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In the last few years, hedge funds have become an integral part of the pension fund investment toolkit. Hedge funds can employ a wide range of investment strategies and the breadth of these approaches means that they can help diversify and give an 'absolute returns' flavour to investment portfolios.

But the Alternative Investment Fund Manager (AIFM) directive from the European Union (EU) could affect the choice of hedge funds available to pension funds based in the EU. While the EU may have been unable to reach agreement on the directive in time for July approval as originally planned, work will continue on the details for a planned September vote.

A worst-case scenario is that non-EU funds could be banned from being marketed to EU investors (and possibly prompting retaliatory action from USA against EU funds) severely limiting investment choice for pension schemes. It could also lead to higher costs for EU investors in alternative funds and a blow to the competitiveness of European financial centres, particularly London, which is home for the managers of an estimated 80% of the EU's hedge funds.

The alternative view is that the directive will clip the wings of hedge funds, which some European politicians see as contributing to recent market turbulence and the global financial crisis.

There are sharp differences of opinion over the directive along national lines, with France, Germany and Italy driving the directive and the UK trying to defend hedge funds and, indeed, other funds that could be affected. All collective investment funds outside the European-regulated UCITS regime could be affected, including property and private equity funds, which can lack the liquidity required by UCITS.

Jumping Through Hoops

At present, there are two draft texts for the directive, one from the European Parliament and one from the Council of Ministers. Andrew Rubio, CEO of hedge fund manager outsourcing provider Throgmorton UK says: "The Parliament version is highly political, whereas the Council are trying to be more pragmatic and practical."

Rubio says the typical offshore hedge fund, domiciled in the Cayman Islands or a similar jurisdiction but managed from London, would have to operate under the third-country provisions of the directive. "They won't be able to market in the EU unless they get a passport that the directive talks about. That looks like it could contain impractical provisions," he adds.

Key Asset Management legal counsel Yunus Mangera says: "It seems inconceivable that regulators would try to inhibit institutional investors from investing where they wish, but that's not what the current drafts say." On the positive side, Mangera adds that recent comments from the French and German finance ministers on institutional investor freedom were encouraging.

However, another concern is that the level two process of creating an EU directive, normally used for incorporating guidance, could in this case be used to add substantive provisions, which could limit the amount of risk that hedge funds can take. Mangera says: "Where we end up at the end of the level two process is anyone's guess."

One startling possibility is that pension funds themselves could come under the scope of the directive. Managing partner Frederic Ponzo of asset management consultancy Greyspark Partners says: "There is a significant probability that pension funds investing into hedge funds, above a certain threshold of assets under management, will be deemed 'fund of funds'." However, Stuart Martin, international financial services group partner at lawyers Dechert LLP, says that the intention appears to be that institutions for occupational retirement provision investing entirely on their own account, which is likely to cover pension funds, will be exempt from regulation under the directive.

Limited Choice

Even if pension schemes avoid being caught up in the directive, they could find their choice of hedge funds is restricted. Some funds domiciled outside Europe might decide to concentrate on serving investors in the USA and Asia. Increasing allocations to existing investments in non-EU funds could be harder to do. While, under the Council draft of the directive, it is possible that European investors may technically be able to invest in offshore hedge funds that are not marketed in Europe, Martin says: "It may be very difficult for pension funds to invest in something that cannot be marketed to them." He adds that pension funds may well have to invest with non-EU managers via segregated managed accounts, rather than pooled funds, following the directive. That may create problems for smaller pension funds and limit asset allocation opportunities in global markets.

Rather than investing in offshore funds, pension schemes may favour onshore versions of hedge funds launched under the UCITS III regulations, but some think that these vehicles will suffer in comparison.

Whether the new regulations will prevent hedge fund blow-ups is also highly debateable. For example, the Madoff scandal was the result of criminal behaviour, not the sort of excessive risk-taking that would be curbed by the directives. Ponzo comments: "A large number of hedge funds were surfing the bull market, generating inflated performance, thanks to leverage. When credit [and therefore leverage] was withdrawn, they couldn't sustain a poor business model."

Others point out that a determinant of whether a hedge fund blew up during the credit crunch was how it was invested in the key area of credit. Those long on credit almost certainly did badly, while funds that shorted credit, particularly sub-prime mortgages, should have produced stellar returns. The new regulations would have had no effect in this regard.

Protection or Politics?

On the role of leverage, Merchant Capital director George Cadbury says: "By minimising the amount of leverage, you are significantly reducing the possibility of blow-ups, although there will, of course, be the inherent risk of mismanagement." However, Rubio says the AIFM directive was like using a sledgehammer to crack a nut in terms of reducing the risk of blow-ups and adds: "It has nothing to do with investor protection and everything to do with political expediency." And RWC Partners head of business development Dan Mannix comments: "It is a big misconception that there have been a lot of hedge fund blow-ups. In 2008, a number of funds lost 15% to 25% and that was not a good experience for investors. Some funds did underperform, but you can't confuse mismanaging client expectations with fund blow-ups."

The AIFM directive is certainly something pension funds and their advisers should keep under review. In its final form, it could have a major impact on pension fund investment in hedge funds and other alternative assets, although it is too early to be certain about this. Stricter regulations may reduce the chance of hedge fund blow-ups, although this is not a given, but are almost certain to lead to poorer performance levels and increased costs. Some European politicians, no doubt see this as a worthwhile compromise, but many in the UK will hope that the regulations are revised in the drafting process, allowing pension funds the freedom to invest where they choose.

This article first appeared in Pensions Insight on 30 June 2010. For more details, please visit