The alternative investment fund managers' directive : an evaluation of its impact on the hedge fund industry's practices

Abstract

The financial markets are nowadays facing increasing regulatory requirements through the enactment of new Directives and Legislation with the aim of protecting investors as well as market integrity particularly since the recent credit crisis. At the same time, reports show that whilst the level of investor inflows and assets under management within the hedge fund industry have increased, the number of players in this industry has not. Motivated by such shifts in the industry, this dissertation seeks to determine the impact of regulations on hedge funds. This is done by using the Alternative Investment Fund Managers’ Directive (“AIFMD”) as the first piece of EU Legislation which regulates the European hedge fund industry. In this respect, it examines how the implementation of this Directive has impacted hedge fund practices in terms of return misreporting. It also seeks to analyse the level of exposure by hedge funds to key risks identified by the AIFMD as well as the extent of risk-adjusted performance achieved after the implementation of the Directive.

Accordingly, in order to achieve the above, this dissertation empirically analyses the monthly returns of 233 hedge funds, which have been impacted by the transposition of the AIFMD across varying degrees, over the period covering from January 2010 to August 2016. Return misreporting has been assessed through a number of tests which were undertaken on the reported returns. On the other hand, a regression analysis through the adoption of an extended Fung and Hsieh’s (2004) seven-factor model, was used to examine the risk-adjusted performance and the risk factor loadings.

Findings suggest that regulation does impact hedge fund practices and performance. In this respect, it is shown that after the implementation of the AIFMD, return misreporting by hedge funds impacted by the AIFMD decreased. This in turn signifies that increased regulatory oversight can lead to a reduction in opportunistic behaviour by hedge fund managers. Likewise, requirements to have an independent risk management function and adequate risk management techniques appear to have provided a more balanced risk exposure towards common risk factor loadings (such as market risk and credit risk), post implementation of the Directive. It has also been found that investors appreciate the value of hedge fund oversight such that they are willing to forego alpha in order to be invested in regulated fund structures.

This research has therefore shown that whilst there is undoubtedly a cost towards regulation in fund performance, one ultimately needs to also account for the investors’ risk appetite and the investors’ trade-off between investing in a regulated structure and return.