Last Sunday (1), under the heading “In Caymans, It’s Simple to Fill a Hedge Fund Board”, an article appeared online at dealbook.nytimes.com saying how over the last decade in the Cayman Islands hedge funds have grown “from a cottage industry into a big business on the Cayman Islands.”

To the investor ignorant like me, I have never understood what a ‘hedge fund is’ so first I had to have a better understanding. The best definition I found on the website www. investopedia.com. This is what it says:

A hedge fund is “an aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year.

They further explain: “For the most part, hedge funds (unlike mutual funds) are unregulated because they cater to sophisticated investors. In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.

“It is important to note that hedging is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market (mutual funds generally can’t enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn’t accurate to say that hedge funds just “hedge risk”. In fact, because hedge fund managers make speculative investments, these funds can carry more risk than the overall market.”

Back to the NY Times article that was written by Azam Ahmed, it says, “Many funds run by United States money managers have their legal residence [in the Cayman Islands] for tax reasons. And because of a quirk in the island’s tax code, these funds must appoint a board. As a result, dozens of operations have sprouted up on the Caymans to supply directors, from one-man bucket shops to powerhouse law firms. Directors are often Cayman-based professionals: accountants, lawyers and administrators of hedge funds.”

The article says a typical director, who offers guidance and oversight to the funds” is paid between $5,000 – $30,000 a year. There are 9,000 domiciled on Grand Cayman.

However, major investors are questioning the value of offshore directors, “especially in light of recent hedge fund frauds, liquidations and missteps.”

“You might as well save your $5,000 and buy a rubber stamp,” Luke Dixon, a senior investment manager at the British pension fund USS, which oversees more than £32 billion ($50 billion) is quoted as saying.

The article mentions Don Seymour, of DMS, a onetime hedge fund auditor at PricewaterhouseCoopers, who refused to disclose how many boards he sits on. The article says ‘roughly’ 180 “according to the Foundation for Fund Governance.”

Quoting Mr. Seymour, (he) “likens his work as a hedge fund director to that of a top doctor, who can see hundreds of patients a year. Just as every patient is not equally sick, every directorship is not equal. I’m the guy that actually created the regulatory framework for hedge funds here.”

Paul Harris of IMS says, “focusing on numbers won’t tell investors whether a director can fulfill his responsibilities. Sometimes two boards are too much.” Mr. Harris does not require his directors to disclose how many boards they serve on.

With hedge funds, directors sit on the boards of dozens of distinct hedge fund managers. And directors face far fewer requirements than mutual fund directors.

The Cayman law firm Ogier, according to the article, offers hedge funds director services. “That has raised questions about the dual role they can play, representing the hedge fund as counsel, and the investors of the same fund as directors.

The law firm Walkers sold its directorship business, “citing in part those potential conflicts of interest.”

The article finishes with a quote from Ingrid Pierce, a partner in Walkers: “There is a trend toward complete independence. I think we’ll see more of that.”

Even though US President Obama raised far more cash from hedge funds than any other candidate in the 2008 election cycle, he on more than one occasion called for Congress to close the tax loophole that allows carried interest to be taxed at a lower rate than ordinary income.

 

Hedge funds and private equity managers are compensated largely by carried interest and have benefited from the preferential tax treatment.

 

Many hedge fund billionaires, like Tom Steyer, is backing Obama’s re-election bid. Steyer threw in a $5 million donation—the single largest sum donated— to fight Proposition 23, a 2010 California ballot that would have quashed a law to REDUCE GREENHOUSE GAS EMISSIONS! According to an article in Forbes, “he drove around the state campaigning and worked the phones to get donations from the likes of Bill Gates ($700,000) and billionaire hedge fund manager Julian Robertson ($500,000). His efforts paid off: The proposition was soundly defeated.”

I wouldn’t hedge any bets that hedge funds are here to stay. People will always want to take advantage of market movements and hedge funds are a very profitable way to do so. However, regulation and restriction must be a future player in their survival. Banks have been prop trading (trading hedge funds with its own money – its balance sheet, its borrowed capital, as opposed to its customers’ money, so as to make a profit for itself) and this has proved to be too risky. That will be prohibited.

For the whole NY Times article go to: