MFA Issues Best Practices for Hedge Fund Managers

The Managed Funds Association has issued its latest edition of sound practices for hedge fund managers, including substantive updates on valuation, risk management and responsibilities to investors. The best practices are also heavy on disclosure to investors, including soft dollar arrangements. They also embrace risk management and best execution. The MFA also introduced a model due diligence questionnaire designed for all types of investors, including high net worth individuals, pension fund managers and nonprofits.

Generally, hedge fund managers should establish management policies and oversight appropriate for the size and complexity of the fund and for its trading activities. They should also determine the risk and trading policies for each fund they manage based on the specific investment objectives described in the offering documents.

Importantly, hedge fund managers should carefully select and monitor any mission critical, third-party service providers performing key business functions, such as prime brokerage.

Disclosure to investors is a centerpiece of the sound practices. Hedge fund managers should disclose any relationships between themselves and service providers that may give rise to potential material conflicts of interest. They should also provide investors with information regarding the fund’s investment objectives and strategies, range of permissible investments, and material risk factors.

Of significance to hedge fund managers with UK operations is disclosure of side letters and other similar arrangements containing terms enhancing an investor’s ability to redeem shares or interests or make a determination as to whether to redeem shares or
interests that might reasonably be expected to put other investors in the same class at a material disadvantage.

The best practices also call for fund managers to develop and maintain a code of ethics and personal trading policies and communicate the material aspects of this code to investors.

Hedge fund managers should disclose their use of soft dollar arrangements to investors in each fund that they manage. Disclosure should be made prior to engaging in such arrangements. They should evaluate the types of products and services subject to the soft dollar arrangements. The evaluation should determine the extent to which products or services have research functions or are developed by a third party and provided by a broker.

Risk management is also a key component of the best practices. Hedge fund managers should have a risk management process appropriate to the fund’s size, complexity, and portfolio structure. As part of risk management, hedge fund managers should perform stress tests to determine how potential large changes in market prices and other risk factors could affect a hedge fund’s value.

The principle of best execution is also embedded in the best practices. When seeking best execution for all types of instruments, hedge fund managers should execute transactions in such a manner that the execution quality on an aggregate, periodic basis is the most favorable under the circumstances. In assessing whether this standard is met, they should consider the full range and quality of a counterparty’s services.