ‐2,22% ‐7,71%
29‐févr‐08 0,80% 4,03% ‐0,74%
31‐mars‐
08 ‐1,13% ‐1,67% ‐1,25%
30‐avr‐08 0,06% ‐0,32% 4,98%
31‐mai‐08 1,51% 0,34% 1,11%
30‐juin‐08 1,10% ‐0,32% ‐8,10%
31‐juil‐08 ‐0,18% 0,69% ‐2,53%
31‐août‐
08 0,29% ‐1,03% ‐1,60%
30‐sept‐
08 ‐2,25% ‐4,42% ‐12,08%
31‐oct‐08 ‐1,25% 0,00% ‐19,05%
30‐nov‐08 ‐0,51% 0,00% ‐6,72%
31‐déc‐08 1,49% ‐4,76% 3,06%

77

Appendix 5: Glossary, if not mentioned the definition are provided by investopedia.com
Absolute return: The return that an asset achieves over a certain period of time. This measure looks at
the appreciation or depreciation (expressed as a percentage) that an asset ‐ usually a stock or a mutual
fund ‐ achieves over a given period of time. Absolute return differs from relative return because it is
concerned with the return of a particular asset and does not compare it to any other measure or
benchmark.
AIMA, the Alternative Investment Management Association: the hedge fund industry's global, not‐for‐
profit trade association with over 1,100 corporate members worldwide.
Alpha: 1. A measure of performance on a risk‐adjusted basis. Alpha takes the volatility (price risk) of a
mutual fund and compares its risk‐adjusted performance to a benchmark index. The excess return of
the fund relative to the return of the benchmark index is a fund's alpha. 2. The abnormal rate of return
on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital
asset pricing model (CAPM).
Arbitrage: The simultaneous purchase and sale of an asset in order to profit from a difference in the
price. It is a trade that profits by exploiting price differences of identical or similar financial instruments,
on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it
provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of
time.
Bear Market: A market condition in which the prices of securities are falling, and widespread pessimism
causes the negative sentiment to be self‐sustaining. As investors anticipate losses in a bear market and
selling continues, pessimism only grows. Although figures can vary, for many, a downturn of 20% or
more in multiple broad market indexes, such as the Dow Jones Industrial Average (DJIA) or Standard &
Poor's 500 Index (S&P 500), over at least a two‐month period, is considered an entry into a bear
market.
Bull Market: A financial market of a group of securities in which prices are rising or are expected to rise.
The term "bull market" is most often used to refer to the stock market, but can be applied to anything
that is traded, such as bonds, currencies and commodities.
Drawdown: The peak‐to‐trough decline during a specific record period of an investment, fund or
commodity. A drawdown is usually quoted as the percentage between the peak and the trough.
Fixed‐Income Arbitrage: An investment strategy that attempts to profit from arbitrage opportunities in
interest rate securities. When using a fixed‐income arbitrage strategy, the investor assumes opposing
positions in the market to take advantage of small price discrepancies while limiting interest rate risk.
Global Macro Strategy: A hedge fund strategy that bases its holdings‐‐such as long and short positions
in various equity, fixed income, currency, and futures markets‐‐primarily on overall economic and
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political views of various countries (macroeconomic principles).
High‐Water Mark: The highest peak in value that an investment fund/account has reached. This term is
often used in the context of fund manager compensation, which is performance based.
Leverage: The use of various financial instruments or borrowed capital, such as margin, to increase the
potential return of an investment.
Lock Up Period: Window of time in which investors of a hedge fund or other closely‐held investment
vehicle are not allowed to redeem or sell shares. The lock‐up period helps portfolio managers avoid
liquidity problems while capital is put to work in sometimes illiquid investments.
Long Position: 1.The buying of a security such as a stock, commodity or currency, with the expectation
that the asset will rise in value.2. In the context of options, the buying of an options contract.
Long Term Capital Management LTCM: A large hedge fund led by Nobel Prize‐winning economists and
renowned Wall Street traders that nearly collapsed the global financial system in 1998 as a result of
high‐risk arbitrage trading strategies.
Market risk is the risk that the value of an investment will decrease due to moves in market factors
Maturity: 1. The length of time until the principal amount of a bond must be repaid. 2. The end of the
life of a security.
Moral Hazard: The risk that a party to a transaction has not entered into the contract in good faith, has
provided misleading information about its assets, liabilities or credit capacity, or has an incentive to
take unusual risks in a desperate attempt to earn a profit before the contract settles.
Mutual Fund: An investment vehicle that is made up of a pool of funds collected from many investors
for the purpose of investing in securities such as stocks, bonds, money market instruments and similar
assets. Mutual funds are operated by money managers, who invest the fund's capital and attempt to
produce capital gains and income for the fund's investors. A mutual fund's portfolio is structured and
maintained to match the investment objectives stated in its prospectus.
Net Asset Value (From Vernimmen.com): This is a solvency‐oriented concept that attempts to compute
the funds invested by shareholders by valuing (see also valuation) the company’s various assets after
deduction of liabilities. Net asset value is an accounting and in some instances tax‐related term, rather
than a financial one. Synonymous with book value of shareholders’ equity.
Offshore: Located or based outside of one's national boundaries.
Return on Investment (From Vernimmen.com): Return on investment is the expected increase in the
cash flows generated by the operating cycle as a result of investment outlays. Return on investment is
the compensation for forsaking instant consumption. Return on investment can simply be called return.
Risk Free Index, Libor 3 months USD: The LIBOR is the world's most widely used benchmark for short‐
term interest rates. It's important because it is the rate at which the world's most preferred borrowers
79

are able to borrow money. It is also the rate upon which rates for less preferred borrowers are based.
For example, a multinational corporation with a very good credit rating may be able to borrow money
for one year at LIBOR plus four or five points. Countries that rely on the LIBOR for a reference rate
include the United States, Canada, Switzerland and the U.K.
Risk Free Rate of Return: The theoretical rate of return of an investment with zero risk. The risk‐free
rate represents the interest an investor would expect from an absolutely risk‐free investment over a
specified period of time.
Securitization: The process through which an issuer creates a financial instrument by combining other
financial assets and then marketing different tiers of the repackaged instruments to investors. The
process can encompass any type of financial asset and promotes liquidity in the marketplace.
Security and Exchange Commission: A government commission created by Congress to regulate the
securities markets and protect investors. In addition to regulation and protection, it also monitors the
corporate takeovers in the U.S. The SEC is composed of five commissioners appointed by the U.S.
President and approved by the Senate. The statutes administered by the SEC are designed to promote
full public disclosure and to protect the investing public against fraudulent and manipulative practices
in the securities markets. Generally, most issues of securities offered in interstate commerce, through
the mail or on the internet must be registered with the SEC.
Systemic Risk: Risk that affects an entire financial market or system, and not just specific participants. It
is not possible to avoid systemic risk through diversification.
Tax Haven: A country that offers individuals and businesses little or no tax liability.
Track Record (Accounting Records): All of the documentation and books involved in the preparation of
financial statements or records relevant to audits and financial reviews. Accounting records include
records of assets and liabilities, monetary transactions, ledgers, journals, and any supporting
documents such as checks and invoices.
Turner Review: is a Report produced by the British FSA as a “Regulatory Response to the Global
Banking Crisis”

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Bachelor Thesis

Source: Ressources Naturelles Canada, www.nrcan-rncan.gc.ca

This directive represents the key requirements; nothing prevents countries to put in action stricter

Annual Volatility (since 14,04% 14,38% 15,96%

Transtrend DTP Enhanced Sunrise Expanded Diversified MSCI Index World EQ.

4.1.3.1 Advanced Comparison 1: Brookdale International Partners LP/Brummer &

Sortino ‐0,32 ‐1,30 ‐1,32

4.1.3.2 Advanced Comparison 2: Sunrise Capital Expanded Diversified/Transtrend DTP

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