The presence of over 100 domestic hedge funds showcases the recent considerable growth of the industry in Israel. Here’s why hedge funds have become so popular.
What Is a Hedge Fund?
A hedge fund is a type of investment fund that can employ numerous different investment strategies. For instance, many seek to exploit volatility fluctuations, basis risk, or arbitrage opportunities. In Israel, hedge funds are usually set up as limited partnerships, either Israeli or foreign. An entity connected to a professional fund manager acts as general or managing partner, and the investors are the limited partners. The minimum investment amount is usually high, and the fund manager manages the fund to maximize investor returns, thereby exploiting risk. The fund manager is a limited company, and the investors are individuals or organizations who have no involvement in managing the fund.
Regulation under Israeli Law
There is no bespoke regulation for hedge funds in Israel. However, many provisions found in documents establishing hedge funds derive from regulations relating to, for example, tax, mutual funds, and securities laws. Because hedge managers’ fees are performance-related, they may not hold a portfolio management or advice license, under section 24 the Regulation of Investment Advice, Investment Marketing and Portfolio Management Law, 5755-1995. Hedge fund companies usually deal with eligible investors, and this brings an exemption from certain sections of the Advice Law under section 3(a)(11). Others manage money for a family member, or are individuals managing money for fewer than five people, and so are exempt under section 3(a)(7) or section 3(a)(3). This lower regulatory burden is attractive to fund managers seeking to establish their own track record.
However, managers remain liable for compliance with the Anti-Money Laundering Order, and need to identify their investors and their source of funds. Furthermore, they must ensure they have appropriate levels of insurance and management controls in their business.
The Industry Association
The Israel Hedge Funds Association was established in 2015 to: “(i) represent and promote the common interests of the hedge fund industry with governmental bodies; (ii) provide recommendations for best practices in the industry; (iii) provide access to professional information; and (iv) broaden and deepen market and public knowledge about the industry.” A large and increasing number of hedge funds are members, and look to the IHFA for guidance on global best practices for various aspects of hedge fund management.
Israeli Hedge Funds USPs
Israeli hedge funds tend to be small, in terms of assets under management – only a handful manage more than USD 100 million. This, together with small teams and a quick decision-making process, means Israeli hedge funds are able to implement their strategies more nimbly than larger funds in the same market segment globally. It could be argued that this has been reflected recently in relatively attractive returns.
For Israeli investors who can afford to invest in them, the local hedge fund sector offers a welcome method of diversifying investment exposure, due to traditional funds and investment opportunities being very conservative (usually long-only equity, or debt or property mutual funds).
Managers usually receive a management fee of 2-2.5% per annum, and a performance fee of 20% of the profit in excess of the fund benchmark.
Performance fees are collected if the fund has risen above what is called the “high water mark,” which means its previous highest performance return from an earlier return, in order to avoid the investor paying a performance fee twice on the same upside.
Israeli Tax Obligations
Israeli hedge funds are established as LPs instead of companies, due to tax efficiencies that arose from a precedent pre-ruling issued to early movers in the Israeli hedge fund industry. These early movers sought and obtained a ruling from the ITA that it would not look to each and every investor in a fund for tax payment on the aggregate calculation of their individual realizations, but would instead tax the fund on an annual basis at 30%. In order to ensure investors can meet the annual tax payment, many funds make an annual investor distribution that matches the tax liability. This modus operandi has proved popular, and has been replicated by numerous subsequent hedge fund promoters, due to its simplicity. However, for larger funds, funds where the majority of investors are non-Israelis, and institutions, traditional international hedge fund structures, which allow for zero tax deductions at the fund level, may be more appropriate.