WASHINGTON, DC | NEW YORK
Sound Practices for Hedge Fund Managers | 01

TABLE OF CONTENTS

Preface ....................................................................................................1

Introduction .............................................................................................1

Section 1 Recommendations: Management, Trading, 

and Information Technology Controls ...........................1 

1.1 Management and Trading Controls .......................2

1.6 Information Technology Controls ...........................5

1.9 Third-Party Service Providers .................................8

Section 2 Recommendations: Responsibilities to Investors ...........1

2.1 Responsibilities to Investors ...................................2

Section 3 Recommendations: Determination of Net Asset Value ..1

3.1 Verification of the Existence of Assets

and Liabilities .........................................................2

3.6 Determination of Fair Value ...................................7

3.7 Responsibility for Valuation ....................................8

3.8 Pricing Policies and Procedures .............................9

3.10 Frequency of NAV Determinations ......................13

3.11 Financial Statement Close Process.......................14

Section 4 Recommendations: Risk Management...........................1

4.1 Structure of Risk Management Process ..................2

4.4 Market Risk .............................................................4

4.11 Funding Liquidity Risk ............................................9

Sound Practices for Hedge 

Fund Managers
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02 | Table of Contents

4.14 Counterparty Credit Risk ......................................10

4.15 Leverage ..............................................................11

4.16 Operational Risk ...................................................12

4.17 Risk Monitoring Valuation ....................................13

Section 5 Recommendations: Regulatory Controls .......................1

5.1 Regulatory Controls ...............................................2

Section 6 Recommendations: Trading Relationship 

Management, Monitoring, and Disclosure ....................1

6.1 Documentation Policies and Controls ....................2

6.5 Best Execution .......................................................5

6.7 Execution and Clearing Arrangements ..................7

6.8 Soft Dollar Arrangements .......................................8

Section 7 Recommendations: Business Continuity, Disaster

Recovery, and Crisis Management .................................1

7.1 Business Continuity, Disaster

Recovery, and Crisis Management .........................2

Appendix I Glossary and Selected Sources Used .............................1

Selected Sources Used .................................................15

Appendix II Model Due Diligence Questionnaire for 

Hedge Fund Investors ....................................................1

I. Investment Manager Overview ..............................3

II. Overview of Activities of the Investment

 Manager .................................................................7

III. Fund Information ....................................................8
Sound Practices for Hedge Fund Managers | 03

Appendix III Supplemental Information on Risk 

Monitoring Practices for Hedge Fund 

Managers ........................................................................1

I. Overview: The Risks Faced by a Hedge

Fund Manager ...........................................................2

II. Market Risk ................................................................7

III. Funding Liquidity Risk .............................................16

IV. Leverage ..................................................................21

V. Counterparty Credit Risk .........................................29

Appendix IV Guidance for Hedge Funds and Hedge Fund 

Managers on Developing Anti-Money Laundering

Programs (Release No. 2) ...............................................1

Introduction ....................................................................2

Historical Background .....................................................3

MFA’s Efforts to Promote Sound Practices

in Anti-Money Laundering for the

Hedge Fund Industry ......................................................6

Applicability of the 2007 AML Guidance ........................8

Individualized Assessment and Application

of 2007 AML Guidance ...................................................9

Recommendations ........................................................12

Annex A

Definitions ...............................................................40

Annex B

Model Anti-Money Laundering Attestation ............47

Annex C

Proposed Template for Anti-Money

Laundering Policies and Procedures .......................53
04 | Table of Contents

Annex D

Sample Provisions for Fund Administrators,

Investor Intermediaries, and Subscription

Documents ..............................................................68

Annex E

Sample Board Resolutions ......................................84

Annex F

Members of Financial Action Task Force

on Money Laundering ..............................................87

Annex G

List of FATF Non-Cooperative Jurisdictions .............88

Annex H

Lists Maintained by the Office of Foreign

Assets Control ..........................................................89

Annex I

Money Laundering Advisories Issued by

the Financial Crimes Enforcement Network

of the U.S. Department of Treasury ..........................90

Annex J

Countries and Financial Institutions That

Have Been Designated by the U.S. Department

of Treasury as Being of “Primary Money

Laundering Concern” ...............................................91

Appendix V U.S. Regulatory Filings by

Hedge Fund Managers ..................................................1

Appendix VI Checklist for Hedge Fund Managers to Consider 

in Developing a Compliance Manual .............................1

Appendix VII Checklist for Hedge Fund Managers 

to Consider in Developing a Code of Ethics .................1

Table of Contents
Sound Practices for Hedge Fund Managers | 01

Sound Practices for Hedge Fund Managers

About Managed Funds Association

Hedge fund managers are vital participants in the global capital markets, 

yet they remain largely misunderstood by the media, the government, and 

the public-at-large. In light of the U.S. Court of Appeals for the District of 

Columbia decision overturning the SEC’s rule requiring registration of most 

hedge fund managers, the recent pension reform legislation, and the tremendous growth and increased visibility of the industry, hedge fund managers 

are under heightened scrutiny in the United States and abroad. This scrutiny 

necessitates focused advocacy, consistent messages, and shared experiences 

for the industry. 

For over 16 years, Managed Funds Association (“MFA”) has been the 

unifying voice of the hedge fund industry. MFA’s mission is to protect the 

interests of the industry, to educate policy makers, and to assist its Members 

better grow and conduct their businesses. 

MFA achieves its success through four major areas:

Protect

MFA is the preeminent advocate for the hedge fund industry in the United 

States with a primary focus of protecting the integrity and the efficiency of 

the capital marketplace by representing the interests of industry participants 

on Capitol Hill. MFA works tirelessly with policy makers, in both Houses 

of Congress, and regulators, to shed light on what has been mischaracterized as a secretive industry. MFA navigates the political landscape through 

its lobbying initiatives and extensive contacts throughout Washington, D.C. 

MFA has strength in numbers that no individual Member or group can 

replicate—MFA’s Members manage a vast majority of the almost $2 trillion 

industry. MFA exports these advocacy efforts outside of Washington, D.C. 

to the states and internationally, including the United Kingdom, Japan, 

India, and other regions.

Preface
Preface

Promote

In conjunction with its advocacy efforts in Washington, D.C. and abroad, 

MFA works to reshape the media’s misrepresentations and the public’s 

misperceptions about the hedge fund industry. MFA is able to promote the 

benefits of alternative investments, including hedge funds, to the global 

financial marketplace as a whole, in a way that individual managers could 

not accomplish on their own. MFA operates as a clearinghouse of information by virtue of its representation of the industry so that it can engage the 

media and the public on a variety of issues impacting the industry without 

a spotlight shining on any one particular manager. MFA is able to dispel 

myths, to encourage understanding, and to disseminate messages to the media and among the general public with a uniform, collective voice to ensure 

consistent clarity. 

Educate

MFA recognizes that its initiatives with the government, the press, and the 

public are irrelevant if MFA’s Members do not operate according to high 

ethical standards and reputable business practices. Therefore, MFA regularly 

educates its Members about the best practices for any hedge fund manager 

who wishes to enter the marketplace. MFA’s Sound Practices for Hedge Fund 

Managers is the most recognized and well-respected resource for hedge fund 

managers seeking to foster a culture of compliance. MFA hosts conferences, 

seminars, and other educational events to help train hedge fund managers and industry counterparts, such as lawyers and accountants, and to lay 

the foundation for consistent market practices across the broad spectrum 

of hedge fund strategies. MFA’s active involvement enables its Members to 

collectively help shape best practices that will foster growth of the industry. 

Additionally, MFA communicates to its Members about changes in legislation and regulation impacting all aspects of the industry. 

Participate

MFA’s success is contingent upon the continued support of its Members. 

MFA seeks the financial support of industry participants and substantive 

involvement in MFA committees, activities, and events. MFA’s Board of 

Directors and other committees are comprised of prominent industry participants. MFA’s advocacy on Capitol Hill is most effective with the participation of its Members. Participation provides Members with access—both 

collectively and individually—to influential policy makers. Each conference, 

02 | Preface
seminar, and event is made possible by the involvement of individual Members. The largest participants in the hedge fund industry are MFA’s most 

active Members and most significant financial contributors. Upon joining, 

each Member of MFA gains an instant peer group of the most influential 

leaders in the hedge fund industry and receives opportunities to interact 

with them in an unparalleled way. 

MFA Members are paramount in helping the industry prosper. MFA 

Members provide two assets that are fundamental for MFA to succeed in 

its mission: financial support in the form of annual MFA Membership dues 

and conference sponsorship and attendance, and substantive participation 

in a variety of committees, working groups, and other activities. Without 

continued and growing support in the form of Member dues, MFA would 

not be able to succeed in its mission. 

MFA is led by its President, Executive Vice President/Chief Operating 

Officer, Executive Vice President/Chief Administrative Officer, and an 

executive team of legal, government affairs, membership and marketing 

professionals. An administrative staff assists MFA executives with the details 

necessary to advance the association’s strategic mission. For more information about MFA, visit www.managedfunds.org.

Managed Funds Association

2025 M Street, N.W. (headquarters)

Suite 610

Washington, D.C. 20036

202.367.1140 

360 Madison Avenue

18th Floor

New York, NY 10017

212.808.1102

Sound Practices for Hedge Fund Managers | 03
About the 2007 Edition

MFA has published the 2007 edition of its Sound Practices for Hedge Fund 

Managers in a new three-ring binder format and design, making the document easier to navigate and update. As needed and appropriate, MFA will 

circulate updated pages and sections to its Members, so that Members can 

simply replace the outdated pages or sections.

MFA is certain this new format will make the document more readily 

accessible to hedge fund managers as they seek to operate in accordance 

with industry best practices. 

In preparing Sound Practices for Hedge Fund Managers, MFA consulted with Akin 

Gump Strauss Hauer & Feld LLP and, with respect to Appendix IV—Guidance for 

Hedge Funds and Hedge Fund Managers on Developing Anti-Money Laundering 

Programs (Release No. 2), with Schulte Roth & Zabel LLP.

Preface

04 | Preface
Sound Practices for Hedge Fund Managers | 01

Sound Practices for Hedge Fund Managers

MFA publishes its Sound Practices for Hedge Fund Managers (“Sound 

Practices”) for the benefit of its Members and the global Hedge Fund1 

industry. Currently in its fourth iteration (previous editions were published 

in 2000, 2003, and 2005), Sound Practices contains recommendations that 

provide Hedge Fund Managers, operating as single-manager Hedge Fund 

complexes, with a framework of internal policies, practices, and controls from 

a peer-to-peer perspective (the “Recommendations”). MFA principally directs 

the Recommendations toward all Hedge Fund Managers, both U.S.-based 

and non-U.S., with business operations and investments in the United States 

and its territories. However, MFA recognizes the truly global structure of 

the Hedge Fund marketplace, and has developed Sound Practices so that the 

Recommendations are useful tools for Hedge Fund Managers around the 

world. As the pre-eminent resource for establishing standards of excellence, 

Sound Practices creates a framework from which all Hedge Fund Managers 

may tailor the Recommendations to meet their needs in order to develop 

and implement a culture of compliance. 

Public Policy & the Hedge Fund Industry

Sound Practices has been acknowledged by Hedge Fund Managers, as well 

as investors, regulators, and market counterparties, as the seminal resource 

for developing and maintaining sound business practices. For example, 

the “Counterparty Risk Management Policy Group II”, in its 2005 Report, 

Toward Greater Financial Stability: A Private Sector Perspective, encouraged 

“hedge fund managers, for the purpose of best practices,” to adopt an earlier 

edition of Sound Practices. The 2007 edition demonstrates the continued 

commitment of MFA and its Members to address both the current regulaIntroduction

1 The terms “Hedge Fund” and “Hedge Fund Manager” are defined later in this 

Introduction under General Considerations Relating to Hedge Funds, Hedge Fund 

Managers, and Investors. Other capitalized and/or italicized terms and certain technical words and phrases used in this document that are not defined in the text itself are 

defined in Appendix I—The Glossary and Selected Sources Used.
02 | Introduction

Introduction

tory environment and public policy issues surrounding Hedge Funds. MFA 

believes that the 2007 edition directly responds to the President’s Working 

Group on Financial Markets’ (the “PWG”) Agreement Among PWG and 

U.S. Agency Principals on Principles and Guidelines Regarding Private Pools of 

Capital, which the PWG published in February 2007 to establish the current public policy approach for all private pools of capital, including Hedge 

Funds (the “PWG Agreement”). The principles set forth in the PWG Agreement apply equally to Hedge Fund Managers (and other managers of private 

pools of capital), their counterparties and creditors, investors and fiduciaries, 

and financial regulators, encouraging all parties to be vigilant in achieving 

soundness in the financial markets through collaborative market discipline: 

 Private pools of capital bring significant benefits to the financial markets. 

However, these pools of capital also present challenges for market participants 

and policymakers. Investors, creditors, counterparties, pool managers, and 

supervisors must be aware of these challenges . . . and work to address them. 

Public policies that support market discipline, participant awareness of risk, 

and prudent risk management are the best means of protecting investors and 

limiting systemic risk. 

PWG Agreement, Section 1.

The PWG Agreement strongly encourages Hedge Fund Managers to develop 

industry sound practices as a means of achieving the market discipline 

necessary to satisfy the PWG’s public policy approach. Specifically, the PWG 

Agreement urges Hedge Fund Managers to “have information, valuation and 

risk management systems that meet sound industry practices that enable 

them to meet the expectations of creditors, counterparties, fiduciaries and 

investors.” MFA has designed Sound Practices to respond to the PWG’s 

recommendations by comprehensively addressing issues associated with the 

recent growth and dynamic nature of the Hedge Fund industry. Moreover, 

Hedge Fund Managers who adapt the Recommendations to their firms 

will contribute meaningfully to the internal soundness of individual Hedge 

Funds they operate and to the strength of the financial markets in which 

they participate. 

The PWG Agreement is the PWG’s first official statement applicable to 

Hedge Fund Managers since its 1999 report, Hedge Funds, Leverage, and 

the Lessons of Long-Term Capital Management, which included a specific 

recommendation that the Hedge Fund industry establish a set of sound 
Sound Practices for Hedge Fund Managers | 03

practices for risk management and internal controls. A small group of Hedge 

Fund Managers published the first edition of Sound Practices for Hedge Fund 

Managers in 2000 in direct response to this recommendation and focused 

primarily on risk management. MFA subsequently published 2003 and 

2005 editions to reflect industry developments and to expand the subject 

matter covered. 

The international regulatory community, including the “Group of Seven”

and “Group of Eight” heads of state, has encouraged MFA and Hedge Fund 

Managers to continue to develop sound practices in order to strengthen 

market discipline through risk management practices. The Financial Stability Forum (“FSF”), established in 1999 by the Group of Seven Finance Ministers (the “G7 Finance Ministers”) and central bank governors, published 

its Update of the FSF Report on Highly Leveraged Institutions in May 2007 

(the “FSF Report”), in response to a request by the G7 Finance Ministers 

to update the FSF’s 2000 report. The FSF Report highlights some of the 

recent private sector and public policy initiatives aimed at protecting against 

systemic risks and sets forth recommendations to build on these ongoing 

efforts. For Hedge Funds, the FSF Report states:

 The global hedge fund industry should review and enhance existing 

sound practice benchmarks for hedge fund managers in the light of expectations for improved practices set out by the official and private sectors.

The FSF Report.

Sound Practices answers these international public sector calls to improve 

market discipline. As mentioned earlier, the Recommendations provide a 

framework for all Hedge Fund Managers, regardless of regulatory jurisdiction, to develop proper and sound internal business operations, which, if 

adhered to, will contribute to MFA’s and the Hedge Fund community’s 

dedication to a robust, competitive, and stable global financial marketplace.

Hedge Funds, the Global Financial Marketplace, 

and MFA’s Recommendations 

Hedge Funds, like credit providers (such as banks and other financial institutions), are key participants in international financial markets. However, the 

activities of Hedge Fund Managers differ greatly from those of credit providers. These other financial institutions generally seek to eliminate or minimize 
04 | Introduction

Introduction

the risks of their businesses through hedging and other risk management 

methods. Hedge Fund Managers, on the other hand, are in the business 

of seeking and assuming calculated risks, and do so in order to achieve the 

absolute returns desired by their Hedge Fund investors. MFA believes, as 

do key policy makers, that this activity is beneficial to financial markets:

 [Hedge funds’] rapid growth is one of the most important developments in 

U.S. financial markets in the past decade or so. Hedge funds vary widely 

in their investment strategies and in the types of risks they take. Overall, 

however, most economists agree that the rise of hedge funds has been a positive 

development for investors and for financial markets. They have stimulated 

an extraordinary amount of financial innovation in recent years; and, using 

many of these new financial tools, they have greatly enhanced the liquidity, 

efficiency, and risk-sharing capabilities of our financial system. 

Remarks by Ben S. Bernanke, Chairman, Board of Governors of 

the Federal Reserve System, at the New York University Law School, 

New York, New York (April 11, 2007).

By participating in the market as risk seekers, Hedge Fund Managers provide needed liquidity to financial markets, which can help reduce systemic 

risk and, at the same time, ensure the overall viability of the marketplace. 

In this sense, Hedge Funds often act as risk absorbers in markets. They do so

by serving as ready counterparties to those wishing to hedge risk, especially 

when markets are volatile, thereby reducing pressure on market prices while 

increasing liquidity. In addition, Hedge Fund Managers typically trade based 

on extensive research, which brings more accurate price information, and 

therefore, price efficiencies to the markets. Without the research and commitment of capital by Hedge Fund Managers, the markets potentially would 

have wider price spreads, as well as more pronounced pricing inefficiencies 

and illiquidity. Hedge Funds also often provide investors with valuable portfolio diversification—such diversification can reduce individual investor risk 

and, as a result, overall marketplace risk.

MFA recognizes, however, the concerns expressed by policy makers with 

respect to certain activities of Hedge Funds and the potential for systemic 

risk. Since the publication of the 2005 edition of Sound Practices, regulatory 

supervisors have taken particular interest in over-the-counter (“OTC”) 

“derivatives”, particularly credit derivatives. Regulators have expressed 

concern that a major credit event could have a substantial impact on global 
Sound Practices for Hedge Fund Managers | 05

financial markets. Consequently, the PWG specifically addresses OTC 

derivatives with respect to its directive that Hedge Fund Managers develop 

industry sound practices:

 [R]isk management and valuation policies employed by private pools of capital should comply with the industry sound practices. Such pools also should 

implement and comply with industry sound practices to strengthen processing, 

clearing, and settlement arrangements for credit derivatives and other overthe-counter derivatives. 

PWG Agreement, Section 9.2.

With the goal of reducing systemic risk vis-à-vis the derivatives marketplace, 

MFA works with major derivatives dealers, under the direction of the Federal Reserve Bank of New York, to address operational challenges of processing 

trades. MFA’s experiences in this and other public policy and private sector 

initiatives have greatly shaped the Recommendations. 

Objectives of MFA’s Recommendations

1. Strengthen Business Practices of the Hedge Fund Industry through a 

Strong Framework of Internal Policies and Practices. The Recommendations serve to educate Hedge Fund Managers by providing peer group 

consensus on standards for internal management controls on the subjects 

covered herein and by addressing the convergence of internal control standards across the financial services industry. The Recommendations go beyond 

the requirements imposed by U.S. laws or regulations. Moreover, MFA has 

developed and updated the Recommendations in the belief that the most 

effective form of industry oversight is self-discipline and self-monitoring 

by Hedge Fund Managers as part of a shared responsibility with market 

counterparties, investors, and regulators, to unify the overarching principles 

set forth in the PWG Agreement. The Recommendations, if adopted, should 

enhance the ability of Hedge Fund Managers to manage operations, satisfy 

responsibilities to investors, comply with applicable regulations, and address 

unexpected market events. 

2. Encourage Individualized Assessment and Application of Recommendations, as One Size Does Not Fit All. The strategies, investment approaches, 

organizational structures, and amount of assets managed by individual 

Hedge Fund Managers vary greatly. Mindful of this reality, MFA has 
06 | Introduction

Introduction

written the Recommendations with enough specificity and ample flexibility 

to provide meaningful guidance regardless of those differences. MFA cannot 

address all the considerations that should be taken into account in determining whether and how to apply a particular Recommendation. The Recommendations are not static, one-size-fits-all, prescriptive requirements that 

all Hedge Fund Managers must follow in exactly the same manner. Rather, 

each Hedge Fund Manager should assess the Recommendations based 

on the size, nature, and complexity of its organization, its strategies, and 

resources, as well as the objectives of the Hedge Funds it manages, and tailor 

and apply the Recommendations, as appropriate. 

A Hedge Fund Manager may be able to implement some Recommendations fairly easily or unilaterally. Other Recommendations, however, may 

require substantial planning and significant budgetary commitments, 

internal systems changes, infrastructure development, and/or services and 

expertise offered by third parties. Some Hedge Fund Managers may have 

specific personnel who perform each of the various practices described in the 

Recommendations. Other, generally smaller, Hedge Funds may have personnel who perform multiple roles while still satisfying the objectives of the 

Recommendations. A Hedge Fund Manager may also use Sound Practices

as a tool to conduct periodic self-assessments as to the effectiveness of its 

individual implementation of the Recommendations.

3. Enhance Market Discipline in the Global Financial Marketplace. 

By evaluating the Recommendations and applying those that are relevant 

to its particular business model, a Hedge Fund Manager can continue to 

strengthen its own business practices. In doing so, the Hedge Fund Manager 

enhances investor protection and abates systemic risk. Hedge Fund Managers, by individually adapting and tailoring the Recommendations to meet 

their business models, in aggregate will contribute to overall market soundness. MFA will further adapt and refine the Recommendations as the Hedge 

Fund industry and global financial markets continue to evolve. 

General Considerations Relating to Hedge Funds, 

Hedge Fund Managers, and Investors

Hedge Fund Defined. No statutory or regulatory definition of a Hedge 

Fund exists. Historically, the term “hedge fund” referred to an investment 

vehicle with the ability to hedge the value of its assets (e.g., through the use 

of options or the simultaneous use of “long positions” and “short sales”). 
Sound Practices for Hedge Fund Managers | 07

However, the term “hedge fund” as understood in the current financial 

marketplace describes a wide range of investment vehicles that can vary 

substantially in terms of size, strategy, business model, and organizational 

structure. Thus, some Hedge Funds may not engage in “hedging” activities 

at all (e.g., some Hedge Funds may engage only in “buy and hold” or other 

strategies that do not involve hedging in the traditional sense). 

For purposes of Sound Practices, MFA defines a Hedge Fund as follows:

A pooled investment vehicle that generally meets the following criteria: 

(1) it is not marketed to the general public (i.e., it is privately-offered); 

(2) it is limited to high net worth individuals and institutions; (3) it is not 

registered as an investment company under relevant laws (e.g., U.S. Investment Company Act of 1940, as amended); (4) its assets are managed by a 

professional investment management firm that shares in the gains of the 

investment vehicle based on investment performance of the vehicle; and 

(5) it has periodic but restricted or limited investor redemption rights.

MFA does not intend the term Hedge Fund, as used in these Recommendations, to capture private investment funds that are “purely” traditional 

private equity, venture capital, or real estate funds. MFA recognizes, however, that individual Hedge Funds may pursue these and other investment 

strategies in accordance with their “offering documents”.

Relationship between Hedge Funds and Their Hedge Fund Managers. 

MFA makes the following assumptions about the relationship between 

a Hedge Fund and its Hedge Fund Manager in setting forth the 

Recommendations: 

• A professional investment management firm (e.g., a Hedge Fund 

Manager) manages the assets of each Hedge Fund;

• The term Hedge Fund Manager includes Hedge Fund Managers that are 

registered with the U.S. Securities and Exchange Commission (“SEC”) 

as investment advisers, and those exempt from registration, under the 

Investment Advisers Act of 1940 (the “Advisers Act”), as amended;

• The Hedge Fund Manager is a legal entity governed by a person or group 

of persons, acting through a management committee, board of directors, 

or other body, or directly as officers or members of the Hedge Fund 
08 | Introduction

Introduction

Manager, with the authority and responsibility to direct and oversee the 

Hedge Fund Manager’s activities (a Hedge Fund Manager’s “governing 

body”); 

• The organizational and constituent documents of the Hedge Fund 

Manager’s governing body are the “governing documents”; 

• The “senior management” of a Hedge Fund Manager signifies the Chief 

Executive Officer, Chief Financial Officer, and others at the highest 

level of the decision-making process for the day-to-day operations of the 

Hedge Fund’s business;

• The Hedge Fund Manager’s governing body has the legal authority and 

responsibility to direct and oversee the activities of the Hedge Fund; and

• The governing body of the actual Hedge Fund may be the Hedge Fund 

Manager itself (e.g., as the general partner or managing member of the 

Hedge Fund) or an independent body that delegates the investment 

management function of the Hedge Fund to the Hedge Fund Manager 

pursuant to an investment management agreement.

With those assumptions in mind, the client of a Hedge Fund Manager is the 

Hedge Fund. Although a Hedge Fund Manager has relationships with the 

investors in a Hedge Fund, the Hedge Fund Manager provides its investment advice to the Hedge Fund in accordance with the investment strategy 

and objectives set forth in the Hedge Fund’s offering documents, rather than 

any specific objectives or directives of any individual Hedge Fund investor. 

A Hedge Fund Manager typically receives compensation, in part, based on 

the performance of the Hedge Funds it manages and often significantly 

invests directly in those funds. This structure creates a strong alignment 

of interests between a Hedge Fund’s other investors and the Hedge Fund 

Manager. 

N.B. The nature and structure of Hedge Funds and their relationships with 

Hedge Fund Managers vary substantially, and these assumptions may not apply to 

all Hedge Funds or Hedge Fund Managers. For the purposes of Sound Practices,

MFA assumes that a Hedge Fund Manager will apply each relevant Recommendation, as deemed appropriate, to each of the Hedge Funds it manages.
Sound Practices for Hedge Fund Managers | 09

Relationship between Hedge Funds and Their Investors. Certain legal documents, which may include an offering memorandum, limited partnership 

or limited liability company agreement, subscription agreement, or similar 

contracts, govern the relationship between a Hedge Fund and its investors 

(referred to collectively in this document as “offering documents”). Whether 

investing in a U.S. domiciled limited partnership as a limited partner or in 

a non-U.S. domiciled company as a shareholder, the investor is typically a 

passive participant in the Hedge Fund with no right of participation in the 

management of the Hedge Fund and generally with limited voting rights. 

A Hedge Fund investor’s liability is generally limited to the extent of its 

investment in a Hedge Fund. 

As noted above, although the client of a Hedge Fund Manager is the Hedge 

Fund, the Hedge Fund Manager generally communicates with the investors 

with respect to all matters related to the Hedge Fund, including 

its investment objectives, strategies, terms, and conditions of an investment 

in the Hedge Fund. 

Regulatory restrictions generally require investors in Hedge Funds to meet 

certain requirements, such as net worth or other financial sophistication 

standards, which the PWG Agreement supports:

 Investor protection concerns can be addressed most effectively through a 

combination of market discipline and regulatory policies that limit direct 

investment in such pools to more sophisticated investors. 

PWG Agreement, Section 2.

U.S. laws and regulations, for instance, generally require investors in Hedge 

Funds—whether institutional or individual investors—to satisfy financial 

net worth and other criteria in order to invest in a Hedge Fund. To further 

bolster investor protection, managers of certain institutional investors, such 

as pension fund plans, are fiduciaries with a legal duty to act in the best 

interest of plan beneficiaries when making any investments on behalf of the 

institution, in Hedge Funds, or otherwise. 

Since its inception, MFA has consistently promoted this policy approach 

as a means of achieving investor protection when needed. 
Introduction

Irrespective of their jurisdiction of origin, investors in Hedge Funds should 

have the ability to understand and evaluate for themselves an investment 

in a Hedge Fund and the corresponding risks. Hedge Fund Managers also 

reasonably expect that investors in a Hedge Fund would not expose themselves to risks they could not tolerate. In furtherance of these expectations, 

investors generally conduct extensive due diligence of the Hedge Fund and 

the Hedge Fund Manager before making a financial commitment to invest. 

The PWG Agreement sets forth these concepts in its recommendations to 

investors. 

Overview and Organization of the Recommendations 

Recognizing the shared responsibility to ensure the vitality, stability, and 

integrity of financial markets, MFA works collaboratively with other segments of the marketplace to develop solutions for areas deemed vulnerable 

by financial regulators. Above all, MFA and its Members recognize the 

need to be at the forefront of the development of sound industry practices, 

particularly in areas such as documentation and transactional practices, risk 

management, and valuation, in order both to mitigate risks to the financial 

system that could emanate from the activities of Hedge Funds or their 

counterparties and to ensure Hedge Funds continue to provide their recognized benefits to the global financial marketplace. MFA has crafted the 

Recommendations accordingly.

MFA has divided the Recommendations into the following seven substantive sections. 

Section 1: The management, internal trading, and information technology 

controls that a Hedge Fund Manager should establish.

Section 2: Responsibilities to investors and proposed practices intended to 

assist a Hedge Fund Manager in fulfilling these responsibilities.

Section 3: Determination of net asset value, including verification of 

assets and liabilities, valuation policies and procedures, and the 

financial statement close process.

Section 4: Risk measurement and management practices to ensure that the 

risk policies of a Hedge Fund Manager are observed.

10 | Introduction
Section 5: Key regulatory controls and compliance issues.

Section 6: Trading relationships, monitoring, and disclosure, including 

recommendations for documentation policies, “best execution”

practices, and soft dollar arrangements, which aim to help 

govern the relationship between a Hedge Fund Manager and 

its market counterparties.

Section 7: Business continuity, disaster recovery, and crisis management 

planning.

In addition, Sound Practices contains the following seven appendices to the 

Recommendations:

Appendix I: A glossary of key terms and selected sources used throughout 

Sound Practices (certain capitalized and/or italicized terms and 

certain technical words and phrases that are not defined in 

the body of the document can be found in the glossary).

Appendix II: A Model Due Diligence Questionnaire for Hedge Fund Investors 

(commonly asked questions a Hedge Fund Manager should 

be prepared to receive from current or prospective investors).

Appendix III: Supplemental information on risk monitoring practices for 

Hedge Fund Managers (in furtherance of Section 4).

Appendix IV: Guidance for Hedge Funds and Hedge Fund Managers on 

Developing Anti-Money Laundering Programs (Release No. 2).

Appendix V: U.S. regulatory filings that may be applicable to a Hedge 

Fund Manager (not exhaustive, but provides a starting point 

for a Hedge Fund Manager in identifying applicable filing 

requirements and developing policies to comply with such 

requirements).

Sound Practices for Hedge Fund Managers | 11
Introduction

Appendix VI: Checklist for Hedge Fund Managers to consider in developing a compliance manual (neither prescriptive, nor intended 

to cover each consideration that may be relevant for a particular Hedge Fund Manager).

Appendix VII: Checklist for Hedge Fund Managers to consider in developing a code of ethics (neither prescriptive, nor intended to 

cover each consideration that may be relevant for a particular 

Hedge Fund Manager).

No Substitute for Legal or Other Professional Advice 

The Recommendations are not intended to serve as, or be a substitute for, 

professional advice. This document neither seeks to cover the specific legal 

requirements with which a Hedge Fund Manager must comply, nor is it exhaustive. Hedge Fund Managers should consult with their professional legal, 

accounting, compliance, tax, and other advisers in determining the applicability of the Recommendations to their business operations and appropriate 

methods for implementing the applicable Recommendations.

12 | Introduction
Sound Practices for Hedge Fund Managers

Sound Practices for Hedge Fund Managers | 01

The Recommendations in Section 1 present fundamental policies for 

a Hedge Fund Manager in its management and trading operations. 

Section 1 includes Recommendations for a Hedge Fund Manager 

to establish trading and risk parameters corresponding to the investment objectives of each Hedge Fund it manages. The Recommendations provide guidance on the oversight of both internal and external 

portfolio managers, and on review processes to effectively monitor 

trading activities and operations to ensure compliance with the predetermined trading and risk parameters. The Recommendations also 

include information technology (“IT”) guidance in order to control 

changes to any software applications, data, and IT infrastructure and 

to maintain proper security therein. Finally, the Recommendations in 

Section 1 provide guidance on relationships with third-party service 

providers that perform key business functions, such as calculating net 

asset value (“NAV”) or monitoring risk. 

1. Recommendations: 

Management, Trading, and 

Information Technology Controls
Management and Trading Controls

1.1 

A Hedge Fund Manager should establish management policies and 

practices appropriate for its size, nature, and complexity and for its 

trading activities for each Hedge Fund it manages.

A Hedge Fund Manager should 

establish management policies for 

trading activities documentation, 

NAV determination, risk analysis, 

compliance, and other key areas as 

appropriate. A Hedge Fund Manager should adopt an organizational 

structure that facilitates effective 

oversight to ensure compliance with 

the established management policies. 

A Hedge Fund Manager should 

review its policies and practices at 

least annually and update them as 

appropriate (e.g., to reflect changes 

in structure or strategy, extraordinary 

market events, or new applicable 

regulations).

1.2 

A Hedge Fund Manager should determine the investment, risk, and 

trading policies for each Hedge Fund it manages based on the specific 

investment objectives described in the respective Hedge Fund’s 

offering documents.

A Hedge Fund Manager should allocate capital and risk among portfolio 

managers, strategies, asset classes, 

and other relevant categories, to fit 

each Hedge Fund’s performance 

objectives and targeted risk profile. 

A Hedge Fund Manager should 

periodically re-examine allocations 

and adjust them as appropriate. In 

addition, a Hedge Fund Manager 

should establish appropriate trading 

parameters and risk limits for each 

allocation, as these parameters fit 

into the portfolio. The Hedge Fund 

Manager should adjust the trading parameters and risk limits as 

necessary to reflect various market 

and other changes. These principles 

are developed more fully in Section 

4—Risk Management.

02 | Management, Trading, and Information Technology Controls
1.3 

A Hedge Fund Manager should impose appropriate controls to ensure 

that its portfolio management and trading activities are consistent with 

the allocation policies and trading parameters.

A Hedge Fund Manager’s senior 

management should regularly review 

the trading activities and performance of each Hedge Fund’s portfolio 

and regularly evaluate the associated 

risk levels. To do so, the Hedge 

Fund Manager should require internal reports that provide senior management with information regarding 

the trading activities, performance, 

and risk levels of each investment 

strategy. Each report should identify 

any and all deviations from trading 

parameters and risk limits.

A Hedge Fund Manager that manages one or more Hedge Funds and 

one or more managed accounts 

(commonly referred to as “sideby-side management”) should 

develop and implement internal 

policies and procedures to govern 

the allocation of investment 

opportunities across Hedge Funds 

and managed accounts. See Section 

2, Responsibilities to Investors, 

Recommendation 2.8.

A Hedge Fund Manager’s controls 

should also ensure that its portfolio 

management and trading activities 

are consistent with its policies and 

procedures governing transactions 

with counterparties. See Section 6—

Trading Relationship, Management, 

Monitoring, and Disclosure. 

Sound Practices for Hedge Fund Managers | 03
1.5 

A Hedge Fund Manager should have appropriate approval processes 

and documentation for retaining sub-advisers and other external 

portfolio managers.

A Hedge Fund Manager should 

develop due diligence and approval 

processes for selecting and retaining a sub-adviser or other external 

portfolio manager to manage any 

capital over which the Hedge Fund 

Manager has investment discretion. When a Hedge Fund Manager 

invests such capital with an external 

portfolio manager in a managed 

account, the Hedge Fund Manager 

should clearly define in a written 

agreement with the external portfolio 

manager the trading restrictions and 

limits, reporting requirements, and 

termination provisions applicable to 

their relationship.

1.4 

A Hedge Fund Manager should establish policies for monitoring the 

trading activities and performance of each portfolio manager to which 

it allocates capital.

A Hedge Fund Manager should 

subject all of its portfolio managers, including external portfolio 

managers, to controls and review 

processes based on the amount of 

assets managed, form of allocation, 

and trading strategy. A Hedge Fund 

Manager should monitor the trading 

activities and performance of all 

portfolio managers on a periodic 

basis. Frequency of evaluation will 

depend on the form of the allocation 

(e.g., monthly performance review of 

the management of a passive investment in a Hedge Fund versus more 

frequent review of the management 

of a significant “managed account” 

investment). 

Management and Trading Controls

04 | Management, Trading, and Information Technology Controls
Information Technology Controls 

1.6 

A Hedge Fund Manager should establish policies and procedures to 

control changes to any software applications, data, and IT infrastructure.

A Hedge Fund Manager should 

establish control policies and procedures to ensure that any changes 

to the production software applications, data, and infrastructure (e.g., 

hardware) that support the overall 

business processes occur only with 

authorization, testing, and approval. 

A Hedge Fund Manager should 

employ, to the extent feasible, the 

following policies and procedures:

• Authorization controls over the 

development or acquisition of IT 

resources (e.g., hardware, software); 

• Version control management; 

• Segregation of personnel and 

technical environments for the 

development of, testing of, and 

implementation of changes; 

• Appropriate testing and approval 

of changes prior to usage in 

production; and 

• Back-out and recovery plans in 

the event of an implementation 

problem. 

The Hedge Fund Manager should 

maintain documentation of the 

above policies and related activities.

Sound Practices for Hedge Fund Managers | 05
1.7

A Hedge Fund Manager should establish policies and procedures for 

logical and physical security over software applications, data, and IT 

infrastructure.

A Hedge Fund Manager should 

establish information security 

policies and procedures in order 

to define the controls required to 

secure the data and systems used 

in its operations. In its policies and 

procedures, a Hedge Fund Manager 

should address the security and 

usage of computer applications, 

databases, operating systems, hardware, and networks. A Hedge Fund 

Manager should employ, to the 

extent feasible, the following 

policies and procedures: 

• Personnel responsibilities for 

information security; 

• Physical access controls to production systems and data storage 

(e.g., media, USB keys);

• Authentication controls (e.g., passwords) that govern how users and 

processes verify their identity to 

obtain access to systems and data;

• Entitlement controls that speak 

to the level of access (e.g., read, 

update) a user or process has to 

systems and data; and

• Audit logging and monitoring 

controls internally and at the 

network perimeter.

Policies and procedures should take 

into account the addition of new 

personnel, modification of existing 

access rights, and removal of access. 

A Hedge Fund Manager should 

maintain documentation of the 

security administration activities.

Information Technology Controls 

06 | Management, Trading, and Information Technology Controls
1.8 

A Hedge Fund Manager should establish policies and procedures for 

IT operations, including backup and recovery of data, scheduling, and 

problem management.

A Hedge Fund Manager should implement policies and procedures to 

help ensure that all necessary data is 

properly backed up so that it can be 

accurately and completely recovered 

if a system outage or compromise 

of data integrity occurs. In addition, a Hedge Fund Manager should 

prepare a detailed business continuity, disaster recovery, and crisis 

management (“BC/DR”) plan in 

order to help ensure the continuity 

of business operations in the event 

of disaster. A Hedge Fund Manager 

should test and update the plan on 

a regular basis. See Section 7—

Business Continuity, Disaster 

Recovery, and Crisis Management 

for more guidance. 

A Hedge Fund Manager should also 

have procedures in place to execute 

programs, including data transmissions, as planned and to identify and 

resolve deviations from scheduled 

processing in a timely manner. 

A Hedge Fund Manager should 

implement policies and procedures 

in order to identify, resolve, review, 

and analyze any problems or incidents in a timely manner.

Sound Practices for Hedge Fund Managers | 07
1.9 

A Hedge Fund Manager should carefully select and monitor any missioncritical, third-party service providers performing key business functions 

(e.g., prime brokerage, risk monitoring, valuation, or BC/DR functions) 

or it or any Hedge Fund it manages based on such service provider’s 

experience with those particular Hedge Fund operations.

Mission-critical service providers are 

those service providers a Hedge Fund 

Manager requires to ensure prompt 

and accurate execution and processing of transactions and to meet 

regulatory reporting requirements. A 

Hedge Fund Manager should define 

clearly in written agreements with 

mission-critical, third-party service 

providers the roles, responsibilities, 

and liability of such service providers. A Hedge Fund Manager should 

periodically evaluate the performance 

of mission-critical service providers. 

A Hedge Fund Manager should disclose to the Hedge Funds it manages 

relationships between the Hedge 

Fund Manager and service providers 

that may give rise to potential 

material conflicts of interest. See 

the Recommendations in Section 

7—Business Continuity, Disaster 

Recovery, and Crisis Management 

for the issues associated with thirdparty service providers.

Third-Party Service Providers

08 | Management, Trading and Information Technology Controls
Sound Practices for Hedge Fund Managers

Sound Practices for Hedge Fund Managers | 01

The Recommendations in this section address the key elements 

a Hedge Fund Manager should consider in providing investment 

management services to a Hedge Fund, while balancing the interests 

of Hedge Fund investors. As described in the Introduction, investors 

in Hedge Funds—whether institutional or individual—are required 

by law or regulation to satisfy financial net worth and other criteria 

in order to invest in a Hedge Fund. For example, some institutional 

investors, such as pension plans, are represented by fiduciaries 

subject to heightened regulation of investment activities in order to 

protect beneficiaries. Irrespective of the type of investor, all Hedge 

Fund investors should have the tools to understand and evaluate for 

themselves any risks associated with an investment in a Hedge Fund. 

A Hedge Fund Manager should provide Hedge Fund investors with 

adequate information (as described in this section) to enhance the 

investors’ ability to understand and evaluate their investment in the 

Hedge Fund. Moreover, a Hedge Fund Manager should develop 

policies and procedures to address situations involving potential or 

actual material conflicts of interest generally consistent with these 

Recommendations.

2. Recommendations: 

Responsibilities to Investors
Responsibilities to Investors

2.1 

A Hedge Fund Manager should foster a management environment that 

appropriately recognizes its responsibility to act in the interest of each 

Hedge Fund it manages.

A Hedge Fund Manager is retained 

by a Hedge Fund to act as its 

investment manager. In that capacity, a Hedge Fund Manager has a 

responsibility to act in the interest 

of its client, the Hedge Fund, and 

in the interest of the Hedge Fund’s 

investors. A Hedge Fund Manager 

must also act in accordance with its 

investment management agreement 

with the Hedge Fund, the offering 

documents of the Hedge Fund, and 

applicable law. When a Hedge Fund 

Manager has more than one client 

(e.g., other Hedge Funds or managed accounts), it should act in a 

manner consistent with its fiduciary 

duties to each client. This requires 

the Hedge Fund Manager to balance 

the interests of all client accounts 

against its own interests to the 

extent the Hedge Fund Manager’s 

interests are reasonable and properly 

disclosed. Such balancing of interests, fiduciary duties, and resulting 

conflicts are the same as with other 

asset managers (e.g., private equity 

firms, mutual funds, etc.). 

2.2 

A Hedge Fund Manager should provide prospective and existing Hedge 

Fund investors with information regarding the Hedge Fund’s investment 

objectives and strategies, range of permissible investments, material risk 

factors, and the material terms of an investment in the Hedge Fund. This 

information should be sufficient to enhance the ability of investors to 

understand and evaluate their investment in the Hedge Fund.

As part of their due diligence review, 

prospective and existing Hedge 

Fund investors may ask a Hedge 

Fund Manager questions regarding the terms of an investment in a 

Hedge Fund, as well as the management and investment practices of 

the Hedge Fund Manager. A sample 

checklist of commonly asked questions or requested information is 

provided in Appendix II—MFA’s 

Model Due Diligence Questionnaire 

for Hedge Fund Investors. When 

asked questions from prospective 

02 | Responsibilities to Investors
Sound Practices for Hedge Fund Managers | 03

Hedge Fund investors, a Hedge 

Fund Manager may choose to 

respond to such questions with 

standardized answers that can be 

supplemented as needed. 

Informative disclosure regarding 

the material terms of an investment 

in a Hedge Fund (e.g., applicable 

charges, expenses, withdrawal or 

redemption rights and restrictions, 

reporting, use of “side pockets”, etc.) 

and the Hedge Fund’s investment 

objectives and strategies enhance the 

ability of investors to form proper 

expectations as to the Hedge Fund’s 

performance. Therefore, a Hedge 

Fund Manager should attempt to 

prepare appropriate disclosures for 

dissemination to Hedge Fund investors on a timely basis, without compromising proprietary information 

regarding the Hedge Fund’s trading 

positions. See Recommendation 

2.4 below for a discussion of material risk factors that a Hedge Fund 

Manager should consider disclosing 

to Hedge Fund investors.

When a Hedge Fund Manager 

changes the objectives or strategies of a Hedge Fund, the range of 

permissible investments, or terms 

of an investment in a Hedge Fund, 

the Hedge Fund Manager should 

evaluate and consider consulting its 

legal counsel to determine whether 

disclosure to Hedge Fund investors 

is necessary and whether consent 

should be obtained from Hedge 

Fund investors. After evaluating 

the circumstances, a Hedge Fund 

Manager may fairly determine that it 

need not make additional disclosure 

and/or obtain consent from investors 

to changes in the objectives or strategies of the Hedge Fund. A Hedge 

Fund Manager should evaluate the 

materiality of the change in light of 

the variety of objectives employed 

by the Hedge Fund Manager and 

any periodic communications that 

are made to Hedge Fund investors 

regarding a Hedge Fund’s activities. 

A Hedge Fund Manager should 

review at least annually a Hedge 

Fund’s offering documents and any 

standardized answers or responses 

to a due diligence questionnaire 

to (1) ensure that the documents 

reflect current information and 

disclosures regarding the Hedge 

Fund’s objectives and strategies, 

and (2) determine if any modifications are required due to any 

changes in any material terms of an 

investment in a Hedge Fund, or any 

legal, regulatory, tax, or other developments. A Hedge Fund Manager 

should communicate any material 

modifications of a Hedge Fund’s 

offering documents to existing 

investors by delivery of the updated 

offering documents or by other 

correspondence.
2.3 

A Hedge Fund Manager should assess whether its operations or particular 

circumstances may present actual or potential conflicts of interest and 

should attempt to appropriately disclose any material conflicts of interest 

to Hedge Fund investors.

A Hedge Fund Manager should 

develop policies and procedures 

to assess and appropriately disclose 

any material conflicts of interest 

to Hedge Fund investors. Potential 

conflicts that a Hedge Fund 

Manager may need to disclose, 

if applicable, include:

• Relationships with brokers and 

other service providers;

• Conflicts generated by fee 

arrangements;

• Proprietary trading of the Hedge 

Fund Manager and personal/

employee trading;

• Use of “Soft Dollar Arrangements” 

and/or expense pass-through 

provisions; 

• Conflicts that may arise in the 

context of side-by-side management of multiple accounts, such 

as the allocation of investment 

opportunities among Hedge 

Funds or accounts managed by 

the Hedge Fund Manager; and

• Conflicts generated by interestedparty transactions or relationships 

with affiliated persons.

Responsibilities to Investors

04 | Responsibilities to Investors
Sound Practices for Hedge Fund Managers | 05

2.4 

A Hedge Fund Manager should work with its legal counsel to identify 

and adequately describe risks to be disclosed to Hedge Fund investors.

Examples of the types of risks that 

a Hedge Fund Manager should 

consider disclosing are the risks 

associated with: 

• Incentive compensation structure;

• Lack of assurance as to 

performance;

• A specific strategy or particular 

types of investment instruments 

and investment markets;

• Limited liquidity and restrictions 

on redemptions (e.g., those resulting from redemption “gates” and 

side-pocket investments);

• Use of leverage and margin 

(including leverage embedded 

in derivative instruments);

• Potential loss of key management 

personnel; 

• Taxation and “ERISA” status and 

considerations;

• Valuation of assets, including 

valuation of side-pocket investments or other illiquid or nonmarketable investments;

• Broker and other “counterparty” 

insolvency; and

• Presence or absence of regulatory 

oversight of the Hedge Fund and 

Hedge Fund Manager.
2.5

A Hedge Fund Manager should periodically provide Hedge Fund 

investors with relevant performance data and, when appropriate, risk 

information regarding the strategy and terms of the Hedge Fund. 

Relevant periodic disclosures to 

Hedge Fund investors may include:

• Performance measures, such as 

NAV calculations, strategy performance attribution, and similar 

information;

• Capital measures, such as assets 

under management; and

• Risk measures that are appropriate 

to the Hedge Fund.

Responsibilities to Investors

06 | Responsibilities to Investors

2.6 

When a Hedge Fund Manager has the discretion to grant (or has in the 

past granted)—through a side letter or similar arrangement—any more 

favorable rights to certain investors that may have a material impact on 

other investors, the Hedge Fund Manager should (1) make appropriate 

disclosures to investors in the Hedge Fund and (2) consider issues associated with the approval and monitoring of any special terms to investors.

Examples of certain types of rights 

that may have a material impact on 

other Hedge Fund investors may 

include, but are not limited to, 

more favorable transparency and/or 

liquidity rights.

Hedge Fund Managers with operations in the United Kingdom should 

exercise caution in connection with 

the use of side letters and other 

similar arrangements. The Financial 

Services Authority (the “FSA”) has 

pronounced that, when exercising 

regulatory functions, it will consider a guidance note issued by the 

Alternative Investment Management 

Association, a U.K.-based alternative 

investment industry association, with 

respect to the use of these arrangements. The guidance note, in summary, states that firms are required 

to disclose the existence of side 

letters that contain 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 of interests at a material 

disadvantage.
2.7 

A Hedge Fund Manager should develop and maintain trade allocation 

policies, disclose the material aspects of these policies to its Hedge Fund 

investors, and document any material deviations therefrom. A Hedge 

Fund Manager should include the material aspects of its trade allocation 

policies in a Hedge Fund’s offering documents and, with respect to a 

U.S.-registered investment adviser, in the Hedge Fund Manager’s Form 

ADV that is filed with the SEC.

Sound Practices for Hedge Fund Managers | 07

2.8 

A Hedge Fund Manager should deliver annual audited financial statements to Hedge Fund investors in a timely manner or as may otherwise 

be prescribed by laws or regulations.

A Hedge Fund Manager should 

engage qualified independent auditors to audit the annual financial 

statements of any Hedge Fund with 

investors not affiliated with the 

Hedge Fund Manager. Detailed 

guidance on the development of 

a Hedge Fund Manager’s policies 

to determine NAV and the Financial 

Statement Close Process (“FSCP”) 

are provided in Section 3—

Determination of Net Asset Value. 

2.9 

A Hedge Fund Manager should develop valuation policies and procedures, recognizing that Hedge Fund investors may both subscribe to and 

redeem interests in a Hedge Fund in reliance on the values derived from 

such policies and procedures. 

Detailed guidance on the development of a Hedge Fund Manager’s 

policies to verify assets and liabilities, 

determine NAV, and the FSCP 

are provided in Section 3— 

Determination of Net Asset Value. 
2.10 

A Hedge Fund Manager should develop and maintain a code of ethics 

and personal trading policies that include the appropriate use of material, non-public information. A Hedge Fund Manager should communicate 

the material aspects of this code and policies to Hedge Fund investors.

A Hedge Fund Manager’s code of 

ethics, personal trading policies, and 

monitoring of trading activity should 

seek to prevent and detect improper 

trading by its personnel, taking into 

account: the nature of the Hedge 

Fund Manager’s business; type of 

investments or instruments traded; 

and applicable laws, rules, and regulations in all applicable jurisdictions. 

See Section 5—Regulatory Controls 

for additional guidance. See Appendix VII—Checklist for Hedge 

Fund Managers to Consider in 

Developing a Code of Ethics for a 

menu of items that a Hedge Fund 

Manager may wish to consider in 

developing a code of ethics and 

personal trading policies. This code 

and policies may include: the use 

of blackout periods; restricted lists; 

reviews; holding periods; and prohibitions on certain types of trades 

and/or required pre-approval/clearance of certain transactions, such as 

initial public offerings, private placements/limited offerings, or securities 

on any restricted list.

Responsibilities to Investors

08 | Responsibilities to Investors
2.11 

A Hedge Fund Manager should establish policies and procedures designed to (1) safeguard information related to its Hedge Fund trading 

activities, as well as information subject to confidentiality obligations, and 

(2) prevent the misuse of this information (including investor or customer 

information), taking into account the nature of the Hedge Fund Manager’s 

business and type of investments or instruments traded. 

A Hedge Fund Manager’s policies 

and procedures should address the 

protection of information relating to 

the Hedge Fund’s trading activities, 

as well as the protection of confidential information provided to the 

Hedge Fund or the Hedge Fund 

Manager by the Hedge Fund 

investors and other third parties. 

In the United States, for example, 

with respect to individuals who 

are investors in a Hedge Fund, the 

Hedge Fund Manager should ensure 

that its policies and procedures meet 

the requirements of the SEC’s Regulation S-P promulgated under the 

Gramm-Leach-Bliley Act. Moreover, 

a Hedge Fund Manager should 

establish appropriate information 

barriers within its firm to effectuate 

the foregoing. 

Sound Practices for Hedge Fund Managers | 09 
10 | Responsibilities to Investors

2.12 

A Hedge Fund Manager should disclose to Hedge Fund investors its 

relationships with prime brokers and other brokers that involve potential 

material conflicts of interest and, taking into account the nature of the 

Hedge Fund Manager’s business and type of investments or instruments 

traded, develop the appropriate policies and procedures. 

Appropriate considerations, potential disclosures, and policies may 

include:

• Disclosure of material relationships between the Hedge Fund 

Manager and brokers; 

• Disclosure of material affiliated 

or interested-party transactions;

• Policies and disclosures on use 

of Soft Dollar Arrangements (see 

Recommendation 2.13); and

• Discussion of how the Hedge 

Fund Manager seeks to meet 

its best execution obligations 

to clients and of any directed 

brokerage arrangements. See 

Section 6—Trading Relationship 

Management, Monitoring, and 

Disclosure, Recommendation 6.5.

Responsibilities to Investors
Sound Practices for Hedge Fund Managers | 11 

2.13 

A Hedge Fund Manager should disclose its use of Soft Dollar Arrangements to existing and potential investors in each Hedge Fund it manages. 

This disclosure should be made prior to engaging in such arrangements 

and should disclose the Hedge Fund Manager’s policies with respect to 

these arrangements.

Disclosure of Soft Dollar Arrangements may include:

• Whether the Hedge Fund 

Manager’s use of the products 

and services provided by a broker 

pursuant to Soft Dollar Arrangements does not exclusively benefit 

the Hedge Fund whose trades 

generate the relevant brokerage 

commissions or fees;

• The types of products and services 

that may be received through 

Soft Dollar Arrangements in an 

appropriate level of detail, and 

whether the use of Soft Dollar 

Arrangements falls within the safe 

harbor of Section 28(e) of the 

Securities Exchange Act of 1934, 

as amended.

For guidance on a Hedge Fund 

Manager’s determinations and policies relating to Soft Dollar Arrangements, see Section 6—Trading 

Relationship Management, 

Monitoring, and Disclosure, 

Recommendations 6.8 and 6.9.

2.14

A Hedge Fund Manager should establish and maintain policies relating 

to gifts and entertainment, and other payment or receipt of money or 

property from any person in a non-business capacity that may create the 

appearance of impropriety to Hedge Fund investors.
Sound Practices for Hedge Fund Managers

Sound Practices for Hedge Fund Managers | 01

This section sets forth guiding principles a Hedge Fund Manager 

should consider in fulfilling one of the most important functions of 

its operations: the determination of NAV. A Hedge Fund Manager, 

in consultation with the governing body of a Hedge Fund, should 

establish policies and procedures for the determination of NAV that 

are fair, consistent, and verifiable. It is important for a Hedge Fund 

Manager to recognize that Hedge Fund investors may subscribe to 

and redeem interests in the Hedge Fund in reliance on the values 

derived from these policies and procedures. The Recommendations 

in this section cover various aspects of a Hedge Fund Manager’s 

NAV policies and procedures, including: (1) policies and procedures 

with respect to verifying the existence of assets and liabilities 

(financial and non-financial); (2) policies for the manner and frequency of computing NAV based on U.S. generally accepted accounting 

principles (“U.S. GAAP”) or International Accounting Standards 

(“IAS”) with respect to each Hedge Fund; (3) policies regarding 

the appropriate disclosure of material, NAV-related information to 

Hedge Fund investors; (4) policies and procedures to ensure pricing 

is fair, consistent, and verifiable; (5) policies for the manner and frequency of computing portfolio valuation for the purposes of internal 

risk monitoring of the portfolio; and (6) policies and procedures for 

the establishment of the FSCP, which is the last part of the process 

for determining NAV. 

3. Recommendations: 

Determination of Net Asset Value
Verification of the Existence of Assets and Liabilities

3.1 

A Hedge Fund Manager should establish procedures to independently 

verify the existence of financial assets and liabilities.

The existence of financial assets and 

liabilities is a critical element in the 

computation of NAV. A Hedge Fund 

Manager should develop practices to 

ensure trades are processed accurately 

and on a timely basis. A Hedge Fund 

Manager should establish these 

practices based on a review and 

understanding of the Hedge Fund 

Manager’s business structure. A 

Hedge Fund Manager should establish, implement, and enforce robust 

policies, procedures, and internal 

controls for each stage of the trading 

cycle, including: trade initiation; 

execution; confirmation; settlement; 

reconciliation; and accounting. 

In addition, a Hedge Fund Manager 

should establish, implement, and 

enforce procedures for the verification of non-financial assets and 

liabilities. A Hedge Fund Manager 

should maintain formal documentation to support its non-financial 

accruals. See Recommendation 3.12 

regarding verification of non-financial assets and liabilities (e.g., accruals 

zfor expenses and fees).

Section 1—Management, Trading, 

and Information Technology 

Controls and Section 6—Trading 

Relationship Management, Monitoring, and Disclosure provide a Hedge 

Fund Manager with additional 

guidance that may supplement the 

Recommendations provided in this 

section, focusing specifically on the 

determination of NAV.

02 | Determination of Net Asset Value
3.2 

A Hedge Fund Manager should establish policies and procedures for 

the control and processing of purchases and sales of financial assets and 

liabilities.

A Hedge Fund Manager should 

establish policies for the processing 

of purchases and sales of financial 

assets and liabilities. These policies 

may include thresholds for specific 

levels of approvals. A Hedge Fund 

Manager should also establish adequate segregation of duties among 

those who are authorized to trade, 

those who are responsible for recording trade activity, and those who are 

responsible for reconciling the trade 

activity. Logical access rights to data 

and software application supporting 

these processes should enforce the 

required segregation of duties. In 

addition, a Hedge Fund Manager 

should develop and implement procedures prior to executing trades in 

new financial assets and liabilities 

or with new counterparties. See 

Section 6—Trading Relationship 

Management, Monitoring, and 

Disclosure for more information 

on documentation policies and 

procedures in transacting with 

counterparties.

Sound Practices for Hedge Fund Managers | 03
3.3 

A Hedge Fund Manager should establish policies and procedures for the 

periodic reconciliation of the Hedge Fund Manager’s recorded financial 

assets and liabilities to statements produced by independent sources.

A Hedge Fund Manager should 

reconcile trade information entered 

into its portfolio accounting system 

with the trade information recorded 

by third parties on a daily basis. In 

addition, to the extent practical, 

a Hedge Fund Manager should 

reconcile cash balances to balances 

recorded or statements published by 

third parties at the end of each day. 

If a Hedge Fund Manager discovers 

any differences between these balances or statements, it should, 

to the extent practical, investigate 

any differences on a timely basis.

In order to verify the existence 

of financial assets and liabilities, 

a Hedge Fund Manager should 

reconcile its internal financial statements to statements produced by 

recognized independent financial 

institutions on a monthly basis. 

A Hedge Fund Manager should 

attempt to reconcile any differences 

between the statements, recognizing 

that differences could exist between 

a counterparty’s statement and a 

prime broker’s statement.

Verification of the Existence of Assets and Liabilities

04 | Determination of Net Asset Value
Sound Practices for Hedge Fund Managers | 05

3.4 

A Hedge Fund Manager should establish procedures for obtaining confirmations and performing periodic reconciliations of OTC derivatives with 

its respective counterparties.

To the extent applicable, a Hedge 

Fund Manager should implement and comply with evolving 

industry practices to strengthen its 

processing, clearing, and settlement 

arrangements for OTC derivatives. 

These practices may include the 

use of protocols for issuing and 

completing trade confirmations and 

obtaining prior written consent for 

assignments.

In addition, the industry has established protocols for basic derivatives 

documentation, including master 

agreements, master trade confirmations, security agreements, guarantees, and related documentation, as 

well as industry-standard documentation for foreign exchange, currency 

forwards, currency options, and 

related OTC transactions. A Hedge 

Fund Manager should consider the 

use of such protocols and documentation to achieve operational efficiencies in the negotiation and execution 

of basic derivatives documentation 

with counterparties.

In addition to the foregoing, a 

Hedge Fund Manager should establish a practice of reconciling its OTC 

derivatives records with the records 

of its respective counterparties on a 

monthly basis. This practice would 

require that the Hedge Fund Manager receives monthly statements 

from its respective counterparties.
3.5

A Hedge Fund Manager should establish policies for maintaining 

sufficient internal documentation of transactions involving non-publicly 

traded financial investments (other than OTC derivatives) for the purpose 

of facilitating and ensuring the verification of the Hedge Fund’s financial 

assets and liabilities.

For non-publicly traded financial 

assets and liabilities (other than the 

OTC derivatives described above), a 

Hedge Fund Manager should maintain adequate supporting documentation as evidence of the existence of 

a transaction. In addition, a Hedge 

Fund Manager should maintain 

internal documentation in a manner, 

and to a sufficient degree, to enable 

it to track and support unfunded 

commitments to third parties. The 

purpose of this policy is to ensure 

the accuracy of amounts recorded 

as assets and liabilities.

A Hedge Fund Manager should 

establish and implement procedures 

for: the dissemination of regular 

corporate action updates; the determination of the applicable corporate 

action; and the recording of such 

corporate actions.

Verification of the Existence of Assets and Liabilities

06 | Determination of Net Asset Value
3.6 

A Hedge Fund Manager should adopt an appropriate accounting 

standard that incorporates the concept of “fair value”.

Determination of Fair Value

Sound Practices for Hedge Fund Managers | 07

For NAV purposes, a Hedge Fund 

Manager should value investments 

according to U.S. GAAP or IAS. A 

Hedge Fund Manager should recognize that there may be differences 

in determining fair value of financial 

assets and liabilities as between 

U.S. GAAP and IAS 39: Financial 

Instruments, Recognition and 

Measurement under International 

Financial Reporting Standards. 

Under either standard, however, 

a Hedge Fund Manager should 

comply with the relevant accounting standard that incorporates the 

concept of fair value.

Generally, U.S.-based Hedge Fund 

Managers employ U.S. GAAP 

Financial Accounting Standards 

Board's Statement of Financial 

Accounting Standards No. 157, 

Fair Value Measurements (“FAS 

157”) to value their financial investments. Under FAS 157, fair value 

is defined as the price that would 

be received to sell an asset or paid 

to transfer a liability in an orderly 

transaction between market participants at the measurement date. In 

measuring fair value, FAS 157 also 

establishes a fair value hierarchy that 

prioritizes the inputs that are applied 

to valuation techniques. 
3.7 

A Hedge Fund Manager, in consultation with its governing body, should 

determine the party who bears ultimate responsibility for the valuation 

of investments and disclose this information to Hedge Fund investors.

If ultimate responsibility for valuation of investments does not lie 

with the Hedge Fund Manager, 

the Hedge Fund Manager should 

provide oversight in the valuation 

process. This oversight may include 

regular meetings and approvals of 

pricing methodologies.

A Hedge Fund Manager may deem 

it necessary to establish a separate 

committee, such as a valuation or 

pricing committee, to oversee the 

determination of fair value in the 

valuation process. The establishment 

of a valuation committee may mitigate the risk of actual or potential 

conflicts. A valuation committee, 

if formed, should be comprised of 

individuals who have the authority 

and experience to provide meaningful oversight of the valuation process. 

When a valuation committee regularly solicits and employs the advice 

of external experts in the valuation 

process (such as Fund Administrators), the use of these experts could 

help prove the independence of the 

committee.

Where certain responsibilities (e.g., 

position verification, pricing affirmation, etc.) for determining a Hedge 

Fund’s NAV are contractually 

assigned to a Fund Administrator, a 

Hedge Fund Manager should review 

and analyze its contract with the 

Fund Administrator to determine 

the Fund Administrator’s level of 

responsibility for determining NAV. 

Before a contract is executed between them, a Fund Administrator 

and a Hedge Fund Manager should 

agree as to the roles and responsibilities between them in valuing 

financial assets and liabilities of the 

Hedge Fund Manager and/or its 

Hedge Funds.

Responsibility for Valuation

08 | Determination of Net Asset Value
3.8 

A Hedge Fund Manager’s pricing policies and procedures should be fair, 

consistent, and verifiable.

A Hedge Fund Manager should, to 

the extent practical, either calculate 

or verify the accuracy of prices independent of the investment decision 

process. To that end, a Hedge Fund 

Manager should rely on price quotes 

from external sources whenever 

practical and establish policies for 

determining the value of assets for 

which appropriate external price 

quotes are not reasonably available. 

In addition, a Hedge Fund Manager 

should document the process used 

to determine whether to implement 

recommendations of a pricing service, as well as circumstances in which 

it is appropriate to override a pricing 

service’s recommendation.

When available, a Hedge Fund 

Manager should consider validating 

prices of financial assets and liabilities with a secondary source and 

investigating significant differences 

between the primary and secondary 

source. For example, when a pricing 

model is used to value OTC investments, the output of the model 

may be compared to a counterparty 

quote. In addition, a Hedge Fund 

Manager should consider the role 

of the Fund Administrator in the 

price validation process. Wherever 

possible, a Fund Administrator 

should independently price the 

financial assets and liabilities of 

the Hedge Fund.

Certain instruments held in Hedge 

Fund portfolios may have more than 

one official price that can be used 

for valuation purposes. Examples 

of this are financial assets and liabilities traded on multiple exchanges, 

(including dual-listed securities), 

those that trade across multiple time 

zones, and certain OTC derivatives. 

In determining which settlement 

price to use in these instances, 

a Hedge Fund Manager should 

consider the exit price and what 

the Hedge Fund would realize as 

of the time that the Hedge Fund 

closes its books and determines 

NAV. Should a security close on a 

foreign exchange prior to the valuation by the Hedge Fund Manager, 

the Hedge Fund Manager should 

consider the time zone movements 

that occur in markets subsequent 

to the foreign close, particularly in 

situations when there is shareholder 

activity in the relevant security.

Sound Practices for Hedge Fund Managers | 09 

Pricing Policies and Procedures
10 | Determination of Net Asset Value

3.9 

A Hedge Fund Manager should establish pricing policies and procedures 

that assure that NAV is marked at fair value. 

A Hedge Fund Manager should 

choose reliable and recognized pricing sources to the extent practical. 

The existence of written pricing 

policies and procedures is a critical 

element to the control structure surrounding a Hedge Fund Manager’s 

pricing of portfolio investment 

instruments. The Hedge Fund 

Manager’s governing body should 

establish these policies based on a 

thorough review and understanding 

of the totality of the Hedge Fund 

Manager’s business structure (e.g., 

range and complexity of instruments 

traded, stipulations contained in the 

Hedge Fund’s offering documents, 

liquidity terms offered to Hedge 

Fund investors, etc.). In addition, a 

Hedge Fund Manager should review 

these policies either (1) with the 

person(s) responsible for making 

investment decisions for the Hedge 

Fund or the valuation committee, 

as the case may be, or (2) with the 

Hedge Fund’s independent auditors. 

In any case, a Hedge Fund Manager 

should consistently apply its pricing 

policies and procedures.

Pricing policies and procedures 

should clarify the role of each party 

in the valuation process, identify the 

pricing source for each instrument, 

and include resolution procedures 

for pricing and capture exceptions. 

A Hedge Fund Manager should 

periodically update these policies 

and procedures for new types of 

instruments, as well as changes in 

applicable accounting standards. 

Where practical, a Hedge Fund 

Manager should develop practices 

and/or systems for capturing pricing 

data for their trading positions from 

independent sources on a daily basis. 

A Hedge Fund Manager should also 

adopt procedures for periodically 

verifying the accuracy of pricing 

data and for reviewing any material 

discrepancies between price sources. 

Where an instrument is not actively 

traded or where obtaining price 

information requires significant 

effort, less frequent pricing may 

be appropriate depending on the 

nature and the size of the trading 

position and the size, structure, and 

investment objective and strategy 

of the Hedge Fund. For positions 

traded when the only external source 

of fair value may be quotes from 

relevant market-makers (the number 

of which, based on the liquidity of 

the position, may be very limited), 

a Hedge Fund Manager should 

also consider the number of quotes 

desired to gain comfort with the fair 

value. This may also lead to model 

Pricing Policies and Procedures
Sound Practices for Hedge Fund Managers | 11 

pricing as discussed below in this 

Recommendation 3.9.

The range of OTC instruments that 

may require alternate pricing sources 

include derivative instruments, 

asset-backed securities, fixed income 

instruments, and other similar 

instruments. However, if these alternate sources are unavailable, either 

because the transactions are one-ofa-kind or not actively traded, the 

only market for these instruments 

may be with the transaction’s counterparty. These instruments could 

be valued: (1) by obtaining a quote 

or estimate from the counterparty; 

(2) based on a pricing model; or (3) 

any combination thereof. Where a 

pricing model is used, a Hedge Fund 

Manager should make sure that it is 

in a position to explain and support 

the model parameters used in determining the valuation. In addition, 

the Hedge Fund Manager should 

consider “back-testing” the pricing 

model in order to assess its accuracy. 

Where market prices do not exist 

or are not indicative of fair value, 

a Hedge Fund Manager should 

establish valuation methods for NAV 

purposes. For example, in valuing 

certain instruments, a Hedge Fund 

Manager may consider seeking input 

from its portfolio management team 

in order to take advantage of their 

expertise. Nonetheless, a Hedge 

Fund Manager must ensure that the 

appropriate amount of control and 

oversight exists, potentially through 

a valuation committee, as discussed 

in Recommendation 3.7.

A Hedge Fund Manager may use 

alternative approaches for valuing 

illiquid or otherwise hard-to-value 

financial assets and liabilities. Among 

the various approaches to valuing 

these types of assets and liabilities 

are: obtaining broker or counterparty quotes; performing model pricing; 

and receiving independent appraisals. These three types of approaches 

should be included in the overall 

valuation policy of a Hedge Fund 

Manager. When obtaining broker 

quotes to value illiquid and hard-tovalue financial assets and liabilities, 

a Hedge Fund Manager should 

attempt to obtain multiple broker 

quotes and develop a methodology 

for calculating an average price, or 

be able to support the price ultimately used. For financial assets 

and liabilities valued using a pricing 

model, a Hedge Fund Manager 

should give consideration to obtaining counterparty quotes to assess 

the reasonableness of the pricing 
12 | Determination of Net Asset Value

and liabilities with investor interests 

in order to achieve fairness to investors (e.g., side pockets), the Hedge 

Fund Manager should recognize that 

creation of this mechanism does not 

change the principles or methods 

used for determining fair value of the 

illiquid financial assets and liabilities.

A Hedge Fund Manager should 

monitor the performance of pricing 

services to ensure consistency in the 

services provided. 

model valuation. Where independent appraisals are obtained, a Hedge 

Fund Manager should evaluate each 

independent appraiser’s qualifications and experience in valuing an 

illiquid or otherwise hard-to-value 

financial asset or liability and the 

extent to which it can provide price 

assurance.

If a Hedge Fund Manager has used 

a mechanism to align the investment 

strategy of illiquid financial assets 

3.9 continued

Pricing Policies and Procedures
Sound Practices for Hedge Fund Managers | 13 

Frequency of NAV Determinations

indicative NAV more frequently, 

based on estimates of accrued fees, 

income and expenses, and trading 

profits and loss, which may 

be used for internal purposes, 

such as risk monitoring. See also 

Section 4—Risk Management, 

Recommendations 4.12 and 4.17. 

A Hedge Fund’s official NAV is 

typically determined on an established periodic basis and is used for 

the purposes of disclosure and for 

the pricing of Hedge Fund investor subscriptions and redemptions. 

Separately, a Hedge Fund Manager 

may also prepare an estimated or 

3.10

A Hedge Fund Manager should establish policies for the frequency 

of determining a Hedge Fund’s NAV.
14 | Determination of Net Asset Value

Financial Statement Close Process

other accounting activities. This 

policy should include: (1) preparing 

the trial balance and any necessary 

consolidations; (2) accumulating, 

preparing, reviewing, and posting 

journal entries; and (3) drafting and 

reviewing the financial statements 

and related disclosures.

A Hedge Fund Manager should 

delegate the responsibility of the 

FSCP to personnel conversant in the 

relevant U.S. GAAP or IAS, as well 

as any applicable regulatory requirements. This delegation of responsibility will ensure that the financial 

statements prepared, whether they 

are internal management reports or 

external regulatory reports, are in 

compliance with U.S. GAAP or IAS, 

as the case may be, or applicable 

regulatory requirements. A Hedge 

Fund Manager should define 

access rights to data and software 

applications supporting the FSCP 

to enforce appropriate segregation 

of duties.

The FSCP is the process whereby 

the results of various transactions 

are summarized, reviewed, consolidated, edited, and used for reporting 

to investors and management. In 

the FSCP, the calculation of NAV 

should take into account not only 

the fair value of the financial assets 

and liabilities (as described above) in 

the portfolio (sometimes referred to 

as “trading P&L”), consistent with 

appropriate accounting principles 

(U.S. GAAP or IAS), but also accruals of interest, dividends, and other 

receivables, as well as fees, expenses, 

and other payables. This is critical as 

Hedge Fund investors will both buy 

and sell interests in a Hedge Fund 

on the basis of NAV. 

A Hedge Fund Manager should 

establish a policy around the FSCP 

that transforms the transactions 

reflected in accounting records into 

financial statements and related 

disclosures, and that generally represents a process entirely separate from 

3.11

A Hedge Fund Manager should establish policies and procedures for 

periodic closing of books and records consistent with appropriate 

accounting principles.
Sound Practices for Hedge Fund Managers | 15 

When a Hedge Fund Manager uses 

a Fund Administrator, the Hedge 

Fund Manager should establish 

procedures to review the calculation of NAV provided by the Fund 

Administrator. This may include 

analyzing and reviewing in detail the 

package provided by the Fund Administrator when no internal records 

are kept, or reconciling the records 

provided by the Fund Administrator to the Hedge Fund Manager’s 

internal records.

A Hedge Fund Manager should 

have procedures in place to review 

the recordation of all financial and 

non-financial assets and liabilities. 

The recording of many of these 

accounts, such as the accruals for 

interest and dividends, ties in closely 

with the corporate action process 

that a Hedge Fund Manager should 

establish. For non-financial assets 

and liabilities, including management fees, incentive fees, and other 

liabilities, the Hedge Fund Manager 

should have a review process in 

place to ensure that these assets and 

liabilities are properly calculated and 

recorded when determining NAV. 

3.12

As part of the FSCP, a Hedge Fund Manager should incorporate procedures for the review and recordation of all financial and non-financial 

assets and liabilities (including accruals of interest, dividends, and recordation of all non-financial asset and liabilities, including management fees, 

incentive fees, and other liabilities).
16 | Determination of Net Asset Value

Hedge Fund Manager should take 

measures to ensure Hedge Fund 

investors are allocated their appropriate share of profits or losses within 

a given period. A Hedge Fund 

Manager can accomplish this by 

performing reasonableness checks 

on the returns of investors, such as 

calculating the rate of return of each 

investor for a period to verify that all 

investors with identical rights and fee 

arrangements have identical returns.

The allocation of income and 

expense to Hedge Fund investors is 

an integral part of the FSCP. Allocations are typically performed by the 

Fund Administrator or by a division 

within a Hedge Fund Manager’s 

back office. A Hedge Fund Manager 

should establish, implement, and 

enforce procedures to ensure that 

all new investors and exiting investors are allocated profits or losses in 

appropriate periods. In addition, a 

3.13

A Hedge Fund Manager should review the allocation of income and 

expense to Hedge Fund investors. 

Financial Statement Close Process

financial statements. By standardizing the way information is presented 

on a periodic basis to Hedge Fund 

investors and in annual financial 

statements, a Hedge Fund Manager 

will ensure that the investors receive 

consistent information throughout 

the year.

The way in which a Hedge Fund 

Manager reports to Hedge Fund 

investors should be consistent from 

period-to-period. A Hedge Fund 

Manager should also attempt to 

provide consistent information as 

between periodic reports and a 

Hedge Fund’s annual audited 

3.14

In relation to reporting to Hedge Fund investors, a Hedge Fund Manager 

should incorporate procedures that seek consistency between periodic 

reports and annual audited financial statements.
Sound Practices for Hedge Fund Managers

Sound Practices for Hedge Fund Managers | 01

The Recommendations in this section address the key elements of 

a Hedge Fund Manager’s risk management process. Hedge Fund 

Managers allocate Hedge Fund assets to mitigate risks in order to 

maximize associated returns. In this context, effective risk management is central to a Hedge Fund’s success over time. Key aspects 

of a robust Hedge Fund process dealing with risk include: risk measurement; risk monitoring; and risk management. Additional information on risk monitoring is provided in Appendix III—Supplemental 

Information on Risk Monitoring Practices for Hedge Fund Managers.

A Hedge Fund’s risk management process generally focuses on risks 

generating the largest potential losses, which for most Hedge Funds 

are “market risks”. In addition, risk management gives appropriate consideration to other types of risk to which a Hedge Fund is 

exposed, including “funding liquidity” risks, counterparty “credit 

risks”, and “operational risks”. See Appendix I for definitions of the 

foregoing italicized terms. 

4. Recommendations: 

Risk Management
Structure of Risk Management Process

4.1 

A Hedge Fund Manager should have a risk measurement process 

appropriate to its size, complexity, and portfolio structure.

The risk measurement process 

should: (1) develop risk metrics 

covering the major risks to which 

a Hedge Fund is exposed; (2) seek 

to develop qualitative information 

regarding risks that are not well 

captured by quantitative metrics; 

and (3) where feasible and appropriate in terms of a particular Hedge 

Fund’s portfolio, develop approaches 

to compare return metrics with risk 

metrics in order to evaluate return 

earned on a Hedge Fund portfolio 

per unit of quantifiable risk taken 

on that portfolio.

The risk measurement process 

should include the regular calculation of risk metrics developed for 

quantifiable risks, as well as periodic 

gathering of qualitative information on risks that are not sufficiently 

captured by quantitative metrics. 

A Hedge Fund Manager should 

calculate the various relevant risk 

metrics, as it deems appropriate, along various dimensions of 

disaggregation of the Hedge Fund’s 

portfolio, such as risk type, product, 

and portfolio manager.

4.2 

A Hedge Fund Manager should have a risk monitoring process 

appropriate to its size, complexity, and portfolio structure.

A Hedge Fund Manager’s risk 

monitoring process should include 

the production of regular risk reports 

to an appropriate level of detail, 

representing a Hedge Fund’s major 

risk exposures and highlighting key 

changes in these exposures. 

Appropriate personnel of the Hedge 

Fund Manager should regularly 

review reasonably detailed information on major risk exposures and 

should highlight any key developments for the governing body. This 

review should take into account risk 

reports and other relevant quantitative and qualitative information 

regarding the rationale for and the 

risks and returns of the Hedge Fund 

Manager’s trading strategies. 

02 | Risk Management
4.3 

A Hedge Fund Manager should have a risk management process 

appropriate to its size, complexity, and portfolio structure.

The governing body of a Hedge 

Fund Manager should periodically 

review quantitative and qualitative 

information regarding major risk 

exposures and realized and anticipated returns on risks taken. 

The governing body of a Hedge 

Fund Manager should review the 

nature and magnitude of risk 

exposure at the Hedge Fund and/or 

strategy levels to ensure consistency 

with the risk and return information 

that was communicated to Hedge 

Fund investors in the Hedge Fund’s 

offering documents.

The periodic review process should 

include: (1) assessing the performance of trading strategies, traders, 

and trading positions; and (2) taking 

appropriate decisions to adjust 

any of these factors to enhance the 

risk-adjusted performance of the 

Hedge Fund.

Sound Practices for Hedge Fund Managers | 03
4.4 

A Hedge Fund Manager should have controls to protect the integrity of 

information used in its risk measurement, monitoring, and management 

processes.

A Hedge Fund Manager should 

develop controls to protect the integrity of: (1) a Hedge Fund’s trading 

positions and other information used 

in risk measurement and risk monitoring; and (2) the risk and return 

information produced and used in 

the measurement, monitoring, and 

management processes.

Risk measurement and monitoring 

processes should be implemented 

by personnel of the Hedge Fund 

Manager who can provide a critical 

perspective on the Hedge Fund’s risk 

positions and are responsible to 

the governing body of the Hedge 

Fund Manager. 

The personnel team responsible 

for the risk measurement and 

monitoring processes should possess 

sufficient expertise to understand 

in detail the nature of the Hedge 

Fund Manager’s trading strategies 

and the main drivers of the risk and 

anticipated returns of its investments. This team should also have 

access to all data and resources 

necessary to effectively execute 

their responsibilities.

Market Risk

04 | Risk Management
4.5 

A Hedge Fund Manager should measure quantifiable, position-level 

market risk exposures on a reasonably consistent basis across the various 

portfolios and trading positions of the Hedge Funds it manages.

A Hedge Fund Manager should generally quantify exposures using “riskadjusted” metrics. These metrics may 

include, for example, delta-equivalent exposure for equity positions, 

PV01 and credit spread 01 for fixed 

income positions, and “gamma” and

“vega” for material option positions. 

A Hedge Fund Manager may find 

useful notional exposure measures 

in its risk management processes as 

a supplement to risk-adjusted measures. A Hedge Fund Manager should 

not, however, use notional exposure 

measures without other measures 

in this context unless the notional 

exposure measures are materially 

identical to risk-adjusted measures 

or risk-adjusted measures cannot 

be estimated robustly.

4.6 

A Hedge Fund Manager should calculate, report, and review aggregations 

of position-level market risk metrics along dimensions that highlight major 

aspects of a Hedge Fund’s market risk exposure.

The dimensions of aggregation 

relevant to market risk exposure will 

depend on a Hedge Fund’s risk exposures and organizational structure. 

In terms of risk exposures, relevant 

dimensions of aggregation may 

include: principal risk factors (such 

as national markets for equity or 

yield curves for fixed income); type 

of instruments (such as government 

bond, interest rate swap, interest 

rate option, corporate bond, credit 

default swap, etc.); industry sectors; 

and maturity.

In terms of organizational structure, 

relevant dimensions of aggregation may include the sub-portfolios 

managed within a Hedge Fund by 

individual portfolio managers.

Sound Practices for Hedge Fund Managers | 05
4.7

A Hedge Fund Manager should calculate, report, and review volatility 

metrics for portfolios and, if appropriate, relevant sub-portfolios.

Relevant portfolios for which volatility metrics can be calculated may 

include a Hedge Fund, as a whole, 

and sub-portfolios based on risk type 

and organizational structure. 

Volatility metrics are generally most 

reliable as risk management tools. 

When relevant historical pricing data 

display reasonably stable volatilities 

and/or correlations, a Hedge Fund 

Manager should calculate and review 

volatility metrics for exposures.

One class of volatility metrics 

addresses the realized variability 

of gains/losses for a portfolio over 

time (where the size and composition of portfolio positions may 

have changed). Metrics in this class 

include realized standard deviation 

of historical trading P&L or return 

and realized drawdown from peak.

A second class of metrics consists 

of forecasts of the anticipated future 

variability of gains/losses for a 

specific and unchanging portfolio. 

Examples of such metrics are referred 

to as “Value-at-Risk” or “VAR” 

and forecasted standard deviation 

of future trading P&L.

Market Risk

06 | Risk Management
4.9 

A Hedge Fund Manager should understand the liquidity characteristics 

of the various assets in the portfolios of the Hedge Funds that it manages. 

“Asset liquidity” is a measure of how 

easily and at what cost an asset can 

be sold in the market. Liquidity 

varies across asset types, time, and 

market conditions. Measures of 

liquidity may be expressed as the 

amount held as a percentage of: daily 

trading volume; issue size; or open 

interest. Another measure of asset 

liquidity is the bid/ask pricing spread 

for an asset. 

4.8 

A Hedge Fund Manager should perform “stress tests” to determine how 

potential large changes in market prices and other risk factors could affect 

a Hedge Fund’s value.

Stress tests assess the impact of 

potential large market changes in 

prices on a Hedge Fund’s value, 

taking into account relevant nonlinearities in the relationship between portfolio value and size of the 

change in market prices. Stress tests 

may consider large price changes 

in various markets one-by-one or 

jointly in multiple markets. 

Stress tests of joint market price 

changes with a particular market or 

economic motivation are often called 

“scenario analysis” and may consist of 

scenarios of market behavior that are 

either historical or prospective.

Sound Practices for Hedge Fund Managers | 07 
4.10 

A Hedge Fund Manager should be aware of limitations of the metrics 

and models that it uses in its market risk measurement, monitoring, 

and management processes.

A Hedge Fund Manager should 

not expect market risk metrics, 

individually or collectively, to provide a complete view of market risk. 

For example, measures of risk-adjusted exposure may prove misleading in cases where market behavior 

differs substantially from past behavior, or when non-linear price effects 

from options are substantial.

Measures of portfolio volatility, such 

as standard deviation and VAR, 

seek to assess the risk of moderately 

infrequent market movements. A 

Hedge Fund Manager should not 

rely on these measures as dispositive 

indicators of portfolio performance in highly extreme events. In 

addition, these measures may fail 

(to a smaller or larger extent) even 

as guides to the impact of moderately infrequent events, because 

future market dynamics can differ 

from past dynamics. In light of this 

concern, a Hedge Fund Manager 

should periodically compare realized 

portfolio returns to standard deviation and VAR (or other measures of 

portfolio volatility).

Stress tests may fail to provide 

advance warning of a potential 

large loss if they do not adequately 

probe weaknesses in a Hedge Fund’s 

present portfolio or if markets move 

in an unforeseen manner. In this regard, a Hedge Fund Manager should 

periodically update stress tests in 

light of recent developments in the 

structure of a Hedge Fund’s portfolio 

and/or in the dynamics of financial 

markets.

Market Risk

08 | Risk Management
4.11

A Hedge Fund Manager should monitor and manage current and 

expected future sources of and draws on liquidity (cash).

A Hedge Fund needs cash liquidity 

to trade, meet margin calls, make 

payments to creditors and suppliers, and satisfy redemption requests. 

Robust funding liquidity can 

enhance Hedge Fund performance 

by providing flexibility to maintain 

or add to risk positions in periods 

when market stress presents trading 

opportunities.

In monitoring and managing current 

and expected future sources and uses 

of cash, the Hedge Fund Manager 

should generally take into account 

payment obligations, cash presently 

held, terms governing redemptions 

of Hedge Fund interests, the ability 

to raise cash by selling assets (taking 

account the asset liquidity of these 

assets), and funding arrangements 

negotiated with counterparties such 

as prime brokers and lenders.

Funding Liquidity Risk

Sound Practices for Hedge Fund Managers | 09

4.12 

A Hedge Fund Manager should plan for potential periods of funding 

liquidity stress characterized by a sharp rise in needed cash relative to 

available cash.

A Hedge Fund Manager should 

assess a Hedge Fund’s cash and “borrowing capacity” under large historical drawdowns and under conditions 

of severe market stress. In addition to 

the factors relevant for more normal 

market conditions mentioned in 

Recommendation 4.11, this analysis 

should consider potential stress-period actions by creditors and investors. 

Possible adverse actions by creditors 

include: reluctance to release collateral owed or to fund credit lines; 

decisions to increase “haircuts” and 

collateral requirements; and use of 

contractual rights to terminate trading relationships based on NAV triggers. Investors will more likely seek 

redemptions in a period of stress.
10 | Risk Management

4.13 

To enhance the stability of financing and trading relationships, a Hedge 

Fund Manager should maintain an open dialogue with its credit providers 

and counterparties with respect to credit terms and conditions, including 

the extent of financial and risk information to be provided to such parties.

A Hedge Fund Manager and its 

counterparty should agree to the 

extent of risk information to be 

provided to each other depending 

on their requirements and the extent 

and nature of the relationship.

A Hedge Fund Manager should 

require a counterparty’s credit 

department to provide assurances 

that it will only use financial and 

other confidential information furnished by the Hedge Fund Manager 

for credit evaluation purposes and 

that it will not make available that 

information to any member of a 

counterparty’s trading business.

Funding Liquidity Risk 

4.14

A Hedge Fund Manager should understand and manage its exposure to 

potential defaults by trading counterparties.

A Hedge Fund Manager should 

identify acceptable counterparties 

based on a counterparty’s creditworthiness and set appropriate risk limits 

based on such analysis. A Hedge 

Fund Manager should establish, 

implement, and enforce appropriate 

documentation policies and procedures as set forth in the Recommendations in Section 6—Trading Relationship, Management, Monitoring, 

and Disclosure. 

Once a trading relationship with a 

counterparty is established, a Hedge 

Fund Manager should ensure that 

the counterparty’s creditworthiness 

is appropriately monitored. A Hedge 

Fund Manager should also seek to 

establish appropriate collateral arrangements with counterparties and, 

if possible, establish the ability to 

make and respond to collateral calls. 

See Section 6—Trading Relationship, Management, Monitoring, and 

Disclosure, Recommendation 6.4.

Counterparty Credit Risk
4.15 

A Hedge Fund Manager should monitor leverage by considering metrics 

of financial statement-based leverage and metrics of risk-based leverage.

A Hedge Fund Manager should recognize that the term “leverage” may 

be defined in a variety of different 

ways and that, although not an independent source of risk, leverage can 

be important because of its magnifying effects on market risk, credit risk, 

and liquidity risk. 

To ensure that the use of leverage is 

appropriate, a Hedge Fund Manager 

should manage the leverage associated with its strategies by using appropriate risk monitoring measures. 

A Hedge Fund Manager should pay 

special attention to the manner in 

which leverage affects the Hedge 

Fund Manager’s ability to manage 

portfolio risks to which the portfolio 

is subject.

Leverage

Sound Practices for Hedge Fund Managers | 11
12 | Risk Management

4.16 

A Hedge Fund Manager should seek to limit a Hedge Fund’s exposure 

to potential operational risks, including reconciliation errors, data entry 

errors, fraud, system failures, and errors in valuation or risk measurement 

models.

A Hedge Fund Manager should 

consider the following measures, 

among others, to limit or mitigate 

operational risk:

• Random, periodic spot checking 

of relevant activities;

• Monitoring of risk, either internally with an appropriate level 

of checks and balances to ensure 

objectivity of risk analysis, or 

through reliance on external service 

providers;

• Maintaining a single, centralized 

position data set (to avoid the 

errors inherent in maintaining 

multiple or regionalized data sets);

• Establishing adequate internal 

controls and review processes, including appropriate segregation of 

duties, controls over incoming and 

outgoing cash flows and balances 

with counterparties, daily confirmation of trades and positions, 

etc.; and

• Reviewing operational risk, including legal, compliance, and transactional policies. See the Recommendations in Section 5—Regulatory 

Controls and Section 6—Trading 

Relationship, Management, 

Monitoring, and Disclosure. 

Operational Risk 
4.17 

A Hedge Fund Manager should establish policies for determining when 

risk monitoring valuation methods may differ from NAV for operational 

or risk analysis reasons.

A Hedge Fund Manager should 

generally use portfolio values used to 

calculate NAV for risk monitoring 

valuation, unless the Hedge Fund 

Manager has determined that operational or risk analysis reasons may justify a different approach. For example, 

a Hedge Fund Manager may choose 

to discount prices for risk analysis purposes if it is doubtful that quoted bids 

or offers are prices at which a trade 

could actually be executed. See Section 

3—Determination of Net Asset Value, 

Recommendation 3.9 for additional 

guidance.

Risk Monitoring Valuation

Sound Practices for Hedge Fund Managers | 13
Sound Practices for Hedge Fund Managers

Sound Practices for Hedge Fund Managers | 01

The Recommendations in Section 5 are designed to encourage a 

Hedge Fund Manager to develop a strong regulatory compliance 

infrastructure. These Recommendations provide guidance to a 

Hedge Fund Manager with respect to monitoring and managing its 

regulatory responsibilities in all jurisdictions in which it has business 

operations or conducts investment activity. Depending on the size 

and scope of operations, this may require the commitment and 

management of significant internal and external resources. As provided in this section, a Hedge Fund Manager should assign oversight responsibilities to qualified personnel for: the internal regulatory compliance functions; development of compliance policies and 

procedures; training of personnel; and monitoring of developments 

in applicable laws, rules, and regulations. Moreover, a Hedge Fund 

Manager should retain qualified external professionals for needed 

expertise in discrete areas.

5. Recommendations: 

Regulatory Controls
Regulatory Controls

5.1 

A Hedge Fund Manager should create a management environment that 

fosters a culture of compliance and should devote adequate internal 

resources to compliance with all laws, rules, and regulations applicable 

to its business operations and market conduct.

A Hedge Fund Manager, regardless 

of its registration status with a regulatory agency, is required to comply 

with a wide variety of laws, rules, 

and regulations (including those of 

local, state, federal, and international jurisdictions). These laws, rules, 

and regulations may include market 

surveillance requirements, which 

provide that a Hedge Fund Manager 

or Hedge Fund must furnish information and reports to regulators 

in connection with its trading and 

investment activities. 

A Hedge Fund Manager registered 

with a regulatory body, such as the 

SEC, the Commodity Futures 

Trading Commission (“CFTC”), 

or with like-regulatory bodies in 

non-U.S. jurisdictions, is subject 

to specific obligations that a nonregistered Hedge Fund Manager is 

not. A non-registered Hedge Fund 

Manager should evaluate which of 

the various laws, rules, and regulations are applicable to it despite its 

non-registered status (e.g., anti-fraud 

rules). A non-registered Hedge Fund 

Manager should also evaluate nonmandatory laws, rules, and regulations and determine as a matter 

of policy whether complying with 

them may assist in the furtherance 

of its compliance program for its 

business and investment activities.

Overall, a Hedge Fund Manager 

should, in reliance on its internal 

and external resources (including 

prime brokers, administrators, attorneys, and accountants), ensure 

that its personnel are cognizant of 

and adequately trained to comply 

with the laws, rules, and regulations 

applicable to its business operations, 

as well as those of the Hedge Funds 

it manages. 

The regulatory environment for 

Hedge Funds and Hedge Fund 

Managers is evolving. Accordingly, a 

Hedge Fund Manager, using internal 

resources and/or external service providers, should be vigilant in ensuring 

that it monitors any developments 

with respect to laws, rules, and 

regulations to which it, or the Hedge 

Funds it manages, may be subject. A 

Hedge Fund Manager should ensure 

that its policies and procedures are 

updated periodically and that its 

personnel are appropriately trained. 

02 | Regulatory Controls
A Hedge Fund Manager should 

monitor regulatory developments 

through consultations with attorneys 

and other advisers and through reviews of the various pronouncements 

issued or published by regulatory 

bodies (including self-regulatory 

organizations) and relevant trade 

groups or associations, such as MFA.

5.2 

The policies and procedures of a Hedge Fund Manager with regards to 

international operations or investment activity should be geared to comply with laws, rules, and regulations in all jurisdictions in which it conducts 

trading activities or business.

A Hedge Fund Manager’s policies 

and procedures should take into 

account the requirements of the 

jurisdictions in which it and the 

Hedge Funds it manages conduct 

business or investment activities. 

Each jurisdiction may have laws, 

rules, and regulations that govern 

market conduct, filings or reports, 

anti-money laundering (“AML”) or 

“know your customer” rules, private 

placements, marketing, etc.

Sound Practices for Hedge Fund Managers | 03
Regulatory Controls

5.3 

A Hedge Fund Manager’s senior management should be involved in the 

compliance program and appoint or hire an individual to develop and 

monitor compliance with all applicable laws, rules, and regulations by 

the Hedge Fund Manager and the Hedge Funds it manages.

For purposes of these Recommendations, the individual who is appointed or hired to develop and monitor 

legal compliance is referred to in 

this section as the “chief compliance 

officer”. The chief compliance officer 

may be a member of the Hedge 

Fund Manager’s personnel, may 

serve in this capacity alone, or as 

one of several areas of responsibility. 

The selection criteria for the chief 

compliance officer should include 

seniority within the firm, knowledge 

of investment and trading strategies 

and business operations for each 

Hedge Fund managed by the Hedge 

Fund Manager, and familiarity with 

applicable legal requirements. For a 

SEC-registered Hedge Fund Manager, the Advisers Act requires that 

the Hedge Fund Manager designate 

a chief compliance officer to administer its policies and procedures, and 

that this person meets certain criteria 

as set forth in the act.

A Hedge Fund Manager should 

ensure that the chief compliance 

officer has the internal and external 

resources to carry out his or her duties and actively monitor and ensure 

that the Hedge Fund Manager and 

its Hedge Funds comply with U.S. 

and international laws, rules, and 

regulations applicable to the Hedge 

Fund Manager’s business and the 

Hedge Fund Manager’s activities. 

A Hedge Fund Manager’s chief 

compliance officer should be involved in all aspects of the compliance program, including preparation of policies and procedures, as 

well as compliance monitoring. 

A Hedge Fund Manager should give 

consideration to the reporting lines 

of the chief compliance officer and 

establish reporting lines that are 

adequate to help ensure appropriate 

involvement of senior management 

in the development of policies 

and procedures and compliance 

monitoring.

04 | Regulatory Controls
5.4

A Hedge Fund Manager should establish written compliance policies and 

procedures that comprehensively address all applicable laws, rules, and 

regulations tailored to its specific business operations.

A Hedge Fund Manager should 

have comprehensive policies and 

procedures in place specifically 

tailored to address the laws, rules, 

and regulations applicable to its investment management business and 

investment activities. While many 

service providers offer model or “offthe-shelf” compliance policies and 

procedures, a Hedge Fund Manager 

and its compliance personnel should 

tailor policies and procedures to the 

business of the Hedge Fund Manager and the Hedge Funds it manages. 

The tailored policies and procedures 

should take into account the types 

of investments made or instruments 

traded, as well as the jurisdictions 

in which the Hedge Fund Manager 

conducts business and investment 

activities.

While not exhaustive, the checklist 

available in Appendix VI—Checklist 

for Hedge Fund Managers to 

Consider in Developing a Compliance Manual contains possible components of compliance policies and 

procedures. For additional guidance 

regarding the regulations governing 

compliance policies and procedures 

(which are required to be adopted by 

investment advisers registered with 

the SEC) see the SEC’s Web site 

(www.sec.gov/rules/final/ia-2204.

htm).

N.B. The following Recommendations address more particular areas 

that should be addressed as part of the 

written policies and procedures for 

regulatory compliance.

Sound Practices for Hedge Fund Managers | 05
06 | Regulatory Controls

5.5 

A Hedge Fund Manager should identify all required U.S. and international 

regulatory filings and clearly allocate responsibility for oversight of these 

filing obligations to appropriate personnel or service providers who will 

supervise and ensure timely compliance with applicable regulations and 

filing requirements.

The investment activities of Hedge 

Funds involve many types of instruments (e.g., securities, bonds, or futures) across the global financial marketplace. Accordingly, a Hedge Fund 

Manager must comply with many 

filing obligations. Appendix V—U.S. 

Regulatory Filings by Hedge Fund 

Managers contains a list of certain 

U.S. federal reporting requirements 

and other regulations that may be 

applicable to a Hedge Fund Manager 

operating, trading, and/or marketing in the United States. A Hedge 

Fund Manager should review similar 

types of filing requirements in other 

jurisdictions. 

Regulatory Controls
5.6

As part of its written compliance policies and procedures, a Hedge 

Fund Manager should include a code of ethics specifically designed for 

its business operations. The code should set standards of professional 

conduct for its personnel consistent with the Hedge Fund Manager’s 

fiduciary duties and other applicable laws. The code should also include 

procedures for handling material, non-public information to the extent 

relevant and applicable.

A Hedge Fund Manager’s written 

code of ethics should address, where 

applicable, the following: standards 

of conduct for covered persons; 

protection of material, non-public 

information; compliance with federal 

securities laws; reporting and reviewing personal securities transactions; 

and reporting violations of the code 

of ethics to a designated person.

A professional code of conduct 

or code of ethics should set forth 

guidelines and expectations for the 

conduct of a Hedge Fund Manager’s 

personnel. A Hedge Fund Manager should develop a procedure to 

ensure that employees understand 

and accept the code. For example, a 

Hedge Fund Manager may require 

employees to undergo periodic 

verifications in the form of a written 

attestation of the relevant employee’s 

understanding and acceptance of the 

code (e.g., as required of SEC-registered Hedge Fund Managers), or in 

such other form as the Hedge Fund 

Manager determines is appropriate 

for its business.

Similar to the compliance policies 

and procedures referenced in 

Recommendation 5.4, a Hedge 

Fund Manager should develop a 

code of ethics tailored to the business of the Hedge Fund Manager. 

The code of ethics should adequately address any conflicts of interest 

that are present in the Hedge Fund 

Manager’s business. 

The SEC requires that registeredinvestment advisers adopt a code 

of ethics for their personnel in 

compliance with SEC regulations. 

A copy of these regulations is available on the SEC Web site (www.sec.

gov/rules/final/ia-2256.htm).

While not exhaustive, the checklist 

available in Appendix VII—Checklist for Hedge Fund Managers to 

Consider in Developing a Code of 

Ethics contains sample components 

of a code of ethics.

Sound Practices for Hedge Fund Managers | 07
08 | Regulatory Controls

Regulatory Controls

5.7

As part of its overall regulatory compliance program, a Hedge Fund 

Manager should establish AML policies and procedures and ensure 

that its personnel and service providers follow appropriate investor 

identification procedures.

AML regulations are in force in nearly all jurisdictions in which Hedge 

Funds and Hedge Fund Managers 

operate. Through either internal 

resources or third parties such as 

Fund Administrators, a Hedge Fund 

Manager must ensure it follows all 

applicable AML regulations with 

respect to customer identification. 

The Hedge Fund Manager should 

also ensure it has established and 

implemented required AML policies 

and procedures. 

For practical guidance in this evolving area of law, a Hedge Fund Manager should consult MFA’s updated 

Guidance for Hedge Funds and Hedge 

Fund Managers on Developing 

Anti-Money Laundering Programs 

(Release No. 2) (the “AML Guidance”), attached to Appendix IV. 

Counterparties that are subject to 

the “know your customer” requirements in various jurisdictions may 

require a Hedge Fund Manager or 

a Hedge Fund to provide extensive 

information. Accordingly, a Hedge 

Fund Manager should prepare itself 

for the due diligence processes conducted by counterparties. As part of 

this process, a Hedge Fund Manager 

may wish to use the AML attestation 

letter (attached as Annexes B-1 and 

B-2 to the AML Guidance at Appendix IV) to facilitate this process.
5.8 

As part of its compliance program, a Hedge Fund Manager should 

develop document retention policies and procedures and create and 

retain required books and records related to business operations.

A Hedge Fund Manager should 

design policies and procedures to 

ensure the retention of accurate and 

complete records. It should employ, where reasonable, appropriate 

electronic data management systems. 

A Hedge Fund Manager should also 

establish a policy relating to the appropriate length of time records are 

retained, taking into consideration 

its organizational structure and business activities.

For an SEC-registered Hedge Fund 

Manager, the SEC’s rule relating 

to the maintenance of books and 

records is detailed as to the types 

of records required. The SEC has 

interpreted this rule to include 

retention of relevant email. The 

types of records generally relate to 

business accounting matters such as: 

accounting ledgers, bank statements, 

and bills; written agreements with 

investors; performance history; and 

recommendations distributed to a 

certain number of persons. Generally, an SEC-registered Hedge Fund 

Manager is required to retain records 

for five years. 

With respect to performance and 

valuation data, a Hedge Fund Manager should give consideration to the 

retention of records to support the 

valuation of a Hedge Fund’s investments and the determination of a 

Hedge Fund’s performance. A Hedge 

Fund Manager should adequately 

verify the use of a particular track 

record of an individual trader or 

portfolio manager relating to their 

employment with the Hedge Fund 

Manager.

Sound Practices for Hedge Fund Managers | 09
10 | Regulatory Controls

Regulatory Controls

5.9

A Hedge Fund Manager should adequately train all personnel to be 

familiar and comply with its compliance policies and procedures.

A Hedge Fund Manager should 

develop procedures to ensure that 

employees understand and accept its 

compliance policies and procedures. 

These procedures may include a verification of an employee’s understanding and acceptance of the policies 

and procedures, which may take the 

form of a written attestation or in 

such other form as the Hedge Fund 

Manager determines is appropriate 

for its business. A Hedge Fund Manager should require new employees 

to undergo verification upon the 

commencement of employment and 

existing employees to renew their 

verification at appropriate intervals.

Areas in which a Hedge Fund 

Manager should consider training 

employees include: misuse of material, non-public information; use of 

third-party paid consultants; AML; 

protection of investors’ confidential 

information; securities reporting 

requirements; etc. A Hedge Fund 

Manager may customize training by 

job functions. Other subject areas 

may require training of all personnel 

(e.g., personal trading, anti-discrimination, anti-sexual harassment, gifts, 

and entertainment). 

A Hedge Fund Manager should devote adequate resources to ongoing 

training programs for its personnel, 

which should include appropriate 

follow-up training, as applicable.
5.10

A Hedge Fund Manager should regularly review and update its compliance policies and procedures and should establish internal controls to 

monitor compliance.

A Hedge Fund Manager should 

review and update its compliance 

policies and procedures at least 

annually. A Hedge Fund Manager 

may conduct the review on 

a one-time annual review basis, 

on a rolling annual review basis, 

or other appropriate schedule to 

ensure that the policies and 

procedures remain current. 

A Hedge Fund Manager should 

regularly monitor whether its 

personnel are complying with the 

Hedge Fund Manager’s policies and 

procedures through spot-checks, risk 

assessments, and other appropriate 

measures. 

Sound Practices for Hedge Fund Managers | 11
Sound Practices for Hedge Fund Managers

Sound Practices for Hedge Fund Managers | 01

The Recommendations in this section are intended to provide 

Hedge Fund Managers with guidance on how to manage their 

trading relationships with third parties. These relationships include 

those with brokers and those in which a Hedge Fund transacts on a 

principal-to-principal basis. These Recommendations cover a Hedge 

Fund Manager’s pursuit of a consistent and methodical approach to 

documenting transactions with third parties in order to enhance the 

legal certainty of its investments. In addition, to the extent applicable, this section also provides guidance on seeking to obtain best 

execution and establishing guidelines for using and disclosing Soft 

Dollar Arrangements. 

6. Recommendations: 

Trading Relationship Management,

Monitoring, and Disclosure
Documentation Policies and Controls

6.1 

A Hedge Fund Manager should seek to ensure timely execution of 

necessary transaction documents and enforceability of transactions.

To the extent practical, a Hedge 

Fund Manager should implement 

the following practices:

• Establish procedures for entering 

into counterparty trading relationships, taking into consideration 

the nature of the trading counterparty, the type of trading relationship being created, and the specific 

product to be traded;

• Establish appropriate documentation procedures for trading 

depending on market practice, 

type and tenor of transaction, 

and relative related risk. These 

documentation procedures may 

include requirements for written 

agreements (including master 

agreements) and confirmations. 

Generally, a Hedge Fund Manager 

should seek to ensure that written 

agreements are in place with counterparties prior to executing any 

transactions or as soon as practical 

thereafter. Where a Hedge Fund 

Manager conducts certain trading 

activities in the absence of a written agreement (or prior to the conclusion of a written agreement), 

the Hedge Fund Manager should 

consider, among other factors, 

its trading relationship with the 

counterparty in question, and the 

materiality of the risk in trading in 

reliance on an oral agreement (e.g., 

"Statute of Frauds" considerations);

• Establish procedures for ensuring: 

(1) communication between and 

among counterparties, Fund Administrators, and/or other thirdparty service providers; (2) that 

the appropriate service providers 

have the proper trade capture and 

other capabilities to enable timely 

execution and documentation of 

transactions; and (3) that service 

providers are aware of and able 

to implement the Hedge Fund 

Manager’s transactional policies 

and procedures; and

• Use multi-lateral electronic transaction matching and confirmation 

systems for OTC derivatives to the 

extent acceptable and economically feasible for a relevant product.

02 | Trading Relationship Management, Monitoring, and Disclosure
6.2 

A Hedge Fund Manager should consider using a database to track the 

status of trading documentation and key provisions and terms it has 

negotiated, such as termination events and events of default. The Hedge 

Fund Manager should manage any risks associated with variations in these 

key provisions. 

Sound Practices for Hedge Fund Managers | 03

6.3 

A Hedge Fund Manager should seek consistent bilateral terms with 

counterparties to the extent appropriate and feasible in order to enhance 

stability during periods of market stress or declining asset levels. 

For example, to the extent approvable and feasible, a Hedge Fund 

Manager may seek to negotiate 

standardized events of default and 

other termination or collateral 

events to achieve consistency in 

documentation. A Hedge Fund 

Manager should consider avoiding 

provisions that permit counterparties to terminate or make demands 

for collateral solely at their discretion or based upon subjective 

determinations. Alternatively, 

a Hedge Fund Manager should 

at a minimum seek to mitigate the 

risk associated with such provisions 

through use of notice and cure 

periods. Over time, factors such as 

creditworthiness, market standards, 

market conditions, regulations, 

operational capacity, or trading 

platforms may change. A Hedge 

Fund Manager should assess from 

time to time whether it is advisable 

to attempt to renegotiate its trading 

terms with its various counterparties 

in response to such changes.
6.4 

A Hedge Fund Manager should seek to negotiate bilateral collateral 

agreements for certain types of transactions, taking into account the relative creditworthiness of the parties and the nature of the transactions.

Bilateral collateral agreements are 

appropriate in many OTC derivatives transactions, as well as certain 

exchange-traded derivative transactions. To the extent a Hedge Fund 

Manager enters into bilateral collateral arrangements, a Hedge Fund 

Manager should seek to establish 

such arrangements either internally 

or through reliance on external 

resources that permit the Hedge 

Fund Manager to effectively and 

regularly make calls for deliveries 

and returns of collateral from 

counterparties when permitted. 

Generally, a Hedge Fund 

Manager should ensure that appropriate security interests are created 

and perfected when collateral is 

received as part of a transaction or 

trading relationship.

Documentation Policies and Controls

04 | Trading Relationship Management, Monitoring, and Disclosure
Best Execution

Sound Practices for Hedge Fund Managers | 05

6.5 

A Hedge Fund Manager should seek best execution in its trading 

activities for the benefit of the Hedge Funds it manages

Generally, when seeking best execution for all types of instruments, 

a Hedge Fund Manager 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, a Hedge Fund Manager should 

consider the full range and quality of 

a counterparty’s services. Factors a 

Hedge Fund Manager may consider 

in seeking best execution include, 

but are not limited to: 

• Prompt and reliable execution; 

• The quality, comprehensiveness, 

timeliness, and frequency of available research and market information provided by the executing 

broker;

• The financial strength, integrity, 

and stability of the broker or 

counterparty; 

• The ability of the executing broker 

to execute transactions (and commit capital) of size in liquid and 

illiquid markets without disrupting the market for the security; 

• The competitiveness of commission rates in comparison with 

other brokers satisfying the Hedge 

Fund Manager’s other selection 

criteria; and 

• The ability of the executing broker 

to maintain confidentiality. 

Due to the lack of transparency in 

the market for certain non-equities, 

such as certain structured products and derivative products, the 

review process and analysis of best 

execution for such products will 

be different than for equity trades 

(e.g., the factors listed above may 

be weighted differently) and will 

involve additional factors specific to 

structured and derivative products 

transactions. 

A Hedge Fund Manager should be 

mindful of actual conflicts of interest 

that arise when transacting with brokers and counterparties and disclose 

them as appropriate. See Section 

2—Responsibilities to Investors, 

Recommendation 2.3. 

For regulatory guidance on the subject of best execution, a Hedge Fund 

Manager should review the SEC’s 

release on Guidance Regarding 

Client Commission Practices Under 

Section 28(e) (www.sec.gov/rules/

interp/2006/34-54165.pdf), and the 

FSA’s Consultation Papers on Best 

Execution (www.fsa.gov.uk/pubs/cp/

cp154.pdf) and Bundled Brokerage 

and Soft Commission Arrangements 

(www.fsa.gov.uk/pubs/cp/cp176.

pdf).
6.6

As part of its compliance policies and procedures, a Hedge Fund 

Manager should periodically review the firm’s relationship with each 

counterparty executing transactions on behalf of every Hedge Fund 

it manages to assess whether the counterparty continues to provide 

best execution.

The degree to which a Hedge 

Fund Manager engages with a 

particular counterparty will largely 

determine the need for and frequency of these periodic reviews 

of counterparty relationships. In 

its review, a Hedge Fund Manager 

should use a methodology that is 

appropriate for its business.

Best Execution

06 | Trading Relationship Management, Monitoring, and Disclosure
Execution and Clearing Arrangements

Sound Practices for Hedge Fund Managers | 07

6.7

A Hedge Fund Manager should carefully consider the selection of its 

execution and clearing counterparties based on factors relevant to the 

trading relationship. 

A Hedge Fund Manager’s process 

for entering into execution and clearing arrangements with a particular 

counterparty often involves entering 

into legal agreements, developing 

operational documents, and accepting financing rates. In selecting a 

counterparty for execution or clearing services, a Hedge Fund Manager 

should weigh relevant factors including, but not limited to:

• The operational efficiency with 

which transactions are processed 

and cleared, taking into account 

the order size and complexity; 

• The operational expertise and 

range of services offered by the 

clearing broker in providing 

clearing and custody services for 

the products traded by the Hedge 

Fund Manager;

• The commission rate and other 

financing terms charged by the 

clearing broker;

• The clearing broker’s responsiveness to the Hedge Fund Manager;

• The clearing broker’s confidentiality policies and procedures;

• The clearing broker’s regulatory 

oversight and responsibilities; and

• The clearing broker’s creditworthiness.
6.8 

Because Soft Dollar Arrangements may impact the evaluation of best 

execution, a Hedge Fund Manager, if applicable to its operations and 

trading activities, should make determinations regarding its Soft Dollar 

Arrangements and should develop policies relating to the use of these 

arrangements.

If a Hedge Fund Manager uses Soft 

Dollar Arrangements, its policies 

should include procedures and documentation requirements for thirdparty arrangements with brokers 

and other counterparties. In making 

determinations and policies, a Hedge 

Fund Manager should consider 

arrangements relating to transactions in instruments other than 

securities. Applicable laws, rules, or 

regulations can also guide a Hedge 

Fund Manager’s determinations and 

policies. For example, if the Hedge 

Fund Manager has operations in the 

United Kingdom, it should consider 

any FSA consultation papers on the 

subject. Additionally, if the Hedge 

Fund Manager is subject to ERISA, 

it should ensure its arrangements do 

not violate ERISA. Policies may also 

vary depending on a Hedge Fund 

Manager’s customized advisory 

arrangements.

Policies may include, depending on 

the nature of the Hedge Fund 

Manager’s business: (1) commission 

sharing arrangements and proprietary arrangements addressing, as 

appropriate approved broker-dealers 

and products/services; (2) reliance 

or non-reliance on the safe harbor 

of Section 28(e); and (3) procedures 

for approval of such arrangements 

and related terms. 

A Hedge Fund Manager should 

make a good faith determination 

that the amount of commission is 

reasonable in relation to the value 

of the brokerage and research services 

provided by the broker-dealer and 

in light of the terms of the particular 

transaction or the Hedge Fund 

Manager’s overall responsibilities 

with respect to its discretionary 

accounts.

Soft Dollar Arrangements 

08 | Trading Relationship Management, Monitoring, and Disclosure
A Hedge Fund Manager relying on 

the safe harbor provided by Section 

28(e) should determine whether the 

brokerage and research services are 

covered within the safe harbor (as 

set forth in Section 28(e)(3)). The 

SEC indicates that “the focus should 

be on whether the product or service 

provides lawful and appropriate 

assistance to the money manager 

in the carrying out of his responsibilities.”1

A Hedge Fund Manager with 

Soft Dollar Arrangements that fall 

outside of the safe harbor provided 

by Section 28(e) should ensure that 

its arrangements are consistent with 

its duties to investors and determine 

whether the products and services 

received fall within the disclosed 

usage of Soft Dollar Arrangements. 

See Section 2—Responsibilities to 

Investors, Recommendation 2.13. 

Sound Practices for Hedge Fund Managers | 09 

1 See SEC Guidance Regarding Client Commission Practices Under Section 28(e) 

of the Securities Exchange Act of 1934, as amended.
10 | Trading Relationship Management, Monitoring and Disclosure

6.9 

A Hedge Fund Manager should evaluate the types of products and 

services subject to its Soft Dollar Arrangements.

As part of its evaluation, a Hedge 

Fund Manager should determine 

the extent to which products or 

services have research functions or 

are developed by a third party and 

provided by a broker. A Hedge 

Fund Manager relying on Section 

28(e) should make proper allocation 

of products or services with mixed 

uses (i.e., computer hardware that 

assists an adviser in research functions and in non-research functions) 

so that non-research services are paid 

for from the Hedge Fund Manager’s 

funds. Certain arrangements, such as 

commission sharing arrangements, 

can assist a Hedge Fund Manager in 

obtaining best execution by allowing 

it to use the broker providing best 

execution to execute the trade and 

to pay commissions to other brokers 

from whom it receives research 

or services through Soft Dollar 

Arrangements. 

The SEC’s Guidance Regarding 

Client Commission Practices Under 

Section 28(e) (www.sec.gov/rules/

interp/2006/34-54165.pdf) provides 

steps for analyzing: (1) whether a 

particular product or service is an 

eligible research or brokerage service 

within the specific statutory limits 

of the safe harbor; (2) whether the 

product or service actually provides 

lawful and appropriate assistance 

in the performance of an adviser’s 

investment decision-making responsibilities, including the appropriate 

treatment of “mixed-use” items; and 

(3) whether the amount of client 

commissions paid is reasonable in 

light of the value of the products or 

services provided by the broker-dealer. The release also discusses thirdparty research and the permissibility 

of client commission arrangements 

under the safe harbor.

Additional guidance can be found 

in the FSA’s Consultation Paper on 

Bundled Brokerage and Soft Commission Arrangements (www.fsa.

gov.uk/pubs/cp/cp176.pdf). This 

publication makes two main proposals: (1) that goods and services that 

are reasonably anticipated should 

be excluded from those that can 

be purchased with commission, 

whether under soft or bundled arrangements (and the document sets 

out the goods and services to which 

this restriction should apply); and 

(2) where a Hedge Fund Manager 

buys any other services additional to 

trade execution with its customers’ 

commission, it should determine the 

cost of those services and rebate an 

equivalent amount to its customers’ 

funds. 

Soft Dollar Arrangements 
Sound Practices for Hedge Fund Managers | 01

Sound Practices for Hedge Fund Managers

The Recommendations in this section provide a Hedge Fund 

Manager with guidance on developing policies and procedures to 

prepare for unexpected events that would either interfere with or 

cause harm to its personnel or infrastructure, or hamper or prohibit 

the continuation of business operations. While the need to establish 

functional BC/DR plans is not unique to Hedge Fund Managers, 

they have responsibilities to the Hedge Funds they manage to have 

such plans in place. The inability to carry out routine trading and risk 

monitoring functions (even on a very short-term basis) as a result of a 

disruption could lead to large financial losses.

7. Recommendations: 

Business Continuity, Disaster 

Recovery, and Crisis Management
Business Continuity, Disaster Recovery, 

and Crisis Management

7.1 

A Hedge Fund Manager should develop a comprehensive BC/DR plan 

that establishes clear policies and procedures for internal personnel and 

external service providers to prepare for unexpected events.

In developing a BC/DR plan, 

a Hedge Fund Manager should 

consider and prepare for events that 

could have a significant impact on 

personnel, investment, and other 

key business operations. The primary goals of any BC/DR plan are 

to protect personnel from harm and 

to maintain business operations for 

Hedge Funds under management.

Certain Hedge Fund Managers 

may be subject to regulatory or selfregulatory agencies that require 

them to have BC/DR plans. The 

components of a comprehensive 

BC/DR plan should address, without limitation:

• The loss of a “key person”;

• National or local natural disasters;

• Acts of terrorism;

• Pandemics;

• Fires;

• IT system malfunctions or 

corruption; and

• Similar highly disruptive events.

The preparation involved to protect 

a Hedge Fund Manager’s operations 

will likely be extensive and, depending on the size of operations, may 

require substantial internal personnel resources to develop the BC/DR 

plan. For a Hedge Fund Manager 

with smaller operations, it may be 

advisable to seek the assistance of 

external third parties with appropriate expertise. 

A Hedge Fund Manager’s senior 

management should work with personnel responsible for IT, treasury, 

accounting, trading, and operations to develop a plan specifically 

tailored for the business realities of 

the Hedge Fund Manager and the 

Hedge Funds it operates. The plan 

should consider the personal safety 

and security of the Hedge Fund 

Manager’s employees.

Overall, a Hedge Fund Manager 

should designate one member of 

its personnel team with ultimate 

responsibility for developing and 

executing the BC/DR plan, if 

circumstances require. Developing 

the plan will likely require senior 

management to review business02 | Business Continuity, Disaster Recovery, and Crisis Management
critical applications, test the BC/DR 

plan for resiliency, and update the 

plan as needed.

External service providers and 

government agencies may provide 

templates for BC/DR plans. See 

Recommendation 7.12 for suggested 

government and private sector 

sources of information.

7.2 

A Hedge Fund Manager should establish a BC/DR plan that provides 

contingencies in the event of the death or incapacity of its founder or one 

of its key persons, including succession planning.

A Hedge Fund Manager’s BC/DR 

plan should include plans to ensure 

compliance with any key person 

provisions that may exist in partnership or similar agreements, side 

letters, and master agreements, as 

well as policies and procedures to 

promptly disclose such an event. 

In drafting a BC/DR plan, a Hedge 

Fund Manager with key person 

provisions that give investors withdrawal rights should also consider 

the impact of the potential withdrawals by investors on business 

operations. Moreover, a Hedge Fund 

Manager should develop a succession planning protocol in the event 

of the loss of a key person. 

Sound Practices for Hedge Fund Managers | 03

7.3 

A Hedge Fund Manager should establish policies and procedures 

to protect personnel in the event of a crisis making the work environment unsafe.

A Hedge Fund Manager’s BC/DR 

plan should include policies that 

prepare for: (1) the potential need to 

immediately evacuate the premises; 

or (2) any condition that makes the 

Hedge Fund Manager’s office(s) unusable. Possible crisis event scenarios 

include: (1) basic evacuation in the 

case of a fire; or (2) plans for working offsite when personnel cannot 

reach their office due to (a) hazardous conditions (e.g., severe storms or 

terrorist attacks), and (b) diseases or 

epidemics that make it inadvisable 

for personnel to travel to the Hedge 

Fund Manager’s offices.
Business Continuity, Disaster Recovery, 

and Crisis Management

7.4 

A Hedge Fund Manager should establish a written BC/DR plan that 

outlines practices to be followed in an emergency or significant market 

disruption. 

A Hedge Fund Manager should 

ensure, to the greatest extent practical, that appropriate personnel will 

have the ability to monitor a Hedge 

Fund’s existing portfolio positions 

and execute transactions when 

necessary in the event of a market 

emergency or other severe market 

disruption. The Hedge Fund Manager should establish time objectives 

for recovery of trading positions or 

operations that are appropriate to its 

business.

The most important element in a 

BC/DR plan is the identification 

and replication of mission-critical 

systems, meaning those systems a 

Hedge Fund Manager requires to 

ensure prompt and accurate processing of transactions and to meet 

regulatory reporting requirements.

A Hedge Fund Manager should 

consider, among others, the following basic elements in developing a 

BC/DR plan that addresses market 

disruptions:

• Financial assessments and 

operations;

• Means of communication 

between and among managers, 

personnel, and Hedge Fund 

investors;

• The physical location of the 

parties;

• The ability to evaluate the impact 

of an event on the Hedge Fund 

Manager and the Hedge Funds it 

manages and their counterparties; 

and

• Mechanisms to ensure the safety 

and preservation of the Hedge 

Fund’s assets until they can be 

redeemed in order to ensure the 

orderly liquidation of assets in the 

case where the Hedge Fund Manager’s business cannot continue.

04 | Business Continuity, Disaster Recovery, and Crisis Management
7.5

A Hedge Fund Manager should review its BC/DR plan to ensure it is 

consistent with applicable laws, rules, and regulations. A Hedge Fund 

Manager’s BC/DR plan should establish practices to be followed in an 

emergency or significant market disruption with respect to communications with personnel or external parties.

A Hedge Fund Manager should consider addressing the following items 

in a written BC/DR plan:

• Developing a communication plan 

to contact essential parties (e.g.,

senior management, portfolio 

managers, risk managers, brokers 

and trading counterparties, legal 

or compliance officers, directors 

of human resources, vendors, and 

disaster recovery specialists);

• The communication plan should 

include an instant or early notification to alert personnel and key 

outside parties of an actual or 

potentially disruptive event or 

emergency;

• The communication plan should 

include policies on email in the 

event of a disruptive event; and

• The communication plan 

should be tested and updated, 

as appropriate.

Sound Practices for Hedge Fund Managers | 05
06 | Business Continuity, Disaster Recovery, and Crisis Management

7.6 

A Hedge Fund Manager’s BC/DR plan should include systems for storing 

and protecting hard and soft copies of documents, trade records, and 

essential communications.

The policies and procedures should 

include:

• Backing up or copying essential 

documents and data and storing 

the information offsite in hardcopy or electronic format; and

• Considering the impact of business 

interruptions encountered by third 

parties and identifying ways to 

minimize that impact.

Business Continuity, Disaster Recovery, 

and Crisis Management

7.7 

A Hedge Fund Manager’s BC/DR plan should provide for IT contingency 

arrangements that factor in geography, accessibility of records, security, 

environment, and cost.

A Hedge Fund Manager should 

consider maintaining back-up power 

supplies onsite in the event that the 

main power source is disrupted.

Additionally, a Hedge Fund Manager should consider establishing 

back-up facilities or the ability to 

continue business in a separate geographic area from the Hedge Fund 

Manager’s primary facilities. Such 

a site may be “hot”, or “mirrored”, 

and could be either synchronous 

or asynchronous. A “hot site” is 

configured with all system hardware, 

infrastructure, and support personnel, and the “mirrored site” 

is more comprehensive as it has fully 

redundant infrastructure, systems, 

and data. A Hedge Fund Manager 

should consider one of these types 

of alternate sites in accordance with 

the Hedge Fund Manager’s size and 

budgetary constraints.

A Hedge Fund Manager, to the 

extent that its own personnel are not 

trained in providing redundant IT 

and other services, should consider 

working with outside consultants in 

order to determine its needs and the 

available technologies and services 

designed to meet these needs as part 

of its BC/DR plan.
7.8

A Hedge Fund Manager’s BC/DR plan should establish a person or team 

responsible for monitoring regulatory and reporting compliance requirements in the event of a disaster or interruption with trading operations.

A Hedge Fund Manager may be 

subject to a number of reporting 

requirements with U.S. or international regulators. A regulator may 

not suspend these requirements in 

the event of a crisis or emergency 

affecting a particular Hedge Fund 

Manager. This would be most applicable in the case where the emergency or disruption is limited to an 

individual Hedge Fund Manager, 

rather than an event impacting a 

larger geographic area or a financial 

market or markets. Accordingly, the 

Hedge Fund Manager should designate appropriate personnel responsible for ensuring that any regulatory 

obligations can be fulfilled in the 

event of an unexpected disruption 

to business operations, to the extent 

practical or feasible.

Sound Practices for Hedge Fund Managers | 07

7.9

A Hedge Fund Manager should determine whether it is necessary to use 

third-party service providers and vendors in establishing its BC/DR plan.

7.10

A Hedge Fund Manager should establish contingency plans for responding to the failure of a third-party fund administrator, credit provider, or 

other mission-critical party that would affect a Hedge Fund’s market, 

credit, or liquidity risk.

Contingency planning should 

address responses to a third party’s 

failure to provide services necessary 

for a Hedge Fund Manager to conduct operations. This would include 

addressing transfers to back-up 

clearing systems and offsite retention storage, and failures of prime 

brokers, credit providers, and other 

service providers, including back-up 

providers.
08 | Business Continuity, Disaster Recovery, and Crisis Management

Business Continuity, Disaster Recovery, 

and Crisis Management

7.11

A Hedge Fund Manager should test and update its BC/DR plan at least 

annually, to ensure that all personnel know their roles and that technology 

is sufficient during the BC/DR contemplated event.

7.12

A Hedge Fund Manager should be aware of resources available from the 

federal and local governments, and international regulators, if applicable, 

to gather information about threat dissemination services that are targeted at the financial services sector and that provide information regarding 

threats to physical and cyber security.

To the extent that the federal, state, 

and local governments offer threat 

alert services, a Hedge Fund Manager should investigate subscribing to 

these services as part of its business 

continuity and disaster recovery 

program. One such service is the 

Financial Services/Information 

Sharing Alert Center (“FS/ISAC”), 

(www.fsisac.com).

The National Futures Association 

requires its member commodity 

trading advisors and commodity 

pool operators to maintain a BC/DR 

plan (www.nfa.futures.org).

A Hedge Fund Manager with international operations may also consult 

“MiFID”, which provides expectations on BC/DR plans.
Advisers Act | Investment Advisers Act of 1940, as amended.

AML | Anti-money laundering.

Asset liquidity | See liquidity and liquidity risk.

Back-test or back-testing | An examination of the results generated by a 

model (e.g., a Value-at-Risk model) as compared to actual or realized results 

in order to assess the accuracy of the model.

Balance sheet leverage | See leverage measures.

BC/DR | Business continuity, disaster recovery, and crisis management.

Best execution | Generally means the execution of client trades at the best 

net price in consideration of all relevant circumstances. 

Borrowing capacity | The amount of money a Hedge Fund can borrow 

from a broker or dealer or other credit provider (e.g., in order to fund purchases of securities). For example, according to Regulation T of the Federal 

Reserve Board (12 C.F.R. 220.4), a borrower may borrow up to 50% of the 

value of a security, depending on the type of security.

Cash | Cash balances held in bank accounts and short-term, high-quality 

marketable securities, such as government bonds.

Sound Practices for Hedge Fund Managers | 01

APPENDIX I

Certain capitalized and/or italicized terms and certain technical 

words and phrases in the Recommendations are defined in the 

glossary. Terms contained in this glossary are defined for the purpose of the Recommendations and may have a wider or different 

meaning outside the context of the Recommendations. 

Glossary and Selected 

Sources Used
Cash market | A market in which goods are purchased either immediately 

for cash, as in a cash and carry contract, or in which they are contracted for 

presently, with delivery and payment occurring shortly thereafter. All terms 

of the contract are negotiated between buyer and seller.

CFTC | The United States Commodity Futures Trading Commission.

Chief compliance officer | An individual responsible for developing and 

monitoring compliance with all applicable laws, rules, and regulations by 

a Hedge Fund Manager and the Hedge Funds it manages.

Collateral | An asset that is pledged as security, or whose title is transferred 

to a secured party, in order to secure payment or performance obligations. 

If the party providing collateral defaults, the asset pledged or transferred 

may be taken and sold by the secured party to satisfy obligations of the 

pledgee/transferee. Instruments that are typically accepted as collateral under 

collateral agreements include government securities, cash and, to a lesser 

extent, corporate debt, agency debt, equities, and letters of credit. Collateral 

generally serves to mitigate counterparty credit risk (see credit risk).

Collateral agreement | An agreement between two parties governing the 

delivery and use of collateral. Key provisions of such agreements are: 

collateral delivery and return requirements; the rights of the secured party in 

the collateral; the level of unsecured credit risk that each party is willing to 

assume (i.e., mark-to-market exposure thresholds above which the transfer 

of collateral is required); the type of instruments that can be posted as collateral; minimum transfer amounts; haircut provisions; among others.

Collateral call | A notice given by a secured party to the provider of 

collateral informing the latter that the change in the market value of a 

position has required the posting of collateral.

Collateral event | An event that triggers an increase in the amount of 

collateral related to a transaction or group of transactions under a collateral 

agreement or master agreement (for example, rather than causing a termination of all transactions that are subject to a master agreement).

Commodity | Generally, an article of commerce or a product that can be 

used for commerce. In the United States, the term is often narrowly used to 

refer to products underlying futures contracts traded on regulated futures 

02 | Appendix I

Glossary
exchanges. The types of commodities that underlie such contracts include 

both physical and financial commodities such as agricultural and energy 

products, metals, foreign currencies, and interest rate and equity instruments 

(see futures). Commodities are also traded in the forward and cash markets.

Concentration | Arises when a significant percentage of a Hedge Fund’s 

portfolio is exposed to the same or similar market factors or other risk 

factors, increasing the risk of losses caused by adverse market or economic 

events affecting such risk factors. Hedge Fund Managers may track concentration levels with respect to asset classes, industry sectors, regions, or other 

relevant areas.

Confirmation | Generally refers to the written statement that follows any 

trade in the securities markets. Confirmation is issued immediately after a 

trade is executed. It spells out settlement date, terms, commission, etc.

Correlation | A standardized measure of the relative movement between 

two variables, such as the prices of two different securities. The level of 

correlation between two variables is measured on a scale of –1 to +1. If two 

variables move up or down together, they are positively correlated. If they 

tend to move in opposite directions, they are negatively correlated.

Counterparty | A third party that enters into transactions with a Hedge 

Fund.

Counterparty Risk Management Policy Group II | A group of senior officials from major financial institutions and chaired by E. Gerald Corrigan, 

Managing Director of Goldman Sachs, seeking to examine efficiency in the 

private sector and stability of the global financial system.

Credit provider | A bank, securities firm, or other third party that extends 

credit to a Hedge Fund, either in connection with financing a Hedge Fund’s 

purchases of securities or other instruments or through stand-alone loan 

facilities. A counterparty may be viewed as a credit provider when it engages 

in synthetic financing OTC derivative transactions with a Hedge Fund.

Credit risk | The risk that an issuer of a security (asset credit risk) or a 

counterparty (counterparty credit risk) will not meet its obligations when 

due. Asset credit risk also includes sovereign risk where the potential loss 

is related to the financial solvency of a sovereign issuer of a security. 

Sound Practices for Hedge Fund Managers | 03
Counterparty credit risk is frequently broken down into component risks 

for monitoring purposes (see, e.g., settlement risk and pre-settlement risk).

Credit spread | The difference between the yield (or percentage rate of 

return) of a Treasury security and a non-Treasury debt security (e.g., a 

corporate bond) that are identical in most respects (particularly the term 

of the obligation), except with respect to credit rating.

Derivative | This refers to a financial instrument in which the value 

depends on, or is derived from, the value of an underlying asset, index, 

rate, or instrument.

Equity | In the context of investing, a synonym for stocks or shares of 

companies. When used in connection with accounting, equity refers to the 

amount by which the assets of an entity exceed its liabilities. With respect 

to Hedge Funds, equity refers to capital investment.

ERISA | The United States Employee Retirement Income Security Act 

of 1974, as amended.

Fair value | Generally refers to the price at which a single unit of an instrument would trade between disinterested parties in an arm’s-length transaction. Fair value does not generally take into account control premiums (the 

price difference between the market price per share of an individual security 

and the price per share of a block of securities that carries the power to control a corporation) or discounts for large or illiquid positions (see liquidity).

FAS 157 | Financial Accounting Standards Board’s Statement of Financial 

Accounting Standards No. 157, Fair Value Measurements, issued under U.S. 

GAAP.

Financial statement-based leverage | See leverage measures.

Form ADV | The SEC’s uniform application for investment adviser 

registration.

FSA | The United Kingdom’s Financial Services Authority.

FSCP or Financial Statement Close Process | The process whereby the 

results of various transactions are summarized, reviewed, consolidated, 

edited, and used for reporting to investors and management.

04 | Appendix I

Glossary
FSF | The Financial Stability Forum is a body convened in April 1999 to 

promote international financial stability through information exchange and 

international cooperation in financial supervision and surveillance. The 

FSF brings together on a regular basis national authorities responsible for 

financial stability in significant international financial centers, international 

financial institutions, sector-specific international groupings of regulators 

and supervisors, and committees of central bank experts. The FSF seeks to 

coordinate the efforts of these various bodies in order to promote international financial stability, improve the functioning of markets, and reduce 

systemic risk. The FSF issued a report in May 2007 reassessing the financial 

stability issues and systemic risks posed by hedge funds. The report recognizes the contribution hedge funds have made to financial innovation and 

market liquidity. At the same time, it notes heightened risk measurement, 

valuation, and operational challenges for market participants and makes 

various recommendations.

FSF Report | The Update of the FSF Report on Highly Leveraged Institutions

published in May 2007 by the FSF.

Fund Administrator | Refers to a third-party service provider offering 

certain back and front office administrative services to a Hedge Fund and/or 

Hedge Fund Manager. Such services may include maintaining the principal corporate records, communicating with a Hedge Fund’s investors and 

sending financial statements to its investors, providing registrar and transfer 

agent services in connection with the issuance, transfer, and redemption of 

interests in a Hedge Fund, processing subscription and redemptions, calculation of NAV, and providing other clerical services in connection with the 

day-to-day administration of the Fund.

Funding liquidity | See liquidity and liquidity risk.

Gamma | Refers to the rate of change in an option’s delta for a one-unit 

change in the price of the underlying asset. As a measure of a measure, it is 

considered a secondary derivative of the underlying asset’s price.

Gate | Refers to a restriction on withdrawals or redemptions from a Hedge 

Fund whereby the Hedge Fund limits redemptions to a pro rata portion of 

requested redemptions up to a pre-determined percentage of capital for a 

specific redemption period.

Sound Practices for Hedge Fund Managers | 05
Governing body | Refers to a person or group of persons, acting through 

a management committee, board of directors, or other body, or directly as 

officers or members of the Hedge Fund Manager, with the authority and 

responsibility to direct and oversee the Hedge Fund Manager’s activities.

Governing documents | Refers to the organizational and constituent documents of the Hedge Fund Manager entity.

Gross balance sheet assets | See leverage measures.

Group of Seven | A group comprised of Finance Ministers and Central 

Bank Governors of Canada, France, Germany, Italy, Japan, the United 

States, and the United Kingdom for the purpose of monitoring fiscal and 

monetary policies. 

Group of Eight | An international forum for the governments of Canada, 

France, Germany, Italy, Japan, Russia, the United Kingdom, and the United 

States. Together, these countries represent about 65% of the world economy. 

The group’s activities include year-round conferences and policy research, 

culminating with an annual summit meeting attended by the heads of 

government of the member states.

Haircuts | The difference between the market value of an asset posted as 

collateral and the value attributed to the asset by a secured party in determining whether the collateral requirements related to the asset have been 

met. A haircut is intended to protect a party that receives collateral from 

fluctuations in the value of such collateral.

Hedge Fund | A pooled investment vehicle that generally meets the following criteria: (1) it is not marketed to the general public (i.e., it is privatelyoffered); (2) it is limited to high net worth individuals and institutions; (3) 

it is not registered as an investment company under relevant laws (e.g., U.S. 

Investment Company Act of 1940); (4) its assets are managed by a professional investment management firm that shares in the gains of the investment vehicle based on investment performance of the vehicle; and (5) it has 

periodic but restricted or limited investor redemption rights.

Hedge Fund Manager | A professional investment management firm that 

serves as investment manager for a Hedge Fund and manages the Hedge 

Fund’s assets and investments.

06 | Appendix I

Glossary
Holding period | The period over which Value-at-Risk is calculated (e.g., 

one day, three days, one week, 10 days). The holding period should reflect 

the amount of time it would take to liquidate or neutralize the positions in 

the relevant portfolio.

IAS | International Accounting Standards.

Illiquid instrument | See liquidity.

Interest rate term structure | The relationship among interest rates of fixed 

income instruments with different maturities usually depicted as a graph, 

also referred to as a “yield curve”.

IT | Information technology.

Key person | An individual, principal, or member of a Hedge Fund’s personnel that is critical to the operations and performance of the Hedge Fund 

Manager.

Legal risk | The risk of loss arising from uncertainty in laws, regulations, 

or legal actions that may affect transactions between parties. Legal risk may 

include issues related to the enforceability of netting agreements, the perfection of collateral, the capacity of parties, and the legality of contracts, among 

others.

Leverage | A factor (rather than an independent source of risk) that influences the rapidity with which changes in market risk, credit risk, or liquidity 

risk change the value of a portfolio.

Leverage measures | Generally, Hedge Funds use two types of leverage 

measures. Financial statement-based leverage measures compare the nominal 

sizes of Hedge Fund balance sheet positions to a Hedge Fund’s equity. Riskbased leverage measures assess the relationship between the risk of a Hedge 

Fund’s portfolio and its capacity to absorb the impact of that risk.

Liquidity | There are two separate, but related types of liquidity. Funding 

liquidity is the ability of a Hedge Fund to hold its market positions and 

meet the cash and/or collateral demands of counterparties, other credit 

providers, and investors (see collateral call and redemption). Asset liquidity refers to the ability to liquidate an asset quickly, and in large volume, 

Sound Practices for Hedge Fund Managers | 07
without substantially affecting the asset’s price. An asset that cannot be 

liquidated in a short period of time without substantially affecting the asset’s 

price is considered an illiquid instrument.

Liquidity risk | With respect to asset liquidity, the inability to sell an asset 

quickly and/or in large volume at a reasonable price. With respect to funding liquidity, the risk that a party will not have or cannot obtain sufficient 

funds to meet its obligations.

Long positions | Generally, this term means that an investor has purchased 

a stock with the expectation that its price will rise. A long position is sometimes referred to as being “long the market”. Investors who are “bullish” 

about the market will take a long position, expecting higher prices in the future. The vast majority of investors take a long position in the market when 

they invest and investors who purchase for the long-term almost always take 

a long position. Investors who subscribe to the theory of “buying low and 

selling high” will take a long position. The opposite of a long position is a 

short position. Investors who short the market sell stock (as opposed to 

buying stock) in the expectation of lower prices in the future.

Margin | A certain amount of assets that must be deposited in a margin 

account in order to secure a portion of a party’s obligations under a contract 

(see margin account). For example, to buy or sell an exchange-traded futures 

contract, a party must post a specified amount which is determined by the 

exchange, referred to as an “initial margin”. In addition, a party will be 

required to post “variation margin” if the futures contracts change in value. 

Margin is also required in connection with the purchase and sale of securities where the full purchase price is not paid upfront or the securities sold 

are not owned by the seller.

Margin accounts | The account in which margin is held for securities or 

exchange-traded futures or options. Positions that are subject to margin 

requirements are generally valued, or “marked-to-market”, daily, and additional margin may be required if the market value of a position declines.

Market factors | Refers collectively to interest rates, foreign exchange rates, 

equity prices, commodity prices, and indices constructed from these rates 

and prices, as well as their volatility and correlation.

08 | Appendix I

Glossary
Market risk | Narrowly defined, it is the risk of a decline in value of a 

Hedge Fund’s portfolio resulting from changes in market factors. Since asset 

liquidity risk and the credit risk of an asset’s issuer may also affect the value 

of instruments in a portfolio, Hedge Funds frequently manage all of these 

risks jointly as market risk.

Master agreement | An agreement, such as the 1992 ISDA Master Agreement form published by the International Swaps and Derivatives Association, Inc., that sets forth the overarching terms and conditions governing all 

OTC transactions between two parties that are subject to such master agreement. A master agreement typically includes payment netting and closeout 

netting provisions (see netting).

MFA | Managed Funds Association.

MiFID | Markets in Financial Instruments Directive.

Model | A program or process that is designed to create a depiction of 

reality through graphs, pictures, or mathematical representations.

NAV or net asset value | The fair value of a Hedge Fund’s assets minus the 

fair value of its liabilities. Under U.S. GAAP, NAV computations should 

include accrued interest, dividends, and other receivables of the Hedge 

Fund, as well as accrued expenses and other payables. NAV would generally not include special adjustments that may be made to valuations for risk 

monitoring purposes, such as adjustments for illiquidity concerns. NAV is 

the basis for determining the prices applicable to investor subscription and 

redemptions. 

Netting | Netting involves aggregating payment amount, collateral or 

closeout valuation exposures on multiple transactions between the same two 

counterparties and reducing them down to a single net exposure amount by 

offsetting the positive exposures with the negative. Netting provisions are 

typically included in master agreements and collateral agreements between a 

Hedge Fund and its counterparty.

Off-balance-sheet transaction | A transaction entered into by a Hedge 

Fund that does not appear on its balance sheet. Until the adoption of 

Financial Accounting Standards Board’s Statement 133, most derivatives had 

been treated as off-balance-sheet transactions.

Sound Practices for Hedge Fund Managers | 09
10 | Appendix I

Offering documents | Refers to documents such as an offering memorandum, limited partnership or limited liability company agreement, subscription agreement, or similar contracts governing the relationship between a 

Hedge Fund and its investors.

Operational risk | The risk of loss due to system breakdowns, employee 

fraud or misconduct, errors in models or natural or man-made catastrophes, 

among other risks. It may also include the risk of loss due to the incomplete 

or incorrect documentation of trades. Operational risk may also be defined 

by what it does not include: market risk; credit risk; and liquidity risk.

OTC or over-the-counter transaction | A transaction between parties that 

is not executed on an organized exchange, but instead privately negotiated 

on a bilateral basis between the parties. Stocks of smaller companies, forward 

contracts on physical commodities and currencies, bank and securities loans, 

repurchase agreements, and derivatives are traded in OTC markets.

Pooled investment vehicle | An investment entity, such as a limited 

partnership, limited liability company, trust, corporation, or similar form of 

enterprise operated for the purpose of trading securities or other investment 

instruments, and that is exempt from registration under the U.S. Investment 

Company Act of 1940.

Portfolio manager | A person who invests and manages an amount of 

capital allocated to it by a Hedge Fund Manager on behalf of a Hedge Fund. 

Portfolio managers may be either employees of the Hedge Fund Manager 

itself or external managers who are actively managed by the Hedge 

Fund Manager or with whom the Hedge Fund Manager makes a passive 

investment.

Pre-settlement risk | A form of credit risk; refers to the risk that a counterparty will default on an OTC derivative contract prior to the contract’s 

settlement at expiration.

PWG | President’s Working Group on Financial Markets.

PWG Agreement | The Agreement among PWG and U.S. Agency Principals 

on Principles and Guidelines Regarding Private Pools of Capital, published on 

February 22, 2007.

Glossary
Sound Practices for Hedge Fund Managers | 11

Prime broker | A brokerage firm providing multiple services to a Hedge 

Fund that are beyond the scope of those offered by a traditional broker, such 

as clearing and settlement of securities transactions, financing, recordkeeping, custodial services, and research capabilities.

Recommendations | The recommendations set forth in Sound Practices.

Redemption | The redemption of shares or other interests in, or 

withdrawals of funds from, a Hedge Fund by an investor.

Risk-based leverage measure | See leverage measures.

Scenario analysis | Similar to a stress test, the practice of subjecting a 

model (e.g., a Value-at-Risk model) to adjusted inputs in order to assess the 

impact of a specified scenario of market events on a Hedge Fund’s portfolio. 

(See stress test, Value-at-Risk, and model). A scenario could be historical 

(e.g., by reproducing the events of October 1987) or hypothetical (e.g., by 

simulating an event that would stress the market factors to which the Hedge 

Fund is most exposed).

SEC | The United States Securities and Exchange Commission.

Section 28(e) | Section 28(e) of the Securities Exchange Act of 1934, 

as amended.

Senior management | Refers to members of a group of senior executives or 

other management body with the authority and responsibility to direct and 

oversee a Hedge Fund Manager’s day-to-day activities on behalf of a Hedge 

Fund(s).

Settlement risk | The risk that a counterparty will fail to perform its obligations under a contract on the settlement date; a form of credit risk.

Sharpe Ratio | A measure that is widely used by investors to evaluate the 

performance of a portfolio or to compare the performance of different 

portfolios on a “risk-adjusted” basis. The numerator of the Sharpe Ratio is 

a measure of a portfolio’s return during a given period, generally the return 

earned on the portfolio in excess of the risk-free rate of return over one year. 

The denominator of the ratio is a measure of the risk incurred in achiev-
12 | Appendix I

ing the return, usually measured as the standard deviation of the portfolio’s 

daily return. The higher the Sharpe Ratio, the better the portfolio’s return in 

risk-adjusted terms. While the Sharpe Ratio contains information similar to 

that contained in a VAR measure, the two measures have different purposes 

and different perspectives. VAR is a forward-looking measure that is strictly 

a risk measurement tool; the Sharpe Ratio is a retrospective measure that 

compares risk and return information for an elapsed period.

Short sale | Generally, means borrowing a security (or commodity futures 

contract) from a broker and selling it, with the understanding that it must 

later be bought back (hopefully at a lower price) and returned to the broker. 

Short selling is a technique used by investors who try to profit from the 

falling price of a stock.

Side-by-side management | The management by a Hedge Fund Manager 

managing both one or more Hedge Funds and managed accounts.

Side letter | Generally, refers to an agreement with an investor that varies 

the terms of a Hedge Fund’s governing documents with respect to that 

investor.

Side pocket | Generally, refers to an investment in an illiquid or non-marketable instrument that is accounted for separately from the other assets of 

the Hedge Fund.

Soft Dollar Arrangement | An arrangement whereby a Hedge Fund 

Manager directs transactions to a broker, in exchange for which the broker 

provides, in addition to transaction execution, other products and services 

to the Hedge Fund Manager.

Sound Practices | MFA’s Sound Practices for Hedge Fund Managers.

Spread | The excess of the price or yield on a particular security or instrument relative to a benchmark. For example, the “spread over Treasury” is the 

difference between the yield for a certain fixed income instrument and the 

yield for a comparable U.S. Treasury security.

Standard deviation | Technically, a statistical measure of the dispersion of 

a set of numbers around a central point. Standard deviation measures the 

volatility, or uncertainty, of investment returns, and is therefore commonly 

used to measure the risk of a portfolio. The higher the standard deviation of 

a portfolio, the higher the uncertainty of the portfolio’s return.

Glossary
Sound Practices for Hedge Fund Managers | 13

Statute of Frauds | A collective term describing the various statutory provisions that render unenforceable certain types of contracts unless they are 

evidenced by a written document.

Stress test | A general term for the practice of subjecting a model (e.g., a 

Value-at-Risk model) to inputs that are adjusted to represent extreme or 

unusual changes in market factors. The sources of stress may be actual historical changes in market factors or hypothetical changes.

Systemic risk | The risk that the failure of a significant market participant 

in a payment or settlement system to meet its obligations when due will 

cause other participants or financial institutions to be unable to meet their 

obligations. Such a failure could potentially cause significant market liquidity or credit problems and threaten the stability of financial markets.

Third-party service provider | A firm that provides certain administrative, 

technical, financial, or other services to a Hedge Fund Manager that chooses 

to outsource parts of its operations.

Trading P&L | The fair value of the financial assets and liabilities in a 

Hedge Fund’s portfolio.

U.S. GAAP | United States generally accepted accounting principles.

Valuation | The process of determining the value of positions in a Hedge 

Fund portfolio. Valuation serves two distinct purposes: it provides the base 

input for both the risk monitoring process and the calculation of a Hedge 

Fund’s NAV, which serves as the basis for pricing investor subscriptions and 

redemptions.

Value-at-Risk or VAR | An integrated measure of the market risk of a portfolio of assets and/or liabilities. At the most general level, VAR is a measure 

of the potential change in value of a specified portfolio over a specified time 

interval or holding period, resulting from potential changes in market factors (e.g., prices and volatilities). The VAR measure is based on the distribution of potential changes in the value of the portfolio and is expressed in 

terms of a confidence level. A Hedge Fund Manager’s risk management team 

may choose to use VAR to estimate the maximum expected amount a Hedge 

Fund could lose over a specified time horizon at a specified probability 

level. For instance, the risk management team could calculate the maximum 
14 | Appendix I

expected loss for a one-day period at a 95% probability level (i.e., the level 

of loss that should be exceeded on only five trading days out of 100).

The challenge in calculating an accurate VAR is determining the distribution of potential value changes for market factors, which requires the risk 

management team to choose a methodology for modeling potential changes 

in market factors. Different methods are currently used to determine such 

distribution when calculating VAR (e.g., Historical Simulation Method, 

Monte Carlo Simulation Method, Analytic Variance—Covariance Method).

Vega | One of the Greek factor sensitivities used by traders to measure 

exposures in derivatives portfolios.

Volatility | A measure of risk based on the standard deviation of an asset’s 

return (see standard deviation). The greater the degree of an asset’s volatility, 

the greater the risk of the asset.

Worst historical drawdown | The largest decrease in the value of a Hedge 

Fund measured as the difference between the highest and lowest value since 

its inception or during a given period of time (e.g., last five years).

Glossary
Sound Practices for Hedge Fund Managers | 15

Selected Sources Used

Readers of this document may wish to review the select sources listed below 

that are cited in Sound Practices.

• President’s Working Group on Financial Markets’ Agreement Among PWG 

and U.S. Agency Principals on Principles and Guidelines Regarding Private 

Pools of Capital, published in on February 22, 2007.

• Counterparty Risk Management Policy Group II 2005 Report, Toward 

Greater Financial Stability: A Private Sector Perspective.

• SEC’s Regulation S-P, Privacy of Consumer Financial Information, 

promulgated under the Gramm-Leach-Bliley Act, as amended.

• U.S. GAAP’s Financial Accounting Standards Board’s Statement of 

Financial Accounting Standards No. 157, Fair Value Measurements.

• Investment Advisers Act of 1940, as amended.

• Commodity Exchange Act, as amended.

• Securities Act of 1933, as amended.

• Securities Exchange Act of 1934, as amended.

• USA PATRIOT Act of 2001, as amended.

• MFA’s updated Guidance for Hedge Funds and Hedge Fund Managers on 

Developing Anti-Money Laundering Programs (Release No. 2).

• Guidance Regarding Client Commission Practices Under Section 28(e) 

of the Securities Exchange Act of 1934, as amended (www.sec.gov/rules/

interp/2006/34-54165.pdf).

• Consultation Papers on Best Execution (www.fsa.gov.uk/pubs/cp/cp154.pdf).

• Bundled Brokerage and Soft Commission Arrangements (www.fsa.gov.

uk/pubs/cp/cp176.pdf).

• Financial Services/Information Sharing Alert Center (www.fsisac.com).

• National Futures Association (www.nfa.futures.org).
Sound Practices for Hedge Fund Managers | 01

APPENDIX II

This Model Due Diligence Questionnaire was prepared and published by Managed Funds Association (“MFA”) in consultation with 

Hedge Fund Members of MFA and outside groups representing 

Hedge Fund investors. This questionnaire was designed to identify 

the kinds of questions that a potential investor may wish to consider 

before investing in a Hedge Fund. In particular, we have tried to 

identify questions that may help amplify on or provide additional 

details to the disclosure in a Hedge Fund’s offering documents.

We believe that Hedge Funds are valuable to our capital markets 

and provide investors with valuable portfolio diversification and risk 

management. Our goal is to provide potential investors in Hedge 

Funds a questionnaire to be used as a reference in performing their 

due diligence before investing in a Hedge Fund.

MFA Members have diverse strategies, investment styles, risk tolerances and legal structures. Therefore, this questionnaire is designed 

to provide a basis for investors to commence their due diligence 

and is not designed to be an exhaustive list of questions that may be 

relevant to an investor. We encourage the use of this document as a 

resource in conducting due diligence in connection with an investment in a Hedge Fund, but also urge users to modify this document 

to address their particular needs and to address any additional matters that they consider material to an investment in a Hedge Fund. 

This document is also incorporated into MFA’s Sound Practices for 

Hedge Fund Managers (2007 Edition) as Appendix II.

Before responding to any question in this, or any other questionnaire, a Hedge Fund Manager must recognize and take into consideration applicable securities laws and its responsibilities under 

those laws. Therefore, an investor should bear in mind that a Hedge 

Fund Manager may modify, as it deems appropriate, in light of the 

Hedge Fund Manager’s business and legal or regulatory obligations, 

any question in this or any other questionnaire. In addition, a Hedge 

Model Due Diligence Questionnaire

for Hedge Fund Investors
02 | Appendix II

Fund Manager may choose not to respond to a particular question 

in light of confidentiality concerns. Any information provided in this 

questionnaire by a Hedge Fund Manager is current only as of the 

date this questionnaire is completed and the Hedge Fund Manager 

has no obligation to update or supplement any of the answers given, 

and assumes no responsibility for the accuracy of the answers provided after the date the questionnaire is completed.

 

About MFA

MFA is the voice of the global alternative investment industry. Its 

Members include professionals in hedge funds, funds of funds, and 

managed futures funds. Established in 1991, MFA is the primary 

source of information for policy makers and the media and the 

leading advocate for sound business practices and industry growth. 

MFA Members represent the vast majority of the largest Hedge Fund 

groups in the world who manage a substantial portion of the almost 

$2.0 trillion invested in absolute return strategies. MFA is headquartered in Washington, D.C., with an office in New York.

For more information, please contact Managed Funds Association’s 

government relations team at 202.367.1140 or visit our Web site at 

www.managedfunds.org.

This document is for informational purposes only and is not and should 

not be construed as an offer to sell or a solicitation of an offer to buy any 

interest in any entity or investment vehicle. Any offer to sell or solicitation of 

an offer to buy will only be made pursuant to a confidential private offering 

memorandum of the applicable investment vehicle (“Memorandum”). The 

information in this document is qualified in its entirety and limited by reference to such Memorandum, and in the event of any inconsistency between 

this document and such Memorandum, the Memorandum shall control. This 

document is not a complete description of the businesses engaged in by the 

Hedge Fund Manager and/or any of its affiliates or clients. Accordingly, this 

document does not contain all material information that may be useful to 

your evaluation and contains generalizations and categorizations in light of 

the format of these questions.

Model Due Diligence Questionnaire 

for Hedge Fund Investors
A. General Information:

1. Firm Name:

2. Firm Headquarters:

3. Placement Agent, if any:

4. Placement Agent Address:

5. Contact Name:

6. Contact Telephone Number:

7. Contact Fax:

8. Contact Email:

B. Firm Description

Please provide a brief description of the firm.

C. Investment Manager Entities and Organizational Structure 

Please describe the relevant entities of the investment manager or adviser

and their ownership structure. Have there been any material changes to the

entities themselves (e.g., additions or deletions) or to the ownership structure

of those entities in the past three years?

D. Personnel

1. Please briefly describe the background of the firm’s key investment

personnel.

2. For the firm’s key investment personnel that have left the firm over the

past three years, please explain any non-routine reasons for the departures.

3. Please describe the firm’s supervisory structures (e.g., management

committees).

Sound Practices for Hedge Fund Managers | 03

I. Investment Manager Overview 
04 | Appendix II

4. How many employees does the firm have supporting investment management businesses in total? How many by function? If the firm or its

affiliates maintain multiple offices, how are these employees distributed

geographically?

E. Service Providers

1. Auditor

 a. Who audits the investment vehicles managed by the firm?

 b. Does the auditor have an affiliation or any business relationship with

the firm or any of its affiliates outside of the audit relationship itself?

Has the firm or any of its affiliates retained the auditor or any of its

affiliates for other engagements, such as consulting services, financial

statement preparation, or tax services? If so, please describe.

 c. Has the current auditor audited the firm’s investment vehicles in each

of the last three years? If not, please describe the circumstances of any

audit engagement changes made.

 d. Has any investment vehicle managed by the firm ever received a qualified audit opinion? If so, please describe.

 e. Has an auditor ever requested a material restatement of financial statements or performance results of any investment vehicle managed by the

firm? If so, please describe.

2. Has the firm engaged any third-party marketing agent? If so, please

describe the terms of this engagement.

3. Who serves as legal counsel for the firm?

4. Does the firm outsource any accounting or operational functions to third

parties? If so, please describe. Does the firm periodically review the performance of any such service providers? How is this review conducted?

Model Due Diligence Questionnaire 

for Hedge Fund Investors
F. Compliance System and Registrations with 

Regulatory Authorities

1. Please describe the firm’s compliance regime. Does the firm have a designated Chief Compliance Officer (CCO)? If so, please briefly describe the

background of the CCO, and explain whether the CCO has any responsibilities other than those relating to compliance matters.

2. Is the firm or any of its affiliates registered with any regulatory authorities? If so, please describe. If the firm has not registered with the U.S.

Securities and Exchange Commission as an investment adviser, please

explain the exemption upon which the firm currently relies and if it

intends to register in the next 12 months.

3. Does the firm maintain and periodically review written compliance policies and procedures, including a code of ethics? If not, please explain.

4. Does the firm have a written policy on the handling and safeguarding of

any material, non-public information in its possession, including a process to educate employees? If not, how is material, non-public information

protected, and how are these processes communicated to employees?

5. Does the firm have written policies regarding personal account trading

by employees? If so, please describe. If not, is personal account trading

monitored, and how are standards of conduct communicated to

employees?

6. Does the firm maintain written procedures on the provision and receipt

of gifts and entertainment? If not, how is such activity monitored, and

how are standards of conduct communicated to employees?

7. Does the firm maintain written Anti-Money Laundering (“AML”)

procedures? Is there a designated AML compliance officer? If not,

how are AML checks conducted?

8. Please describe any material soft dollar arrangements the firm currently

maintains.

9. Please describe any material directed brokerage arrangements the firm

currently maintains.

Sound Practices for Hedge Fund Managers | 05
06 | Appendix II

Model Due Diligence Questionnaire 

for Hedge Fund Investors

G. Legal Proceedings

1. In the past five years: (a) have there been any criminal or administrative proceedings or investigations against the firm, a principal or key

employee of the firm, or any affiliate of the firm; or (b) have there been

any civil proceedings against the firm, a principal or key employee of the

firm, or any affiliate of the firm in each case that resulted in an adverse

disposition? If so, please describe.

2. Is the firm currently aware of any pending criminal or administrative

proceedings against the firm, a principal or key employee of the firm,

or any affiliate of the firm?

3. Have any adverse dispositions materially impacted any of the funds

or accounts managed by the firm?

H. Infrastructure and Controls

1. Please describe the firm’s current trading, portfolio management, and

post-trade reconciliation and accounting infrastructure, identifying any

significant deployments of third-party software.

2. Please describe how trades are generally executed. What types of controls

are typically used to help prevent unwanted executions from occurring?

3. Please describe the typical trade reconciliation process and frequency.

What segregations of duty are generally employed in the process?

4. Please describe how cash or other asset transfers can be authorized, both

for transfers within a vehicle managed by the firm, as well as to external

parties. What types of controls are generally used to prevent unwanted

transfers from occurring?

5. Please describe how the firm handles trading errors.

6. Does the firm or its affiliates retain errors and omissions insurance?
2. Market Risk

I. Business Continuity

Does the firm maintain a written BC/DR plan? If not, how does the firm

plan to maximize its ability to recover from business interruptions?

Sound Practices for Hedge Fund Managers | 07

II. Overview of Activities of the 

Investment Manager 

A. Vehicles Managed

1. Please provide a description of the major investment vehicles managed

by the investment manager.

2. What are the aggregate assets under management of the investment

manager?

3. Does the firm manage separate accounts? If so, please describe.

4. Does the investment manager or any of its employees have an interest in

any of the investment vehicles managed by the investment manager? If

so, what is the amount of this interest in the aggregate?

B. Other Businesses

Does the investment manager engage materially in other businesses apart

from asset management? If so, please describe.

C. Conflicts of Interest

1. Please describe those conflicts of interest that you consider material to

the management of the investment vehicles. How do you address these

conflicts?

2. Does the firm engage in cross-trades or principal cross-trades with or

among the accounts and/or investment vehicles it manages? If so, what

controls are generally in place to protect the participating investment

vehicles or accounts?
Model Due Diligence Questionnaire 

for Hedge Fund Investors

08 | Appendix II

3. Does the firm have any affiliates or subsidiaries that are broker-dealers

or execution agents? If yes, do these broker-dealers or execution agents:

(a) execute on behalf of investment vehicles managed by the firm; and

(b) charge commissions or mark-ups on these executions or otherwise

bill expenses to investment vehicles managed by the firm in instances in

which the investment vehicle is not the sole owner of the execution agent

or broker-dealer? If so, please describe these arrangements.

III. Fund Information 

A. Fund Overview and Investment Approach

1. Please describe the fund’s legal structure.

2. Please provide a brief description of the investment strategies generally

deployed by the fund.

3. What types of financial instruments does the fund generally trade?

4. In which geographical markets does the fund generally trade?

5. Approximately how many positions does the fund generally hold?

What is the typical maximum position size?

6. Please describe the portfolio turnover.

B. Fund Capital and Investor Base 

1. What is the capital base of the fund?

2. How many investors are currently invested in the fund?

3. If the fund maintains a master-feeder structure with both U.S and nonU.S. feeder entities, what percentage of the capital base is invested in the

U.S. fund? The non-U.S. feeder fund?
C. Fund Terms

1. Are there multiple classes of interests or multiple feeder entities in

the fund?

2. Please list, for each class of interest or feeder:

 a. Investment minimum;

 b. Management fee;

 c. Performance fee, including hurdle rates, high-water marks, and loss

carryforwards, if any; and

 d. Redemption terms, including any fees payable, lock-ups, gating

provisions, or other restrictions.

3. Can the investment manager suspend redemptions, suspend the payment

of redemption proceeds, pay redemption proceeds in-kind, or otherwise

elect to deviate from the redemption terms described in 2(d) above? If so,

please describe.

4. Have gates been imposed in the past? If so, under what circumstances

were the gates imposed? If gates have been imposed in the past, have

those gates been lifted? If so, under what circumstances were the gates

lifted?

5. Does the firm generally charge additional expenses to the fund, including

operating expenses, audit fees, administrative fees, fund organizational

expenses, legal fees, sales fees, salaries, rent, or other charges not detailed

in (2) above? If so, please describe. What was the total amount of these

expenses in each of the last three calendar years as a percentage of total

fund assets under management, if applicable?

6. What is the firm’s policy with regard to side letters? Do any investors in

the fund experience fee or redemption terms that differ materially from

those listed above? If so, please describe.

Sound Practices for Hedge Fund Managers | 09 
D. Performance History

Please provide a performance history for the fund.

E. Risk Management

1. Please describe the firm’s risk management philosophy and discuss the

approach used by the firm in the management of the fund’s exposure

to: equity, interest-rate, currency, and credit market risk (as applicable);

financing and counterparty risk; and operational risk.

2. Does the firm rely on third parties to perform any portion of its risk

management function?

3. What types of risk measures does the firm use in its risk management

function?

F. Valuation

1. Please describe the process of valuation of the fund’s positions, including

valuation process for positions that do not have a market price. Please

discuss in particular the frequency of valuation and whether any thirdparty services are employed in the valuation process (and, if so, how these

third parties are monitored).

2. Has the fund had a material restatement of its financial statements or any

prior results since inception? If so, please describe. Was the restatement

the result of an audit by an external auditing firm?

G. Fund Service Providers

1. If the fund employs an administrator, please provide its contact

information.

2. Please provide information concerning legal counsel used by the fund,

if any.

3. Please name the main prime brokers used by the fund.

H. Investor Communications

What types of investor communication does the fund currently provide,

and with what frequency?

Unless otherwise indicated, the information below is as of [recent date].

Model Due Diligence Questionnaire 

for Hedge Fund Investors

10 | Appendix II
1 Valuation policies and practices are discussed in Sound Practices in Section 3—

Determination of Net Asset Value. While not explicitly part of the risk management 

team, proper valuation practices are crucial to effective risk monitoring.

This appendix begins by providing 

an overview of the risks faced by 

a Hedge Fund Manager in Section 

1—Management, Trading, and 

Information Technology Controls.1

The descriptions of the practices 

for monitoring market risk (Section 

2—Responsibilities to Investors), 

funding liquidity risk (Section 3—

Determination of Net Asset Value), 

and leverage (Section 4—Risk 

Management) form the core of this 

appendix and address the following 

key issues:

• Risk monitoring techniques. This 

appendix will discuss generally 

certain techniques that are often 

used in financial markets for 

monitoring market risk—VAR, 

scenario analyses and stress tests, 

and back-testing;

• The importance of analyzing 

funding liquidity risk. While the 

measures for monitoring funding 

liquidity described in this appendix 

are used in other industries, Hedge 

Fund Managers should focus significant attention on funding liquidity given the impact it can have on 

the viability of a Hedge Fund; and

• Leverage in the context of Hedge 

Funds. While leverage is not 

unique to Hedge Funds, the 

MFA’s Sound Practices for Hedge Fund Managers | 01

APPENDIX III

The objective of this appendix is to elaborate upon the supplemental discussion of risk management practices contained in Section 

4—Risk Management. This appendix describes the general array 

of risk management techniques and methodologies currently available, in addition to addressing the specific techniques and methodologies that should be considered as part of sound risk monitoring 

practices for Hedge Fund Managers. The latter discussion includes 

further explanations of valuation, liquidity, and leverage from the 

perspective of Hedge Fund Managers.

Supplemental Information on 

Risk Monitoring Practices for 

Hedge Fund Managers
While observers often distinguish 

four broad types of risk—market 

risk, credit risk, liquidity risk, and 

operational risk2—it is important to 

recognize that these risks are interrelated. Indeed, Hedge Fund Managers should recognize that “market 

risk” incorporates elements of credit 

risk and liquidity risk. Defined most 

narrowly, market risk focuses on the 

impact of changes in the prices of 

(or rates for) securities and deriva02 | Appendix III

2 “Sovereign risk” may be viewed either as “credit risk”, if the potential loss is related to 

the financial solvency of the sovereign, or as “market risk”, if the potential loss is related 

to policy decisions made by the sovereign that changes the market value of positions (e.g., 

currency controls). “Legal risk”, other than those covered by the preceding discussion of 

“sovereign risk”, would be included as “operational risk”.

market risk inherent in a Hedge 

Fund, coupled with the constraints 

imposed by funding liquidity, 

make the amplifying effect of leverage of particular concern to 

a Hedge Fund Manager. 

This appendix describes a group of 

static leverage measures, both financial statement-based and risk-based 

leverage measures. Also described in 

this appendix are dynamic leverage 

measures that can provide additional 

information to the Hedge Fund 

Manager.

This appendix concludes with a 

description of practices for monitoring counterparty credit risk (Section 

5—Regulatory Controls). Because 

Hedge Funds generally deal with 

counterparties having high credit 

quality, the credit risk of counterparties may be of less concern to Hedge 

Fund Managers than the other 

sources of risk, but should nonetheless by appropriately monitored.

I. Overview: The Risks Faced by 

a Hedge Fund Manager 

Effective risk management requires that the Hedge Fund Manager recognize and understand the source of the returns the Hedge Fund is earning 

(i.e., the risks to which the Hedge Fund is exposed). Consequently, one 

of the primary responsibilities of the Hedge Fund Manager’s risk management team is to identify and quantify the sources of risk.

Supplemental Information on Risk Monitoring 

Practices for Hedge Fund Managers
tives, the volatilities of those prices, 

and the correlations between pairs of 

prices on the value of the portfolio. 

However, elements of liquidity risk 

and credit risk have a similar focus. 

For example:

• Changes in liquidity impact on the 

value of a security or derivative. 

This element of liquidity risk is 

sometimes referred to as asset or 

“market” liquidity risk; and

• Changes in the creditworthiness 

of an entity impact on the value 

of a security or derivative issued 

by or indexed to that entity.

Because these three risks all focus 

explicitly on changes in the value 

of an asset or the portfolio, Hedge 

Fund Managers should integrate 

the monitoring and management 

of them (i.e., view them as a group, 

rather than individually). Hence, 

in Section 2 of this appendix, “market risk” will encompass the credit 

risk associated with assets held in 

the portfolio and asset (or market) 

liquidity risk, as well as the more 

commonly cited market risk factors: 

interest rate risk; foreign exchange 

rate risk; equity price risk; and 

commodity price risk.

In addition to having an impact on 

the value of securities or derivatives 

held by the Hedge Fund, changes 

in funding liquidity can impact the 

Hedge Fund Managers’ ability to 

finance its positions. Section 3 of 

this appendix will indicate why this 

risk is of greater concern to Hedge 

Fund Managers than to other entities and will describe the techniques 

that should be used by Hedge Fund 

Managers to monitor funding 

liquidity risk.

The Hedge Fund Manager should 

also consider “leverage”. However, 

leverage is not an independent 

source of risk; rather, it is a factor 

that influences the rapidity with 

which changes in market risk, credit 

risk, or liquidity risk factors change 

the value of the portfolio. Indeed, it 

is essential to consider what leverage 

means—or does not mean—in the 

context of a Hedge Fund:

• A single leverage number may not 

contain very much information.

As will be illustrated in this appendix, a risk-reducing transaction can 

increase some leverage measures 

while decreasing others;

• The liquidity or price volatility 

of the position being leveraged 

is relevant to assessing effective 

leverage. The leverage employed 

by a Hedge Fund that holds oneyear Treasury bills with ten-to-one 

leverage may be of less concern 

than that employed by a Hedge 

Fund levered two-to-one with 

respect to the S&P 500 Index;

1.0 Overview: The Risks Faced by a Hedge Fund Manager

Sound Practices for Hedge Fund Managers | 03
The Risks Faced by a Hedge Fund Manager

Stylized Portfolios

In Sections 2, 3, and 4, of this appendix, a collection of stylized portfolios and balance sheets are used to illustrate and compare the measures of market risk, funding liquidity risk, and leverage that are also 

discussed in the Recommendations. As described below, these simple 

portfolios are composed of various combinations of three hypothetical 

securities (which are denoted as Asset 1, Asset 2, and Asset 3) and two 

derivative contracts. Two of the securities are lower risk assets, with 

annualized volatility of 30% and 25%, respectively. The third asset is a 

higher risk asset with annual volatility of 60%. The two derivatives are 

simple futures contracts on the two low risk securities; therefore, they 

have the same volatility as those securities.

Each portfolio is part of a simple balance sheet. It is assumed that $100 

of investor equity funds each strategy. To calculate all of the various 

risk measures, the stylized balance sheets also indicate a cash position, a 

futures margin position, and a liability account that reflects any financing transactions. The required futures margin is 10% in cash, which is 

not counted as liquidity. In addition, up to 50% of Asset 1, 2, or 3 can 

be borrowed, and 50% of the proceeds from a short sale are available to 

finance investments.

For each portfolio, various measures of market risk, liquidity, and 

leverage have been calculated. Note that not all the risk measures are 

relevant for every portfolio.

04 | Appendix III

• A Hedge Fund’s capacity to 

absorb losses—its “funding liquidity”—is relevant to assessing its 

effective leverage. Leverage should 

be measured relative to a Hedge 

Fund’s capacity to absorb losses. 

A Hedge Fund that has a relatively 

high level of financial statementbased leverage may pose a smaller 

risk than a less levered Hedge Fund 

with low cash positions, limited 

borrowing capacity, or Hedge 

Fund investors that can withdraw 

their funds on short notice; and

• Other factors may also be 

relevant to the assessment of 

Hedge Fund’s effective leverage. 

These may include such considerations as the level of position 

concentration in the Hedge Fund 

portfolio, overall market volatility 

and correlation conditions, 

and other “situation-specific” 

considerations.
• Portfolios 1 and 2 illustrate positions with identical market risk but 

different investments to implement the strategy. Portfolio 1 is an 

un-leveraged investment in Asset 1, while Portfolio 2 uses the futures 

contract on Asset 1 to implement the same strategy.

• Portfolios 3 and 4 are leveraged versions of Portfolios 1 and 2. The 

use of balance sheet leverage (Portfolio 1) or additional derivatives 

contracts (Portfolio 2) has the effect of increasing the market risk of 

both portfolios.

• Like Portfolios 3 and 4, Portfolio 5 is more risky than Portfolios 1 and 

2. Instead of employing traditional leverage, however, the additional 

risk arises because the manager switches from a lower-risk strategy 

(invests in Asset 1) to a higher-risk investment strategy (invests in 

Asset 3). 

• Portfolios 6 and 7 use long and short investments to illustrate the 

effect of a type of hedging by being long in one asset and short in 

another that is positively correlated with the first. In Portfolio 6, the 

strategy is implemented in the cash market, while Portfolio 7 achieves 

identical market risk using a combination of cash and futures. As 

discussed later, these portfolios illustrate the complexity that can appear as the portfolio increases in size—although Portfolios 6 and 7 are 

generally less risky than Portfolios 3 and 4, there are conditions under 

which these can become significantly more risky.

• Portfolios 8 and 9 are used to illustrate the effect of matched book 

assets—either in the futures market or the cash market—on traditional 

leverage and liquidity measures. Portfolios 8 and 9 represent the same 

net positions as Portfolios 1 and 2; however, the positions are established by combining a short position in Asset 1 or futures on Asset 1 

(i.e., -20) with long positions in the same asset (i.e., 100), rather than 

only long positions (i.e., 80).

Sound Practices for Hedge Fund Managers | 05
06 | Appendix III

As noted above, for Hedge Fund 

Managers, changes in credit quality 

that affect the value of the portfolio 

through a change in the price of 

securities owned are incorporated 

into “market risk”. However, Hedge 

Fund Managers are also exposed to 

counterparty credit risk. Changes in 

the credit quality of counterparties 

can impose costs on the Hedge Fund 

either in the form of an increase in 

expected losses due to counterparty 

failure to perform or by forcing the 

Hedge Fund Manager to find alternative counterparties.

Operational risks faced by Hedge 

Fund Managers are much the same 

as those faced by other financial institutions—data entry errors, fraud, 

reconciliation errors, and system 

failures and errors in valuation or 

risk measurement models. The appropriate techniques and practices 

to deal with these risks are, likewise, 

the same techniques and practices 

used by other entities. As noted in 

the Recommendations, these include 

random spot checks, maintenance of 

a single, centralized data set, contingency plans for responding to failures 

in the Hedge Fund Manager’s systems, or for responding to the failure 

of a third-party service provider.

The Risks Faced by a Hedge Fund Manager

Table 1: Stylized Portfolios

Unlevered Levered Unlevered Long/Short Unlevered 

Cash versus Cash versus High Risk Strategy Strategy with

Futures Futures Cash versus Matched

Futures Book Assets

Cash Futures Levered Futures High Risk Long/ Long/ Hedged Hedged

Only Only Cash Cash Short Short Cash Futures

 Cash Mixed

Summary Balance Sheet

Capital 100 100 100 100 100 100 100 100 100

Borrowing 0 0 30 30

(outright or repo)

Investments

Cash Market 

Transactions

 Asset 1 80 120 120 120 100, -20

 Asset 2 -60

 Asset 3 80

Derivatives Market 

Transactions

 Futures on Asset 1 80 120 100, -20

 Futures on Asset 2 -60

Cash 20 92 10 88 20 10 4 10 88

Futures Margin 0 8 0 12 0 0 6 0 12

Portfolio 1 2 3 4 5 6 7 8 9 
A Hedge Fund Manager should 

employ a consistent framework for 

measuring the risk of loss for a portfolio (and relevant subcomponents 

of the portfolio). In order for the 

Hedge Fund Manager to manage 

the risks that the Hedge Fund faces, 

its risk management team needs to 

produce some useful measures and 

analyses of risk. While the choice of 

framework or model for measuring 

risk should be left to each Hedge 

Fund Manager, the Hedge Fund 

Manager should be aware of the 

structural limitations of the model 

selected and actively manage these 

limitations, including the impact of 

any model breakdown.

For example, measuring the degree 

to which the portfolio is diversified 

(e.g., the percentages of the portfolio 

allocated to different asset classes or 

to different geographical regions) 

may be useful, but it is important 

for the Hedge Fund Manager to 

recognize and understand the correlations between positions. For 

complex portfolios, many summary 

measures of market risk do not 

reflect such correlations.

One model that is intended to provide a summary market risk measure 

that incorporates correlations 

between positions is VAR. VAR 

measures the maximum change in 

the value of the portfolio that would 

be expected at a specified confidence 

level over a specified holding period. 

For example, if the 95% confidence 

level one-day VAR for a portfolio is 

$500,000, one would expect to gain 

or lose more than $500,000 in only 

five of every 100 trading days on 

average. One of the roles of the risk 

management team is to identify the 

factors affecting the risk and return 

of the Hedge Fund’s investments, 

both within individual portfolios 

and across the entire range of activities of the Hedge Fund Manager. 

Those factors should be incorporated into the risk monitoring process 

and, where appropriate, be included 

in the market risk model. Factors 

that are commonly incorporated in 

a market risk model include:

• Prices for equities and/or equity 

indices;

• Level and shape of the interest 

rate term structure in relevant 

currencies;

Sound Practices for Hedge Fund Managers | 07

II. Market Risk

Encompassing the credit risk associated with securities and derivatives 

in the portfolio and asset liquidity risk, as well as interest rate risk, foreign 

exchange rate risk, equity price risk, and commodity price risk.
08 | Appendix III

Market Risk

• Foreign exchange rates;

• Commodity prices;

• Credit spreads;

• Nonlinearities (particularly for 

instruments with elements of 

optionality);

• Volatilities; and

• Correlation.

The risk management team may also 

consider incorporating “asset liquidity” (i.e., the potential exposure to 

loss attributable to changes in the 

liquidity of the market in which the 

asset is traded) as an additional factor. Measures of asset liquidity that 

may be considered include:

• The number of days that would 

be required to liquidate and/or 

neutralize the position in question; 

and

• The value that would be lost if 

the asset in question were to be 

liquidated and/or neutralized 

completely within such period.

Parameter Selection

In order to calculate a VAR measure, 

a number of parameters should be 

input; these parameters describe the 

positions in the portfolio and the 

underlying markets. In addition, users of VAR should select across three 

methodologies that have become 

standard forms of VAR over the past 

several years:

• Variance/Covariance. Under this 

method, which is probably the 

most widely used VAR methodology, the program draws volatility (variance) and correlation 

(covariance) information from data 

histories, for each position in the 

portfolio, and calculates the volatility estimate under the assumption that the returns for the overall 

portfolio will assume a normal 

distribution. It is the least process 

intensive and perhaps the easiest of 

the VAR methodologies;

• Historical Volatility. Under this 

approach, the VAR portfolio 

actually is repriced each day over 

the data history, a daily trading 

P/L calculation is derived and 

ranked in ascending order. The 

risk estimate is then set at the level 

consistent with the confidence 

interval selected for the analysis. 

Historical volatility is very process 

intensive, but is considered by 

many to be the most effective form 

of VAR; and

• Monte Carlo Simulation. Under 

the Monte Carlo approach, the 

portfolio is repriced across large 

numbers of random observations that are consistent with the 

volatility history of the underlying 
2. Market Risk

3 Parameter selection is only applicable for Variance/Covariance matrix.

instruments. Like historical VAR, 

these observations are then ranked 

in ascending order, and the risk 

estimate is set at a level consistent 

with the applicable confidence 

interval. Historical Monte Carlo 

VAR is typically only used for 

very complex portfolios, featuring 

abundant nonlinearities.

Each method, if applied accurately 

and in a manner consistent with the 

risk and capital allocation policies of 

the Hedge Fund, can be an effective, 

if imperfect, means of estimating 

exposure.

In addition to the selection of VAR 

methodology, for a given portfolio, 

the parameters most likely to have 

a significant impact on the VAR 

value are the time horizon or holding period (the period of time that 

would be necessary for the portfolio 

to be liquidated or neutralized), the 

confidence level (the probability that 

the change in the value of the portfolio would exceed the VAR), and 

the variance-covariance data (which 

reflects the volatility of the individual 

market factors and the correlation 

between pairs of factors). These parameters are explained further below.

Time Horizon

The time horizon or holding period 

used in the VAR calculation is 

intended to reflect the time period 

necessary to liquidate (or neutralize) the positions in the portfolio. 

In practice, if the Hedge Fund has 

positions in thinly traded or illiquid 

instruments, it is difficult to determine the correct liquidation/neutralization period for the portfolio. 

Consequently, good practice is to 

use standard holding periods (e.g., 

one day, three days, five days, and 

10 days in the base-case VAR calculation and then employ stress tests 

to determine the degree of holding 

period risk in the portfolio).

Confidence Level

There is no mathematical formula 

that defines the appropriate confidence level; the appropriate confidence level is determined by the 

business circumstances of the entity. 

Different types of businesses should 

and do use different confidence 

levels. The appropriate confidence 

level for a specific Hedge Fund will 

be a business decision that is determined by the specific circumstances 

of the Hedge Fund. Senior management of the Hedge Fund Manager 

should be actively involved in this 

determination. 

Variance-Covariance Data3 

While the measure of the risk of 

individual market factors (i.e.,

the variances of the market factors) 

is important, the question of the 

Sound Practices for Hedge Fund Managers | 09
degree of correlation (i.e., covariance) between pairs of market factors 

is critical, because correlation has 

such a large impact on the VAR calculation. A number of VAR models 

use historic correlations. However, 

since historic correlations are unstable (especially during periods of market stress), the Hedge Fund Manager 

should employ scenario analyses and 

stress testing (see below) to ascertain 

the impact of inaccurate correlation 

assumptions.

Beyond a Single VAR Number

Hedge Fund Managers should 

recognize that a single VAR number 

is not sufficient to capture all risks 

faced by the Hedge Fund and that 

successful risk management requires 

the risk management team to analyze both the sensitivity of the VAR 

to alternative market conditions 

and the reliability of the VAR 

calculations.

Scenario Analysis

By their nature, VAR calculations 

are based on “typical” market days. 

Periods of market stress or crisis—

the very times of greatest concern 

—will not be well represented in 

the data for a typical period; so the 

resulting VAR number will underestimate the risks of severe markets. 

To address this limitation, the 

Hedge Fund Manager should 

perform scenario analyses regularly, 

to assess the VAR for the current 

portfolio in periods of market stress.

In creating scenario analyses, a 

Hedge Fund Manager should use 

both historical stress periods (e.g., 

October 19, 1987 when the equity 

markets “crashed”, the Asian financial crisis of 1997, and the stock 

market declines after March 2000 

(bursting of the “dot-com” bubble)).

Stress Testing

Hedge Fund Managers should stress 

test the VAR number by changing 

the parameters of the VAR model. 

Stress tests permit the Hedge Fund 

Manager to see what will happen 

to the VAR number if the actual 

values of market factors (i.e., prices, 

rates, volatilities, etc.) differ from the 

values used as inputs in the base-case 

VAR calculation.

Among the potential changes in 

market conditions that should be 

considered in stress testing are:

• Changes in prices;

• Changes in interest rate term 

structures; and

• Changes in correlations between 

prices.

Market Risk

10 | Appendix III
If the portfolio contains options or 

instruments with options characteristics, additional changes that should 

be considered as part of stress 

testing are:

• Changes in volatilities; and

• Changes in nonlinearities 

(e.g., convexity or gamma).

Hedge Fund Managers also should 

consider including the effects of 

changes in the liquidity of various 

assets in their stress testing. For 

example, Hedge Fund Managers 

could examine the effects of changing the holding period. A horizon 

of several days may reveal strings of 

losses (or gains) that, while individually consistent with the one-day 

predicted distributions, in total add 

up to a significant deviation from 

the market risk model’s predicted 

distribution.

Rather than changing the holding 

period to reflect the illiquidity of 

securities or derivatives, the Hedge 

Fund Manager could gauge the 

impact of illiquidity by inputting 

changes for the appropriate market 

risk factors that are reflective of multiple-day market price movements 

(as opposed to single-day changes).

If specific asset liquidity factors 

are incorporated in the market risk 

model, these asset liquidity factors 

can be “stressed” to examine the 

impact of: (1) changes in the value 

that could be lost if the position 

in question were to be liquidated 

and/or neutralized completely during the standard holding period; or 

(2) changes in the number of days 

required to liquidate and/or neutralize the position in question.

Of particular concern to Hedge 

Fund Managers are “breakdowns” 

in the correlations reflected in current market data. In times of market 

crisis, the correlations between 

asset prices or rates can change dramatically and unexpectedly, with 

the result that positions that were 

thought to be diversifying—or even 

hedging —end up compounding 

risk. While it remains difficult to 

hedge correlation risk, stress tests 

to evaluate the impact of correlation 

changes permit the Hedge Fund 

Manager to help ensure that, when 

the Hedge Fund Manager selects the 

assets to be included in the portfolio, the Hedge Fund is accepting the 

desired level of correlation risk (and 

is being compensated for bearing 

that risk).

Sound Practices for Hedge Fund Managers | 11
Market Risk

12 | Appendix III

Illustrative Risk Measures

Table 2 contains several illustrative VAR measures for each of the nine 

stylized portfolios introduced earlier:

• Standard VAR – A 95% One-Day VAR is calculated using the historical volatilities for the assets and assuming the correlation between 

Assets is 0.3;

• Stressed VAR 1 – The 95% One-Day VAR is recalculated increasing 

the volatility of each asset by 50% (i.e., to 45% for Asset 1, to 37.5% 

for Asset 2, and to 90% for Asset 3) and increasing the correlation 

between all assets to 0.9; and

• Stressed VAR 2 – The 95% One-Day VAR is recalculated again 

increasing the volatilities by 50% as above, but decreasing the correlation between assets to zero. 

Table 2 provides confirmation of some general propositions regarding 

the VAR measures:

• Identical positions have the same VAR regardless of whether they 

are implemented in the cash market (e.g., Portfolio 1) or the futures 

market (e.g., Portfolio 2). Identical in this case refers to the fact that 

the cash and futures positions represent the price risk associated with 

the same asset and in the same amount as discussed below, other risk 

measures, such as liquidity, are not identical;

• VAR can be increased via traditional balance sheet leverage or the use 

of additional derivatives contracts. Portfolios 3 and 4 illustrate the 

effect of leverage on the first two portfolios;

• VAR can be increased by choosing higher risk assets, regardless of 

leverage, as illustrated in Portfolio 5; and

• A hedge is not always a hedge. The “hedge” established via Portfolios 

6 and 7 presumes that Assets 1 and 2 are positively correlated. Under 

normal conditions (i.e., when correlation equals 0.3 in this example) 

the tendency of Asset 1 and Asset 2 to move together results in the 

VAR of Portfolio 6 being similar to the VAR of Portfolio 3 even 

though the total position size is larger. When the correlation gets 

more positive (Stressed VAR 1), the hedge is better, and VAR stays 
Sound Practices for Hedge Fund Managers | 13

Table 2: Markets of Market Risk

Unlevered Levered Unlevered Long/Short Unlevered 

Cash versus Cash versus High Risk Strategy Strategy with

Futures Futures Cash versus Matched

Futures Book Assets

Cash Futures Levered Futures High Risk Long/ Long/ Hedged Hedged

Only Only Cash Cash Short Short Cash Futures

 Cash Mixed

Summary Balance Sheet

Capital 100 100 100 100 100 100 100 100 100

Borrowing 0 0 30 30

(outright or repo)

Investments

Cash Market 

Transactions

 Asset 1 80 120 120 120 100, -20

 Asset 2 -60

 Asset 3 80

Derivatives Market 

Transactions

 Futures on Asset 1 80 120 100, -20

 Futures on Asset 2 -60

Cash 20 92 10 88 20 10 4 10 88

Futures Margin 0 8 0 12 0 0 6 0 12

Risk Measures

Standard VAR (asset 2.50 2.50 3.76 3.76 5.01 3.61 3.61 2.50 2.50

Correlation = 0.3)

Stressed VAR 1 3.76 3.76 5.64 5.64 7.51 3.67 3.67 3.76 3.76

(Vol+50%; Asset

 Correlation = .90)

Stressed VAR 2 3.76 3.76 5.64 5.64 7.51 6.10 6.10 3.76 3.76

(Vol+50%; Asset

 Correlation = 0)

Sharpe Ratio 1.05 1.05 1.05 1.05 1.32 0.69 0.69 1.05 1.05

Portfolio 1 2 3 4 5 6 7 8 9 

relatively unchanged even though overall volatility in the market has 

increased by 50%. However, when the correlation gets less positive 

(Stressed VAR 2), the hedge is much less effective and the combined 

effect of higher volatility and lower correlation results in a significantly larger VAR. As was the case with the earlier portfolios, the use 

of futures or cash market investments does not change the market risk 

measure, as evidenced by the identical VAR of Portfolios 6 and 7. 
Back-testing

Perhaps even more important than 

analyzing the sensitivity of the VAR 

number is “back-testing” the VAR to 

see how it performed. By comparing 

actual changes in the value of the 

portfolio to the changes generated 

by the VAR calculation, the Hedge 

Fund Manager can gain insight into 

whether the VAR model is accurately measuring a Hedge Fund’s risk.

In back-testing, one expects that 

the portfolio will lose more than 

the VAR from time to time. For example, a 95% one-day VAR should 

be exceeded five days in every 100 

trading days on average. When the 

actual changes in the value of the 

portfolio exceed VAR, the Hedge 

Fund Manager should determine 

the source of the discrepancy (i.e.,

whether the VAR measure is flawed 

or whether this loss is simply one 

which was expected given the confidence level employed). Other potential sources of deviations include:

• A change in the composition of 

the portfolio between calculation 

and observation;

• Pricing models under/overstated 

obtainable prices;

• A change in the underlying 

market, including changes in the 

volatility, correlation, or liquidity 

of the factors used in the market 

risk model; and

• Model(s) did not adequately 

capture sources of risk.

Relating Earnings and Risk

It was noted at the outset that effective risk management requires the 

Hedge Fund Manager to recognize 

and understand the risks the Hedge 

Fund faces. That, in turn, requires 

the Hedge Fund Manager to understand the various sources of the 

Hedge Fund’s earnings, both the size 

of the earnings and their volatility.

One way that Hedge Fund Managers can accomplish this attribution 

is by decomposing the daily value 

changes by market factors. The objective is to determine if the actual 

changes were what would have been 

predicted, given the now known 

changes in the market factors. If the 

observed change in the value of the 

portfolio differs significantly from 

the change that would be expected, 

given the composition of the portfolio and the observed changes in 

the market factors, the differences 

should be reconciled.

Such a source-of-return and sourceof-risk attribution process sets the 

stage for linking performance measurement with risk measurement. 

The Sharpe Ratio is widely used by 

Market Risk

14 | Appendix III
2. Market Risk

Sound Practices for Hedge Fund Managers | 15

While VAR and the Sharpe Ratio 

contain some similar information, 

the two measures are different tools, 

designed for different purposes. 

VAR is primarily a risk measurement tool. The Sharpe Ratio is a 

summary measure, combining both 

risk and return information. Moreover, while VAR is a risk measure 

and the denominator of the Sharpe 

Ratio contains a risk measure, these 

two risk measures are quite different. The risk measure used in the 

denominator of the Sharpe Ratio is 

a historical measure; it characterizes 

the actual volatility of the return 

over some historical period. In 

contrast, VAR is intended to be a 

prospective measure of risk. 

4 The Sharpe Ratio is attributed to William F. Sharpe, who described a measure of 

“return to variability” for use in comparing investment performance.

investors to measure a portfolio’s 

risk-adjusted performance over a 

specific period.4 The numerator of 

the Sharpe Ratio is a measure of 

portfolio return during the period; 

the denominator is a measure of 

the risk incurred in achieving the 

return. (For example, over the past 

decade the Sharpe Ratio for the 

S&P 500 has been approximately 

1.2.) Investors prefer higher Sharpe 

Ratios, since a higher Sharpe Ratio 

indicates that the portfolio earned 

superior returns relative to the level 

of risk incurred.

There are a number of ways in 

which return and risk could be calculated. Below is the Sharpe Ratio 

for an arbitrary portfolio—designated as Portfolioj

—calculated using 

the most common conventions 

for measuring return and risk. The 

numerator is the return earned on 

the portfolio (Rj) in excess of the 

risk-free rate of return (Rf) (i.e., 

the interest rate earned on risk-free 

securities such as U.S. Treasury 

securities) over the same period. The 

denominator—the risk incurred—is 

measured as the standard deviation 

of the portfolio’s daily return j.

 Rj

-Rf

(Sharpe Ratio)j = j
Liquidity Crisis Cycle

Hedge Fund Managers should be concerned about a confluence of risks 

(i.e., market or credit risk events affecting illiquid positions that are 

leveraged). Such a confluence of events could require the Hedge Fund 

to liquidate positions into a market that cascades in price because of a 

high volume of liquidation orders. Such a situation could be decomposed into three stages:

1. A loss that acts as the triggering event.

2. A need to liquidate positions in a disorderly manner to raise cash 

because of this loss. The liquidation may be required either because 

the Hedge Fund should post margin with its counterparties or 

because of redemptions by investors due to the loss.

3. A further drop in the Hedge Fund’s NAV as the market reacts to 

actions by the Hedge Fund. Obviously, attempts by the Hedge Fund 

to sell in too great a quantity or too quickly for the market liquidity to bear can cause a further drop in prices, precipitating a further 

decline in the Hedge Fund’s NAV, and leading in turn to yet a 

further need to liquidate to satisfy margin calls or redemptions. This 

downward spiral can be exacerbated if other market participants 

have information about the Hedge Fund’s positions.

The point of no return comes when the effect of liquidation has a 

greater impact on the value of the remaining Hedge Fund position 

than the amount of cash raised from the liquidation. If this happens, 

the Hedge Fund is caught in an accelerating, downward spiral, and 

eventually it will not be able to satisfy the demands of its creditors or 

investors. Once the losses move beyond a critical point, it becomes 

a self-sustaining crisis that feeds off of the need for liquidity, a need 

imposed by the demands of the Hedge Fund’s creditors and investors.

III. Funding Liquidity Risk

While other entities face funding liquidity risk, this risk is a more central 

concern to Hedge Fund Managers than others, because funding liquidity 

problems can rapidly increase a Hedge Fund’s risk of failure. As is described in the following box, a lack of funding liquidity can contribute 

to a crisis situation for the Hedge Fund.

16 | Appendix III
Because of its importance, Hedge 

Fund Managers should focus significant attention and resources on 

measuring and managing funding 

liquidity risk. There exist a range 

of measures Hedge Fund Managers 

can use to track funding liquidity 

risk. Hedge Fund Managers should 

monitor the liquidity available in 

the Hedge Fund by tracking its cash 

position (i.e., cash and short-term 

securities issued by high-credit-quality entities) and its borrowing capacity (e.g., access to borrowings under 

margin rules or credit lines).

Beyond measures of available liquidity, Hedge Fund Managers should 

also monitor measures of relative 

liquidity. Hedge Fund Managers should relate the measures of 

liquidity (Cash or Cash + Borrowing capacity) to the need for that 

liquidity. The following measures 

are indicators of a Hedge Fund’s 

potential need for liquidity:

• Equity or NAV. Generally, a larger 

Hedge Fund will require greater 

levels of liquidity. However, a 

Hedge Fund’s need for liquidity 

during periods of market stress is 

determined not only by the size 

of the portfolio, but also by the 

characteristics of the assets it holds 

(in addition to a Hedge Fund’s 

need to fund redemptions). Consequently, Hedge Fund Managers 

need to have measures of potential 

liquidity that reflect the riskiness 

of the portfolio;

• Worst Historical Drawdown. This 

indicator provides a measure of 

risk and of the amount of liquidity 

the Hedge Fund has required in 

the past. This measure is, however, 

a backward-looking measure of 

risk and may not be indicative of 

the Hedge Fund’s current exposure; and

• VAR. As aforementioned, VAR 

is currently the most widely used 

prospective measure of market 

risk. Consequently, tracking the 

ratio of Cash or Cash + Borrowing capacity to VAR provides the 

Hedge Fund Manager with an 

indication of whether the Hedge 

Fund’s liquidity relative to its need 

for liquidity is rising or falling.

Sound Practices for Hedge Fund Managers | 17
Funding Liquidity Risk

Illustrative Liquidity Measures

Table 3 on page 20 contains the results of calculating five of the 

liquidity measures discussed in this section for each of the nine 

stylized portfolios.

Available liquidity is measured by cash that is not committed as margin, and by cash plus the “borrowing capacity” of the assets. For the 

three cash market assets, it is assumed that 50% of the value of a long 

position can be borrowed (i.e., assume current Regulation T margin 

requirements if the three assets were equities). For simplicity, short positions in the assets are assumed to have a 50% margin requirement, in 

effect, allowing 50% of short trades to be used to fund long positions, 

or for cash.

Several features of funding liquidity risk measurement are evidenced 

by the stylized portfolios.

• Other things being equal, futures (and derivatives in general) require 

the Hedge Fund Manager to use significantly less cash (at origination) than would an equivalent position established via a cash market 

transaction. This is evidenced by Portfolios 1 and 2. However, not 

reflected in these numbers is the interrelation of market risk, funding 

liquidity risk, and leveraging. While the cash position uses more 

cash at origination than does the futures position, if the value of the 

underlying asset were to change dramatically, the resulting margin call 

on the futures position could have a significant impact on the Hedge 

Fund’s cash position.

• For the same amount of initial capital, the use of leverage (e.g., Portfolios 3 and 4) both consume borrowing capacity and increase VAR; 

so, measures of available liquidity and relative measures indicate that 

liquidity declines.

• Use of leverage in the cash market decreases available cash faster 

than the identical strategy implemented with futures. The increase 

in traditional balance sheet leverage (i.e., use of margin to buy assets) 

in Portfolio 3 sharply reduces both absolute and relative measures of 

liquidity since either cash or borrowing capacity is consumed in the 

process. The identical economic leverage is obtained using futures 

in Portfolio 4, but the decrease in liquidity is less pronounced. The 

caveat about future cash requirements for futures positions that was 

raised in the first point applies here, as well.

18 | Appendix III
Q Use of a relative liquidity measure (e.g., VAR/(Cash + Borrowing 

capacity)) captures the impact of investing in higher risk assets, while 

holding the amount invested constant. Portfolio 5 shows that while 

absolute liquidity is the same as for Portfolio 1, liquidity relative to 

VAR has decreased (i.e., VAR is a higher percentage of available cash).

Q Portfolios 6 and 7 illustrate once again that identical market risk 

portfolios present different funding liquidity risk profiles. Portfolio 7, 

which uses futures to short Asset 2 while borrowing against Asset 1, is 

less liquid than Portfolio 6 that shorts Asset 2 in the cash market. The 

difference is simply that short positions in futures (and derivatives in 

general) do not generate cash.

Sound Practices for Hedge Fund Managers | 19

Additional insight about funding 

liquidity can be gained by looking at 

the variability in the relative liquidity 

measure over time. A relative liquidity measure that varies over time is 

evident and consistent with “effective 

liquidity” (i.e., the assets are liquid 

and the manager is willing to take 

advantage of that liquidity).

Beyond simply monitoring liquidity, 

Hedge Fund Managers should manage liquidity in several dimensions. 

Foremost is the use of the Hedge 

Fund Manager’s experience and 

judgment to maintain liquidity levels that are adequate given the risk of 

loss and/or the likelihood of investor 

redemptions. Also, Hedge Fund 

Managers should strengthen lines 

of communication with their credit 

providers, providing them with summary measures of the Hedge Fund’s 

risk and liquidity consistent with the 

nature of the relationship. Hedge 

Fund Managers should actively 

manage (or monitor) the cash in 

margin accounts. Similarly, Hedge 

Fund Managers should negotiate 

haircuts, the speed at which prime 

brokers can dictate an increase in 

margin rates, and bilateral collateral 

agreements, where appropriate, to 

further reduce the likelihood of 

running out of liquidity.
20 | Appendix III

Funding Liquidity Risk

Table 3: Measures of Liquidity

Unlevered Levered Unlevered Long/Short Unlevered 

Cash versus Cash versus High Risk Strategy Strategy with

Futures Futures Cash versus Matched

Futures Book Assets

Cash Futures Levered Futures High Risk Long/ Long/ Hedged Hedged

Only Only Cash Cash Short Short Cash Futures

 Cash Mixed

Summary Balance Sheet

Capital 100 100 100 100 100 100 100 100 100

Borrowing 0 0 30 30

(outright or repo)

Investments

Cash Market 

Transactions

 Asset 1 80 120 120 120 100, -20

 Asset 2 -60

 Asset 3 80

Derivatives Market 

Transactions

 Futures on Asset 1 80 120 100, -20

 Futures on Asset 2 -60

Cash 20 92 10 88 20 10 4 10 88

Futures Margin 0 8 0 12 0 0 6 0 12

Standard VAR (asset 2.50 2.50 3.76 3.76 5.01 3.61 3.61 2.50 2.50

Correlation = 0.3)

Liquidity Measures

Measures of Available

Liquidity

 Cash 20 92 10 88 20 10 4 10 88

 Cash + Borrowing 60 92 40 88 60 70 34 60 88

 Capacity

Relative Measures

 Cash/Equity 20% 92% 10% 88% 20% 10% 4% 10% 88%

 (Cash + Borrowing 60% 92% 40% 88% 60% 70% 34% 60% 88%

 Capacity)/Equity

 VAR/(Cash + 4.2% 2.7% 9.4% 4.3% 8.3% 9.0% 10.6% 4.2% 2.8%

 Borrowing 

 Capacity) 

Portfolio 1 2 3 4 5 6 7 8 9 
IV. Leverage

As the Recommendations made clear, leverage is neither a concept that 

can be uniquely defined, nor is it an independently useful measure of risk. 

Nevertheless, leverage is important to Hedge Fund Managers because 

of the impact it can have on the three major quantifiable sources of risk: 

market risk; credit risk; and liquidity risk.

Leverage is not a uniquely defined 

concept. For example, a variety of 

“leverage” measures are used in the 

areas of banking and finance. These 

measures, which are described in 

more detail below, may be financial 

statement-based (also referred to as 

“asset-based”), risk-based, or investor-based. The financial statementbased measures attempt to capture 

the traditional notion of leverage as 

“investing borrowed funds”. Using 

borrowed money (or its equivalent) 

enables an investor to increase the 

assets controlled for a given level of 

equity capital. Financial statementbased measures of leverage relate 

some measure of asset value to equity. Both returns and risk, relative 

to equity, are magnified through the 

use of traditional, financial statement-based leverage. The risk-based 

measures of leverage capture another 

aspect associated with leverage, 

namely, the risk of insolvency due to 

changes in the value of the portfolio. 

The risk-based measures relate a 

measure of a Hedge Fund’s market risk to its equity (or liquidity). 

Although useful in this capacity, as 

described below, risk-based leverage measures do not convey any 

information about the role borrowed 

money plays in the risk of insolvency. Investor-based leverage measures 

the extent to which dollars entering 

a hedge fund are themselves levered.

No single measure captures all of the 

elements that market participants, 

regulators, or market observers attribute to the concept of leverage. 

Indeed, examples will be presented 

in which a risk-reducing transaction 

increases some leverage measures 

while decreasing others. This leads 

to the observation that leverage is 

not an independently useful concept, but should be evaluated in the 

context of the quantifiable exposures 

of market, credit, and liquidity.

While continuing to track and use 

financial statement-based measures 

of leverage, Hedge Fund Managers should focus their attention 

on measures of leverage that relate 

the riskiness of the portfolio to 

the capacity of the Hedge Fund to 

absorb that risk (i.e., the measures 

should include elements of market 

risk (including the credit risk associated with assets in the portfolio) 

Sound Practices for Hedge Fund Managers | 21
and funding liquidity risk). Hedge 

Fund Managers should focus on 

such measures because traditional 

financial statement-based leverage by 

itself does not necessarily convey risk 

of insolvency. To say that one Hedge 

Fund is levered 2-to-1 while another 

is not levered does not necessarily mean that the levered Hedge 

Fund is more risky or more likely 

to encounter liquidity problems. If 

the levered Hedge Fund is invested 

in government securities while the 

Hedge Fund that is not levered is 

invested in equities, financial statement-based leverage would lead to 

erroneous conclusions about the 

risk of the two funds. In this sense, 

financial statement-based measures 

of leverage are arguably deficient 

since they convey the least information about the nature and risk of the 

assets in a portfolio.

Risk-based measures, see below, 

present a measure of market risk 

(usually VAR) relative to a measure 

of the resources available to absorb 

risk (cash or equity). However, in 

doing so, risk-based measures effectively condense several dimensions 

of risk into a single number. The 

result of this compression is that 

some of the detail is lost; the specific 

effect of leverage is intertwined with 

dimensions of market, credit, and 

liquidity risk. To illustrate, consider 

two funds with identical risk-based 

leverage. One Hedge Fund employs 

2-to-1 accounting leverage while 

investing in “low risk” strategies 

(e.g., long/short strategies) using 

borrowed funds, while the other 

Hedge Fund uses no accounting 

leverage but employs “high risk” 

strategies (e.g., macro-directional) 

and large cash reserves. One is “high 

risk” and “high cash” and the other 

is “low risk” and “low cash/high borrowing”, yet each achieves the same 

risk-based leverage. This comparison 

highlights the second reason why 

leverage measures are not independently useful—more comprehensive measures blend the effect of 

multiple risk dimensions. To assess 

the contribution of leverage requires 

additional information.

Financial Statement-Based 

Leverage Measures

There exist a number of widely used 

and generally accepted financial 

statement-based measures of leverage. In addition to the pragmatic 

recognition that counterparties and 

credit providers routinely request 

these measures, a more compelling rationale for calculating these 

measures is that they can contribute 

to an understanding of leverage 

measures that incorporate risk. This 

is particularly true when accounting 

and risk-based leverage are tracked 

over time.

Certain accounting measures can 

also provide information regarding 

Leverage

22 | Appendix III
Sound Practices for Hedge Fund Managers | 23

how much direct or indirect credit 

in the form of repurchase agreements, short sales, or derivatives are 

employed by a Hedge Fund. However, it should be recognized that 

even these financial statement-based 

measures have serious weaknesses, 

discussed below, particularly as 

stand-alone measures of leverage. 

The most widely used and generally 

accepted financial statement-based 

measures of leverage are those that 

relate items from a Hedge Fund’s 

balance sheet.

• “Gross Balance Sheet Assets”

to Equity: On-Balance-Sheet 

Assets/Equity. This straightforward measure is easily calculated 

from published financial statements; however, it fails to incorporate two important elements of a 

Hedge Fund’s effective leverage:

- The risk-reducing effect of 

on-balance-sheet hedges is not 

recognized. Adding a hedge 

to the balance sheet increases 

assets and thereby increases this 

leverage measure, even though 

the transaction may substantially 

offset the risk of another asset; 

and

- The full notional amount of 

derivative instruments is not required to be recorded on the balance sheet. To the extent the full 

notional amount is not recorded, 

this measure may understate the 

Hedge Fund’s true economic risk.

• Net Balance Sheet Assets to 

Equity: (On-Balance-Sheet 

Assets-Matched Book Assets)/

Equity. While this measure requires 

more detailed information about 

the positions in a Hedge Fund’s 

portfolio, it does provide a partial 

solution to the shortcomings of 

the Gross Balance Sheet Assets to 

equity measure by including offsets and direct hedges as reflected 

in matched book assets. However, 

important elements of the Hedge 

Fund’s effective leverage are still 

not incorporated:

- This measure does not reflect 

portfolio correlation or less 

direct hedges that fall outside 

the definition of matched book 

assets; and

- This measure does not 

incorporate off-balance-sheet 

instruments.

Other financial statement-based 

measures have been proposed to 

capture off-balance-sheet transactions (e.g., forward contracts, swaps 

and other derivatives). 

Risk-Based Leverage 

Measures

Risk-based leverage measures reflect 

the relation between the riskiness 

of a Hedge Fund’s portfolio and the 

capacity of the Hedge Fund to absorb the impact of that risk. While 
not the only measure that could 

be used, the Hedge Fund’s equity 

provides a useful measure of “capacity”. There are, however, different 

measures of market risk that could 

be used as the risk measure:

• Volatility in Value of Portfolio/

Equity. This is a measure of actual 

performance volatility over a given 

horizon relative to equity. While 

useful, it is subject to criticism. 

Since it is a retrospective measure, 

it is less useful if the composition 

of the portfolio changes or if 

future market conditions are not 

like historical conditions. Moreover, it does not isolate the effect 

of financing on the risk of the 

Hedge Fund since it includes 

financed assets;

• VAR/Equity. This measure gives 

a picture of the Hedge Fund’s 

capacity to absorb “typical” market 

movements. The criticism of such 

a measure is that it does not reflect 

the risk of the Hedge Fund’s portfolio in extreme markets; and

• Scenario-Derived Market Risk 

Measure/Equity. To assess the impact of extreme events, the leverage 

measure could be calculated using 

a market risk measure derived from 

analysis of extreme event scenarios 

(or stress tests). This measure gives 

senior management information 

about the Hedge Fund’s ability to 

absorb extreme market events.

Leverage

24 | Appendix III
Illustrative Leverage Measures

Table 4 contains the results of calculating all of the financial statementbased leverage measures and two of the risk-based leverage measures 

discussed in this section. Note that net balance sheet leverage and 

net accounting leverage are only relevant for Portfolios 8 and 9, because 

these portfolios are the only ones in which the long and short positions 

can be netted under accounting rules.

Leverage can be interpreted in several ways: as the use of borrowed 

money to fund larger asset positions than would otherwise be achievable; and as the use of economic leverage to increase effect of a given 

change in market prices on the value of a Hedge Fund’s equity.

The illustrative portfolios demonstrate several common features of 

financial statement-based and risk-based leverage:

• The most common leverage measure, gross balance sheet leverage

(or assets/equity) is not indicative of the types of assets employed or 

the amount of risk assumed. In the illustration, gross balance sheet 

leverage is the same in Portfolios 1, 2, 4, 5, and 9 even though the 

risk and investment strategy differ significantly across portfolios. 

Similarly, while the amount of risk assumed in Portfolio 8 is identical to the risk assumed in Portfolio 1, the levels of gross balance sheet 

leverage differ;

• The purpose of the net balance sheet leverage measure is to adjust for 

matched book assets. Comparison of net balance sheet leverage with 

gross balance sheet leverage for Portfolio 8 shows an instance where 

this occurs;

• Gross accounting leverage, which sums assets, liabilities, and futures 

is not informative about investment strategy (cash versus futures) or 

the market risk of the portfolio. Note that the riskiest portfolio as 

measured by VAR, Portfolio 5, has the lowest accounting leverage. 

Similarly, Portfolios 1 and 2 are low risk, yet gross accounting 

leverage varies by 80% between them;

Sound Practices for Hedge Fund Managers | 25

continued
• Net accounting leverage adjustments for matched book assets and derivatives that hedge on-balance-sheet positions are seen by comparing 

gross accounting leverage with net accounting leverage for Portfolios 

8 and 9. Note that this measure does not capture the use of a futures 

position to offset an identical futures position (i.e., the matched 

futures in Portfolio 9). The risk-based leverage measures come closer 

to capturing the nature of the risks as reflected in the specific strategies. (Note Portfolios 1, 2, 8, and 9.) However, they too miss certain 

aspects of the risk picture. For example, Portfolios 3 and 4 have the 

same VAR/equity, but the cash market strategy employed in Portfolio 3 uses more cash and borrowing capacity, and is therefore riskier 

from a liquidity standpoint (VAR is 9.4% of liquidity in Portfolio 3

compared to only 4.3% of liquidity in Portfolio 4); and

• Stress and scenario analysis are essential elements of liquidity and leverage analyses. The long/short strategy employed in Portfolios 6 and 

7 is similar in risk-based leverage to Portfolios 3 and 4 until one looks 

at the stress scenarios. Because of the reliance on correlation, the 

leverage of Portfolios 6 and 7 is potentially much larger in a period 

of market stress. 

26 | Appendix III

Leverage
Sound Practices for Hedge Fund Managers | 27

Table 4: Measures of Leverage

Unlevered Levered Unlevered Long/Short Unlevered 

Cash versus Cash versus High Risk Strategy Strategy with

Futures Futures Cash versus Matched

Futures Book Assets

Cash Futures Levered Futures High Risk Long/ Long/ Hedged Hedged

Only Only Cash Cash Short Short Cash Futures

 Cash Mixed

Summary Balance

Sheet

Capital 100 100 100 100 100 100 100 100 100

Borrowing 0 0 30 30

(outright or repo)

Investments

Cash Market 

Transactions

 Asset 1 80 120 120 120 100, -20

 Asset 2 -60

 Asset 3 80

Derivatives Market 

Transactions

 Futures on Asset 1 80 120 100, -20

 Futures on Asset 2 -60

Cash 20 92 10 88 20 10 4 10 88

Futures Margin 0 8 0 12 0 0 6 0 12

Standard VAR 2.50 2.50 3.76 3.76 5.01 3.61 3.61 2.50 2.50

(asset Correlation=0.3)

Leverage Measures

Accounting-Based 

Measures

Gross Balance Sheet 1 1 1.3 1 1 1.6 1.3 1.2 1

Leverage

Net Balance Sheet 1 1

Leverage

Gross Accounting 1 1.8 1.6 2.2 1 2.2 1 1.4 2.2

Leverage

Net Accounting 1.2 2.2

Leverage

Risk-Based Measures

VAR/Capital 2.50% 2.50% 3.76% 3.76% 5.01% 3.61% 3.61% 2.50% 2.50%

Stress 1 VAR/ 3.76% 3.76% 5.64% 5.64% 7.51% 3.67% 3.67% 3.76% 3.76%

Capital

Stress 2 VAR/ 3.76% 3.76% 5.64% 5.64% 7.51% 6.10% 6.10% 3.76% 3.76%

Capital

Portfolio 1 2 3 4 5 6 7 8 9 
While the preceding leverage measures are the ones most commonly 

used by Hedge Fund Managers, 

other measures may be used to analyze leverage. Indeed, because of the 

interrelation between market risk, 

funding liquidity risk and leverage, 

measures of funding liquidity risk 

described in Section 4—particularly 

Cash + Borrowing Capacity relative 

to VAR—also provide the Hedge 

Fund Manager with insights about a 

Hedge Fund’s leverage.

Dynamic Measures of Leverage

A crucial factor influencing a Hedge 

Fund’s ability to absorb the impact 

of extreme market events is the 

degree to which a Hedge Fund 

can modify its risk-based leverage, 

especially during periods of market 

stress.

Treating equity as constant, there are 

two ways a Hedge Fund Manager 

could reduce risk-based leverage:

• If a Hedge Fund Manager wishes 

to continue an existing investment 

strategy, risk-based leverage could 

be reduced by reducing traditional 

leverage resulting from either onor off-balance-sheet transactions; 

and

• A Hedge Fund Manager could 

reduce risk-based leverage by 

reducing the level of risk that is 

being accepted (e.g., by changing 

strategy or the types of assets being 

held in the portfolio). To track the 

degree to which the Hedge Fund 

is able to modify its risk-based 

leverage, the Hedge Fund Manager 

should track variations in the 

Hedge Fund’s market risk measure 

(e.g., VAR) over time.

The following two measures could 

be used to track the relationship 

over time between measures of 

market risk and actions taken by 

the Hedge Fund Manager to adjust 

leverage. Both of these measures 

consider a short time interval (one 

day, two days,..., one week); and, 

both assume that equity is constant:

• Changes in Portfolio Market 

Risk. A decline in a portfolio’s 

market risk measure (e.g., VAR) 

in a period following an increase 

in that market risk measure in 

the preceding period could be evidence of the Hedge Fund Manager’s ability to de-lever the portfolio 

during a period of market stress 

(the market risk measure could be 

VAR or the observed volatility of 

the value of the portfolio during 

the relevant period); and

Leverage

28 | Appendix III
• Relationship between a Change 

in Market Risk and a Subsequent 

Change in Cash + Borrowing 

capacity. All other things being 

equal, if a Hedge Fund Manager 

is able to reduce the portfolio’s 

financial statement-based leverage, 

the result would be an increase 

in cash or in borrowing capacity. 

Therefore, an increase in Cash + Borrowing capacity in a period 

following an increase in the market 

risk measure for the portfolio (e.g., 

VAR) could be evidence of the 

Hedge Fund Manager’s reacting to 

market stress by reducing leverage.

V. Counterparty Credit Risk

Hedge Fund Managers enter into transactions with a variety of counterparties including banks, securities firms, exchanges, and other financial institutions. The risk of loss to the Hedge Fund as a result of the failure of a 

counterparty to perform as expected constitutes counterparty credit risk.

Credit risk is present to some extent 

in almost any dealing with a third 

party, including the settlement of securities and derivatives transactions, 

repurchase agreements, collateral 

arrangements, and margin accounts. 

It is also present in open derivatives 

positions where the exposure of one 

counterparty to another will change 

over the life of the contract as the 

contract’s value fluctuates. Hedge 

Fund Managers should be aware of 

and track concentrations of credit 

risk with particular counterparties, 

and where applicable, different 

regions of the world.

One of the factors that should be 

considered in determining how willing a Hedge Fund Manager should 

be to enter into a transaction with a 

specific counterparty is the loss that 

its Hedge Fund would suffer were 

the counterparty to default. That, 

in turn, depends on the magnitude 

of the Hedge Fund’s exposure to 

the counterparty and the likelihood 

of default (i.e., the counterparty’s 

creditworthiness).

An assessment of exposure to a particular counterparty should include 

analysis of the following elements 

of exposure:

• Current replacement cost. The 

amount the Hedge Fund would 

lose if its counterparty were to 

become insolvent immediately and 

the Hedge Fund Manager had to 

replace the contract in the market;

Sound Practices for Hedge Fund Managers | 29
Counterparty Credit Risk

• Potential exposure. A probabilistic assessment of the additional 

exposure that could result if the 

counterparty does not default immediately but instead defaults at 

some date in the future. Potential 

exposure is particularly applicable 

to derivatives transactions where 

exposure is reciprocal and likely 

to change substantially before the 

contract expires;

• The probability of loss. The 

likelihood of a default by the 

counterparty over the relevant 

time horizon. This is a function 

of the counterparty’s current credit 

quality, the length of the transaction, and possibly the nature of 

the transaction itself; and

• Risk mitigation and documentation. The extent to which 

collateral, netting provisions, or 

other credit enhancement reduces 

the magnitude of the exposure 

to a counterparty. Hedge Fund 

Managers can greatly reduce their 

credit exposure to counterparties 

by negotiating bilateral netting 

and collateral provisions in their 

documentation and establishing 

document management processes 

to ensure transactions are documented consistently and in 

a timely manner.

30 | Appendix III
Sound Practices for Hedge Fund Managers | 01

APPENDIX IV

Introduction .....................................................................2

Historical Background......................................................3 

MFA’s Efforts to Promote Sound Practices

 in Anti-Money Laundering for the

 Hedge Fund Industry.................................................6

Applicability of the 2007 AML Guidance ........................8

Individualized Assessment and Application

 of 2007 AML Guidance..............................................9

Recommendations.........................................................12

Annex A Definitions......................................................................40

Annex B Model Anti-Money Laundering Attestation...................47

Annex C Proposed Template for Anti-Money

 Laundering Policies and Procedures........................53

Annex D Sample Provisions for Fund Administrators,

 Investor Intermediaries, and Subscription

 Documents...............................................................68

Annex E Sample Board Resolutions.............................................84

Annex F Members of Financial Action Task Force

 on Money Laundering..............................................87

Annex G List of FATF Non-Cooperative Jurisdictions ..................88

Annex H Lists Maintained by the Office of Foreign

 Assets Control..........................................................89

Annex I Money Laundering Advisories Issued by

 the Financial Crimes Enforcement Network

 of the U.S. Department of Treasury .........................90

Annex J Countries and Financial Institutions

 That Have Been Designated by the

 U.S. Department of Treasury as Being of

 “Primary Money Laundering Concern” ...................91

Guidance for Hedge Funds and 

Hedge Fund Managers on Developing 

Anti-Money Laundering Programs 

(Release No. 2)
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

Introduction

Managed Funds Association (“MFA”) is pleased to publish the second 

release of the Guidance for Hedge Funds and Hedge Fund Managers on 

Developing AML Programs (the “2007 AML Guidance”). This document 

is incorporated into Sound Practices for Hedge Fund Managers (“Sound 

Practices”) so that Hedge Fund Managers may incorporate AML recommendations into their overall internal controls and procedures.1

 This document 

is the first update to MFA’s original Preliminary Guidance for Hedge Funds 

and Hedge Fund Managers on Developing AML Programs, published on 

March 28, 2002 (the “Preliminary Guidance”). 

In October 2001, immediately following the enactment of the USA Act 

of 2001 (the “PATRIOT Act” or the “Act”), MFA began analyzing the Act’s 

potential impact on MFA members and preparing Members for expected 

AML regulations. The Preliminary Guidance was published as a result of these 

initial efforts. At the time of publication of the Preliminary Guidance, the 

Financial Crimes Enforcement Network of the U.S. Department of Treasury 

(“FinCEN”) had not yet published final rules requiring AML compliance 

with the PATRIOT Act. In the years since the PATRIOT Act, and in the 

absence of formal defined AML obligations, MFA’s members have used the 

Preliminary Guidance to develop their internal AML policies. FinCEN has 

since published proposed rules for the Hedge Fund industry, investment 

advisers (“IAs”) and commodity trading advisors (“CTAs”). Although, as 

of August 2007, Hedge Funds, IAs, and CTAs still were not subject to final 

AML rules, the proposed rules, together with a number of other significant 

developments in AML regulation and industry practice, have impacted the 

AML compliance of Hedge Funds and Hedge Fund Managers. 

MFA recognizes that AML compliance has been and continues to undergo 

great change as regulations implementing the PATRIOT Act are promulgated and as industry practice develops. Accordingly, MFA is publishing this 

1 The terms “Hedge Fund” and “Hedge Fund Manager” are defined consistently with 

Sound Practices for Hedge Fund Managers. These and other definitions applicable 

to the anti-money laundering (“AML”) procedures (such as “Investor”), are set forth 

in Annex A to the Appendix to the 2007 AML Guidance for convenience. When the 

term “Recommendation” is used in the 2007 AML Guidance, it refers to the numbered 

recommendations in this appendix.

02 | Appendix IV
Sound Practices for Hedge Fund Managers | 03

second release, the 2007 AML Guidance, in connection with the publication 

of Sound Practices in order to inform its members of relevant AML developments and to help Hedge Funds and Hedge Fund Managers implement or 

enhance their AML programs in a timely manner. MFA will publish a third 

release of this document once final AML regulations for Hedge Funds, IAs 

and CTAs are issued.

Historical Background 

Presently, Hedge Funds and Hedge Fund Managers are subject to certain 

existing laws, including federal, state, and foreign statutes criminalizing 

money laundering, certain relevant reporting provisions of the Bank Secrecy 

Act (“BSA”), and the economic sanctions programs administered by the 

U.S. Department of Treasury’s Office of Foreign Assets Control (“OFAC”).

Title III of the PATRIOT Act, entitled the International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001, amended the BSA 

to expand AML measures and apply them to many financial institutions. 

Notably, as discussed more fully below, Section 352 of the PATRIOT Act 

provides that each financial institution must establish an AML program. 

As defined in the PATRIOT Act, the term “financial institution” includes, 

among others, any entity that is “an investment company”, as well as any 

entity that is registered (or required to register) as a commodity pool operator (“CPO”) or a CTA under the Commodity Exchange Act (“CEA”). At 

the time that MFA originally published its Preliminary Guidance, it was not 

clear whether the reference to an investment company would be construed 

to include a Hedge Fund, which is excepted from the definition of an 

investment company under the Investment Company Act of 1940 (“Investment Company Act”). When U.S. Department of Treasury issued interim 

final rules applying the AML program requirements of Section 352, among 

others, to banks, registered securities broker-dealers, futures commission 

merchants, and mutual funds, it recognized the definition of “investment 

company” under the Investment Company Act, as well as the exclusions 

from the definition, and deferred extending the rule to unregistered investment companies. Specifically, U.S. Department of Treasury temporarily 

exempted closed-end investment companies and Hedge Funds, as well as 

CPOs and CTAs, among others, from the requirements of Section 352.2 At 
the time, U.S. Department of Treasury stated that it expected to review and 

analyze the extent to which the exempted businesses might be used by money launderers or terrorist financiers and to issue a series of additional rules 

that would require the exempted businesses to establish AML programs. 

The U.S. Department of Treasury has clearly confirmed its intention to 

require Hedge Funds, commodity pools, and similar investment vehicles 

to establish AML programs under Section 352 of the PATRIOT Act. On 

September 18, 2002, FinCEN issued a proposed AML program rule, (this 

rule as amended and supplemented shall be herein after referred to as the 

“Proposed AML Program Rule”), requiring certain investment companies that are not registered with the Securities and Exchange Commission 

(“SEC”) to establish AML programs.3 Those entities included private investment funds, Hedge Funds, private equity funds, venture capital funds, commodity pools, and real estate investment trusts (collectively, “Unregistered 

Investment Companies” or “UICs”).

The proposed rule was consistent, in many respects, with the approach 

taken by MFA in the Preliminary Guidance. Of particular note, however, 

in this proposed rule was a provision requiring every UIC to file a notice 

identifying itself and providing basic contact and other descriptive information with FinCEN. 

Specifically, the Proposed AML Program Rule for UICs applies to: (1) an 

issuer that, but for the exclusions provided would be an investment company 

under the Investment Company Act; (2) a commodity pool; and (3) a company that invests primarily in real estate and/or interests therein. To narrow 

the definition of a UIC so that it encompassed only those companies that 

pose a risk of money laundering activities, FinCEN proposed three limitations on the definition and three exceptions to the scope of the term.4

 Under 

2

 The exemption, which was initially set to expire on October 24, 2002, was extended on 

October 28, 2002 until the final rules are issued for deferred financial institutions.

3 The Proposed AML Program Rule was issued partially in response to a recommendation in an investment company study undertaken at the request of Congress, which was 

issued by the Secretary of the U.S. Department of Treasury, in conjunction with the 

Federal Reserve and the SEC. See A Report To Congress In Accordance With Section 

356(c) Of The Uniting And Strengthening America By Providing Appropriate 

Tools Required To Intercept And Obstruct Terrorism Act (PATRIOT Act) (Dec. 

31, 2002). 

04 | Appendix IV

Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs
Sound Practices for Hedge Fund Managers | 05

the proposed definition, a UIC would include only those companies that:

• Permit an Investor to redeem any portion of his or her ownership interest 

within two years after that interest was purchased; 

• Have total assets of $1,000,000 or more (including received subscriptions to invest) as of the end of the most recently completed calendar 

quarter; and 

• Are organized under the laws of a State or the United States, sell ownership interests to U.S. persons, or are organized, operated, or sponsored 

by U.S. persons.

In addition, on April 28, 2003, FinCEN simultaneously issued Proposed 

AML Program Rules for IAs and CTAs. The Proposed AML Program Rule 

for IAs applies to: 

(1) SEC-registered advisers that have a principal office and place of business 

in the United States and that report to the SEC that they have assets under 

management on form ADV; or 

(2) Advisers in the United States that are not registered with the SEC, but 

have $30 million or more of assets under management, and are relying on 

the registration exemption under Section 203(b)(3) of the Investment 

Advisers Act of 1940.5

The Proposed AML Program Rule for CTAs applies to any CTA that is both 

4 The rule exempts: (a) family companies, i.e., companies owned by a single family as 

described in section 2(a)(51)(A)(ii) of the Investment Company Act, but without 

regard to the amount of assets owned by such companies; (b) employees’ securities companies, i.e., investment companies established by employers for the benefit of employees; 

(c) employee benefit plans that are not construed to be pools; and (d) companies that 

are another type of financial institution under the BSA (such as broker-dealers) and 

required to establish their own AML programs under the BSA.

5 The Proposed AML Program Rule excludes from the AML Program requirement the 

following types of IAs: (1) small, state registered firms with less than $30 million in 

assets under management that are not registered with the SEC; (2) IAs that are registered with the SEC, but do not manage client assets; and (3) unregistered IAs required 

to have an AML Program under the BSA as a financial institution in another capacity 

and examined by a Federal functional regulator in that other capacity. The Proposed 

AML Program Rule also permits IAs covered by the rule to exclude from their AML 

Programs any investment vehicle they advise that is already subject to the AML Program 

requirement under the BSA.
registered or required to be registered with the Commodity Futures Trading 

Commission (“CFTC”) under the CEA and that directs client commodity 

futures or options accounts.6

MFA’s Efforts to Promote Sound Practices in AML 

for the Hedge Fund Industry 

Although the Proposed AML Program Rules for UICs, IAs, and CTAs are 

not yet final, MFA continues to believe, as it did at the time of the issuance 

of the Preliminary Guidance, that Hedge Funds and their Hedge Fund Managers should adopt and implement AML programs consistent with Section 

352 of the Act as a matter of sound practice7. As with the Preliminary Guidance, this 2007 AML Guidance is intended to highlight what MFA believes 

to be key elements for Hedge Funds and their Hedge Fund Managers to 

consider in developing an effective AML program, including the requirements to which they are subject under the BSA, and their obligations to 

comply with the OFAC sanctions programs. As stated above, this 2007 

Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

6 Under the Proposed AML Program Rule, the following are not subject to the AML 

Program requirements: (1) any person who is not registered as a CTA by virtue of 7 

U.S.C. 6m or CFTC Rule 4.14(a); (2) CTAs that provide commodity trading advice, 

but do not direct accounts; and (3) persons that choose to register with the CFTC 

as CTAs, even though they are not required to register, and who do not direct client 

accounts. Like the Proposed AML Program Rule for IAs, the Proposed AML Program 

Rule for CTAs permits them to exclude from their AML programs pooled investment vehicles (such as UICs) they advise, which are also subject to the AML Program 

requirement. 

7 MFA believes that Hedge Fund Managers and Hedge Funds should adopt effective 

AML programs for a number of compelling reasons, including, but not limited to: the 

existence of the Proposed AML Program Rules by the U.S. Department of Treasury 

that encourage the adoption of an effective AML program for investment advisers and 

unregistered investment companies which may become final; ensuring compliance with 

applicable criminal statutes prohibiting money laundering and terrorist financing 

and the economic sanctions programs administered by OFAC; satisfying anticipated 

due diligence inquiries from prime brokers and other financial institutions subject 

to the provisions of and regulations promulgated under the BSA, as amended by the 

PATRIOT Act; existing BSA reporting requirements; and minimizing exposure to 

reputational and legal risks, e.g., risks associated with accepting an investment from 

a Prohibited Investor (as defined below).

06 | Appendix IV
Sound Practices for Hedge Fund Managers | 07

AML Guidance updates and replaces the Preliminary Guidance issued by 

MFA in March 2002. 

Moreover, since the PATRIOT Act’s enactment, MFA has actively pursued 

an on-going dialogue with the regulators responsible for developing the 

applicable AML regulations to educate them regarding relevant issues and 

to advocate Members’ interests and views regarding regulations under consideration. Meetings and discussions also regularly occur in a more informal 

manner as particular issues arise regarding implementation of the PATRIOT 

Act by the Hedge Fund industry.

For example, MFA has submitted comment letters to U.S. Department of 

Treasury with respect to the proposed rules8. On November 25, 2002, MFA 

submitted a comment letter with respect to the UIC proposed rule, in which 

it requested clarification of certain provisions. In particular, MFA addressed 

the provision with respect to delegation to third parties and asserted that 

Hedge Funds would be aided by sound regulatory guidance when delegating to a third party the performance of Investor due diligence and offered 

suggestions as to how Hedge Funds should be able to avoid strict liability 

for the AML deficiencies of its third-party delegates. MFA also identified 

issues presented by the proposed rule’s requirement that federal examiners 

be permitted to inspect a third party delegate’s records for the purpose of the 

UIC’s AML program. 

Subsequently, on July 7, 2003, MFA submitted another comment letter 

with respect to the Proposed AML Program Rules for IAs and CTAs. In 

the letter, MFA recommended, among other suggestions, that U.S. Department of Treasury adopt parallel exclusions under the rule for CTAs as were 

proposed under the rule for IAs regarding assets under management. MFA 

sought to exclude from the AML requirements a CTA’s responsibility for 

those accounts that are maintained with a futures commission merchant that 

are already subject to an AML program rule, as the CTA is not involved in 

the flow of assets in and out of such accounts. MFA also sought to provide 

IAs with the ability to rely on certain entities for the performance of Investor 

identification procedures. MFA also requested that IAs and CTAs be permit8 MFA, Comment Letters, Nov. 25, 2002 (UICs) and July 7, 2003 (IAs and CTAs), 

available at (www.managedfunds.org).
ted to rely on the AML programs of foreign financial institutions to the 

extent that such reliance is determined to be appropriate. 

Additionally, in an effort to educate and inform members regarding their 

AML responsibilities, MFA has also organized several informative programs 

in partnership with prominent prime brokers for the benefit of their Hedge 

Fund clients. In addition, MFA has actively participated in conferences and 

seminars addressing the PATRIOT Act’s requirements, including programs 

organized by Bloomberg, AML Law and Compliance Conference, 100 

Women in Hedge Funds, and the Institute for International Research, 

among others. MFA has also engaged in a dialogue with a number of other 

industry organizations representing the broker-dealer industry, the futures 

industry, and the mutual fund industry, where the concerns among these industries have overlapped. For example, MFA has engaged in a dialogue with 

a wide range of major international financial institutions to create a standard 

letter for Hedge Fund Managers, including both registered and unregistered 

IAs and non-U.S. regulated IAs, attesting to counterparties such as prime 

brokers, banks, and other financial institutions that they have established 

AML policies and procedures and that these policies and procedures are 

consistent with MFA’s recommendations (attached hereto as Annex B is 

MFA’s Model AML Attestation, developed in consultation with a wide range 

of major international financial institutions).

Applicability of the 2007 AML Guidance

As with Sound Practices overall, this 2007 AML Guidance is intended primarily for U.S.-based Hedge Funds and Hedge Fund Managers, and offshore 

Hedge Funds with U.S.-based Hedge Fund Managers. MFA also believes 

that the 2007 AML Guidance may be applicable to offshore Hedge Funds 

and Hedge Fund Managers to the extent that they utilize U.S.-based prime 

brokers, since, in order to comply with the requirements of the PATRIOT 

Act and implementing regulations, these prime brokers may require comfort regarding their fund clients’ AML policies, procedures, and controls. 

Similarly, the 2007 AML Guidance may also be applied more generally to 

commodity pools, CPOs, and CTAs based in the United States.9

Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

9 Entities registered with the CFTC must also consider applicable rules and regulations 

issued by the CFTC and the National Futures Association.

08 | Appendix IV
Sound Practices for Hedge Fund Managers | 09

As U.S.-based Hedge Fund Managers often work with offshore Hedge 

Funds and/or administrators, it is also important for U.S.-based Hedge 

Funds to be aware of relevant non-U.S. AML structures, which may be different from, as well as more or less, stringent than the U.S. AML structure. 

These differences may impact the practices of Hedge Fund Managers, 

including for example, the subscription documentation they may require 

of their Investors. 

In light of MFA’s expectation that most Hedge Funds will rely on their 

Hedge Fund Managers for development of and compliance with an appropriate AML program, the 2007 AML Guidance has been written from 

the perspective of the Hedge Fund Manager. If a Hedge Fund were to 

develop an AML program without involvement of its Hedge Fund Manager, 

the 2007 AML Guidance would apply equally to the Hedge Fund itself. 

Similarly, to the extent that a Hedge Fund Manager delegates any AML 

functions to an administrator, that administrator would have to adopt the 

relevant AML program provisions of the Hedge Fund Manager, although 

the Hedge Fund Manager would retain responsibility for compliance under 

the AML regulations. The 2007 AML Guidance therefore speaks of “Hedge 

Fund Managers” as a generic term for the personnel with operating authority over a Hedge Fund or commodity pool, whether that be the personnel of 

the Hedge Fund, the commodity pool, or the employees of the IA, CTA, or 

CPO. Where the Guidance draws more specifically from the rules for UICs, 

IAs, or CTAs, it so indicates. In addition, use of the terms “Unregistered 

Investment Company” and “Hedge Fund” encompasses commodity pools 

unless otherwise indicated.

Individualized Assessment and Application 

of 2007 AML Guidance 

Each Hedge Fund Manager should assess the 2007 AML Guidance in 

light of the characteristics of its Investor base, its business model, and the 

resources of its organization, and, based upon this assessment, apply the 

2007 AML Guidance, as appropriate. 
Given the considerable differences among Hedge Funds, Hedge Fund Managers, and the Investors with whom they deal, MFA believes that no one 

standard or model AML program can be appropriate for all Hedge Funds. 

Hedge Funds vary not only in size, strategy, and organizational structure, 

but also in the profile of their Investor bases. Some Hedge Funds may have 

mainly natural persons as Investors, whereas others may have primarily an 

institutional client base; some maintain relationships with Investor intermediaries and nominees, while others have predominantly “Direct Investors”; 

some have an international client base, while others are purely domestic; 

and some may limit their Investors to insiders and other Investors that are 

known to the Hedge Fund Manager, while others deal with Investors from a 

wide variety of sources. The characteristics of a Hedge Fund’s Investor base 

should influence the AML policies and procedures adopted by the Hedge 

Fund Manager.

Consequently, the 2007 AML Guidance should not be viewed as definitive 

requirements that could be rigidly applied by all Hedge Fund Managers 

or that should serve as a basis either for auditing a Hedge Fund Manager’s 

AML policies and practices or for any legal claim or action. Nor should the 

2007 AML Guidance be viewed as exhaustive or addressing the only issues to 

consider in developing an AML program. In evaluating the relevance of the 

2007 AML Guidance and its ability to implement the recommended policies 

and procedures, a Hedge Fund Manager should recognize that, while some 

recommendations can be implemented easily or unilaterally, others may 

require planning, and in some cases negotiation with, and cooperation by, 

third parties.

As U.S.-based Hedge Fund Managers often work with offshore Hedge 

Funds and/or administrators, it is also important to note, as discussed above, 

that U.S. Hedge Fund Managers may be obligated to implement policies 

that reflect the AML regime of foreign jurisdictions. Since MFA’s issuance 

of its Preliminary Guidance, foreign jurisdictions have significantly enhanced 

their AML requirements for offshore Hedge Funds and/or administrators. 

10 | Appendix IV

Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs
For instance, documents required of Investors in Hedge Funds may be dependent upon the AML structure of the particular foreign jurisdiction. Also, 

U.S.-based Hedge Fund Managers, which are not yet required to file suspicious activity reports (“SARs”) in the United States, may, depending on the 

foreign jurisdiction in which the offshore fund or administrator is located, 

be required to file a SAR. This 2007 AML Guidance does not address any of 

these potentially divergent practices concerning the varying AML regimes of 

foreign jurisdictions. 

In developing an AML program, a Hedge Fund Manager should consult 

with its professional legal and accounting advisers. The 2007 AML Guidance is not intended to serve as a substitute for such professional advice, and 

neither Hedge Funds nor their Hedge Fund Managers should rely upon the 

2007 AML Guidance as a substitute for such advice. 

Sound Practices for Hedge Fund Managers | 11
Recommendations

I. Fundamental Elements of AML Programs

1.1 General

Broad Policy Statement. As part of its AML program, a Hedge Fund Manager 

should adopt a broad statement, at its highest executive level, that clearly 

sets forth its policy against money laundering and any activity that facilitates 

money laundering or the funding of terrorist activities. 

Objectives. The Hedge Fund Manager should clearly state the objectives 

of its AML program, which may include the detection and deterrence of 

instances of money laundering, terrorist financing, and other illegal activity. 

1.2 Basic Elements of the AML Program

The Proposed AML Program Rules for UICs, IAs, and CTAs provide that 

these entities devise and implement, within 90 days following publication 

of a final rule, an AML program that includes, at a minimum, the four basic 

elements set forth in Section 352 of the Act and as developed in more detail 

on the following pages: 

• The development of internal policies, procedures, and controls;

• The designation of a compliance officer;

• An ongoing employee training program; and

• An independent audit function to test programs.

The AML program should be in writing and approved by “Senior Management”. This could be reflected in an approval by their board of directors or 

trustees, or if they do not have such a board, their general partner, sponsor, 

organizer, operator, or other person that has a similar Senior Management 

function with respect to the company.11

12 | Appendix IV

Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

11 A sample resolution of the board of directors of a Hedge Fund Manager adopting 

a policy statement against money laundering and terrorist financing is attached as 

Annex E.
1.3 Internal Policies, Procedures, and Controls

The Hedge Fund Manager should develop written policies, procedures, and 

controls reasonably designed to prevent them from being used to launder 

money or finance terrorist activities and to achieve compliance with applicable requirements of the BSA and its implementing regulations. These 

policies, procedures, and controls should address the vulnerabilities of the 

Hedge Fund Manager, which will vary depending on the nature of its 

particular clients and services. 

Employees of the Hedge Fund Manager should be generally informed of 

the AML policies and procedures adopted by the Hedge Fund Manager and 

familiar with the substance and intent of the Hedge Fund Manager’s AML 

policy and procedures.

1.4 Role of Senior Management and the AML

Compliance Officer

Designation of Anti-Money Laundering Compliance Officer. The Hedge Fund 

Manager should designate an “Anti-Money Laundering Compliance Officer”, who should be, where possible, an officer of the Hedge Fund Manager 

who is competent and knowledgeable regarding applicable requirements 

and money laundering risks. The Hedge Fund Manager should provide 

the Anti-Money Laundering Compliance Officer with adequate authority 

and resources to effectively implement the Hedge Fund Manager’s AML 

program and should be empowered with full responsibility and authority to 

develop and enforce appropriate policies and procedures.

Involvement in Policy Development and Enforcement. Senior Management and 

the Anti-Money Laundering Compliance Officer should be involved in the 

development, adoption, and enforcement of written AML policies, procedures, and controls so as to ensure the efficacy of the Hedge Fund Manager’s 

AML program. 

Involvement in Decision-Making. The AML policies, procedures, and controls should provide that the decision to accept or reject an Investor involves 

the Anti-Money Laundering Compliance Officer when money laundering risks have been identified. Consistent with the Hedge Fund Manager’s 

policies, the Anti-Money Laundering Compliance Officer may consult with 

Senior Management on such decisions, as appropriate. 

Sound Practices for Hedge Fund Managers | 13
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

Determinations Regarding Third Party Reliance. As discussed in Part V, the 

Anti-Money Laundering Compliance Officer should be involved in any 

decision to delegate the performance of Investor identification procedures 

to a third party. 

1.5 Investor Identification Policies and Procedures

Establishing Investor Identification Policies and Procedures. The Hedge Fund 

Manager should establish written policies and procedures regarding Investor 

identification that are reasonably designed to be both feasible and effective 

in achieving the stated objectives of the AML program. Key elements to 

consider in developing these procedures are addressed in Part II. The 2007 

AML Guidance also addresses the delegation to third parties of the performance of Investor identification procedures (as defined below) in Part V.

Review and Update as Necessary. The Hedge Fund Manager should periodically review and update their AML policies and procedures based on applicable amendments to existing AML legislation and regulations, as well as 

changes in the characteristics of the Investor base of the Hedge Fund. In this 

regard, MFA expects to update the 2007 AML Guidance to reflect changes 

in AML law and regulation applicable to the Hedge Fund industry, once the 

proposed rules become final. In particular, a Hedge Fund Manager should 

ensure that Investor due diligence checklists and procedures are updated on 

a periodic basis and that changes are independently reviewed and approved 

by the Anti-Money Laundering Compliance Officer.

1.6 Responsibilities of the Anti-Money Laundering Compliance Officer

The Anti-Money Laundering Compliance Officer’s responsibilities should 

specifically include, among other things:

• Coordinating and monitoring of the Hedge Fund Manager’s day-to-day 

compliance with applicable AML laws and regulations and its own AML 

program;

• Arranging for employee training programs for appropriate personnel 

related to the Hedge Fund Manager’s AML program; 

14 | Appendix IV
• Reviewing any reports of suspicious activity from personnel of the Hedge 

Fund Manager; and 

• Arranging for the performance of an independent audit to evaluate the 

Hedge Fund Manager’s AML policies and procedures.

The Anti-Money Laundering Compliance Officer may serve other functions 

and may serve multiple departments within the Hedge Fund Manager’s 

organization. However, the Anti-Money Laundering Compliance Officer 

should not be responsible for functional areas within the organization where 

money laundering activity may occur. 

1.7 Employee Training Program

Establishment and Content of Program. The Hedge Fund Manager should 

establish AML training programs for all relevant personnel to be conducted 

on a periodic basis, as appropriate. The level, frequency, and focus of the 

training should be determined by the responsibilities of the employees and 

the extent to which their functions bring them into contact with activities 

susceptible to possible money laundering or transactions that could trigger 

BSA reporting obligations. For employees whose functions may expose them 

to such transactions or activities, the training should occur when the employee assumes those duties and periodically during the course of employment. Employees should be notified of any new regulatory requirements, 

with additional training as deemed necessary by the Anti-Money Laundering Compliance Officer. The training program should, among other things: 

• Review applicable AML laws and regulations and recent trends in money 

laundering, including the ways in which such laws and trends relate to 

Hedge Funds; and

• Address elements of the Hedge Fund Manager’s own AML program, 

particularly its Investor identification procedures and policies regarding 

detection of suspicious activity.

Requiring Attendance. The Hedge Fund Manager should develop and maintain policies, procedures, and controls reasonably designed to ensure that all 

appropriate personnel attend the AML training programs, as required.

Sound Practices for Hedge Fund Managers | 15
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

Recordkeeping. Records of all AML training sessions conducted, including 

the dates and locations of the training sessions and the names and departments of attendees, should be retained for at least five years, or for a longer 

period as may be required by applicable laws or regulations.

1.8 Independent Audit Function

The Hedge Fund Manager’s AML program should include an independent audit function on a periodic basis to assess compliance with and the 

effectiveness of its AML program. The independent audit function should 

involve:

• Evaluation by the Hedge Fund Manager’s legal and compliance director 

or officer, external auditors, or counsel of the Hedge Fund Manager’s 

compliance with applicable AML laws and regulations and the Hedge 

Fund Manager’s own AML program; and

• Reporting of the results of this evaluation to the audit committee of the 

board of directors or similar oversight body of the Hedge Fund or Hedge 

Fund Manager.

The Hedge Fund Manager’s AML program should also provide for appropriate follow-up to ensure that any deficiencies detected in the course of the 

audit of its AML program are addressed and rectified.

1.9 Representations to Counterparties on Policies and Procedures

The Hedge Fund Manager, including registered and unregistered IAs and 

non-U.S. regulated IAs, should be prepared to attest to counterparties 

such as prime brokers, banks, and other financial institutions that they 

have established AML policies and procedures and that their policies and 

procedures are consistent with MFA’s recommendations. Major institutions 

should find acceptable MFA’s Model AML Attestation, attached hereto as 

Annex B and developed in consultation with a wide range of major international financial institutions.

16 | Appendix IV
II. Investor Identification Policies and Procedures

2.1 General

Objective. As part of an AML program, a Hedge Fund Manager should 

establish and maintain reasonable procedures that are designed to identify an 

Investor to the extent reasonable and practical (such procedures are referred 

to generally as “Investor identification procedures”). Although Hedge Fund 

Managers and Hedge Funds are not yet subject to customer identification 

program requirements or other AML due diligence under the PATRIOT 

Act, these Investor identification procedures are designed to reduce their 

exposure to criminal liability and reputational harm.

Consider Characteristics of Investor Base. The Hedge Fund Manager’s 

Investor identification procedures should take into account the specific 

risks presented by the Investor base of the Hedge Fund(s) it manages. 

General Premise. The Hedge Fund Manager’s Investor identification 

procedures should further be based on the premise that the Hedge Fund 

Manager should accept an investment from a new Investor only after its 

performance of one of the following due diligence steps:

• The Hedge Fund Manager has undertaken reasonable due diligence 

efforts with respect to the identity of a Direct Investor that is acting on 

its own behalf and not for the benefit of any third party;

• If the Investor is investing on behalf of other underlying Investors, the 

Hedge Fund Manager has undertaken reasonable due diligence efforts 

with respect to the identities of the Investor and the underlying 

Investors; or

• The Hedge Fund Manager has determined that it is acceptable to rely on 

the Investor due diligence performed by a third party, such as a fund administrator or an Investor intermediary, with regard to the Investor (and 

underlying Investors, if applicable). Reliance upon Investor identification 

procedures performed by a third party is addressed in Part V.

Sound Practices for Hedge Fund Managers | 17
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

2.2 Investor Identification Procedures

Perform Procedures Appropriate to Type of Investor. Where the Hedge Fund 

Manager undertakes to conduct reasonable due diligence efforts with respect 

to the identity of an Investor (rather than relying on its fund administrator 

or another third party, as discussed in Part V), it should conduct Investor 

identification procedures based upon the specific characteristics presented by 

an Investor. Possible identification procedures are presented in Recommendations 2.2.1 and 2.2.2, and procedures for screening for “Prohibited Investors” 

(as defined below) are addressed in Recommendation 2.3. Possible enhanced 

procedures for addressing “high risk” Investors are addressed in Recommendation 2.4. These procedures are provided as examples only and are not intended to be prescriptive or exhaustive. For example, a Hedge Fund Manager 

may elect to apply alternative Investor identification procedures based upon 

the specific characteristics of an Investor or apply enhanced measures for 

reasons other than those discussed in the 2007 AML Guidance.

Timing. A Hedge Fund Manager should complete appropriate Investor 

identification procedures with regard to an Investor prior to (or if necessary, within a reasonable time thereafter), accepting an investment from the 

Investor in order to make an assessment regarding the Investor’s identity and 

whether additional due diligence should be conducted with respect to the 

Investor.

Due Diligence Checklists. A Hedge Fund Manager may wish to develop a due 

diligence checklist to facilitate the performance of Investor identification 

procedures.

Document Procedures Undertaken. A Hedge Fund Manager should retain 

copies of all documents reviewed or checklists completed in connection with 

its Investor identification procedures in accordance with its Investor records 

retention policies. See Recommendation 2.6.

Appropriate Identity Provisions Included in Subscription Documents. Fund 

subscription documents should generally require an Investor to:

• Represent and covenant that all evidence of identity provided is genuine 

and all related information furnished is accurate;

18 | Appendix IV
• Agree to provide any information deemed necessary by the Hedge Fund 

Manager to comply with its AML responsibilities and policies; and

• In the case of a Direct Investor, represent that it is investing solely as 

principal and not for the benefit of any third parties.12

Investor Representations. Hedge Fund subscription agreements should contain a general set of representations from the Investor, stating that they are 

in compliance with various U.S. federal, state, and international laws and 

regulations, as well as a set of other disclosures relevant to AML and OFAC 

compliance. The representation should include statements with respect 

to the legitimacy of the source of funds being invested, the status of the 

Investor as a Prohibited Investor, or “Senior Foreign Political Figure/Politically Exposed Person” or “SFPF/PEP”, and if the Investor is a fund of funds or 

an entity that is acting as an agent or nominee, the representation that the 

Investor has adopted AML procedures. See Recommendation 2.4.

2.2.1 Natural Persons as Investors

In order to confirm the identity of a natural person, a Hedge Fund Manager 

should take reasonable steps to ascertain the Investor’s name and address, 

and, if applicable, social security number or taxpayer identification number. 

Where funds are wired to the Hedge Fund Manager or the administrator 

from a financial institution located in a “FATF jurisdiction”13 in which the 

investor is a customer, no additional information is generally necessary, 

unless the Investor is considered a Prohibited Investor or high risk Investor, 

as discussed in Recommendations 2.3 and 2.4, on the following pages.

Sound Practices for Hedge Fund Managers | 19

12 Sample provisions that could be included in subscription documents are attached as 

Annex D-3. The Hedge Fund Manager may also wish to include some or all of these 

sample provisions in amendments (in the form of a letter or otherwise) to subscription 

documents with existing Investors.

13 The term “FATF jurisdiction” is defined in Annex A to the 2007 AML Guidance. 

In establishing a risk-based approach for its AML program, a Hedge Fund Manager 

may wish to classify certain FATF jurisdictions as high risk for money laundering based 

on certain publicly available data (such as the International Narcotics Control Strategy 

Report (“INCSR”), which is an annual report issued by the U.S. Department of State 

that assesses the money laundering risks of various countries and jurisdictions).
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

Where the Investor’s bank is not located in a FATF jurisdiction, the Hedge 

Fund Manager should undertake reasonable due diligence efforts with 

respect to the identity of the Investor in the Hedge Fund by obtaining additional forms of identification from the Investor that may be used to confirm the Investor’s identity (e.g., government issued identification, such as 

official driver’s license with photograph, passport, utility bill containing the 

Investor’s name and address, and/or reports from credit bureaus) or other 

generally available public information confirming the Investor’s identity.

In addition to these document requirements, if the Hedge Fund Manager 

believes it would be reasonable to rely upon a certificate from the Investor 

that the Investor is not a prohibited Investor or high risk Investor, as set 

forth in Recommendations 2.3 and 2.4 below, respectively, such an “AML 

Certification” should be obtained. 

2.2.2 Corporations, Partnerships and Comparable Legal Entities

as Investors

In order to confirm the identity of a legal entity, the Hedge Fund Manager 

should take reasonable steps to ascertain the entity’s name, address, and 

if applicable, taxpayer identification number, and its authority to make 

the contemplated investment. Where funds are wired to the Hedge Fund 

Manager or the administrator from a financial institution located in a FATF 

jurisdiction where the investor is a customer, no additional information is 

generally necessary, unless the Investor is considered a Prohibited Investor or 

high risk Investor, as discussed in Recommendations 2.3 and 2.4, below.

Where the Investor’s bank is not located in a FATF jurisdiction, the Hedge 

Fund Manager should undertake reasonable due diligence efforts with 

respect to the identity of the Investor in the Hedge Fund by obtaining additional forms of identification from the Investor that may be used to confirm 

the Investor’s identity (e.g., documents certifying the existence of the entity 

such as certified articles of incorporation, a government-issued business 

license, a partnership agreement, or a trust instrument) or other generally 

available public information confirming the Investor’s identity.

20 | Appendix IV
Where the investor is neither a publicly-traded company listed on a major, 

regulated exchange (or a subsidiary or a pension fund of such a company), 

nor a regulated institution organized in a FATF jurisdiction, the Hedge 

Fund Manager may wish to gain additional comfort regarding the Investor’s 

identity by obtaining certain of the following, as appropriate, under the 

circumstances:

• Evidence that the Investor has been duly organized in its jurisdiction 

of organization;

• A list of directors, senior officers, and principal equity holders (in order 

to ensure, for example, that none of these persons is a prohibited 

Investor, as set forth in Recommendation 2.3), and/or, if the Hedge Fund 

Manager believes it can reasonably rely upon an AML Certification from 

the Investor, it can obtain a certificate from the Investor that it has implemented and complies with AML policies, procedures, and controls that, 

for example, seek to ensure that none of its directors, officers, or equity 

holders are Prohibited Investors, as set forth in Recommendation 2.3;

• In the case of a trust, evidence of the trustee’s authority to make the 

contemplated investment and either an AML Certification from the 

trustee (if the Hedge Fund Manager believes it would be reasonable to 

rely upon such a certificate) or, alternatively, the identities of beneficiaries, the provider of funds (e.g., settlor(s)), those who have control over 

funds (e.g., trustee(s)), and any persons who have the power to remove 

trustees, as well as the trust and the persons authorized to act on behalf 

of the trust;

• Description of the Investor’s primary lines of business;

• Publicly available information from law enforcement agencies or 

regulatory authorities; or

• If appropriate, Investor’s financial statements and/or bank references.

Sound Practices for Hedge Fund Managers | 21
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

2.3 Prohibited Investors 

A Hedge Fund Manager should not accept any investment from or on 

behalf of any Investor ( a “Prohibited Investor”) that is:

• An individual or entity whose name appears on any lists of prohibited 

persons and entities as may be mandated by applicable law or regulation, 

including the List of Specially Designated Nationals and Blocked Persons

administered by OFAC14 (“OFAC List”) as such lists may be amended 

from time to time; 

• An individual or entity who is from a country or territory prohibited 

by the OFAC sanctions programs; 

• Resident in, or organized or chartered under the laws of, a jurisdiction 

that has been designated by the Secretary of the U.S. Department of 

Treasury under Section 311 of the PATRIOT Act as warranting special 

measures due to money-laundering concerns; or

• A “Prohibited Foreign Shell Bank” (see below).

(See Part IV below for a discussion of OFAC Policies and Procedures.)

Necessity of Checking for Updates to the OFAC Lists. A Hedge Fund Manager 

should update the information that it maintains and relies upon for the 

purposes of checking the above lists as necessary in order to ensure that 

it does not accept an investment from a Prohibited Investor or permit a 

redemption to an Investor that has been added to the OFAC Lists.15

Prohibited Foreign Shell Banks. Hedge Fund Managers should not accept 

investments from or on behalf of a Prohibited Foreign Shell Bank. With 

respect to Investors that are Foreign Banks, Hedge Fund Managers may 

wish to consider obtaining a representation that the bank either: (1) has 

14 For a description of the lists maintained by OFAC, please refer to Annex H. The 

complete OFAC lists may be accessed at (www.treas.gov/ofac). 

15 Where compliance resources are limited, a Hedge Fund Manager may wish to consider 

using a third-party compliance service for assistance with monitoring OFAC lists.

22 | Appendix IV
a “Physical Presence”; or (2) does not have a Physical Presence, but is affiliated with a regulated financial group; and (3) does not provide services to 

Prohibited Foreign Shell Banks.

2.4 High Risk Investors

Prior to accepting an investment from an Investor that the Hedge Fund 

Manager has reason to believe presents high risk factors (a “High Risk 

Investor”) with regard to money laundering or terrorist financing, the Hedge 

Fund Manager should conduct enhanced due diligence with regard to the 

Investor, in addition to standard Investor identification procedures.

The enhanced due diligence procedures undertaken with respect to High 

Risk Investors should be well documented and any questions or concerns 

with regard to a High Risk Investor should be directed to the Anti-Money 

Laundering Compliance Officer. The decision to accept or reject an investment by a High Risk Investor should directly involve a more senior level of 

management than is typically involved in establishing an Investor relationship. Documentation of this decision-making process should also be retained. 

The following are examples of types of Investors that may be deemed to 

present high risk factors with regard to money laundering or terrorist 

financing:

• Investors not located in a FATF jurisdiction;

• Non-U.S. “Private Investment Companies”;

• A SFPF/PEP or an immediate family member or close associate 

of a SFPF/PEP;

• Any Investor resident in, or organized or chartered under the laws of, 

a “Non-Cooperative Jurisdiction” or “NCCT jurisdiction”;

16

Sound Practices for Hedge Fund Managers | 23

16 There are presently no countries or territories that have been designated by FATF 

as non-cooperative with international AML efforts. 
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

• Any Investor whose subscription funds originate from, or are routed 

through, an account maintained at a Prohibited Foreign Shell Bank, or 

an “offshore bank”, or a bank organized or chartered under the laws of a 

Non-Cooperative Jurisdiction, or a bank or financial institution subject 

to special measures under Section 311 of the Patriot Act; 

• Any Investor that is a Foreign Bank subject to enhanced due diligence 

under Section 312 of the PATRIOT Act;17 or 

• Any Investor who gives the Hedge Fund Manager reason to believe that 

the source of its subscription funds may not be legitimate.

Examples of enhanced due diligence procedures that a Hedge Fund Manager 

might consider in order to address high risk factors presented by Investors 

are detailed in Recommendations 2.4.1 (for natural persons) and 2.4.2 (for 

legal entities).

2.4.1 Natural Persons as High Risk Investors

Below are examples of measures a Hedge Fund Manager might consider, 

as appropriate, in order to seek comfort with respect to certain High Risk 

Investors who are natural persons:

• Reviewing pronouncements of U.S. governmental agencies and multilateral organizations such as FATF and the INCSR Report with regard to 

the adequacy of AML and counter-terrorism legislation in the Investor’s 

home country jurisdiction;

24 | Appendix IV

17 Foreign Banks subject to enhanced due diligence pursuant to Section 312 of the 

PATRIOT Act are banks: (1) that operate under an offshore banking license; (2) that 

have a license issued by a non-U.S. country that has been designated as non-cooperative with international money laundering principles or procedures by an intergovernmental group or organization of which the United States is a member and with which 

designation the U.S. representative to the group or organization concurs; or (3) that 

are licensed in a non-U.S. country that has been designated by the Secretary of the 

U.S. Department of Treasury as warranting special measures due to money laundering 

concerns, such as Section 311 special measures.
• Assessing the Investor’s business reputation through review of generally 

available media reports or by other means;

• Considering the source of the Investor’s wealth, including the economic 

activities that generated the Investor’s wealth, and the source of the 

particular funds intended to be used to make the investment; and in particular, where a SFPF/PEP is involved, taking steps to determine whether 

the funds are derived from political corruption; and

• Reviewing generally available public information, such as media reports, 

and other publicly available databases to determine whether the Investor has been the subject of any allegations, investigations, indictments, 

convictions, or other criminal, civil charges, or regulatory actions based 

on violations of AML laws or regulations, or involving allegations of 

corruption, or relating to the financing of terrorists.

2.4.2 Legal Entities as High Risk Investors

Below are examples of measures a Hedge Fund Manager might consider, 

as appropriate, in order to seek comfort with respect to certain High Risk 

Investors who are legal entities:

• Reviewing recent changes in the ownership or Senior Management 

of the Investor;

• If applicable, determining the relationship between the Investor and 

the government of its home country jurisdiction, including whether 

the Investor is a government-owned entity;

• Reviewing pronouncements of U.S. governmental agencies and multilateral organizations such as FATF with regard to the adequacy of AML and 

counter-terrorism legislation in the Investor’s home country jurisdiction; 

• Assessing the Investor’s business reputation through a review of generally 

available media reports or by other means;

• Considering the source of the Investor’s wealth, including the economic 

activities that generated the Investor’s wealth, and the source of the 

particular funds intended to be used to make the investment; and in particular, where a SFPF/PEP is involved, taking steps to determine whether 

the funds are derived from political corruption; and

Sound Practices for Hedge Fund Managers | 25
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

• Reviewing generally available public information, such as media 

reports, and other publicly available databases to determine whether 

the Investor has been the subject of any allegations, investigations, 

indictments, convictions, or other criminal or civil charges or regulatory 

actions, including, violations of AML laws or regulations, or involving 

allegations of corruption, or relating to the financing of terrorists.

2.5 Inadequate Information

If there is inadequate information or Investor identification procedures that 

cannot be performed, the Hedge Fund Manager may refuse to accept the 

investment from the Investor, and file a voluntary SAR, if appropriate. See 

Recommendation 3.2. If the Investor’s subscription to the Hedge Funds is 

approved, the Anti-Money Laundering Compliance Officer should consider 

whether ongoing monitoring is necessary, and, if appropriate, establish a 

method for review by Senior Management and the Anti-Money Laundering 

Compliance Officer.

In addition, Hedge Fund Managers should consider conducting their 

review of publicly available databases on at least an annual basis in order 

to determine whether to continue the relationship.

2.6 Investor Records Retention

The Hedge Fund Manager should establish procedures requiring that 

copies of documents reviewed as part of the performance of its Investor 

identification procedures be retained for an appropriate period of time and, 

at a minimum, the period of time required by applicable law or regulation. 

For example, a Hedge Fund Manager might require that documents be 

retained for so long as an Investor remains invested in one of the Hedge 

Funds it manages and for a minimum of five years following the final 

redemption by the Investor.

26 | Appendix IV
The following are examples of the types of documents that the Hedge Fund 

Manager might wish to retain as part of its Investor records retention policy:

• Copies of documents reviewed in connection with Investor identification 

procedures or enhanced due diligence procedures;

• Investor identification checklists, if any, or similar due diligence 

documentation; and

• Any other documents required to be retained by applicable AML 

legislation.

2.7 Risk-Focused Review of Existing Investors

Based on its own risk assessment, a Hedge Fund Manager should periodically 

review, for example, as part of the audit function addressed in Recommendation 1.8, the adequacy of due diligence performed on existing Investors. As 

appropriate, a Hedge Fund Manager should consider undertaking a periodic 

review of its existing Investor base in order to ensure that no Investor is a 

Prohibited Investor, as defined in Recommendation 2.3.

2.8 Anti-Money Laundering Risks Associated with Receipt/Transfer

and Redemption of Funds

Hedge Fund Managers should consider adopting procedures whereby they 

only accept wire transfers from a financial institution that is incorporated or 

has its principal place of business in a FATF jurisdiction. Funds received into 

a Hedge Fund from an Investor or prospective Investor’s bank or brokerage 

account, should be credited upon redemption to the same bank or brokerage 

account, unless there is a legitimate reason for, and the Anti-Money Laundering Compliance Officer authorizes, such payment into another account. If an 

exception is made and the Anti-Money Laundering Compliance Officer or 

other appropriate officer agrees otherwise, the officer should document the 

rationale behind permitting transfer or payment into another account. Funds 

received from an Investor or prospective Investor should not be transferred 

or credited to any other investment interest without Anti-Money Laundering Compliance Officer or Senior Management approval. In the event an 

Investor makes a request for an early redemption, the Anti-Money Laundering Compliance Officer, in conjunction with Senior Management, should 

Sound Practices for Hedge Fund Managers | 27
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

evaluate the reasons for the request to determine whether there are any 

AML concerns. Such decisions regarding the request for early redemption, 

including the rationale for granting the request in the event such request is 

approved, should be documented. 

III. Suspicious and/or Criminal Activity Monitoring and Reporting

3.1 Suspicious Activity Monitoring

Although Hedge Funds and Hedge Fund Managers are not currently 

required to monitor and report suspicious activity under Section 356 of the 

PATRIOT Act, in the Proposed AML Program Rule, FinCEN encourages 

Hedge Funds and Hedge Fund Managers to file Suspicious Activity Reports 

voluntarily. Moreover, an offshore Hedge Fund or administrator may be 

required to file a comparable suspicious activity report under the laws of its 

own jurisdiction. Therefore, a Hedge Fund Manager’s policies, procedures 

and controls should provide for the detection of suspicious activity and 

should include examples of the types and patterns of activities that may 

require further review to determine whether the activity is suspicious. For 

example, in some circumstances, the following activities or requests, none of 

which per se constitutes suspicious activity, may be indicative of activity that 

may require further investigation:

• An Investor exhibits an unusual concern regarding the Hedge Fund’s 

compliance with government reporting requirements, particularly with 

respect to the Investor’s identity, type of business and assets, or the Investor is reluctant or refuses to reveal any information concerning business 

activities, or furnishes unusual or suspect identification or business 

documents;

• An Investor attempts to make frequent subscriptions or redemptions 

outside of the normal periods;

• An Investor (or a person publicly associated with the Investor) has a 

questionable background or is the subject of news reports indicating 

possible criminal, civil, or regulatory violations; 

28 | Appendix IV
• An Investor appears to be acting as the agent for another entity, but 

declines, evades or is reluctant, without legitimate commercial reasons, 

to provide any information in response to questions about that entity;

• An Investor wishes to engage in investments that are inconsistent with 

the Investor’s apparent strategy;

• An Investor has difficulty describing the nature of his or her business 

or lacks general knowledge of the industry he or she is apparently 

engaged in;

• An Investor makes a misrepresentation to the Hedge Fund that its name 

does not appear on an OFAC List, but the name is discovered during the 

due diligence review process;

• An Investor wishes to engage in investments that are inconsistent with 

the Investor’s apparent investment strategy;

• An Investor attempts, with unusual frequency (taking into account the 

differences between Direct Investors and Investor intermediaries, as appropriate), to make investments, request redemptions, or transfer funds;

• An Investor engages in unusual or frequent wire transfers (taking into 

account the differences between Direct Investors and Investor intermediaries, as appropriate), particularly to unfamiliar bank accounts;

• An Investor requests that redemption proceeds be wired to unrelated 

third parties or to bank accounts in countries other than the Investor’s 

country of origin; 

• An Investor insists on dealing only in cash or cash equivalents;

• An Investor requests that a transaction be processed in such a manner 

so as to avoid the Hedge Fund’s normal documentation requirements; 

• An Investor exhibits a total lack of concern regarding the investment 

program, related risks, the management team, etc.;

• An Investor has difficulty describing the reasons for request for wire 

transfers to unfamiliar bank accounts or jurisdictions other than the 

Investor’s country of residence;

Sound Practices for Hedge Fund Managers | 29
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

• An Investor makes frequent investments followed by requests for 

redemptions, especially if the requests are that the proceeds be wired to 

unrelated third parties or bank accounts in foreign countries;

• An Investor makes non-economic transfers (e.g., substantial financial 

investments followed by a request for redemption with indifference as 

to penalty amounts charged by the Hedge Fund Manager for engaging 

in such transactions);

• An Investor makes or requests transfers to accounts in countries where 

drug trafficking is known to occur or to other high risk countries; 

• An Investor attempts to transfer funds to jurisdictions other than its 

home country jurisdiction;

• An Investor requests a transfer of an investment interest from a foreign 

government to a private person; or

• An Investor requests a transfer of an investment to an unrelated third 

party without a reasonable explanation.

3.2 Suspicious Activity Reporting 

The Hedge Fund Manager’s AML program should require any employee 

who detects suspicious activity or has reason to believe that suspicious activity is taking place to immediately inform his or her immediate supervisor, 

as well as the Anti-Money Laundering Compliance Officer, who should 

determine whether to report the suspicious activity to law enforcement. 

As discussed in Part V below, a Hedge Fund Manager should seek to establish effective lines of communication for addressing suspicious activity detected by its fund administrator or another third party on which the Hedge 

Fund Manager relies for Investor due diligence and provide, for example, 

that the fund administrator or other third party should, where permitted by 

law, immediately notify the Hedge Fund Manager’s Anti-Money Laundering 

Compliance Officer of any suspicious activity relating to the Hedge Fund 

Manager’s funds. 

30 | Appendix IV
The AML program should also remind all employees of the fact that reports 

of suspicious activity are confidential and may not be disclosed to any 

person involved in the transaction and that it is a violation of the BSA for a 

Hedge Fund Manager or the Hedge Fund or its directors, officers, employees, or agents, to notify any person involved in the transaction or any third 

party that a SAR has been filed, except where requested by FinCEN or 

an appropriate law enforcement or regulatory agency. The AML program 

should also address the procedures the Hedge Fund Manager must follow 

in order to maintain the confidentiality of a SAR in the event it receives a 

subpoena or is otherwise requested to disclose a SAR or the information 

contained in a SAR. In that situation, the Hedge Fund Manager must decline to produce the SAR or to provide any information that would disclose 

that a SAR has been prepared or filed, and contact FinCEN for guidance. 

Transactions involving terrorist financing or ongoing money laundering 

schemes should be immediately reported to FinCEN via the Financial 

Institutions Hotline (1-866-556-3974), in addition to filing a SAR regarding the activity in a timely manner, when appropriate. 

3.3 Recordkeeping

The Hedge Fund Manager should maintain copies of all documentation, 

records, and communications relating to a reported transaction on behalf 

of each Hedge Fund. All SARs and supporting documentation related to 

the SARs shall be retained for a period of at least five years. 

IV. OFAC Policy And Procedures

Hedge Funds and Hedge Fund Managers based in the U.S. are subject to 

regulations administered by OFAC and, therefore, must comply with a series 

of laws that impose economic and trade sanctions against: (1) certain foreign 

governments and their agents; (2) agencies, organizations and individuals 

that sponsor terrorism; and (3) international narcotics traffickers. 

Sound Practices for Hedge Fund Managers | 31
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

In order to determine whether either an Investor or the source of a funds 

transfer is covered by an OFAC sanctions program, the Hedge Fund Manager should screen the names of Investors, and to the extent known to the 

Hedge Fund, any of such Investors’ directors, general partners, managing 

members, trustees, settlors, beneficiaries, or beneficial owners (as applicable), 

against the OFAC List and the list of countries subject to OFAC’s sanctions 

programs. Such checks should be done at the time an investment is made, 

any time the OFAC List is updated, and at the time of redemption. 

If an Investor resides in, is a citizen of, or an entity has a place of business in, 

a country or territory named on the OFAC List, or the Investor’s name appears on the OFAC List, Hedge Fund Manager personnel should report the 

information to the Anti-Money Laundering Compliance Officer, who will 

determine whether the transaction must be rejected or blocked, and whether 

the transaction must be reported to OFAC. 

The Hedge Fund Manager must also file an annual report with OFAC 

regarding all blocked property held by the Hedge Fund. 

The procedures may be contracted out to a third-party service provider 

approved by the Anti-Money Laundering Compliance Officer or delegated 

to the administrator, subject to the Anti-Money Laundering Compliance 

Officer’s satisfaction with the administrator’s compliance procedures (see 

Part V, the 2007 AML Guidance).

V. Performance of Investor Identification and other

AML Procedures by Third Parties

5.1 Relationships between Hedge Fund Managers and Third Parties

The Proposed AML Program Rules recognize the ability of a Hedge Fund 

or Hedge Fund Manager to contractually delegate the implementation and 

operation of certain aspects of their AML compliance program to other 

entities through which the company conducts its business, such as fund 

administrators, IAs, CPOs, CTAs, broker-dealers (including prime brokers), 

and futures commission merchants. Consistent with this approach, a Hedge 

Fund Manager typically delegates to a fund administrator the processing 

32 | Appendix IV
of subscription documents and compliance with AML laws and regulations 

applicable in the fund’s jurisdiction of organization.18 Under the Proposed 

AML Program Rules, a Hedge Fund and Hedge Fund Manager that 

delegates responsibility for aspects of the AML program would continue 

to remain fully responsible for the effectiveness of the program.

In addition, the Hedge Fund Manager often relies on third parties such as 

placement agents or asset aggregators for the introduction of Investors to the 

fund. Likewise, certain Investor intermediaries, including fund of funds and 

nominees, may invest in a Hedge Fund on their clients’ behalf. These third 

parties often have direct contact and maintain the primary relationship with 

the Investor and are consequently in the best position to “know the Investor.” As a result, a Hedge Fund Manager may directly or indirectly rely upon 

the Investor identification procedures performed by such third parties, as set 

forth in Part II above. 

5.2 Delegation of Elements of Hedge Fund Manager’s AML Program 

to Third Parties - Administrators, IAs, CTAs

The Anti-Money Laundering Compliance Officer should be directly involved in the decision to delegate to, and the selection of, a third party 

to perform certain elements of the Hedge Fund Manager’s AML Program, 

including Investor identification procedures and SAR and in determining 

whether, and to what extent, such delegation is reasonable and appropriate. 

Such a decision will often be predicated on the Hedge Fund Manager’s interest in directing its AML and due diligence efforts where they are most likely 

to be productive. Taking into account applicable law and regulation, its 

own risk assessment of its Investors and available resources, the Anti-Money 

Laundering Compliance Officer might determine that, absent any specific 

money laundering concerns, it will generally be appropriate to delegate 

particular Investor identification or other AML procedures to a third party, 

such as an administrator, IA, or CTA.

Sound Practices for Hedge Fund Managers | 33

18 In addition, fund administrators organized under the laws of the Bahamas, Bermuda, 

and the Cayman Islands are required to comply with AML laws and regulations enacted 

in these jurisdictions during the past few years. The AML laws and regulations of these 

jurisdictions impose detailed “know your customer” obligations on fund administrators.
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

5.3 Reliance on Third Parties: Placement Agents/Financial Institutions

Based on these same considerations, the Anti-Money Laundering Compliance Officer might also determine that it will generally be appropriate 

(absent any specific money laundering concerns) to rely on the Investor 

identification procedures performed by certain other categories of third 

parties that have introduced the Investor to the Hedge Fund and, therefore, 

may be better suited to conduct those procedures. Such third parties can 

include placement agents or asset aggregators. In addition, Hedge Funds 

may choose to rely on other financial institutions such as:

• A U.S.-regulated financial institution where the Investor is a customer of 

the U.S.-regulated financial institution and the Investor’s investment funds 

are wired from its account at the U.S.-regulated financial institution;19

• A regulated foreign financial institution organized in a FATF jurisdiction, 

where the Investor is a customer of such foreign financial institutions and 

the Investor’s investment funds are wired from its account at the foreign 

financial institution;

• An Investor intermediary, nominee, fund of funds, or asset aggregator 

that is itself a U.S.-regulated financial institution; or

• An Investor intermediary, nominee, fund of funds, or asset aggregator 

that is itself a regulated foreign financial institution organized in a FATF 

jurisdiction.

To the extent that the Hedge Fund Manager believes that the Investor identification procedures performed by a placement agent or regulated foreign 

financial institution, although reliable, may not include procedures that are 

included in the Hedge Fund Manager’s AML policies and procedures (e.g.,

determination of whether an Investor is a Prohibited Investor as defined in 

Recommendation 2.3), the Hedge Fund Manager should either expressly 

34 | Appendix IV

19 As used herein, the term “U.S.-regulated financial institution” would include institutions subject to the AML provisions of the PATRIOT Act, such as a registered brokerdealer and a U.S. branch or agency of a Foreign Bank. Where doubt exists as to the 

existence of a formal customer relationship between such a financial institution and an 

Investor, the Hedge Fund Manager may wish to obtain representations from the financial institution confirming the existence of a customer relationship and the performance 

of customer due diligence.
request that the foreign financial institution confirm that it has performed 

the necessary additional procedures or otherwise provide for the performance of such procedures prior to accepting an Investor through the financial 

institution. 

5.4 Allocation of Responsibilities Between the Parties

Regardless of whether a Hedge Fund delegates its Investor identification procedures to an administrator, IA, or CTA, or whether it relies on 

a financial institution acting as a placement agent or asset aggregator that 

introduced the Investor, agreements with such third parties that either 

introduce or process Hedge Fund investments should clearly allocate AML 

responsibilities between the third party and the Hedge Fund and its Hedge 

Fund Manager, as appropriate. The Hedge Fund Manager should conduct due diligence with respect to the AML policies of the third party by 

familiarizing itself with such policies (by, for example, obtaining a copy or 

a summary of the third-party’s AML policies) and determining whether the 

policies meet the standards set by the Hedge Fund Manager. Agreements 

with third parties should also seek to establish effective lines of communication for addressing Investor due diligence issues and suspicious activity or 

circumstances as they arise. Such agreements should also contemplate means 

by which a Hedge Fund or its Hedge Fund Manager may periodically verify 

or audit the third party’s compliance with its AML policies, procedures, 

and controls.

Agreements with Fund Administrators. A Hedge Fund’s agreement with its 

fund administrator should specifically allocate between the administrator, 

on the one hand, and the fund and the Hedge Fund Manager, on the other 

hand, their respective obligations for compliance with applicable U.S. AML 

laws and regulations, as well as the laws and regulations applicable in the 

fund’s home country jurisdiction.20 Sample representations and covenants 

that could be sought from fund administrators are included in Annex D-1. 

Sound Practices for Hedge Fund Managers | 35

20 The Hedge Fund Manager may wish to seek amendments (in the form of a letter or 

otherwise) to its existing agreements with fund administrators.
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

Agreements with Certain Investor Intermediaries. A Hedge Fund Manager’s agreement with an introducing firm or asset aggregator should clearly 

allocate responsibilities for Investor identification in accordance with the 

policies adopted by the Hedge Fund Manager. Sample representations and 

covenants that could be sought from Investor intermediaries in this regard 

are included in Annex D-2. 

5.5 Risk-Based Assessment of Third Parties’ Anti-Money

Laundering Procedures

As part of its determination as to whether it should delegate to or rely on a 

third party in performing particular AML functions, a Hedge Fund Manager should undertake a risk-assessment of any money laundering concerns 

relating to the third party, taking into account the jurisdiction in which the 

third party is located, as well as various other factors indicative of the quality 

of their AML procedures. This is particularly important, for example, when 

dealing with unregulated entities or entities that are not based in jurisdictions that have been pre-determined to be acceptable to the Hedge Fund 

Manager (e.g., non-FATF jurisdictions). In determining whether the Hedge 

Fund Manager may delegate to or rely on a third party for the purposes of 

performing certain AML functions, the Hedge Fund Manager may wish to 

consider various factors, as appropriate, such as:

• Jurisdiction in which the third party is based and the existence of 

applicable AML laws and regulations. In order to gain comfort regarding the AML structure of another jurisdiction, a Hedge Fund Manager 

may wish to review pronouncements of U.S. governmental agencies and 

multilateral organizations21 regarding the AML laws and regulations in 

such other jurisdiction:

• Regulatory status of third party and affiliates;

• Reputation and history of third party in the investment industry; and

• The AML and Investor due diligence policies, procedures and controls 

implemented by the third party.

36 | Appendix IV

21 In this regard, a Hedge Fund Manager may wish to consult pronouncements and 

publications by FATF (see also Annexes F and G hereto), FinCEN (see also Annex I 

hereto) and the U.S. Department of State’s INCSR Report. 
5.6 Further Assurances

Should the Hedge Fund Manager determine that further assurances from 

any third party are warranted, it may also wish to consider some of the 

following possibilities:

• Requiring the third party to provide the Hedge Fund Manager with a 

copy of its AML and Investor due diligence policies, procedures and 

controls and to promptly notify the Hedge Fund Manager of any 

amendment thereto; 

• Requiring the third party to certify and covenant that it complies 

and will continue to comply with its AML and Investor due diligence 

policies, procedures, and controls;

• Requiring meaningful written representations and covenants as to 

Investors verified by the third party, e.g., a covenant that it will ensure 

that no such Investors are Prohibited Investors, as set forth in 

Recommendation 2.3;

• Requiring the third party to provide access, upon request, to copies 

of documents reviewed by the third party in performing Investor due 

diligence;

• Requiring the third party to submit to a review or audit of its AML policies, procedures, and controls and its compliance with them as they relate 

to the funds managed by the Hedge Fund Manager; and

• In the case of an intermediary or nominee, obtaining evidence of or 

representations as to its authority to make the contemplated investment.

Sound Practices for Hedge Fund Managers | 37
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

VI. Additional BSA Requirements

6.1 Policy Relating to Cash and Cash Equivalents 

Given the close association between cash transactions and money laundering, a Hedge Fund Manager should consider limiting the acceptance of cash 

or cash equivalents such as money orders and traveler’s checks. Where such 

a policy has been adopted, requests for exceptions to this policy should be 

brought to the Anti-Money Laundering Compliance Officer for approval, 

and for possible filing of cash transaction reports on an IRS/FinCEN 

Form 8300.

Pursuant to both the PATRIOT Act and the Internal Revenue Code, the 

Hedge Fund Manager and each Hedge Fund must report the receipt of one 

or more related cash or cash equivalent transactions that exceed $10,000. 

The transactions are reportable on IRS/FinCEN Form 8300 and must be 

filed by the 15th day after the date the cash or cash equivalent was received. 

The AML procedures should describe these requirements and the timing for 

filing these forms, as well as the legal prohibition against “structuring” such 

cash transactions in order to avoid the reporting requirement. Whenever 

patterns of structuring are identified, the Anti-Money Laundering Compliance Officer should be notified. 

6.2 Foreign Bank and Financial Accounts Report

The AML procedures should also address the responsibility of a Hedge Fund 

and Hedge Fund Manager to report any financial interest in, or signature 

or other authority over, any non-U.S. financial accounts, including bank, 

securities, or other types of financial accounts in a foreign country, if the 

aggregate value of those financial accounts exceeds $10,000 at any time 

during the calendar year. Such reports must be made each calendar year by 

filing TD 90-22.1 with FinCEN on or before June 30 of the succeeding 

year. MFA has recently sought guidance from the Internal Revenue Service 

(“IRS”), with respect to the reporting rule and how it applies in various 

scenarios that commonly arise in the Hedge Fund industry. 

38 | Appendix IV
6.3 Reports of Transportation of Monetary Instruments 

The AML procedures should also address the responsibility of a Hedge Fund 

and Hedge Fund Manager to file reports of the physical transportation of 

cash or cash-like monetary instruments, (e.g., all traveler’s checks and various 

other negotiable instruments and securities in bearer form) of more than 

$10,000 into or outside of the United States to the U.S. Customs Service on 

a Report of International Transportation of Currency or Monetary Instruments (“FinCEN Form 105” or “CMIR”). The procedures should also 

address the prohibition on structuring of the transaction so as to avoid the 

CMIR reporting requirement. All questions about CMIR reporting should 

be directed to the Anti-Money Laundering Compliance Officer.

VII. General Recordkeeping Requirements 

All documentation related to a Hedge Fund or Hedge Fund Manager’s 

AML program not addressed above should be retained for a period of 

at least five years. 

Sound Practices for Hedge Fund Managers | 39
ANNEX A: Definitions

1. 2007 AML Guidance is MFA’s Guidance for Hedge Funds and Hedge 

Fund Managers on Developing Anti-Money Laundering Programs 

(Release No. 2).

2. AML is defined as anti-money laundering.

3. The Anti-Money Laundering Compliance Officer is the person 

appointed by Senior Management, among other things, to administer 

the Hedge Fund Manager’s AML program.

4. The BSA is the Bank Secrecy Act, as amended.

5. A Close Associate of a SFPF/PEP is a person who is widely and publicly known (or is actually known by the Hedge Fund Manager or the 

Hedge Fund) to be a close associate of such an individual.

6. The CFTC is the U.S. Commodity Futures Trading Commission.

7. A CMIR or FinCEN Form 105 is a form published by the U.S. 

Customs Service on a Report of International Transportation of 

Currency or Monetary Instruments.

8. The CEA is the Commodity Exchange Act, as amended.

9. A Commodity Pool Operator or CPO is defined under the CEA as 

“any person engaged in a business that is of the nature of an investment 

trust, syndicate, or similar form of enterprise and who, in connection 

therewith, solicits, accepts, or receives from others, funds, securities, 

or property, either directly or through capital contributions, the sale 

of stock or other forms of securities, or otherwise, for the purpose of 

trading in any commodity for future delivery on or subject to the rules 

of any contract market or derivatives transaction execution facility,” 

subject to certain exceptions. Section 1a(5) of the CEA, 7 U.S.C. § 

1a(5). 

40 | Appendix IV

Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs
Sound Practices for Hedge Fund Managers | 41

10. A Commodity Trading Advisor or CTA is defined under the CEA as 

“any person who, for compensation or profit, engages in the business of 

advising others, either directly or [indirectly], as to the value . . . or . . . 

advisability of trading in any contract of sale of a commodity for future 

delivery made or to be made on or subject to the rules of a contract 

market or derivatives transaction execution facility, or any commodity 

option authorized under section 6c [of the CEA], or any leverage transaction authorized under section 23 [of the CEA], or for compensation 

or profit, and as part of a regular business, issues or promulgates analyses or reports concerning any of the activities referred to above, subject 

to certain exemptions. Section 1a(6) of the CEA, 7 U.S.C. § 1a(6).

11. A Direct Investor is an Investor who invests in a Hedge Fund as principal and not for the benefit of any third party.

12. The Financial Action Task Force or FATF is an international organization comprised of representatives of the financial, regulatory, and law 

enforcement communities from around the world, which serves as the 

world leader in the development of effective AML programs. A list of 

current FATF-member jurisdictions is available at (www.oecd.org/fatf), 

and included in Annex F attached hereto.

13. A FATF Jurisdiction is a country or territory that is a member in good 

standing of the FATF. 

14. A Foreign Bank means a bank organized under foreign law, or an 

agency, branch, or office located outside the United States. The term 

does not include an agent, agency, branch, or office within the United 

States of a bank organized under foreign law. 

15. FinCEN is the Financial Crimes Enforcement Network of the U.S. 

Department of Treasury.

16. A Hedge Fund is a pooled investment vehicle that generally meets 

the following criteria: (1) it is not marketed to the general public (i.e.,

privately-offered); (2) it is limited to high net worth individuals and 

institutions; (3) it is not registered as an investment company under 

relevant laws (e.g., U.S. Investment Company Act of 1940); (4) its 
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

assets are managed by a professional investment management firm that 

shares in the gains of the investment vehicle based on investment performance of the vehicle; and (5) it has periodic but restricted or limited 

investor redemption rights. The term Hedge Fund, as used in these 

Recommendations, is not intended to capture private investment funds 

that are “purely” traditional private equity, venture capital, or real estate 

funds, although MFA recognizes that individual Hedge Funds may 

in accordance with their offering documents pursue these and other 

investment strategies. 

17. A Hedge Fund Manager is a professional investment management firm 

that serves as investment manager for a Hedge Fund and manages its 

assets and investments.

18. A High Risk Investor is an Investor that a Hedge Fund Manager has 

reason to believe presents high risk factors with regard to money laundering or terrorist financing. Examples of high risk factors with regard 

to money laundering and terrorist financing can be found in Recommendation 2.4.

19. An Immediate Family Member of a SFPF/PEP means a spouse, parents, siblings, children, and spouse’s parents or siblings.

20. The International Narcotics Control Strategy Report or INCSR is an 

annual report issued by the U.S. Department of State that assesses the 

money laundering risks of various countries and jurisdictions.

21. The IRS is the U.S. Internal Revenue Service. 

22. An Investment Adviser or IA is defined in the Investment Advisers Act 

of 1940 as “any person who, for compensation, engages in the business 

of advising others . . . as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or . . . issues . . . 

analyses or reports concerning securities,” subject to certain exceptions. 

Section 202(a)(11) of the the Investment Advisers Act of 1940, 31 

U.S.C. § 80b-2(a)(11).

42 | Appendix IV
23. An Investment Company is defined under section 3 of the Investment 

Company Act as “any issuer which . . . is or holds itself out as being 

engaged primarily, or proposes to engage primarily, in the business 

of investing, reinvesting, or trading in securities,” subject to certain 

exemptions. 15 U.S.C. §§ 80a-3(a)(1)(A), (c)(1) and (c)(7).

24. Investment Company Act is the U.S. Investment Company Act of 

1940, as amended. 

25. The term Investor includes, unless otherwise indicated, any Direct 

Investor, and any intermediary or nominee that makes an investment 

on behalf of other Investors.

26. The term Investor identification procedures refers to those procedures 

a Hedge Fund Manager establishes and maintains that are designed to 

identify an Investor to the extent reasonable and practical and to reduce 

the Hedge Fund Manager’s exposure to criminal liability and reputational harm.

27. MFA is the Managed Funds Association.

28. A Non-Cooperative Jurisdiction or NCCT jurisdiction means any foreign country that has been designated as non-cooperative with international AML principles or procedures by an intergovernmental group or 

organization, such as FATF, of which the United States is a member and 

with which designation the United States representative to the group or 

organization continues to concur.

29. OFAC is the U.S. Department of Treasury’s Office of Foreign Assets 

Control.

30. The OFAC List is the List of Specially Designated Nationals and Blocked 

Persons administered by OFAC, as such lists may be amended from time 

to time.

31. An offshore bank refers to a non-U.S. bank that possess a license to 

conduct banking activities that prohibits the licensing entity from conducting banking activities with the citizens of, or in the local currency 

of, the jurisdiction that issued the license.

Sound Practices for Hedge Fund Managers | 43
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

32. Physical Presence means a place of business that is maintained by a 

foreign bank and is located at a fixed address, other than solely an 

electronic address or a post-office box, in a country in which the foreign 

bank is authorized to conduct banking activities, at which location 

the foreign bank employs one or more individuals on a full time basis, 

maintains operating records related to its banking activities, and is 

subject to inspection by the banking authority that licensed the foreign 

bank to conduct banking activities.

33. A Politically Exposed Person or PEP is a term used for individuals who 

are or have been entrusted with prominent public functions in a foreign 

country, for example Heads of State or of government, senior politicians, senior government, judicial or military officials, senior executives of state owned corporations, important political party officials, 

etc. Business relationships with family members or close associates of 

PEPs involve reputational risks similar to those with PEPs themselves. 

See FATF 40 Recommendations Glossary at (www.fatfgafi.org/

glossary/0,3414,en_32250379_32236889_35433764_1_1_1_1,00.

html#34285860). 

34. The Preliminary Guidance is MFA’s original Preliminary Guidance 

for Hedge Funds and Hedge Fund Managers on Developing Anti-Money 

Laundering Programs, published on March 28, 2002. 

35. A Private Investment Company or PIC is a type of international business corporation, typically used to hold individual funds and investments in which ownership can be vested through bearer shares or registered shares, which is incorporated frequently in countries that impose 

low or no taxes on company assets or that are bank secrecy havens. PICs 

can offer confidentiality of ownership, as the shares of a PIC may be 

held by a trust, which may hold assets centrally, and provide intermediaries between private banking customers and the potential beneficiaries of the PICs. As a result, PICs are typically viewed by regulators as 

posing money laundering risk and, therefore, requiring enhanced due 

diligence, as appropriate. See Bank Secrecy Act Anti-Money Laundering Examination Manual, Federal Financial Institutions Examination 

Council, at pp. 285-86 (2006). 

44 | Appendix IV
36. A Prohibited Foreign Shell Bank means a bank incorporated in a jurisdiction in which it has no physical presence and which is unaffiliated 

with a regulated financial group. 

37. A Prohibited Investor is: (1) An individual or entity whose name 

appears on: (a) any lists of prohibited persons and entities as may be 

mandated by applicable law or regulation, including the List of Specially 

Designated Nationals and Blocked Persons administered by OFAC as 

such lists may be amended from time to time; (b) such other lists of 

prohibited persons and entities as may be mandated by applicable U.S. 

law or regulation consider specifying other lists to be verified; or (c) 

such other lists of prohibited persons and entities as may be provided to 

the administrator by the Hedge Fund Manager; 

(2) An individual or entity who is from a country or territory prohibited by the OFAC sanctions programs; 

(3) An individual or entity who is a resident in, or organized or chartered under the laws of, a jurisdiction that has been designated by 

the Secretary of the U.S. Department of Treasury under Section 

311 of the PATRIOT Act as warranting special measures due to 

money laundering concerns; or 

(4) A Prohibited Foreign Shell Bank.

38. Proposed AML Program Rules, as amended and supplemented, were 

rules issued by FinCEN on September 18, 2002, which require UICs to 

establish AML programs. The Proposed AML Program Rules were later 

expanded to IAs and CTAs on April 28, 2003 by FinCEN.

39. RIA stands for a registered investment adviser. 

40. The SEC is the U.S. Securities and Exchange Commission. 

41. A Senior Foreign Political Figure or SFPF is: (1) a current or former 

senior official in the executive, legislative, administrative, military, or 

judicial branches of a non-U.S. government (whether elected or not), a 

current or former senior official of a major non-U.S. political party, or 

Sound Practices for Hedge Fund Managers | 45
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

a current or former senior executive of a non-U.S. government-owned 

commercial enterprise; (2) a corporation, business, or other entity that 

has been formed by, or for the benefit of, any such individual; (3) an 

immediate family member of any such individual; and (4) a person who 

is widely and publicly known (or is actually known by the Hedge Fund 

Manager or the Hedge Fund) to be a close associate of such individual. 

For purposes of this definition, a “senior official” or “senior executive” 

means an individual with substantial authority over policy, operations, 

or the use of government-owned resources. See 31 C.F.R. § 103.175(r).

42. SFPF/PEP is a short-hand term used to refer to a Senior Foreign 

Political Figure or Politically Exposed Person. 

43. Senior Management refers to members of a group of senior executives 

or other management body with the authority and responsibility to 

direct and oversee a Hedge Fund Manager’s day-to-day activities on 

behalf of a Hedge Fund or Hedge Funds.

44. Sound Practices is MFA’s Sound Practices for Hedge Fund Managers.

45. A SAR is a Suspicious Activity Report.

46. An underlying Investor is the beneficial owner of shares of stock 

in a company.

47. Unregistered Investment Companies or UICs are certain investment 

companies that are not registered with the SEC, including private 

investment funds, Hedge Funds, private equity funds, venture capital 

funds, commodity pools, and real estate investment trusts.

48. The term U.S.-regulated financial institution includes institutions 

subject to the AML provisions of the Patriot Act.

49. USAAct of 2001 or PATRIOT Act or the Act means the Uniting and 

Strengthening America by Providing Appropriate Tools Required to 

Intercept and Obstruct Terrorism (PATRIOT) Act of 2001 (Pub. L. 

No. 107-56).

46 | Appendix IV
Sound Practices for Hedge Fund Managers | 47

ANNEX B: Model Anti-Money Laundering Attestation

1. For use in dealings with Registered Investment Adviser (“RIA”)/

Unregistered Investment Companies (“FUNDS”) – Annex B-1

2. For use in dealings with Unregistered Investment Advisers/Non-U.S.

Regulated Investment Advisers (“IA”) and Unregistered Investment

Companies (“FUNDS”) – Annex B-2
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

* This form can be used for all FUNDS introduced by an IA, and should be prepared on 

the letterhead of the IA. Where the IA is affiliated with an RIA, the form for an RIA 

should be used. 

ANNEX B-1: Model Anti-Money Laundering Attestation

For use in dealings with Registered Investment Adviser (“RIA”)/

Unregistered Investment Companies (“FUNDS”)*

Name:

Address:

On behalf of the RIA named above, and the FUNDS it manages [or the 

FUNDS managed by its affiliates] (hereafter “RIA/FUNDS”), the undersigned represents and warrants that:

1. The RIA is an Investment Adviser registered with the U.S. Securities and 

Exchange Commission and under the Investment Advisers Act of 1940 

[or a Commodity Trading Advisor (“CTA”) or Commodity Pool Operator (“CPO”) registered under the Commodity Exchange Act]. 

2. The RIA/FUNDS has implemented and currently maintains AML 

procedures that are reasonably designed to be consistent with the AML 

provisions of Sound Practices for Hedge Fund Managers, which Managed 

Funds Association believes are generally in accord with the requirements 

of the Bank Secrecy Act, as amended by the PATRIOT Act of 2001 

(the “PATRIOT Act”). 

3. The RIA/FUNDS has adopted procedures reasonably designed to 

comply with the laws, regulations, and Executive Orders administered 

by the U.S. Department of the Treasury’s Office of Foreign Assets 

Control (“OFAC”), including the List of Specially Designated Nationals 

and Blocked Persons administered by OFAC, as such list may be amended 

from time to time.

48 | Appendix IV
1 The term “investor/shareholder,” as used herein, means any “direct investor” or any 

intermediary or nominee who makes an investment on behalf of other investors/shareholders. A “direct investor” is an investor/shareholder who invests in a Hedge Fund as 

principal and not for the benefit of any third party. 

2

 In appropriate circumstances, this representation letter may be signed by the FUND’s 

Administrator, and prepared on its letterhead. 

Sound Practices for Hedge Fund Managers | 49

CERTIFICATION

On behalf of the RIA/FUNDS, the undersigned hereby certifies that I have 

read the foregoing representations and warranties, and acknowledge that the 

foregoing representations and warranties are true and correct. 

RIA Name:

Address: 

By: Name of Compliance Officer

or Senior Manager:

Title:

Signature: Date:

or:

By: FUND’s Administrator2 :

Name of Authorized Person:

Title:

Signature: Date:

4. The RIA/FUNDS or its designee, including, as appropriate, the 

FUNDS’ administrator, will retain relevant documentation with 

respect to the investor/shareholder,1 including identification information, 

obtained in accordance with the above procedures for five years after the 

date on which the investor/shareholder withdraws from the FUND.

5. Upon a reasonable request, the RIA agrees to recertify in writing the 

representations and warranties provided herein. 
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

ANNEX B-2: Model Anti-Money Laundering Attestation

For use in dealings with Unregistered Investment Advisers/

Non-U.S. Regulated Investment Advisers (“IA”) and

Unregistered Investment Companies (“FUNDS”)*

Name:

Address:

On behalf of the IA named above, and the FUNDS it manages (hereafter 

“IA/FUNDS”), the undersigned represents and warrants that:

1. The IA is organized under the laws of [Insert name of jurisdiction] 

[and regulated by [Insert name of applicable regulator]].

2. The IA/FUNDS has implemented and currently maintains anti-money 

laundering procedures that are reasonably designed to be: (1) consistent 

with the anti-money laundering provisions of Sound Practices for Hedge 

Fund Managers (“Sound Practices”), which Managed Funds Association believes are generally in accord with the requirements of the Bank 

Secrecy Act, as amended by the PATRIOT Act of 2001 (the “PATRIOT 

Act”); and (2) compliant with applicable anti-money laundering laws, 

rules, and regulations of its own jurisdiction. 

3. The IA/FUNDS has, consistent with Sound Practices, applied, and will 

continue to apply, its anti-money laundering procedures to all investors/

shareholders1, and will, in accordance with the laws of its own jurisdiction, take reasonable measures to identify all investors/shareholders.

* This form can be used for all FUNDS introduced by an IA, and should be prepared on 

the letterhead of the IA. Where the IA is affiliated with an RIA, the form for an RIA 

should be used. 

1 The term “investor/shareholder,” as used herein, means any “direct investor” or any 

intermediary or nominee who makes an investment on behalf of other investors/shareholders. A “direct investor” is an investor/shareholder who invests in a Hedge Fund as 

principal and not for the benefit of any third party. 

 

50 | Appendix IV
4. The IA/FUNDS has, consistent with Sound Practices, undertaken appropriate due diligence efforts with respect to each investor/shareholder, including enhanced scrutiny with respect to senior foreign political figures2

/politically exposed persons,3 the preclusion of any prohibited foreign 

shell bank,4 and the screening of any country, territory, individual and/or 

entity prohibited pursuant to applicable economic sanctions programs, 

including, without limitation, all applicable sanctions regimes promulgated or administered by the U.S. Department of Treasury’s Office of 

Foreign Assets Control (“OFAC”), the United Nations, the European 

Union, and/or any other applicable jurisdiction’s economic sanctions 

regime.5 

2 A “senior foreign political figure” is defined as: (1) a current or former senior official 

in the executive, legislative, administrative, military or judicial branches of a non-U.S. 

government (whether elected or not), a current or former senior official of a major nonU.S. political party, or a current or former senior executive of a non-U.S. governmentowned commercial enterprise; (2) a corporation, business, or other entity that has been 

formed by, or for the benefit of, any such individual; (3) an immediate family member 

of any such individual; and (4) a person who is widely and publicly known (or is 

actually known by the IA or the FUND) to be a close associate of such individual. For 

purposes of this definition, a “senior official” or “senior executive” means an individual 

with substantial authority over policy, operations, or the use of government-owned 

resources; and “immediate family member” means a spouse, parents, siblings, children, 

and spouse’s parents or siblings. 

3

 A “politically exposed person” is a term used for individuals who are or have been 

entrusted with prominent public functions in a foreign country, for example, heads 

of state or of government, senior politicians, senior government, judicial or military 

officials, senior executives of state-owned corporations.

4 A “prohibited foreign shell bank” is a bank incorporated in a jurisdiction in which it 

has no physical presence and which is unaffiliated with a regulated financial group.

5 U.S. IAs/FUNDS must comply with the sanctions programs administered by OFAC, 

including the List of Specially Designated Nationals and Blocked Persons administered by OFAC, as such list may be amended from time to time.

Sound Practices for Hedge Fund Managers | 51
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

5. The IA/FUNDS or its designee, including, as appropriate, the FUNDS’ 

Administrator, will retain relevant documentation, including identification information, obtained in accordance with the above procedures 

[for at least five years] after the date on which the investor/shareholder 

withdraws from the FUND. 

6. Upon a reasonable request, the IA/FUNDS agrees to recertify the representations and warranties provided herein. 

CERTIFICATION

On behalf of the IA/FUNDS, the undersigned hereby certifies that I have 

read the foregoing representations and warranties, and acknowledge that the 

foregoing representations and warranties are true and correct. 

IA Name:

Address: 

By: Name of Compliance Officer

or Senior Manager:

Title:

Signature: Date:

or:

By: FUND’s Administrator6 :

Name of Authorized Person:

Title:

Signature: Date:

6 In appropriate circumstances, this representation letter may be signed by the FUND’s 

administrator, and prepared on its letterhead. 

52 | Appendix IV
ANNEX C: Proposed Template for Anti-Money 

Laundering Policies and Procedures*

MFA believes that the template below sets forth the key elements that 

should be included in a Hedge Fund Manager’s AML policies, procedures, 

and controls. AML compliance will be undergoing great change as regulations implementing the PATRIOT Act are promulgated and as industry 

guidance develops over time, and MFA anticipates that it will periodically 

update this template accordingly. Similarly, a Hedge Fund Manager should 

therefore update its AML policies, procedures, and controls as necessary to 

reflect applicable law and regulation and developing industry practice.

Given the degree to which Hedge Funds vary in size and organizational 

structure, as well as in the profile of their Investor bases, MFA believes that 

no one standard or model AML program can be appropriate for all Hedge 

Fund Managers. The appropriateness of policies and procedures for a Hedge 

Fund Manager will depend on a number of factors, including, but not limited to: (1) laws and regulations applicable to the Hedge Fund and Hedge 

Fund Manager; (2) the specific risks presented by the Investor base of each 

Hedge Fund that is managed by the Hedge Fund Manager; (3) the Hedge 

Fund Manager’s relationships with its fund administrator and its Investor 

intermediaries; and (4) the Hedge Fund Manager’s available resources. Consequently, a Hedge Fund Manager’s AML policies, procedures, and controls 

need to be tailored to the specific circumstances presented and should only 

be adopted on the advice of qualified professional advisers.

Sound Practices for Hedge Fund Managers | 53

* Unless otherwise defined, capitalized terms shall have the meanings ascribed to them in 

the 2007 AML Guidance.
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

[Name of Hedge Fund Manager]

ANTI-MONEY LAUNDERING POLICIES,

PROCEDURES AND CONTROLS

Dated as of [insert date adopted/last updated]

I FUNDAMENTAL ELEMENTS OF ANTI-MONEY 

LAUNDERING PROGRAM

 A. Policy Statement

 This section should clearly set forth the Hedge Fund Manager’s 

policy against money laundering and any activity that facilitates 

money laundering or the funding of terrorist activity. (See Recommendation 1.1.) This policy should be adopted at the Hedge Fund 

Manager’s highest executive level.

 The following is an example of such a policy statement:

 “[SENIOR MANAGEMENT/THE BOARD OF DIRECTORS] 

HAS DETERMINED THAT IT IS THE POLICY OF _________

_____ TO SEEK TO PREVENT THE MISUSE OF THE FUNDS 

IT MANAGES AND ITS PERSONNEL AND FACILITIES FOR 

PURPOSES OF MONEY LAUNDERING AND TERRORIST FINANCING. ______________ HAS ADOPTED AND ENFORCES RIGOROUS POLICIES, PROCEDURES AND CONTROLS 

TO DETECT AND DETER THE OCCURRENCE OF MONEY 

LAUNDERING AND OTHER ILLEGAL ACTIVITY.]”

 A statement could also be included to emphasize that: (1) AML 

compliance is the responsibility of every employee of the Hedge 

Fund Manager; and (2) any employee that detects activity that seems 

to be suspicious should immediately report such activity to the AntiMoney Laundering Compliance Officer.

54 | Appendix IV
 B. Objectives of the Anti-Money Laundering Program

 This section should clearly set forth the objectives of the Hedge 

Fund Manager’s AML program. (See Recommendation 1.1.) These 

objectives should include the detection and deterrence of instances of 

money laundering, terrorist financing, and other illegal activity. This 

section should also provide that all employees of the Hedge Fund 

Manager should be generally informed of the AML policy and procedures adopted by the Hedge Fund Manager and be familiar with the 

substance and intent of such policy and procedures (see Recommendation 1.3).

 C. Basic Elements of the Anti-Money Laundering Program

 This section should state the four basic elements of an AML program 

for UICs, IAs, and CTAs under Section 352 of the PATRIOT Act: 

(1) the development of internal policies, procedures, and controls; 

(2) the designation of a compliance officer; (3) an ongoing employee 

training program; and (4) an independent audit function to test programs. Such programs should be in writing and approved by Senior 

Management (see Recommendation 1.2). 

 D. Role of Senior Managment and the Anti-Money Laundering

Compliance Officer

 This section should clearly identify the Anti-Money Laundering 

Compliance Officer appointed by the Hedge Fund Manager and 

provide sufficient contact details for this person. This section should 

also describe the role of Senior Management and the Anti-Money 

Laundering Compliance Officer in the development, adoption, and 

enforcement of written AML policies, procedures, and controls, and 

that it is the responsibility of the Anti-Money Laundering Compliance Officer, in consultation with Senior Management, as appropriate, to decide whether to accept or reject an Investor when the 

Investor has been categorized as high risk. In addition, this section 

Sound Practices for Hedge Fund Managers | 55
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

should provide that the Anti-Money Laundering Compliance Officer 

determine whether to delegate the performance of Investor identification procedures to a third party (see Recommendation 1.4).

 E. Investor Identification Policies and Procedures

 This section should state that the Hedge Fund Manager should 

establish written policies and procedures regarding Investor 

identification, which is addressed in Part II below. In addition, 

the Hedge Fund Manager should periodically review and update 

their AML policies and procedures (see Recommendation 1.5). 

 F. Responsibilities of the Anti-Laundering Compliance Officer

 This section should clearly identify the responsibilities of the 

Anti-Money Laundering Compliance Officer. See Recommendation 

1.6 for a discussion of the role and possible responsibilities of the 

Anti-Money Laundering Compliance Officer. This section might 

also include a statement that: (1) encourages the employees of the 

Hedge Fund Manager to seek the assistance of the Anti-Money 

Laundering Compliance Officer in addressing any money laundering-related concerns that they may have; and (2) directs the employees of the Hedge Fund Manager to immediately report suspicious 

activity to the Anti-Money Laundering Compliance Officer. 

 G. Employee Training Program

 This section should describe the Hedge Fund Manager’s employee 

training program (see Recommendation 1.7) and in particular a 

training program might set forth:

 (1) The general content of the Hedge Fund Manager’s AML training 

program(s);

 (2) Regularity with which the training program will be conducted;

56 | Appendix IV
 (3) Person(s) responsible for conducting the program (e.g., the 

Anti-Money Laundering Compliance Officer); 

 (4) The requirement that each employee comply with the Hedge 

Fund Manager’s policies and procedures;

 (5) Depending on their function, the group of employees that will 

be required to attend the AML training program(s) and procedures to ensure attendance; and

 (6) The procedures for creating and maintaining records of all AML 

training sessions conducted, including the dates and locations of 

the training sessions and the names and departments of attendees, and maintenance of these records for a minimum specified 

period (e.g., five years).

 H. Independent Audit Function

 This section should provide for an independent audit function to 

assess the Hedge Fund Manager’s compliance with, and the effectiveness of, its AML program (see Recommendation 1.8). In particular 

the independent audit function might set forth:

 (1) Regularity with which the independent audit will be performed 

(e.g., annually at a specified time);

 (2) Person(s) responsible for performing the audit (e.g., appropriate 

member of Senior Management or external professionals);

 (3) Procedures applicable to auditing performance of third 

parties upon whom the Hedge Fund Manager relies for the 

performance of Investor identification procedures and other 

AML responsibilities; 

 (4) Evaluation of the Hedge Fund Manager’s compliance with applicable AML laws and regulations and the Hedge Fund Manager’s 

own AML program;

 (5) Reporting of the results of such evaluation to the audit committee of the board of directors or similar oversight body of the 

Hedge Fund or Hedge Fund Manager; and

Sound Practices for Hedge Fund Managers | 57
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

 (6) Appropriate follow-up to ensure that any deficiencies detected 

in the course of the audit of its AML program are addressed 

and rectified.

I. Representations to Counterparties on Policies and Procedures

 This section sets forth the understanding that the Hedge Fund 

Manager may be required to make AML attestations to financial 

institutions, and provides Model Anti-Money Laundering Attestation

attached as Annex B (see Recommendation 1.9).

II. INVESTOR IDENTIFICATION POLICIES AND PROCEDURES

 A. Objectives

 This section should provide that the Hedge Fund Manager should 

establish and maintain reasonable procedures that are designed to 

identify Investors (see Recommendation 2.1).

 B. Consider Characteristics of Investor Base

 This section should provide that the Hedge Fund Manager’s Investor 

identification procedures should take into account the risks of the 

Investor base of the Hedge Fund it manages.

 C. General Premise

 This section should state that the Hedge Fund Manager’s Investor 

identification procedures are based on the general premise that the 

Hedge Fund Manager should only accept an investment from a new 

Investor after its performance of one of the following due diligence 

steps: (1) undertaking reasonable due diligence efforts with respect to 

the Direct Investor; (2) undertaking reasonable due diligence efforts 

with respect to the identity of an Investor, who is investing on behalf 

of other underlying Investors, and the underlying Investors themselves; or (3) determining whether it is acceptable to rely on Investor 

due diligence performed by a third party.

58 | Appendix IV
 D. Investor Identification Procedures

 This section should describe in detail the procedures undertaken by 

the Hedge Fund Manager to conduct reasonable due diligence efforts 

with respect to the identities of Investors to the extent reasonable and 

practical and to ensure that Prohibited Investors are not permitted 

to invest in the Hedge Fund it manages (see Recommendations in 

Part II). To the extent that the Hedge Fund Manager relies on third 

parties to perform certain Investor identification procedures (as 

discussed in Part V of the 2007 AML Guidance and as addressed in 

Part V of this template), this section should take into account those 

arrangements as applicable.

 Investor identification procedures should be based upon the specific 

characteristics presented by the following types of Investors:

 (1) Natural persons

 See Recommendation 2.2.1 for examples of the types of procedures 

that might be included here.

 (2) Corporations, partnerships and comparable legal entities

 See Recommendation 2.2.2 for examples of types of procedures that 

might be included here.

 (3) Prohibited Investors

 This section should clearly identify those types of Investors that are 

prohibited from investing in the Hedge Fund managed by the Hedge 

Fund Manager. See Recommendation 2.3 for examples of the types 

of Investors that should be prohibited from investing; a Hedge Fund 

Manager or Hedge Fund may wish to identify other types of Investors that are prohibited. This section should also include procedures 

that provide for screening for Prohibited Investors, including:

 a. Investors whose names appear on any lists of prohibited 

persons and entities as may be mandated by applicable law or 

regulation, including the List of Specially Designated Nationals 

Sound Practices for Hedge Fund Managers | 59
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

and Blocked Persons administered by the U.S. Department 

of Treasury’s OFAC1, as such lists may be amended from 

time to time;

 b. Investors who are from a country or territory prohibited by 

the OFAC sanctions programs;

 c. Investors who are resident in, or organized or chartered under 

the laws of, a jurisdiction that has been designated by the 

Secretary of the U.S. Department of Treasury under Section 

311 of the PATRIOT Act as warranting special measures due 

to money laundering concerns; or

 d. Prohibited Foreign Shell Bank.

 (4) High Risk Investors

 This section should identify the types of Investors that the Hedge 

Fund Manager considers to be “high risk” and requiring enhanced 

Investor identification procedures. Examples of High Risk Investors 

are discussed in Recommendation 2.4 and include:

 a. Investors not located in a FATF jurisdiction;

 b. Non-U.S. PICs2

;

 c. A SFPF/PEP, an immediate family member, or close associate 

of a SFPF/PEP3;

1

 OFAC’s List of Specially Designated Nationals and Blocked Persons may be accessed 

at (www.treas.gov/ofac). 

2

 See definition of “Private Investment Companies” in Appendix A and the BSA AntiMoney Laundering Examination Manual, Federal Financial Institutions Examination Council, at pg. 292 (2007) (www.ffiec.gov/pdf/bsa_aml_examination_

manual2007.pdf).

3

 See definition of SFPF in Appendix A and the final rule implementing Section 312 of 

the PATRIOT Act, 31 C.F.R. § 103.175(r); see also definition of a PEP in Appendix 

A and the FATF 40 Recommendations Glossary at (www.fatf-gafi.org/glossary/

0,3414,en_32250379_32236889_35433764_1_1_1_1,00.html#34285860).

60 | Appendix IV
 d. Any Investor resident in, or organized or chartered under the 

laws of, a Non-Cooperative Jurisdiction4;

 e. Any Investor whose subscription funds originate from, or 

are routed through, an account maintained at a Prohibited 

Foreign Shell Bank, an offshore bank, a bank organized 

or chartered under the laws of a Non-Cooperative Jurisdiction, or a bank or financial institution subject to special 

measure under Section 311 of the PATRIOT Act;

 f. Any Investor that is a Foreign Bank subject to enhanced due 

diligence under Section 312 of the PATRIOT Act; or 

 g. Any Investor who gives the Hedge Fund Manager reason to 

believe that the source of its subscription funds may not be 

legitimate.

 This section should then address the enhanced Investor identification 

procedures that should be applied to High Risk Investors. 

The procedures should distinguish between:

 a. Natural persons

 See Recommendation 2.4.1 for examples of the types of procedures 

that might be included here.

 b. Legal entities

 See Recommendation 2.4.2 for examples of the types of procedures 

that might be included here.

4

 There are presently no countries or territories that have been designated by FATF 

as non-cooperative with international AML efforts.

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Guidance for Hedge Funds and Hedge Fund Managers 

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 E. Inadequate Information

 This section should specify the Hedge Fund Manager’s procedures 

for handling situations when there is inadequate information obtained with respect to Investors, or Investor identification procedures 

cannot be performed. When Investor subscriptions are approved, 

this section should specify the Hedge Fund Manager’s procedures 

for monitoring such Investors (see Recommendation 2.5).

 F. Investor Record Retention

 This section should describe the Hedge Fund Manager’s procedures 

regarding retention of documents reviewed as part of its performance 

of Investor identification procedures (see Recommendation 2.6).

 G. Risk Focused Reveiw of Existing Investors

 This section should address the Hedge Fund Manager’s procedures 

for the periodic review of the adequacy of its due diligence performed on existing Investors (see Recommendation 2.7).

 H. Anti-Money Laundering Risks Associated with

Receipt/Transfer and Redemption of Funds

 This section should describe the Hedge Fund Manager’s procedures 

for receipt, transfer, and redemption of funds with respect to Investors. Specifically, this section should provide that the Hedge Fund 

Manager should only accept wire transfers from financial institutions 

in FATF jurisdictions and that such funds should only be credited 

upon redemption to that same Investor’s bank or brokerage account, 

unless otherwise approved by the Anti-Money Laundering Compliance Officer and/or Senior Management. Also, this section should 

state that any requests for early redemption should be evaluated 

by the Anti-Money Laundering Compliance Officer and/or Senior 

Management. Decisions regarding these instances should be documented (see Recommendation 2.8).

62 | Appendix IV
III. SUSPICIOUS AND/OR CRIMINAL ACTIVITY

MONITORING AND REPORTING

 A. Suspicious Activity Monitoring

 This section should address the fact that the U.S. Department of 

Treasury encourages the Hedge Fund and Hedge Fund Manager 

to file a SAR voluntarily. This section should also address offshore 

Hedge Funds and administrators who may be required to file a 

comparable suspicious activity report in accordance with the laws 

of their own jurisdiction. See Recommendation 3.1 for examples of 

“red flags” which may require the filing of SARs.

 B. Suspicious Activity Reporting

 This section should provide a statement directing employees of 

the Hedge Fund Manager to immediately report suspicious activity to their immediate supervisor and the Anti-Money Laundering 

Compliance Officer. This section should also provide a statement 

directing employees of the Hedge Fund Manager to keep any such 

SARs confidential. The statement should warn employees not to 

discuss the suspicious activity or the fact that it has been referred to 

the Anti-Money Laundering Compliance Officer with the Investor 

concerned or any third party, except where requested by FinCEN 

or an appropriate law enforcement or regulatory agency (see 

Recommendation 3.2).

 C. Recordkeeping

 This section should address the recordkeeping procedures for 

SARs and supporting documentation related to such SARs, as such 

documentation should be retained for a period of at least five years 

(see Recommendation 3.3).

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IV. OFAC POLICIES AND PROCEDURES

 This section should set forth the Hedge Fund Manager’s policies and 

procedures for screening Investors against the list of countries, territories, individuals, and/or entities prohibited pursuant to the laws, 

regulations, and executive orders administered by OFAC, including the 

List of Specially Designated Nationals and Blocked Persons administered 

by OFAC, as such list may be amended from time to time. This section 

should provide that these procedures may be contracted out to a thirdparty service provider. This section should also set forth the Hedge Fund 

Manager’s policies and procedures for dealing with Investors prohibited 

by OFAC, including the reporting of such Investors to OFAC. 

V. PERFORMANCE OF INVESTOR IDENTIFICATION AND

OTHER AML PROCEDURES BY THIRD PARTIES

 A. Relationships between the Hedge Fund Manager and Third Parties

 This section should address the fact that the U.S. Department of 

Treasury has recognized the ability of a Hedge Fund or Hedge Fund 

Manager to contractually delegate the implementation and operation of certain aspects of its AML compliance program to third 

parties (e.g., fund administrators, IAs, CPOs, CTAs, broker-dealers, 

and futures commission merchants), although the Hedge Fund and 

Hedge Fund Manager remain fully responsible for the program. In 

addition, this section should provide that the Hedge Fund Manager 

may rely upon Investor identification procedures being performed 

by third parties, such as placement agents of Investor intermediaries 

(e.g., fund of funds and nominees who invest in a Hedge Fund 

on their client’s behalf (see Recommendation 5.1)).

64 | Appendix IV
B. Delegation of Elements of Hedge Fund Manager’s Anti-Money

Laundering Program to Third Parties – Fund Administrators,

IAs, and CTAs

 This section should provide that the Anti-Money Laundering 

Compliance Officer should be involved in the decision to delegate 

to, and select, a third party, who should perform certain elements 

of the Hedge Fund Manager’s AML program, and determine 

whether such delegation is reasonable and appropriate (see 

Recommendation 5.2).

C. Reliance on Third Parties – Placement Agents/

Financial Institutions

 This section should provide that the Anti-Money Laundering 

Compliance Officer should also determine whether it is generally 

appropriate to rely on the Investor identification procedures being 

performed by a third party that introduced the Investor to the Hedge 

Fund. See Recommendation 5.3 for examples of such third parties 

which may include placement agents, asset aggregators, or other 

financial institutions (e.g., certain Investor intermediaries, nominees, 

or fund of funds).

 This section should also provide that, to the extent that the third 

party does not perform certain procedures that are included in the 

Hedge Fund Manager’s AML procedures, the Hedge Fund Manager 

should expressly request that the third party perform such procedures 

prior to accepting a new Investor. 

 D. Allocation of Responsibilities between the Parties

 This section should provide that, regardless of whether a Hedge 

Fund delegates its Investor identification procedures to a third party 

or relies on another financial institution, there should be an agreement with such third party clearly allocating AML responsibilities 

between the third party and the Hedge Fund and its Hedge Fund 

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Guidance for Hedge Funds and Hedge Fund Managers 

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Manager (see agreements with fund administrators and Investor 

intermediaries attached hereto as Annexes D-1 and D-2, respectively). This section should also contemplate the way in which a 

Hedge Fund or its Hedge Fund Manager may periodically assess 

the third party’s compliance with its AML policies, procedures, 

and controls. This section should also specify how the Hedge Fund 

Manager will conduct due diligence on the third party’s AML 

policies (see Recommendation 5.4).

 E. Risk-Based Assessment of Third Parties’ Anti-Money

Laundering Procedures

 The section should address a Hedge Fund Manager’s risk-based 

assessment of a third parties’ AML procedures before determining 

whether it should delegate to or rely on a third party in performing 

AML functions (see Recommendation 5.5).

 F. Further Assurances

 This section should set forth further assurances from third parties that a Hedge Fund Manager may consider before determining 

whether it should delegate to, or rely on, a third party for purposes 

of performing certain AML functions. See Recommendation 5.6 

for examples of the types of further assurances that a Hedge Fund 

Manager may wish to consider from a third party.

VI. ADDITIONAL BSA REQUIREMENTS

 A. Policy Relating to Cash and Cash Equivalents

 This section should require the Hedge Fund Manager to implement 

policies, procedures, and controls that limit the acceptance of cash 

or cash equivalents such as money orders and traveler’s checks. In 

addition, this section should address the reporting responsibilities of 

a Hedge Fund and Hedge Fund Managers with respect to the receipt 

of one or more related cash or cash equivalent transactions that ex66 | Appendix IV
ceed $10,000 on the IRS/FinCEN Form 8300. This section should 

also address the legal prohibition against “structuring” in order to 

evade this reporting requirement (see Recommendations 6.1). 

 B. Foreign Bank and Financial Accounts Report

 This section should set forth the responsibilities of a U.S.-based 

Hedge Fund and a U.S.-based Hedge Fund Manager to report any 

financial interest in, or signature or other authority over, any nonU.S. financial accounts, including bank securities or other types of 

financial accounts in a foreign country, if the aggregate value of those 

financial accounts exceeds $10,000 at any time during the calendar 

year (see Recommendations 6.2).

 C. Reports of Transportation of Monetary Instrument

 This section should address the reporting responsibilities of a Hedge 

Fund and a Hedge Fund Manager with respect to the physical transportation of cash or cash-like monetary instruments of more than 

$10,000 into or outside of the United States to the U.S. Customs 

Service on a FinCEN Form 105. This section should also address the 

legal prohibition against “structuring” in order to evade this reporting requirement (see Recommendation 6.3).

VII. GENERAL RECORDKEEPING REQUIREMENTS

 This section should set forth the general recordkeeping requirements 

for a Hedge Fund Manager to retain documents for a period of at least 

five years.

VIII. CONCLUSION

 Any questions, comments or concerns regarding the Hedge Fund 

Manager’s AML policies, procedures, and controls should be directed 

to the Anti-Money Laundering Compliance Officer.

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68 | Appendix IV

ANNEX D: Sample Provisions for Fund Administrators, Investor 

Intermediaries, and Subscription Documents

1. Sample Provisions for Fund Administrators – Annex D-1

2. Sample Provisions for Investor Intermediaries – Annex D-2

3. Sample Provisions for Subscription Documents – Annex D-3
ANNEX D-1: Sample Provisions for Fund Administrators*

Below are examples of representations and covenants that a Hedge Fund 

Manager might seek from a fund administrator. These examples are provided for illustrative purposes only and should not be viewed as prescriptive 

requirements, or as addressing the only issues to consider when seeking representations and covenants from a fund administrator. The appropriateness 

of representations and covenants will depend on a number of factors, including, but not limited to: (1) the AML policies, procedures, and controls 

established by the Administrator; (2) the Hedge Fund Manager’s AML program; (3) the risks presented by a Hedge Fund’s Investor base; and (4) the 

jurisdiction in which the laws of the Administrator is located. Consequently, 

such provisions need to be tailored to the specific circumstances presented 

and should only be adopted on the advice of qualified legal counsel. 

(1) Provisions Related to the Fund Administrator’s Anti-Money

Laundering Program

• The fund administrator has adopted and implemented AML 

policies, procedures, and controls that comply and will continue 

to comply in all respects with the requirements of applicable AML 

laws and regulations in its home country jurisdiction.

• The fund administrator has provided the Hedge Fund Manager with 

a copy or a summary of its AML policies, procedures, and controls, 

and will promptly provide the Hedge Fund Manager with any 

[material/substantive] amendment thereto. [Alternatively, the Hedge 

Fund Manager may wish to incorporate the fund administrator’s 

AML policies, procedures, and controls into its agreement with the 

fund administrator so that the fund administrator’s AML policies, 

procedures, and controls could only be amended with the consent 

of the Hedge Fund Manager.]

• The fund administrator strictly adheres to, and will at all times 

during its relationship with the Hedge Fund Manager strictly adhere 

to its AML policies, procedures, and controls.

• The fund administrator agrees to [annually] submit, at its own 

expense, to an independent audit by [the Hedge Fund Manager] 

Sound Practices for Hedge Fund Managers | 69

* Unless otherwise defined, capitalized terms shall have the meanings ascribed to them 

in the 2007 AML Guidance.
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

[external auditors or other experts agreed by the Hedge Fund 

Manager] to assess its compliance with and the effectiveness of its 

AML policies, procedures, and controls.

(2) Provisions Related to Prospective Investors

• The fund administrator will verify the identities of, and conduct due 

diligence (and, where appropriate, enhanced due diligence) with regard to, all prospective Investors and, where applicable, the principal 

beneficial owners on whose behalf an Investor makes an investment 

in accordance with its AML policies, procedures, and controls and 

[this Agreement/Amendment].

• The fund administrator will hold evidence of the identities of each 

Investor and, where applicable, the beneficial owners on whose 

behalf an Investor makes an investment in accordance with its AML 

policies, procedures, and controls and [this Agreement/Amendment], 

maintain such evidence for at least five years following an Investor’s 

final redemption from [applicable fund(s)], [and make such information available to the Hedge Fund Manager promptly [upon request]].

• The fund administrator will [take all reasonable and practical steps 

to] ensure that it does not accept or maintain subscription funds, 

directly or indirectly, from:

 (a) An individual or entity whose name appears on:

 (i) Any lists of prohibited persons and entities as may be 

mandated by applicable law or regulation, including the 

List of Specially Designated Nationals and Blocked Persons

administered by the U.S. Department of Treasury’s OFAC;1

 (ii) [Such other lists of prohibited persons and entities as may be 

mandated by [applicable][U.S.] law or regulation] [consider 

specifying other lists to be verified]; or

70 | Appendix IV

1

 OFAC’s list may be accessed at (www.treas.gov/ofac).
 (iii) Such other lists of prohibited persons and entities as may 

be provided to the fund administrator by the Hedge Fund 

Manager;

 (b) An individual or entity who is from a country or territory 

prohibited by the OFAC sanctions programs;

 (c) An individual or entity who is a resident in, or organized or 

chartered under the laws of, a jurisdiction that has been designated by the Secretary of the U.S. Department of Treasury under 

Section 311 of the PATRIOT Act as warranting special measures 

due to money laundering concerns; or

 (d) A Prohibited Foreign Shell Bank.

• Prior to accepting an investment from a High Risk Investor, the 

fund administrator will conduct enhanced due diligence with regard 

to such High Risk Investor, [as provided by the fund administrator’s 

AML policies, procedures, and controls] [as agreed upon between 

the Hedge Fund Manager and the fund administrator], in addition 

to routine Investor identification procedures. High Risk Investors 

include:

 (a) An individual or entity not located in a FATF jurisdiction;

 (b) A non-U.S. PIC;

 (c) SFPF/PEP, any member of a SFPF/PEP’s Immediate Family, or 

any Close Associate of a SFPF/PEP;

 (d) An individual or entity resident in, or organized or chartered 

under the laws of, a Non-Cooperative Jurisdiction;

 (e) An individual or entity whose subscription funds originate from, 

or are routed through, an account maintained at a Prohibited 

Foreign Shell Bank, or an offshore bank, or a bank organized or 

chartered under the laws of a Non-Cooperative Jurisdiction, or 

a bank or financial institution subject to special measures under 

Section 311 of the PATRIOT Act;

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 (f) An entity that is a Foreign Bank subject to enhanced due 

diligence under Section 312 of the PATRIOT Act; or

 (g) An individual or entity who gives the fund administrator reason 

to believe that the source of its subscription funds may not be 

legitimate.

• The fund administrator and the Hedge Fund Manager agree that, 

absent any suspicious circumstances, the fund administrator may 

rely upon the due diligence procedures performed with respect to 

Investors whose investment funds are transmitted by the following 

sources: [Identify institutions/entities that the Hedge Fund Manager 

has determined to be worthy of reliance.] For example, a Hedge 

Fund Manager may determine that certain of the following may be 

relied upon:

• A U.S.-regulated financial institution where the Investor is a customer of the U.S.-regulated financial institution and the customer’s 

investment funds are wired from its account at the U.S.-regulated 

financial institution;

• A regulated foreign financial institution organized [in a FATF jurisdiction] [in a jurisdiction determined by the Hedge Fund Manager 

to have an acceptable AML regime] where the Investor is a customer 

of the regulated foreign financial institution and the customer’s 

investment funds are wired from its account at the foreign financial 

institution;

• An Investor intermediary that [has been approved by the Hedge 

Fund Manager] [is itself a U.S.-regulated financial institution or a 

regulated foreign financial institution organized [in a FATF jurisdiction] [in a jurisdiction determined by the Hedge Fund Manager to 

have an acceptable AML structure]].

72 | Appendix IV
(3) Provisions Related to Suspicious Activity

• The fund administrator will immediately notify the Anti-Money 

Laundering Compliance Officer of the Hedge Fund Manager if it 

knows, or has reason to suspect, that a prospective or existing Investor, or the principal beneficial owners on whose behalf a prospective 

or existing Investor has made or is attempting to make, an investment, is among other things, any individual or entity who gives the 

fund administrator reason to believe that the source of its subscription funds may not be legitimate.

• The fund administrator will immediately notify the Anti-Money 

Laundering Compliance Officer of the Hedge Fund Manager if it 

becomes aware of any suspicious activity or pattern of activity or 

any activity that may require further review to determine whether 

it is suspicious.

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Guidance for Hedge Funds and Hedge Fund Managers 

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ANNEX D-2: Sample Provisions for Investor Intermediaries*

Below are sample representations and covenants that a Hedge Fund 

Manager might seek from an Investor intermediary, which, for purposes of 

this annex, may include, without limitation, an introducing firm, an asset 

aggregator, a nominee, or a fund of funds (each, an “Intermediary”). These 

examples should not be viewed as prescriptive requirements, or as addressing 

the only issues to consider in obtaining representations and covenants from 

an Intermediary. The appropriateness of representations and covenants will 

depend on a number of factors, including, but not limited to: (1) the AML 

policies, procedures, and controls established by the Intermediary; (2) the 

Hedge Fund Manager’s own AML program; and (3) the risks presented by a 

Hedge Fund’s Investor base; and (4) the jurisdiction in which the laws of the 

Intermediary is located. Consequently, such provisions need to be tailored 

to the specific circumstances presented and should only be adopted on the 

advice of qualified legal counsel. 

(1) Provisions Relating to Status of Intermediary

• The Intermediary is (select one as applicable):

 (a) A U.S.-regulated financial institution or intermediary based 

in a FATF jurisdiction; or

 (b) An unregulated entity based in a FATF jurisdiction.

• [Where Intermediary invests in its own name:] The Intermediary 

is subscribing/will subscribe for shares in the [applicable fund(s)] 

as a record owner in its capacity as [agent/representative/nominee] 

on behalf of one or more underlying Investors, and agrees that 

the representations, warranties and covenants made in the subscription agreement are made by it on behalf of itself and the underlying Investors.

74 | Appendix IV

* Unless otherwise defined, capitalized terms shall have the meanings ascribed to them

 in the 2007 AML Guidance.
• [Where Intermediary is a banking entity:] The Intermediary has 

(select one as applicable):

 (a) A Physical Presence; or

 (b) It does not have a Physical Presence, but is a regulated affiliate.

• [Where Intermediary invests on behalf of other Investors:] The Intermediary: (1) has all requisite power and authority from the underlying 

Investors to execute and perform the obligations under the subscription agreement; (2) has carried out Investor identification procedures 

with regard to all underlying Investors; and (3) has established the 

identity of all underlying Investors, holds evidence of such identities [and will make such information available to the Hedge Fund 

Manager upon request].

2) Provisions Relating to Intermediary’s Anti-Money

Laundering Program

• The Intermediary has adopted and implemented AML policies, 

procedures, and controls that comply and will continue to comply 

in all respects with the requirements of applicable AML laws and 

regulations in its home country jurisdiction.

• The Intermediary has provided the Hedge Fund Manager with a 

copy or summary of its AML policies, procedures, and controls, 

and will immediately provide the Hedge Fund Manager with any 

[material/substantive] amendment thereto.

• The Intermediary strictly adheres to, and will at all times during its 

relationship with the Hedge Fund Manager strictly adhere to, its 

AML policies, procedures, and controls.

 • The Intermediary agrees to [annually] submit to an independent 

audit at the direction of the Hedge Fund Manager to assess its 

compliance with and effectiveness of its AML policies, procedures, 

and controls.

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(3) Provisions Relating to Prospective Investors

• The Intermediary will verify the identities of, and conduct due diligence (and, where appropriate, enhanced due diligence) with regard 

to, all prospective Investors and, where applicable, the principal 

beneficial owners on whose behalf an Investor is seeking to make an 

investment, in accordance with its AML policies, procedures, and 

controls.

• The Intermediary will hold evidence of the identity of each Investor 

and, if applicable, the beneficial owners on whose behalf an Investor is seeking to make an investment, maintain such evidence for at 

least five years from the date of an Investor’s complete redemption 

from the [applicable fund(s)], [and agrees to make such information 

available to the Hedge Fund Manager [and the fund administrator] 

promptly [upon request]].

• The Intermediary will [take all reasonable and practical steps to] 

ensure that [it does not make an investment, directly or indirectly, 

for or on behalf of] [it does not introduce any Investor that is]:

 (a) An individual or entity whose name appears on:

 (1) Any lists of prohibited persons and entities as may be mandated by applicable law or regulation, including the List of 

Specially Designated Nationals and Blocked Persons administered by the U.S. Department of Treasury’s OFAC, as such 

lists may be amended from time to time;

 (2) [Such other lists of prohibited persons and entities as may be 

mandated by applicable U.S. law or regulation] [consider 

specifying other lists to be verified]; or

 (3) Such other lists of prohibited persons and entities as may 

be provided to the fund administrator by the Hedge Fund 

Manager;

76 | Appendix IV
 (b) An individual or entity who is from a country or territory prohibited by the OFAC sanctions programs;

 (c) An individual or entity who is a resident in, or organized or

chartered under the laws of, a jurisdiction that has been designated by the Secretary of the U.S. Department of Treasury under 

Section 311 of the PATRIOT Act as warranting special measures 

due to money laundering concerns; or

 (d) A Prohibited Foreign Shell Bank.

(4) Provisions Related to High Risk Investors

• Prior to making an investment for or on behalf of a High Risk 

Investor, the Intermediary will conduct enhanced due diligence with 

regard to such High Risk Investor, [as provided by the Intermediary’s 

AML policies, procedures, and controls][as agreed upon between the 

Hedge Fund Manager and the Intermediary], in addition to routine 

Investor identification procedures. High Risk Investors include:

• An individual or entity not located in a FATF jurisdiction;

• A non-U.S. PIC;

• A SFPF/PEP, any member of a SFPF/PEP’s Immediate Family, or 

any Close Associate of a SFPF/PEP;

• An individual or entity resident in, or organized or chartered under 

the laws of, a Non-Cooperative Jurisdiction;

• An individual or entity whose subscription funds originate from, or 

are routed through, an account maintained at a Prohibited Foreign 

Shell Bank, or an offshore bank or a bank organized or chartered 

under the laws of a Non-Cooperative Jurisdiction, or a bank or 

financial institution subject to special measures under Section 311 

of the PATRIOT Act;

• An entity that is a Foreign Bank subject to enhanced due diligence 

under Section 312 of the PATRIOT Act; or 

Sound Practices for Hedge Fund Managers | 77
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• An individual or entity who gives the Intermediary reason to believe 

that the source of its subscription funds may not be legitimate.

(5) Provisions Related to Suspicious Activities

• The Intermediary will immediately notify the Anti-Money Laundering Compliance Officer of the Hedge Fund Manager if it knows, or 

has reason to suspect, that a prospective or existing Investor, or the 

principal beneficial owners on whose behalf a prospective or existing Investor has made or is attempting to make, an investment, is, 

among other things, any individual or entity who gives the Intermediary reason to believe that the source of its subscription funds may 

not be legitimate.

• The Intermediary agrees to immediately notify the Anti-Money 

Laundering Compliance Officer of the Hedge Fund Manager if it 

becomes aware of any suspicious activity or pattern of activity or any 

activity that may require further review to determine whether the 

activity or pattern of activity is suspicious.

78 | Appendix IV
ANNEX D-3: Sample Provisions for Subscription Documents*

Below are examples of types of provisions that a Hedge Fund Manager 

might include in subscription documentation in connection with its Investor identification procedures. These examples should neither be viewed as 

prescriptive requirements, nor as exhaustive or addressing the only issues to 

consider in developing provisions related to Investor identification in subscription documentation. Consequently, such provisions need to be tailored 

to the specific circumstances presented and should only be adopted on the 

advice of qualified legal counsel. 

(1) Provisions Relating to Identity of Investor

• Investor represents that all evidence of identity provided is genuine 

and all related information furnished is accurate.

• Investor agrees to provide any information deemed necessary by 

the Hedge Fund Manager in its sole discretion to comply with its 

AML program and related responsibilities from time to time.

(2) Provisions Relating to Purpose of Investment

For an Investor investing for its own account:

• Investor is subscribing for shares in the [applicable fund(s)] for its 

own account, risk and beneficial interest.

• Investor is not acting as agent, representative, intermediary/nominee, 

or in any similar capacity for any other person.1

• No other person will have a beneficial or economic interest in the 

shares being purchased by the Investor.

• Investor does not have any intention or obligation to sell, distribute, 

assign or transfer all or a portion of the shares to any other person.

Sound Practices for Hedge Fund Managers | 79

* Unless otherwise defined, capitalized terms shall have the meanings ascribed to them

 in the 2007 AML Guidance. 

1

 The term “person” means any nominee account, beneficial owner, individual, bank, 

corporation, partnership, limited liability company, or any other legal entity.
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

 For an Investor Intermediary investing in its own name on behalf of 

other Investors, which, for these purposes, may include, without limitation, an introducing firm, an asset aggregator, a nominee or a fund of 

funds:

• The Intermediary is subscribing for shares in the [applicable fund(s)] 

as a record owner in its capacity as [agent/representative/nominee] 

on behalf of one or more underlying Investors, and agrees that the 

representations, warranties, and covenants made in the subscription agreement are made by it on behalf of itself and the underlying 

Investors.

• The Intermediary: (1) has all requisite power and authority from the 

underlying Investors to execute and perform the obligations under 

the subscription agreement; (2) has carried out agreed Investor identification procedures with regard to all underlying Investors; and (3) 

has established the identity of all underlying Investors [, and] holds 

evidence of such identities [, and will make such information available to the Hedge Fund Manager upon request].

(3) Provisions Relating to Prohibited Investors

• Investor acknowledges that the Hedge Fund Manager prohibits 

any investment in the Hedge Fund by or on behalf of Prohibited 

Investors:

 (a) An individual or entity whose name appears on:

 (1) Any lists of prohibited persons and entities as may be mandated by applicable law or regulation, including the List of 

Specially Designated Nationals and Blocked Persons administered by the U.S. Department of Treasury’s OFAC2 as such 

lists may be amended from time to time;

 (2) [Such other lists of prohibited persons and entities as may 

be mandated by applicable U.S. law or regulation consider 

specifying other lists to be verified]; or

80 | Appendix IV

2

 OFAC’s list may be accessed at (www.treas.gov/ofac).
 (3) Such other lists of prohibited persons and entities as may 

be provided to the fund administrator by the Hedge Fund 

Manager;

 (b) An individual or entity who is from a country or territory prohibited by the OFAC sanctions programs;

 (c) An individual or entity who is a resident in, or organized or chartered under the laws of, a jurisdiction that has been designated by 

the Secretary of the U.S. Department of Treasury under Section 

311 of the PATRIOT Act as warranting special measures due to 

money laundering concerns; or

 (d) A Prohibited Foreign Shell Bank.

• Investor represents and covenants that neither it, nor any person controlling, controlled by, or under common control with, it, nor any 

person having a beneficial interest in it, is a Prohibited Investor, and 

that it is not investing and will not invest in [the applicable fund(s)] 

on behalf of or for the benefit of any Prohibited Investor. Investor 

agrees to promptly notify the [Investor relations representative/fund 

administrator/Anti-Money Laundering Compliance Officer of the 

Hedge Fund Manager] of any change in information affecting this 

representation and covenant.

• Investor acknowledges that, if, following its investment in [the applicable fund(s)], the Hedge Fund Manager, the fund administrator or 

[the applicable fund(s)] reasonably believes that Investor is a Prohibited Investor [or has otherwise breached its representations and covenants [hereunder/as to its identity]], the Hedge Fund Manager may 

be obligated to freeze its investment, either by prohibiting additional 

investments, declining any redemption requests and/or segregating 

the assets constituting the investment in accordance with applicable 

regulations, or its investment may immediately be redeemed by [the 

applicable fund(s)], and it shall have no claim against the Hedge 

Fund Manager, the fund administrator or [the applicable fund(s)] for 

any form of damages as a result of any of the aforementioned actions.

Sound Practices for Hedge Fund Managers | 81
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

• Investor acknowledges that additional investments by Investor 

may be refused and/or a request for redemption may be delayed or 

declined if the Hedge Fund Manager, the fund administrator, or [the 

applicable fund(s)] reasonably believes it does not have satisfactory 

evidence of the Investor’s identity.

(4) Other Possible Disclosures and Acknowledgements

• Investor represents that [except as otherwise disclosed to the Hedge 

Fund Manager in writing,]:

 (a) It is located in a FATF jurisdiction;

 (b) It is not a non-U.S. PIC;

 (c) It is not a SFPF/PEP, any member of a SFPF/PEP’s Immediate 

Family, or any Close Associate of a SFPF/PEP;

 (d) It is not a resident in, or organized or chartered under the laws 

of, a Non-Cooperative Jurisdiction;

 (e) It is not resident in, or organized or chartered under the laws 

of, a jurisdiction that has been designated by the Secretary of 

the U.S. Department of Treasury under Sections 311 of the 

PATRIOT Act as warranting special measures due to money 

laundering concerns;

 (f) It is not a Foreign Bank subject to enhanced due diligence under 

Section 312 of the PATRIOT Act;

 (g) Its subscription funds do not originate from, or will they be 

routed through, an account maintained at a Prohibited Foreign 

Shell Bank, an offshore bank, or a bank organized or chartered 

under the laws of a Non-Cooperative Jurisdiction, or a bank or 

financial institution subject to special measures under Section 

311; or

 (h) It has not given the Hedge Fund Manager any reason to believe 

that the source of its subscription funds is not legitimate.

82 | Appendix IV
• Investor acknowledges and agrees that any redemption proceeds 

paid to it will be paid to the same account from which its investment 

in [the applicable fund(s)] was originally remitted, unless [AntiMoney Laundering Compliance Officer, in its sole discretion], 

agrees otherwise.

• Investor acknowledges and agrees that the Hedge Fund Manager 

may release confidential information about it and, if applicable, 

any underlying Investor or beneficial owner, to regulatory or law 

enforcement authorities, if [Senior Management], in its sole discretion, determines that it is in the best interests of [the applicable 

fund(s)] to do so.

Sound Practices for Hedge Fund Managers | 83
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

ANNEX E: Sample Board Resolutions

1. Adopting Anti-Money Laudering Program and Policy Statement Against

Money Laundering and Terrorist Financing – Annex E-1

2. Appointing Anti-Money Laundering Compliance Officer – Annex E-2

84 | Appendix IV
ANNEX E-1: Sample Board Resolution Adopting Anti-Money 

Laundering Program and Policy Statement Against Money 

Laundering and Terrorist Financing

[Name of Hedge Fund Manager]

WHEREAS, a proposed draft of the anti-money laundering program (the 

“Program”) developed by [Name of Hedge Fund Manager] (the “Company”) and attached hereto as Exhibit A has been distributed to each member 

of the Board of Directors of the Company.

WHEREAS, a proposed draft of the Company’s policy statement against 

money laundering and terrorist financing (the “Policy Statement”), 

attached hereto as Exhibit B, has been distributed to each member of 

the Board of Directors.

NOW, THEREFORE, BE IT RESOLVED, that the Program, in the form 

submitted to the Board of Directors and attached hereto as Exhibit A, be, 

and the same hereby is, approved and adopted, to be effective as of the date 

of adoption of this resolution.

RESOLVED FURTHER, that the Policy Statement, in the form submitted 

to the Board of Directors and attached hereto as Exhibit B, be, and the same 

hereby is, approved and adopted, to be effective as of the date of adoption 

of this resolution.

RESOLVED FURTHER, that the officers of the Company be, and each 

acting alone is, hereby authorized, empowered and directed, for and on 

behalf of the Company, to take or cause to be taken any and all actions as 

such officers may deem necessary or advisable to carry out and perform the 

responsibilities and obligations of the Company under the Program and the 

Policy Statement.

RESOLVED FURTHER, that the officers of the Company are, and each 

acting alone is, hereby authorized to do and perform any and all such acts 

as such officers shall deem necessary or advisable, to carry out the purposes 

and intent of the foregoing resolutions.

Sound Practices for Hedge Fund Managers | 85
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

ANNEX E-2: Sample Board Resolution Appointing 

Anti-Money Laundering Compliance Officer

[Name of Hedge Fund Manager]

WHEREAS, [Name of the Hedge Fund Manager]’s anti-money laundering program (the “Program”) requires the appointment of an Anti-Money 

Laundering Compliance Officer who will be responsible for the day-to-day 

administration of the Program in accordance with the provisions thereof.

RESOLVED, that ______________ is hereby appointed as the Anti-Money 

Laundering Compliance Officer of [Name of Hedge Fund Manager] to 

serve until [his][her] successor shall be duly appointed or, if earlier, until 

[he][she] resigns, is removed from office or is otherwise disqualified from 

serving as the Anti-Money Laundering Compliance Officer.

RESOLVED FURTHER, that the Anti-Money Laundering Compliance 

Officer is hereby authorized to do and perform any and all such acts and 

functions as [he][she] is charged with under the provisions of the Program.

86 | Appendix IV
ANNEX F: Members of Financial Action Task Force 

on Money Laundering*

1) Argentina

2) Australia

3) Austria

4) Belgium

5) Brazil

6) Canada

7) China

8) Denmark

9) Finland

10) France

11) Germany

12) Greece

13) Hong Kong

14) Iceland

15) Ireland

16) Italy

17) Japan

18) Luxembourg

19) Mexico

20) Kingdom of the Netherlands

21) New Zealand

22) Norway

23) Portugal

24) The Russian Federation

25) Singapore

26) South Africa

27) Spain

28) Sweden

29) Switzerland

30) Turkey

31) United Kingdom

32) United States

Please Note: The list of FATF members is amended periodically. 

FATF members are not per se FATF jurisdictions.

* Unless otherwise defined, capitalized terms shall have the meanings ascribed to them

 in the 2007 AML Guidance.

Sound Practices for Hedge Fund Managers | 87
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

ANNEX G: List of FATF Non-Cooperative Jurisdictions*

Currently, there are no countries and territories designated by FATF as noncooperative in the fight against money laundering. An updated list of FATF 

NCCT jurisdictions is available at (www.oecd.org/fatf).

Please Note: The list of Non-Cooperative Jurisdictions is amended periodically. For a current list of Non-Cooperative Jurisdictions, please refer to 

the FATF Web site at (www.fatf-gafi.org/pages/0,2987,en_32250379_

32235720_1_1_1_1_1,00.html).

88 | Appendix IV

* Unless otherwise defined, capitalized terms shall have the meanings ascribed to them

 in the 2007 AML Guidance.
ANNEX H: Lists Maintained by the Office 

of Foreign Assets Control*

A. Persons and Entities Subject to OFAC Sanctions

 See List of Specially Designated Nationals and Blocked Persons 

at (www.treas.gov/ofac).1

B. Countries Subject to OFAC-Administered Sanctions as of June 20072 

1. Belarus

2. Cote d’Ivoire (Ivory Coast)

3. Cuba

4. Democratic Republic 

of the Congo

5. Iran

6. Iraq

Please Note: These lists are amended periodically. For current OFAC Lists, 

please refer to the OFAC Web site at (www.treas.gov/ofac).

7. Liberia 

8. Myanmar (aka Burma)

9. North Korea

10. Sudan

11. Syria

12. Western Balkans

13. Zimbabwe

* Unless otherwise defined, capitalized terms shall have the meanings ascribed to them

 in the 2007 AML Guidance.

1

 This list includes Specially Designated Global Terrorists, including those persons 

listed in Executive Order 13224 – Blocking Property and Prohibiting Transactions 

With Persons Who Commit, Threaten to Commit or Support Terrorism.

2 The OFAC-administered sanctions targeting specific countries take many different 

forms.The sanctions are generally couched in terms of identifying certain targeted individuals or certain prohibited transactions, which may or may not include transactions 

such as Hedge Fund investments. Compliance with regulations promulgated by OFAC 

are beyond the scope of the 2007 AML Guidance.

Sound Practices for Hedge Fund Managers | 89
Guidance for Hedge Funds and Hedge Fund Managers 

on Developing Anti-Money Laundering Programs

ANNEX I: Money Laundering Advisories Issued by the 

Financial Crimes Enforcement Network of the U.S. Department 

of Treasury*

As of June 2007, FinCEN has issued advisories with regard to deficiencies 

in the AML regimes of the following jurisdictions:

1) Belarus

2) Burma (Myanmar)

3) Nauru

4) North Korea

Please Note: FinCEN advisories with regard to the AML regimes in certain 

jurisdictions are issued and withdrawn by the U.S. Department of Treasury 

periodically. Advisories are also issued by FinCEN that generally describe 

trends and developments related to money laundering and financial crime. 

Please refer to the FinCEN Web site at (www.fincen.gov).

90 | Appendix IV

* Unless otherwise defined, capitalized terms shall have the meanings ascribed to them

 in the 2007 AML Guidance.
ANNEX J: Countries and Financial Institutions That Have Been 

Designated by the U.S. Department of Treasury as Being of 

“Primary Money Laundering Concern”*

The countries and financial institutions listed below have been designated 

by the U.S. Department of Treasury as being of “primary money laundering 

concern” and are currently subject to special AML measures under Section 

311 of the PATRIOT Act. An updated list of such countries and financial 

institutions is available at (www.fincen.gov/reg_bsaregulations.html).

1) Burma (Myanmar)

2) Myanmar Mayflower Bank

3) Asia Wealth Bank

4) Banco Delta Asia

5) Commercial Bank of Syria (includes Syrian Lebanese Commercial Bank)

6) VEF Banka

The U.S. Department of Treasury has proposed to similarly designate the 

countries and financial institutions listed below as being of “primary money 

laundering concern” and to impose special measures against them. Notices 

of final designations and the imposition of special measures will be posted 

at (www.fincen.gov/reg_bsaregulations.html).

1) Nauru

2) Belmetalnergo (includes Infobank)

3) First Merchant Bank OSH Ltd. (of Cyprus), including its subsidiaries, 

FMB Finance Ltd., First Merchant International Inc., First Merchant 

Finance Ltd., and First Merchant Trust Ltd.

4) Infobank (including Belmetalnergo)

Sound Practices for Hedge Fund Managers | 91

* Unless otherwise defined, capitalized terms shall have the meanings ascribed to them

 in the 2007 AML Guidance.
Listed below are regulatory filings organized by regulatory agencies 

(excluding tax-related, broker-dealer, and state “blue sky” filings) that 

a Hedge Fund Manager may be required to file in the United States. The 

regulatory filings made by a Hedge Fund Manager will vary depending 

on the type and volume of trading in which it engages, its business 

model, and the jurisdictions in which it operates. For example, like other 

market participants and institutional investors, a Hedge Fund Manager is 

required to make certain regulatory filings in the United States if the size 

of the positions it holds in certain markets reaches “reportable” levels. 

In addition, some Hedge Fund Managers are regulated entities in the 

United States or are otherwise subject to a regulatory regime, and, like 

other similarly situated entities, are required to make certain filings in that 

capacity. MFA notes that this appendix includes the requirement to file 

Form ADV with the SEC under the Advisers Act, but does not address the 

requirements applicable to registered investment advisers pursuant to 

filing that form. A Hedge Fund Manager may also be subject to regulatory 

reporting and filing requirements in jurisdictions in which it conducts its 

business; however, this document does not address non-U.S. filings.

Sound Practices for Hedge Fund Managers | 01

Federal Reserve Bank

Treasury Securities Position and Foreign Exchange Transaction Reporting

1. Large Position Reporting Report of positions in specific Treasury 

security issues that exceed the large 

position threshold specified by the U.S. 

Department of Treasury (minimum 

$2 billion).

Reports are filed in response to notices 

issued by the U.S. Department of 

Treasury if such threshold is met.

continued

APPENDIX V

U.S. Regulatory Filings by 

Hedge Fund Managers
U.S. Regulatory Filings by Hedge Fund Managers

02 | Appendix V

Federal Reserve Bank 

Reports are filed with the Federal Reserve 

Bank of New York and are not public.

2. Form T FC-1 Report of weekly, consolidated data on 

foreign exchange contracts and positions 

of major market participants.

Reports are filed throughout the calendar 

year by each foreign exchange market 

participant having more than $50 billion 

equivalent in foreign exchange contracts 

on the last business day of any calendar 

quarter during the previous year.

The reports are filed with the appropriate 

Federal Reserve Bank acting as agent for 

the U.S. Department of Treasury and are 

not public.

3. Form FC-2 Report of monthly, consolidated data on 

the foreign exchange contracts and foreign 

currency denominated assets and liabilities 

of major market participants.

Reports are filed throughout the calendar 

year by each foreign exchange market 

participant having more than $50 billion 

equivalent in foreign exchange contracts 

on the last business day of any calendar 

quarter during the previous year.

The reports are filed with the appropriate 

Federal Reserve Bank acting as agent for 

the U.S. Department of Treasury and are 

not public.

4. Form FC-3 Report of quarterly, consolidated data on 

the foreign exchange contracts and foreign 

currency denominated assets and liabilities 

of major market participants. continued
Sound Practices for Hedge Fund Managers | 03

Federal Reserve Bank 

 Reports are filed throughout the calendar 

year by each foreign exchange market 

participant that has more than $5 billion 

equivalent in foreign exchange contracts 

on the last business day of any calendar 

quarter during the previous year and that 

does not file Form FC-2.

 Reports are filed with the appropriate 

Federal Reserve Bank acting as agent for 

the U.S. Department of Treasury and 

are not public.

Treasury Auction Filings

5. Treasury Auction Treasury security reports filed as necessary. Confirmations must be filed by any 

customer who is awarded a par amount 

of $500 million or more in U.S. government securities in a Treasury auction. The 

confirmations must include a customer’s 

reportable net long position, if any.

 Confirmations are filed with the Federal 

Reserve Bank to which the bid was submitted and is not public.

Treasury International Capital Forms

6. Forms CQ-1 and CQ-2 Forms filed by U.S. persons having claims 

on, or financial liabilities to, foreigners having balances on deposit with foreign banks 

(in the United States or abroad) or otherwise engaging in transactions in securities 

or other financial assets with foreigners. 

Forms CQ-1 (Financial Liabilities to, and 

Claims on, Foreigner Residents) and 

continued
U.S. Regulatory Filings by Hedge Fund Managers

CQ-2 (Commercial Liabilities to, and 

Claims on, Foreigner Residents) are quarterly reports, which collect data on financial 

and commercial liabilities to, and claims 

on, unaffiliated foreigners held by nonbanking enterprises in the United States. 

The forms must be filed when the 

consolidated total of such liabilities is 

$50 million or more during that period 

or $25 million or more during that period, 

respectively.

 The forms are filed with the Federal 

Reserve Bank of New York and are not 

public except for aggregate information.

7. Form S Form filed by any U.S. person purchasing 

or selling $2 million or more of long-term 

marketable domestic and foreign securities in a month in direct transactions with 

foreign persons.

 The form is filed with the Federal Reserve 

Bank of New York and is not public 

except as to aggregate information.

Securities and Exchange Commission

Sale of Securities by an Issuer Exempt from Registration under 

Regulation D or Section 4(6) under the Securities Act of 1933, 

As Amended

8. Form D Notice of sale filed after securities, such 

as interests in a private hedge fund, are 

sold in reliance on a Regulation D private 

placement exemption or a Section 4(6) 

exemption from the registration provisions 

of the Securities Act of 1933, as amended. 

The form is filed with the SEC and relevant states and is publicly available.

04 | Appendix V

Federal Reserve Bank
Secondary Sale of Restricted and Control Securities under Rule 144 

of the Securities Act of 1933, As Amended

9. Form 144 Form filed as notice of a proposed sale 

of restricted securities or securities held 

by an affiliate of the issuer in reliance on 

Rule 144 of the Securities Act of 1933, as 

amended, when the amount sold during 

any three-month period exceeds 500 shares 

or units or has an aggregate sales price in 

excess of $10,000. The form is filed with the 

SEC and the principal national securities 

exchange, if any, on which such security is 

traded and is publicly available.

Ownership of Equity Securities Publicly Traded in the United States

10. Schedule 13D Disclosure report filed by an investor, including a Hedge Fund and its Hedge Fund 

Manager, who beneficially owns more than 

5% of a class of equity securities publicly 

traded in the United States. The report 

identifies the source and amount of the 

funds used for the acquisition.

 This reporting requirement is triggered by 

direct or indirect acquisition of more than 

5% of beneficial ownership of a class of 

equity securities publicly traded in the 

United States. Amendments must be filed 

promptly for material ownership changes 

or for changes to the beneficial owner’s 

intentions regarding the issuer of securities. 

Some investors may instead report on shortform Schedule 13G, if they are eligible. 

See Item 11. 

 The report is filed with the SEC and is 

publicly available.

Sound Practices for Hedge Fund Managers | 05

Securities and Exchange Commission

continued
06 | Appendix V

U.S. Regulatory Filings by Hedge Fund Managers

11. Schedule 13G Short-form disclosure report filed by a passive investor, including a Hedge Fund and 

its Hedge Fund Manager, who would otherwise have to file a Schedule 13D but who 

owns less than 20% of the subject securities 

(or is a certain U.S.-regulated investment 

business) and has not purchased the securities for the purpose of influencing control 

of the issuer.

 This reporting requirement is triggered by 

direct or indirect acquisition of beneficial 

ownership of more than 5% of a class of equity securities publicly traded in the United 

States. Amendments must be filed annually, 

as well as monthly (for U.S.-regulated investment businesses) or promptly (for other 

passive investors) if ownership changes by 

more than 5% of a class of securities.

 The report is filed with the SEC and is 

publicly available.

12. Forms 3, 4, and 5 A statement of ownership filed by directors, officers, or owners of more than 10% 

of a class of equity securities of a public 

company. The initial filing is on Form 3 and 

changes are reported on Form 4. The annual 

statement of beneficial ownership of securities is on Form 5. The statements contain 

information on a reporting person’s relationship to the company and on purchases and 

sales of the company’s equity securities.

 Form 3 reporting is triggered by: (1) 

acquisition of more than 10% of the equity 

securities of a public company; (2) the 

reporting person becoming a director or 

officer; or (3) the equity securities becomSecurities and Exchange Commission
Sound Practices for Hedge Fund Managers | 07

ing publicly traded, as the case may be. 

Form 4 reporting is triggered by any open 

market purchase, sale, or an exercise of 

options of those reporting under Form 3. 

Form 5 reporting is required annually for 

those insiders having exempt transactions 

not reported on Form 4.

 The statements are filed with the SEC and 

are publicly available.

Registered and Unregistered Institutional Investment Managers

13. Form 13F Quarterly position report filed by registered 

and unregistered institutional investment 

managers (i.e., any person, other than a 

natural person, investing in or buying and 

selling securities for its own account, and any 

person exercising investment discretion with 

respect to the account of any other person) 

with investment discretion over $100 million or more in equity securities publicly 

traded in the United States. Reports contain 

position information about the equity securities under the discretion of the Hedge Fund 

Manager, and the type of voting authority 

exercised by the Hedge Fund Manager.

The reporting requirement is triggered by 

an institutional investment manager holding 

equity securities having an aggregate fair 

market value of at least $100 million on 

the last trading day of a calendar year and 

requires a report as of the end of that year 

and each of the next three quarters.

The reports are filed with the SEC and are 

publicly available.

Securities and Exchange Commission

continued
Material Associated Persons of Registered Broker-Dealers

14. Form 17-H Material Associated Persons Reports, 

(“MAPRs”) filed by registered broker-dealers. Some Hedge Fund Managers are affiliated with registered broker-dealers. MAPRs 

generally include material affiliates and parents and may therefore include an affiliated 

Hedge Fund Manager or the related Hedge 

Fund. Broker-dealers must report: (1) an 

organizational chart of the broker-dealer; (2) 

risk management policies of the brokerdealer; (3) material pending legal proceedings; and 4) additional financial information 

including aggregate positions, borrowing, 

and off-balance sheet risk for each MAPR.

The reporting requirement is triggered by 

status as a broker or dealer registered under 

Section 15 of the Securities Exchange Act 

of 1934, as amended.

This report is filed with the SEC quarterly 

and cumulatively at year-end and is not 

public.

There are also a variety of filings with the 

SEC and the securities self-regulatory organizations that must be made by registered 

broker-dealers and their associated persons.

Investment Adviser Registration under the Investment Advisers Act of 1940

15. Form ADV The SEC’s uniform application for investment adviser registration filed by a Hedge 

Fund Manager eligible to register with the 

SEC under the Advisers Act. This form is 

divided into two parts. Information submitted in Part I is filed electronically with the 

National Association of Securities Dealers 

Securities and Exchange Commission

U.S. Regulatory Filings by Hedge Fund Managers

08 | Appendix V
Investment Adviser Registration Depository and includes information regarding, 

among other things, the investment adviser’s 

business, their educational background, 

and whether they have been sanctioned for 

violating securities or other laws. Information in Part II is geared primarily toward the 

adviser’s clients. Part II contains information 

relating to the business practices, fees, investment strategies, and conflicts of interest 

the investment adviser may have with its 

clients. Part II is not submitted to the SEC 

but is deemed to be filed so long as a copy 

is maintained in the adviser’s files and is 

subject to review by the SEC. Part II (and 

Part I) are required to be updated annually, 

within 90 days of the adviser’s fiscal year 

end, and whenever it becomes materially 

inaccurate. However, certain changes may 

require the investment adviser to promptly 

amend Part I.

Commodity Futures Trading Commission and 

National Futures Association

Commodity Trading Advisors (“CTAs”) and Commodity Pool 

Operators (“CPOs”)

16. CPO and CTA An individual or entity operating or solicitRegistration Forms ing funds for a commodity pool, which

7-R and 8-R; would include a Hedge Fund Manager for

Available Exemptions a Hedge Fund that trades futures or options

on futures, may be required to register 

as a CPO, unless it qualifies for an exemption from registration. An exemption 

from registration is available if the pool is: 

(1) sold only to accredited investors, 

Securities and Exchange Commission

continued

Sound Practices for Hedge Fund Managers | 09
“knowledgeable employees”; or certain 

qualified eligible persons; and (2) engaged in 

limited trading of commodity interests (as 

measured by certain portfolio tests) (CFTC 

Regulation 4.13(a)(3)). There is also an 

exemption from registration for CPOs that 

admit only highly sophisticated participants, 

which include: (1) natural persons who 

are qualified purchasers, knowledgeable 

employees, or non-U.S. persons; and (2) 

entities that are qualified eligible persons 

or accredited investors (CFTC Regulation 

4.13(a)(4)).

An individual or entity that, for compensation or profit, advises others (directly or 

indirectly) as to the value of or advisability 

of buying or selling futures contracts or 

options on futures generally must register 

as a CTA unless it qualifies for the statutory exemption in Section 6m(1) of the 

Commodity Exchange Act or the exemption 

provided in CFTC Regulation 4.14(a)(8). 

Providing advice indirectly includes having 

the authority to allocate the assets of a fund 

or account to another CTA to trade. A 

CTA may avail itself of the Section 6m(1) 

exemption if the CTA has provided futures 

trading advice to 15 or fewer persons (legal 

organizations being deemed a single person) 

in the past 12 months and does not generally hold itself out to the public as a CTA. 

CFTC Regulation 4.14(a)(8) permits a CTA 

to claim exemption from registration if its 

futures trading advice is incidental to its 

securities advice and is given only to certain 

limited categories of clients, including pools 

Commodity Futures Trading Commission 

and National Futures Association

U.S. Regulatory Filings by Hedge Fund Managers

10 | Appendix V
operated under Regulation 4.13(a)(3) or 

4.13(a)(4). These exemptions are available 

to Hedge Fund Managers, whether or not 

registered with the SEC or a state authority.

The documents required for registration as 

a CPO or CTA are: (1) a completed Form 

7-R (which provides CPO or CTA information); (2) a completed Form 8-R (which 

provides biographical data) and fingerprint 

card for each principal (defined to include 

executive officers, directors, and 10% owners), branch office manager, and associated 

person (defined to include persons soliciting 

fund interests or accounts or supervising 

persons so engaged), and proof of passage of 

the “Series 3” exam for each associated person; and (3) proof of passage of the “Series 

3” and futures branch office manager exams 

for each branch office manager.

A person seeking to rely on either the CFTC 

Regulation 4.13(a)(3) or 4.13(a)(4) CPO 

registration exemption must furnish to each 

prospective participant in the relevant pool: 

(1) a statement that the person is exempt 

from registration with the CFTC as a CPO 

and that, unlike a registered CPO, it is not 

required to deliver a disclosure document 

and a certified annual report to participants 

in the pool; and (2) a description of the 

criteria pursuant to which it qualifies for the 

exemption from registration. A person seeking to rely on any of the CPO registration 

exemptions must file with NFA an online 

notice claiming the relevant exemption and 

Commodity Futures Trading Commission

and National Futures Association

continued

Sound Practices for Hedge Fund Managers | 11
providing certain information specified 

in the relevant rule. These disclosures and 

filings must be made no later than the time 

at which a subscription agreement for the 

relevant pool is delivered to a prospective 

participant in such pool.

CFTC Regulation 4.13 requires a person 

claiming exemption from CPO registration 

thereunder to: (1) keep all books and records 

prepared in connection with its activities as a 

CPO for five years from the date of preparation (and maintain such books in a readily 

accessible place for the first two years of such 

period); and (2) ensure that annual reports 

to pool participants (if provided) are prepared in accordance with generally accepted 

accounting principles consistently applied 

(and, if certified, certified in accordance with 

CFTC Regulation 1.16).

A person relying on the CFTC Regulation 

4.14(a)(8) exemption from CTA registration must keep all books and records 

prepared in connection with its activities 

as a CTA for five years from the date of 

preparation (and maintain such books in 

a readily accessible place for the first two 

years of such period). There are also additional requirements with respect to the 

notice that a CTA must file with NFA to 

claim its exemption from registration.

Applications for registration are filed with 

and approved by NFA under authority 

granted to it by the CFTC and the registration documents are generally public except 

for fingerprint cards, although confidenCommodity Futures Trading Commission

and National Futures Association

U.S. Regulatory Filings by Hedge Fund Managers

12 | Appendix V
Commodity Futures Trading Commission

and National Futures Association

tiality may be requested for certain information relating to the principals.

17. Form 3-R Form 3-R is used to report changes to information contained in Form 7-R. The form 

is filed with NFA and is public, though 

confidentiality may be requested for certain 

information relating to principals.

18. Form 8-T Form 8-T filed within 20 days of the termiAssociated Person nation of an associated person, principal, or

Termination branch manager. The form is filed with 

NFA and is generally public. 

19. Annual Report An annual report of a pool must be filed 

pursuant to CFTC Regulation 4.22(c) by 

a pool’s registered CPO (unless the CPO 

is exempt under CFTC Regulation 4.7, as 

described below). The annual report must 

contain certain information, such as actual 

performance information and fees, and 

must be distributed to each participant in 

the pool.

A registered CPO must file the annual report with NFA within 90 days of the pool’s 

fiscal year-end. The annual report is generally publicly available; however, the CFTC 

is prohibited from disclosing information 

that would separately disclose the business 

transactions or market positions of any person, trade secrets, or names of any investors.

20. CPO/CTA This is an annual compliance questionnaire 

Questionnaire concerning business activities of registeredCPOs or CTAs. The questionnaire is filed 

electronically with NFA and is not public.

continued

Sound Practices for Hedge Fund Managers | 13
21. NFA Self-Audits To satisfy continuing supervisory responsibilities, NFA members must annually review 

their operations using a self-examination 

checklist. The checklist focuses on a member’s regulatory responsibilities and solicits 

information on whether a member’s internal 

procedures are adequate for meeting those 

responsibilities.

A written attestation affirming completion 

of the self-examination checklist must be 

signed and dated by a CPO/CTA’s supervisory personnel. The attestation must be 

retained by the member for five years and 

provided to NFA upon request.

22. Certain Claims for Filings made pursuant to CFTC Regulation

Exemption for CPOs and 4.12(b)(3) (notice of claim for exemption

CTAs from certain requirements by a CPO that 

complies with the Securities Act of 1933, 

as amended, and manages a Hedge Fund 

with limited trading in commodity futures 

and options) and CFTC Regulation 4.7(d) 

(notice of claim for exemption by a CPO 

or CTA with “qualified eligible persons” 

as investors).

CFTC Regulation 4.5 provides an exclusion 

from the definition of the term CPO for 

certain qualifying persons. Any person who 

desires to claim the exclusion provided by 

CFTC Regulation 4.5 must file a notice of 

eligibility with NFA.

CFTC Regulation 4.6 provides an exclusion for certain persons from the definition 

of the term CTA. Any person claiming 

exclusion under CFTC Regulation 4.6 must 

Commodity Futures Trading Commission

and National Futures Association

U.S. Regulatory Filings by Hedge Fund Managers

14 | Appendix V
submit to these special calls from the CFTC 

requiring the person to demonstrate compliance with such regulation.

These statements are filed with the CFTC 

and NFA and are public.

23. Disclosure Document CPOs and CTAs are generally required 

to prepare detailed disclosure documents 

containing specified information. These 

documents are filed with NFA and provided 

to investors but are not publicly available.

However, CPOs and CTAs operating under 

CFTC Regulation 4.7, are exempt from the 

disclosure document requirement and are 

only required to provide all material disclosures (and include specified legends on their 

materials). In addition, under the exemption 

provided in CFTC Regulation 4.8, Hedge 

Funds whose Hedge Fund Managers are 

exempt under CFTC Regulation 4.12(b) 

or which sell interests solely to “accredited 

investors” and rely on the safe harbor provisions of Rules 505 or 506 of Regulation 

D under the Securities Act of 1933, as 

amended, may begin soliciting, accepting, 

and receiving money upon providing the 

CFTC and the Hedge Fund investors with 

disclosure documents for the Hedge Fund, 

which requirement may be satisfied through 

providing a private placement memorandum.

24. Year-End Financial Annual reports for Hedge Funds for which

Reports for § 4.7 Funds a CPO has filed an exemption under CFTC 

Regulation 4.7 must contain a Statement of 

Commodity Futures Trading Commission

and National Futures Association

continued

Sound Practices for Hedge Fund Managers | 15
Financial Condition, a Statement of Income 

(Loss), appropriate footnote disclosure, 

other material information, and a legend 

to any claim for exemption. The annual 

report must be presented and computed in 

accordance with generally accepted accounting principles consistently applied and, if 

certified by an independent public accountant, it must be in accordance with CFTC 

Regulation 1.16.

The annual report is filed with NFA and 

distributed to each investor and is not 

public.

25. Form 40 “Statement of Reporting Trader” filed pursuant to CFTC Regulation 18.04 by persons 

who receive a special call by the CFTC, or 

its designee, for holding positions equal to 

or in excess of specified levels. The form 

generally must be filed within ten business 

days after the call. Specified levels are set 

separately for each type of futures contract. 

Form 40 requires disclosure of information 

regarding ownership and control of futures 

and option positions held by the reporting trader, as well as the trader’s use of the 

markets for hedging. Hedging exemptions 

from speculative position limits must be 

reported. The CFTC often issues a special 

call for a Form 40 after receiving a Form 

102 (described below).

The form is filed with the CFTC and is not 

publicly available.

26. Form 102 Form 102 is filed pursuant to CFTC Regulation 17.01 by clearing members, futures 

U.S. Regulatory Filings by Hedge Fund Managers

Commodity Futures Trading Commission

and National Futures Association

16 | Appendix V
commission merchants, and foreign brokers. 

The form identifies persons, including 

Hedge Funds, having financial interest in, 

or trading control of, special accounts in 

futures and options. The CFTC provides 

preliminary information regarding whether 

positions and transactions are commercial or 

noncommercial in nature. The form must 

be filed when the account first becomes 

reportable (i.e., when it first contains futures 

or options positions equal to or in excess of 

specified levels). The form must be updated 

when information concerning financial 

interest in, or control of, the special account 

changes. In addition, the form is used by 

exchanges to identify accounts reported 

through their large trader reporting systems 

for both futures and options.

The form is filed with the CFTC and is 

not public. 

Selected Stock and Futures Exchange Reports 

Application for Exemption from Speculative Position Limits

27. Speculative Position This application is filed for exemption from

Limit Exemption speculative position limits. Exchanges 

generally have speculative position limits 

for physical commodities and stock index 

contracts, and the CFTC has speculative 

position limits for certain agricultural commodities. Exemptions from such limits are 

generally available for hedging transactions. 

Financial contracts, such as interest rate 

contracts, generally have “position accountability” levels rather than strict position 

Commodity Futures Trading Commission

and National Futures Association

continued

Sound Practices for Hedge Fund Managers | 17
limits. Accounts or account controllers 

exceeding position accountability levels 

must justify their positions to an exchange 

or the CFTC upon request. Generally, an 

application for any speculative position limit 

exemption must show that such position is 

a bona fide hedging, risk management, arbitrage, or spread position. The filing is made 

with the appropriate exchange in the case 

of physical commodities and stock index 

contracts and with the CFTC in the case of 

certain agricultural commodities.

Federal Trade Commission and U.S. Department of Justice

Filings Made Prior to Mergers and Acquisitions

28. Hart-Scott-Rodino This notification is filed prior to the 

Notice consummation of certain mergers, acquisitions, and joint ventures. The notification 

includes information about the transaction 

and the participants in the transaction.

As a general matter, both the acquiring 

person and the acquired person must file 

notifications when either the acquiring 

person or the acquired person is engaged in 

U.S. commerce or an activity affecting U.S. 

commerce, and either of the following two 

tests is met:

(1) (A) one person has either total assets or 

annual net sales of $119.6 million or more 

(threshold adjusted annually); and the other 

person has either total assets or annual net 

sales of $12.0 million or more (threshold 

adjusted annually); and (B) as a result of the 

transaction, the acquiring person will hold 

Commodity Futures Trading Commission

and National Futures Association

U.S. Regulatory Filings by Hedge Fund Managers

18 | Appendix V
an aggregate total amount of more than 

$59.8 million (threshold adjusted annually) 

of the voting securities and assets of the 

acquired person; or

(2) as a result of the transaction, the 

acquiring person will hold an aggregate 

total amount of more than $239.2 million 

(threshold adjusted annually) of the voting 

securities and assets of the acquired person, 

regardless of the sales or assets of the acquiring and acquired persons.

Acquisitions of voting securities are exempt 

from filing if they are made “solely for the 

purpose of investment” and if, as a result 

of the acquisition, the securities held do 

not exceed 10% of the outstanding voting 

securities of the issuer. Securities are acquired 

“solely for investment purposes” if the person 

acquiring the securities has no intention of 

participating in the formulation, determination, or direction of the basic business 

decisions of the issuer.

The Hart-Scott-Rodino Act and rules thereunder contain various other exemptions, 

which are complex and require familiarity 

with the concepts and terminology of this 

legislation. The formation of partnerships 

and limited liability companies is potentially 

subject to notification under Hart-ScottRodino, as the result of changes to the

Hart-Scott-Rodino rules that became 

effective on April 7, 2005.

The notice is filed with the Federal Trade 

Commission and the U.S. Department of 

Justice and is not public.

Federal Trade Commission and U.S. Department of Justice

Sound Practices for Hedge Fund Managers | 19
Sound Practices for Hedge Fund Managers | 01

APPENDIX VI

The following checklist has been drafted to assist Hedge Fund 

Managers in developing their own compliance policies and procedures. MFA expects that the contents and specific details of a 

Hedge Fund Manager’s policies and procedures will vary significantly 

depending on factors specific to each Hedge Fund Manager, such 

as, among other things, organizational structure and the strategies 

of the Hedge Funds undertaken by the Hedge Fund Manager. In 

addition, Hedge Fund Managers that are required to register under 

Advisers Act will need to adopt policies and procedures that meet 

the requirements of Rule 206-4(7).1 Some of the requirements of that 

Rule are summarized in the checklist below for the benefit of SECregistered Hedge Fund Managers, but may also be considered as a 

reference for non-registered Hedge Fund Managers, to the extent 

they are appropriate for their operations. By providing this list, MFA 

does not intend to advocate the adoption of policies and procedures 

containing any particular provision, or to provide an exhaustive list 

of the provisions that should be included. MFA hopes that Hedge 

Fund Managers will consider the various categories set forth in this 

checklist in developing policies and procedures that are tailored to, 

and include all provisions appropriate for, their own businesses.

Checklist for Hedge Fund Managers 

to Consider in Developing 

a Compliance Manual

1 All Rules and Sections listed in Appendix VI are in accordance with the Advisers Act.
Checklist for Hedge Fund Managers to Consider

in Developing a Compliance Manual

I. Applicability and General 

Provisions

• Identify Covered Personnel.

Explain what employees, officers, 

directors, and other personnel 

at the Hedge Fund Manager are 

covered (“covered personnel”). 

Note that Rule 206-4(7) requires 

registered investment advisers’ 

compliance policies to apply to 

the adviser and any supervised 

person (“any partner, officer, 

director (or other person occupying a similar status or performing 

similar functions), or employee 

of an investment adviser, or other 

person who provides investment 

advice on behalf of the investment 

adviser and is subject to 

the supervision and control of 

the investment adviser”).

• Purpose of Policies and

Procedures. Set forth policies 

and procedures that are reasonably designed to prevent violations 

of such policies and procedures 

from occurring, and to detect 

and address violations that have 

occurred. Note that Rule 206(4)-7 

requires all registered investment 

advisers to adopt and implement 

policies and procedures reasonably 

designed to prevent the investment adviser and its personnel 

and the entity he or she is advising 

from violating the Advisers Act 

and its rules and regulations.

• Use and Distribution. Distribute 

policies and procedures to all 

covered personnel and make clear 

that it is the responsibility of the 

covered personnel to understand 

the contents of the policies and 

procedures.

II. Chief Compliance Officer

• Appointment and Responsibilities of the Chief Compliance

Officer. Explain that there must 

be a chief compliance officer 

or other similar individual (the 

“Chief Compliance Officer”)* 

appointed and that the Chief 

Compliance Officer is assigned 

primary responsibility for coordinating and supervising compliance with applicable laws and 

regulations, as well as all internal 

procedures adopted by the investment adviser. Note that Rule 206-

4(7) requires registered investment 

advisers to designate an individual 

responsible for administering the 

policies and procedures of the 

Hedge Fund Manager.

* Recommendations for sound practices 

relating to the Chief Compliance 

Officer are contained in Section 

5—Regulatory Controls.

02 | Appendix VI
investment strategies employed 

by the Hedge Fund Manager and 

operational processes, including 

policies on partial fills, de minimis

reallocations, deviations from 

allocation policy, and allocations 

of “New Issues”. Establish a committee, designate an employee, or 

otherwise allocate responsibility to 

review the facts and circumstances 

of opportunities to ensure that the 

Hedge Fund Manager addresses its 

applicable fiduciary duties.

• Maintain Portfolios Consistent with Funds’ Objectives.

Undertake reviews of portfolios 

(electronic and/or manual reviews) 

and establish controls in order to 

detect departures from established 

investment objectives.

• Disclose Information about

Portfolio Management

Processes. Develop disclosure controls to consider whether and the 

way in which policies and changes 

to policies should be reviewed and 

communicated to investors.

• Comply with Applicable

Regulatory Restrictions. Evaluate 

and address applicable regulatory 

requirements, including filing 

requirements with various government regulators* and establish 

timelines and assign oversight 

responsibility for compliance 

to the Chief Compliance Officer 

or a designated employee. 

III. Elements of Policies and 

Procedures

A. Investment Adviser as Fiduciary

Include information detailing a 

Hedge Fund Manager’s applicable 

fiduciary duties and explain that the 

adviser must act solely in the best 

interests of its client and must make 

full and fair disclosure of all material 

facts about the Hedge Fund Manager’s business and business practices 

to its clients.

• Note that all investment advisers,

whether registered or unregistered, are subject to the antifraud 

provisions of Section 206, which 

generally makes it unlawful for an 

investment adviser to engage in 

fraudulent, deceptive, or 

manipulative conduct.

 In addition, note that in adopting 

Rule 206(4)-7, the SEC indicated 

that advisers should consider their 

fiduciary obligations under the 

Advisers Act and formalize policies 

and procedures to address them.

B. Portfolio Management Processes

Include provisions addressing 

controls and procedures for various 

portfolio management processes.

• Allocate Investment Opportunities Fairly among Funds. Create 

procedures for allocating opportunities that relate to types 

of investments involved, and 

Sound Practices for Hedge Fund Managers | 03
04 | Appendix VI

* A list of required U.S. filings that 

Hedge Fund Managers may be 

required to file is contained in 

Appendix V—U.S. Regulatory 

Filings by Hedge Fund Managers.

In the case of registered investment 

advisers, this requirement covers a 

number of substantive provisions 

under the Advisers Act, including:

• Filing and updating Form ADV;

• Proxy voting policies and 

procedures;

• Custody requirements;

• Procedures for solicitation 

activities;

• Books and records;

• Insider trading policies and codes 

of ethics;

• Advertising; and

• Requirements for an advisory 

contract.

C. Trading Practices

Include provisions addressing 

procedures for trading practices 

and execution of strategies.

• Transaction Review. Name 

authorized traders for transactions, establish procedures for 

specific periodic review of certain 

transactions and orders, include 

a retention policy for transaction 

reports, and describe procedures 

for handling transactions upon 

completion, including distribution of confirmations. Establish 

a procedure for handling and 

reporting execution errors.

• Conflicts Review. Establish effective review and approval processes 

for dealing with any conflicts 

of interest that arise, including 

in connection with Soft Dollar 

Arrangements* or other services 

from brokers. This should include 

policies for selection of brokerdealers, use of affiliated brokerdealers, use of agency crosses, 

and disclosure to investors about 

the process for dealing with these 

potential conflicts. **

* Suggestions for soft dollar and best 

execution practices are addressed in 

Section 6—Trading Relationship 

Management, Monitoring, and 

Disclosure.

** Note that Section 206(3) makes 

it unlawful for any investment 

adviser, whether registered or unregistered, to act as a principal on 

the other side of a transaction from 

a client, without first disclosing it 

and obtaining the written consent 

of the client.

Checklist for Hedge Fund Managers to Consider

in Developing a Compliance Manual
• Aggregated Trade Review. Fairly 

allocate aggregated trades among 

Hedge Funds. Establish procedures for when to aggregate trades, 

how to allocate aggregated trades, 

and how to review adherence to 

policy.

D. Trading Activity

Procedures should address proprietary trading of the Hedge Fund 

Manager and personal trading 

activities of supervised persons. 

Note that this element may be 

covered by other policies adopted 

by Hedge Fund Managers. In the 

case of registered investment advisers, Section 204A requires advisers 

to adopt insider trading policies, and 

Rule 204-1 requires registered investment advisers to adopt codes of 

ethics which are required to contain 

provisions covering personal trading 

activities.*

• Establish policies to direct that 

any trading by employees and 

affiliates will be conducted in a 

manner that is consistent with the 

requirements of the policies and 

in a manner consistent with the 

applicable fiduciary duties owed 

by the Hedge Fund Manager.

* Suggestions for elements of trading 

policies and codes of ethics are 

addressed in Appendix VII—Checklist for Hedge Fund Managers to 

Consider in Developing a Code of 

Ethics. 

E. Disclosures

Develop disclosure controls and 

procedures to ensure prompt and 

accurate disclosure to investors and 

any applicable regulators, including 

account statement disclosures.

• Establish a committee or a designated employee to review required 

disclosure documents for accuracy 

and consistency.

• Establish procedures for updating and distributing any required 

information to investors and regulators. In the case of registered investment advisers, this procedure 

should address required updates in 

Form ADV and required financial 

and disciplinary information in 

Rule 206(4)-4.

 Note that Section 207 prohibits 

any person from willfully making 

any untrue statement of a material 

fact, or willfully omitting to state 

any material fact that is required 

to be stated, in any registration 

application or report filed with 

the SEC.

Sound Practices for Hedge Fund Managers | 05
06 | Appendix VI

Checklist for Hedge Fund Managers to Consider

in Developing a Compliance Manual

F. Safeguarding Client Assets

Develop procedures to safeguard 

client assets from conversion or 

inappropriate use by advisory 

personnel.

• Limit authority and access to 

client accounts to designated 

employees and require approval of 

the Chief Compliance Officer for 

deviations from that policy.

• Monitor activity of employees 

with access to client accounts to 

ensure adherence to procedures.

G. Recordkeeping

Create policies that address maintaining complete and accurate 

records of the Hedge Fund Manager 

and all Hedge Funds it manages.

• These policies and procedures 

should be designed to ensure the 

retention of accurate and complete records and may include, as 

appropriate, maintenance of original copies of all records, including 

those created in email, protection 

against electronic destruction, 

development of searchable indices 

of stored data and records, and 

policies relating to access to 

records. A Hedge Fund Manager 

should also establish a policy relating to the length of time records 

are required to be retained that is 

appropriate for its organizational 

structure and business activities.

Note that Rule 204-2 identifies 

certain books and records that 

must be prepared and retained 

by registered investment advisers. For purposes of Section 204, 

books and records include records 

of the private funds for which 

the adviser or a related person 

acts as general partner, managing 

member, or in a similar capacity. This Rule specifies the time 

periods for which such books and 

records must be retained, which is 

generally five years.

H. Marketing and Fees

Include procedures to address 

marketing activities, including use 

of solicitors and payment of fees.

• Develop disclosure controls to 

ensure that arrangements are fully 

and accurately disclosed. Note 

that if a registered investment 

adviser pays a cash fee to a person 

soliciting investors, the adviser 

must meet the requirements of 

Rule 206(4)-3.

• Develop disclosure controls to 

ensure that any performance fees 

are fully and accurately disclosed. 

Note also that registered advisers 

of 3(c)(1) funds may be subject 

to limitations on the ability to 

charge performance fees. Section 

205(a)(1) generally prohibits a 

registered investment adviser from 
receiving a performance fee. However, Rule 205-3 permits a registered investment adviser to receive 

a performance fee from certain 

eligible clients. Registered advisers 

should establish the qualifications 

for “eligible clients” in accordance 

with the rule.

I. Valuation

Include processes to value holdings 

and assess fees based on those 

valuations.*

* Suggestions for valuation practices 

are included in Section 3—

Determination of Net Asset Value.

J. Safeguards for Privacy Protection

of Client Records and Information

Adopt policies to address administrative and physical safeguards for 

the protection of customer records 

and information.

• Develop procedures and lists of 

employees permitted to access client information. Set forth policy 

for providing client information 

to affiliates and non-affiliated 

third parties. Consider requiring 

pre-approval of client or Chief 

Compliance Officer.

 Note that the SEC’s Regulation 

S-P (“Privacy of Consumer Financial Information”) requires registered investment advisers to adopt 

policies and procedures reasonably 

designed to: (1) ensure the confidentiality of customer records and 

information; (2) protect against 

any anticipated threats or hazards 

to the security of customer records 

and information; and (3) protect 

against unauthorized access or use 

of customer records or information that could result in substantial harm or inconvenience to any 

consumer. Registered investment 

advisers are required to distribute 

a notice of their privacy policy to 

each of their underlying investors 

in a fund that are natural persons 

at the time a person becomes an 

investor in a Hedge Fund and, 

going forward, on an annual basis.

K. Business Continuity,

Disaster Recovery, and Crisis

Management Plans

Develop procedures to reduce risk 

to clients as a result of unforeseen 

events that would impact the 

adviser’s ability to continue active 

management of the clients’ assets.*

* Recommendations for BC/DR plans 

are included in Section 7—Business 

Continuity, Disaster Recovery, and 

Crisis Management.

Sound Practices for Hedge Fund Managers | 07
V. Acknowledgment and Training 

• Develop requirements for employees, such as requiring an employee to sign a written statement 

acknowledging his or her receipt 

and understanding of, and agreement to abide by, the policies.

• Require periodic training of 

employees to ensure understanding of, and compliance with, 

policies and procedures.

L. Anti-Money Laundering

Develop policies and procedures 

in connection with the prevention 

of money laundering. This section should include the policy of 

the Hedge Fund Manager regarding cash or cash equivalent bearer 

instruments, its documentation 

policies, its reporting and disclosure 

obligations, as well as the role of the 

Chief Compliance Officer.*

* A more in-depth review is included 

in Appendix IV—Guidance for 

Hedge Fund Managers on Developing Anti-Money Laundering 

Programs (Release No.2).

IV. Review and Updating 

of Policies

• Establish processes for reviewing 

the policies and procedures to 

determine their adequacy and 

the effectiveness of their 

implementation.

• Update policies in the event of 

significant changes to business 

or unforeseen market events.

Note that Rule 206(4)-7 requires 

registered investment advisers 

to conduct this review no less 

frequently than annually.

Checklist for Hedge Fund Managers to Consider

in Developing a Compliance Manual

08 | Appendix VI
Sound Practices for Hedge Fund Managers | 01

APPENDIX VII

The following checklist is intended to assist Hedge Fund Managers 

in developing their own codes of ethics or conduct. MFA expects 

that the codes of ethics or conduct among different Hedge Fund 

Managers will vary significantly depending on factors specific to 

each Hedge Fund Manager, including organizational structure and 

the types of Hedge Funds advised by the Hedge Fund Managers. 

By providing this checklist, MFA does not intend to advocate the 

adoption, of a code of ethics or conduct containing any particular 

provision, and does not intend to provide an exhaustive list of the 

provisions that should be included. Instead, it is MFA’s hope that 

Hedge Fund Managers will consider the various elements of this 

checklist in developing a code of ethics or conduct that is specifically tailored to their own businesses. Moreover, particular provisions 

identified below may be contained in one or more other policy 

manuals, memoranda, or other documents.

Hedge Fund Managers should be aware that those required to 

register with the SEC must establish, maintain, and enforce a code 

of ethics pursuant to Rule 204A-1 of the Advisers Act1 and must offer 

in Part II of their Form ADV to provide such code to clients and prospective clients. The requirements of that rule are summarized in the 

checklist below for the benefit of registered Hedge Fund Managers, 

but may also be considered as a reference for unregistered Hedge 

Fund Managers to the extent such requirements are appropriate to 

their operations. To be adequately implemented, Hedge Fund Managers should consider supporting the principles of conduct set forth 

in any code of ethics or conduct with compliance policies. 

Checklist for Hedge Fund Managers 

to Consider in Developing 

a Code of Ethics

1 All Rules and Sections listed in Appendix VII are in accordance with the Advisers Act.
Checklist for Hedge Fund Managers to Consider

in Developing a Code of Ethics

Hedge Fund Managers should 

consider including the following 

provisions:

Applicability of the Code

• Identification of personnel covered 

(“covered personnel”) by the code 

of ethics or conduct (“the Code”).

• Emphasis on the adherence to the 

provisions of the Code.

 Note that Rule 204A-1 requires 

registered Hedge Fund Managers 

to make the Code available to all 

clients and potential clients of any 

Hedge Fund advised by the Hedge 

Fund Manager, upon request. 

Standards of Conduct

• A provision setting forth standards 

of business conduct for covered 

personnel.

• A statement that covered personnel 

are to comply with all applicable 

federal securities laws, including 

the various applicable provisions 

of the Advisers Act, U.S. Investment Company Act of 1940, the 

Securities Act of 1933, the Securities Exchange Act of 1934, and all 

applicable rules and regulations 

adopted by the SEC. Note that 

Rule 204A-1 requires codes of ethics to include provisions requiring 

supervised persons to comply with 

applicable federal law.

• Articulation of covered personnel’s 

fiduciary duty to act in the client’s 

best interest. For certain Hedge 

Fund Managers, the scope of the 

duties to clients may be set forth 

in investment management agreements, offering documents, or 

other written materials, and 

the Code may make reference 

to these. 

 Note that Rule 204A-1 requires 

standards of conduct that reflect 

the registered investment adviser’s 

fiduciary obligations and the fiduciary obligations of its supervised 

persons.

• A statement that covered personnel should strive to act in a professional and ethical manner. 

• Incorporation of the Hedge Fund 

Manager’s fundamental ideals 

(such as integrity, honesty, trust, 

etc.), as well as the legal, ethical, 

and moral obligations with which 

covered personnel should comply.

Personal Trading

• Policies emphasizing that the 

interests of clients will at all times 

be placed first, and that covered 

personnel will not take advantage 

of their positions for personal 

benefit. 

• Procedures for personal trading, such as “blackout periods”, 

restricted lists, reviews, holding 

periods, and prohibitions on 

certain types of trades. 

02 | Appendix VII
• Requirement that the chief compliance officer should review the 

personal security reports to check 

for any trading improprieties. Note 

that Rule 204A-1 requires Hedge 

Fund Managers to review personal 

securities transactions and holdings 

periodically. 

Client Information

• Policies that identify confidential client information, and then 

ensure that the information is not 

disclosed, other than in the necessary course of business (i.e., on a 

“need to know” basis).

• Policies to prevent the misuse of 

information.

 Note that these confidentiality 

policies may also be contained 

within the compliance policies 

and procedures. See Appendix 

IV—Guidance for Hedge Funds 

and Hedge Fund Managers on 

Developing Anti-Money Laundering Programs (Release No. 2) for 

more information on AML policies as they affect confidentiality policies.

• Procedures for the required 

pre-approval/clearance of certain 

transactions, such as IPOs, private 

placements/limited offerings, or 

securities on any restricted list. 

 Note that Rule 204A-1 requires 

pre-approval before “access persons” (as defined in Rule 204A1(e)(1)) may directly or indirectly 

acquire beneficial ownership in 

any security in an IPO or limited 

offering.

Reporting of Holdings

• Procedures for covered personnel 

to file an initial holding report or 

account statement, covering all 

their current holdings in specified 

investments. This holding report 

should be updated periodically. 

Note that Rule 204A-1 contains 

specific reporting requirements 

for “access persons”, including the 

content and timing of holding 

reports and transaction reports.

• With respect to implementation 

of the foregoing bullet, Hedge 

Fund Managers may consider 

setting up a system to have copies of brokerage statements and 

confirmations of covered personnel delivered directly to the Hedge 

Fund Manager.

• Procedures to report all specified 

types of personal transactions on 

a quarterly basis to designated 

personnel. 

1.0 Overview: The Risks Faced by a Hedge Fund Manager

Sound Practices for Hedge Fund Managers | 03
04 | Appendix VII

Insider Trading

• Formulation of policies that are 

designed to: prevent and detect 

insider trading; reflect the nature 

of the Hedge Fund Manager’s 

business and type of instruments 

traded; and include procedures, 

such as a restricted list and the 

monitoring of trading activity 

by covered personnel. 

• Implement policies to prevent the 

misuse of material, non-public 

information, such as controlling 

access to the information through 

a gatekeeper and controlling the 

ability to make copies of such 

information.

Gifts and Acts of Hospitality

• Creation of policies on the giving 

or receiving of business gifts 

and other acts of hospitality that 

may create the appearance of 

impropriety. 

• Inclusion of provisions that require mandatory reporting of gifts 

accepted in the course of business. 

Consider whether gifts should 

need to cross a certain threshold, 

depending on the nature of the 

Hedge Fund Manager’s business, 

before such reporting would be 

required. 

Acknowledgement, 

Certification, and Training

• Requirement that covered personnel sign an acknowledgement 

that they have received the Code. 

Note that Rule 204A-1 requires 

supervised persons to acknowledge receipt of the Code and any 

amendments.

• Provisions concerning training 

staff on the principles and policies 

of the Code.

• Designation of a person that 

covered personnel can seek advice 

for any questions about the Code. 

• Requirement for conducting 

annual recertification of the 

policies in the Code.

• Requirement that a record be 

kept of the acknowledgements 

by supervised persons. Note that 

Rule 204-2(a)(12)(iii) requires a 

record of acknowledgements for 

each supervised person to be kept 

for five years.

• Requirement that a record be kept 

and maintained by appropriate 

supervisory personnel of the Code 

and any amendments to the Code. 

Note that Rule 204-2(a)(12)(i) 

requires a record of the Code to 

be kept for five years. 

Checklist for Hedge Fund Managers to Consider

in Developing a Code of Ethics
Violations of Code

• Provision for a reporting 

mechanism for any violations 

of the Code. 

Note that Rule 204A-1 requires 

a code of ethics to contain provisions requiring supervised persons 

to report any violations of the code 

of ethics promptly to the chief 

compliance officer or, provided the 

chief compliance officer also receives 

reports of all violations, to other 

persons designated in the code of 

ethics.

• Provision for whistleblower 

protection to those who report 

violations.

• Provisions designed to ensure 

that sensitive information about 

violations is kept confidential 

until otherwise notified by the 

designated person. 

• Policies for when and how an 

investigation is initiated and 

carried out, as well as who has 

responsibility to undertake the 

investigation.

• Determination of whether records 

of every violation or alleged 

violation will be kept and for 

how long. Note that Rule 204-

2(a)(12)(ii) requires that a record 

be kept of any violation of the 

Code and any action taken as a 

result of the violation. 

Sanctions

• Development of appropriate sanctions for breaches of the provisions of the Code, such as suspension, letter of censure, restitution, 

and termination. 

For further reference materials 

on drafting a Code, please see the 

following resources:

• Asset Manager Code of Professional 

Conduct (2005) from the CFA 

Centre for Financial Market 

Integrity (www.cfainstitute.org/

centre/ethics/asset/pdf/asset_

manager_code.pdf); and

• SEC final rule release on the 

Investment Adviser Code of 

Ethics (www.sec.gov/rules/final/

ia-2256.htm).

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