issuing reports, or furnishing analyses on securities. 1
As you can see by these general criteria, the requirements are quite broad. This means that whether an organization is a long‐only mutual fund or a long‐short hedge fund manager, from a regulatory perspective, they are both Investment Advisers.
If an organization does not meet each criterion and isn't exempt for some other reason, then the manager is generally not classified as an Investment Adviser. Why does this classification matter? If a fund manager is not an Investment Adviser, then it would generally not have to register with the U.S. Securities and Exchange Commission (SEC). More specifically, the compliance programs of a registered hedge fund may be distinctively different from an unregistered fund.
Understanding Market Classifications
A market classification is the way a fund chooses to portray itself in the market. Alternatively, it can be the way a fund is classified, typically by investors, based on its actual trading activities. Obviously, it is not in a hedge fund manager's interest to misclassify their activities, but sometimes these two classifications are the same, and in some cases, there may be differences in classification methods, depending on the classification requirements in place.
Market classifications can be contrasted from regulation classification in two primary ways. First, under market classifications, there are no bright‐line criteria determining what constitutes one classification type (i.e., a global macro hedge fund) from another (i.e., an event‐driven hedge fund). For reference, a global macro hedge fund is a fund that follows a strategy of investing in macroeconomic themes, typically utilizing a wide variety of financial instruments on a global basis. An event‐driven hedge fund follows a strategy of investing around the occurrence of certain events, such as corporate mergers or litigation.
Second, there are not necessarily any specific requirements, legal or otherwise, imposed on a manager for labeling themselves, or being labeled, under a market classification. This is in stark contrast to regulatory classification, which can have a material impact on the activities of a fund manager.
Example of Market and Regulatory Classification Differences. To make the distinction between regulatory and market classifications more concrete, let us consider an example. Consider a U.S.‐based fund manager that chooses to promote itself to potential investors as a hedge fund. This would be the market classification from the hedge fund's perspective. A potential investor may take a look at the fund manager's actual, or planned, investment activities and instead classify the fund under a more detailed classification of a global macro hedge fund. This would be an example of how the market classifications can differ, or at least be more specific, between the fund itself and the investor.
As noted earlier, there is no specific regulatory classification for hedge funds, so the fund cannot have the same market and regulatory classification in this case. What would the regulatory classification be? If we focus on just U.S. regulatory classifications, and not any other jurisdictions, and it is a U.S.‐based hedge fund that meets the SEC requirements outlined earlier, then its regulatory classification would be that of an Investment Adviser. As this example demonstrates, a hedge fund, therefore, can be correctly referred to as being in different market or regulatory categories, depending on the specific classification system in place.
When discussing hedge fund compliance, the regulatory classification is typically the driving force over market classifications, as regulatory classifications facilitate the heart of the compliance guidelines that a hedge fund must adhere to. However, it is important to understand the concept of market classification so that the appropriate distinctions can be made between the two classification systems.
Example of multiple regulatory classifications. In the previous example, we alluded to the fact that a hedge fund may have multiple regulatory classifications. One reason for this multiple regulatory classification system is because a hedge fund may be subject to multiple regulatory agencies. To be clear, these classifications may come within the same country or across multiple countries.
In some cases, this oversight is driven by a hedge fund's trading activities. For example, certain hedge funds may engage in the trading of a type of security known as commodity futures. A commodity future is a security that allows a hedge fund to speculate on the future price of commodities, such as lean hogs, coffee, cocoa, and copper. In the United States, if a hedge fund were to engage in futures transactions, they would be regulated by the joint efforts of two different regulators known as the National Futures Association (NFA) and Commodity Futures Trading Commission (CFTC). The NFA is a type of agency known as a self‐regulatory organization (SRO), whereas the CFTC is a federal regulatory agency. SROs will be covered in more detail in Chapter 2.
As part of this oversight by the CFTC and the NFA, a hedge fund may have to register under special regulatory classifications similar to the SEC's Investment Adviser category. Common classifications under the CFTC and NFA regimes are for a fund manager to register as a Commodity Trading Advisor (CTA), a Commodity Pool Operator (CPO), or perhaps as both.
With an understanding of why hedge funds present unique compliance challenges, we can begin to introduce more specifics related to the way compliance is approached in hedge funds. To do this, we will first analyze the makeup of a hedge fund's compliance framework. This will be followed by an introduction of the hedge fund compliance function. Last, the key parties in a hedge fund's compliance framework will be discussed.
A hedge fund's compliance framework is not just the compliance function within the hedge fund itself. This is a common point of confusion among investors in particular. While certainly, the heavy lifting is performed by the compliance function, there are also other elements within the hedge fund that perform compliance‐related functions. Furthermore, outside of the hedge fund, there are a number of service providers and counterparties that also perform compliance‐related functions. This relationship is summarized in Exhibit 1.1.
Exhibit 1.1 Components of a Common Hedge Fund Compliance Framework
Therefore, to fully understand the entire hedge fund compliance playing field, we must look beyond the compliance function within the hedge fund to analyze all of the key compliance stakeholders, both inside and outside the fund.
The hedge fund compliance function, or compliance department, refers to a group within the hedge fund whose responsibility is to develop, implement, maintain, and test compliance policies and procedures. The compliance function often sits alongside other operational groups, such as fund accounting or technology.
One structure for a hedge fund compliance department is a dedicated compliance function. Under this structure, the compliance function only focuses on compliance‐related tasks. This is in contrast to a shared compliance function structure, in which the compliance function may be combined with other departments within the hedge funds. A common structure for a hedge fund with a dedicated compliance function is outlined in Exhibit 1.2.
Exhibit 1.2 Example Organizational Structure of a Hedge Fund with a Dedicated Compliance Function
In a perfect world, every hedge
U.S. Securities and Exchange Commission.
