Financial Times Guide to Investing in Funds

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The prospectus

Leverage and investment restrictions

Leverage restrictions may hold less value than their title suggests when

it comes to offshore funds. Sometimes they are silent on the subject;

more often they include very loose restrictions designed to leave the

manager a lot of flexibility should leverage be used. Professional inves-

tors have said to me that this is normal and quite acceptable, but in

my view this is not right. It is not because we trust managers that

we have to give them carte blanche. I think all prospectuses should

have a limit on leverage. If the manager wants to increase leverage

then it should inform investors and notify them if leverage limits

are breached. That would at least give investors the right to decide to

redeem if they prefer. If it is not in the prospectus an investor simply

has no right to know.

Most prospectuses include some form of investment restrictions that

investors may seek to rely on. These can be based on the standard

investment restrictions required, as I said, in the relevant jurisdiction

(if any) where the fund is set up or depending on its targeted base

of investors. For instance, generally retail funds must include by law

more restrictions such as limited exposure to any one stock to con-

trol concentration risks. Other restrictions that are sometimes seen are

based on those required for a listing: often in Europe this applies in

Ireland. All restrictions are good, although I have known of funds that

simply chose to ignore them. It is rare but if it happens in an offshore

jurisdiction with a dishonest manager it is hard for investors to do

much about it without incurring huge costs.

Confessions of a prospectus writer

There are a number of examples in the industry where the prospectus

includes clauses that directly prejudice investors. I want to illustrate

them so that investors can easily pick up on aspects of prospectuses

they should resist. These examples are related to offshore unregulated

funds which are the funds investors are most likely to struggle with.

They are also often the funds that make the press for related reasons.

case study

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Leverage and investment restrictions 41

Although I did not write any of the prospectuses that contain the

examples below, I can understand what those who did were trying

to achieve. Let me tell you therefore about the consequences for

investors in each case.

Example 1

Here is an example of language that could be included in a prospectus

with regards to leverage:

Snapshot of the prospectus…

Leverage from derivatives

The share of the stock exchange margins on the total fund volume

shall not exceed 35 per cent. This could lead to a one-sided use of

the margin limit at a maximum leverage effect out of derivatives of up

to 12 times the actual fund volume (i.e. 1,200 per cent).

Total leverage of the fund

The expected leverage of investments in higher risk markets (such

as raw material, precious metal, energy) of the fund’s total leverage

is 5-8 times the actual fund volume. The maximum possible leverage

of an exemplary investment (long only) in risky markets may be up

to 15 times the fund volume, i.e. the basic equivalent volume of the

invested options and futures would be up to 15 times higher than the

actual fund volume.

Leverage is a very important topic and the cause of much of the

financial pain felt in 2008. Interestingly in 1998 leverage was also a

primary concern when the famous Long Term Capital Management

(LTCM) fund collapsed bringing to the brink many large financial

institutions (see Chapter 7 for the full story of LTCM). Yet, as you can

read below, not much has changed over a decade in the way leverage

is referred to in many prospectuses, leaving far too much freedom

to managers. Leverage is still, even as I write in 2012, rarely limited

in prospectuses or if it is, it is at levels that do not protect investors

enough, unless of course you are in a regulated European fund.

In effect in the language used here, the fund is pretty free to leverage

under two clauses to quite scary levels! The reality is that the fund

probably does not use this level of leverage. Nevertheless, investors

should wonder why such broad and relatively unlimited clauses are

included in prospectuses in the first place. The fact remains that if

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