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What is luring traditional investment managers into the hedge fund business? One attraction is the absence of regulation and the great freedom to invest in anything that generates a return. In contrast to a mutual fund, which invests in traditional assets, hedge funds have no obligation to a particular investment policy, which gives them the flexibility to move from one class of asset to another − a distinct advantage in a volatile market. Hedge funds employ a wide range of investment strategies, the most prominent of which is short-selling and a lot of leveraging.

As of Friday, about 60 funds operate in Israel, although 40% are actually registered domestically. Another 27% are registered in the Cayman Islands, 18% in the United States and another 15% in the British Virgin Islands.

“Hedge funds aren’t the right thing for the average private investor,” says Danny Tzidon, deputy CEO at Bank Leumi, who had been operating a hedge fund for the bank until it encountered regulatory issues. “Nevertheless, they have room to grow. What is fair to ask is whether the Israeli economy is big enough to host Israeli hedge funds. In my opinion, the answer is yes. There’s no reason not to develop the industry in Israel.”

In order to learn more about the industry, TheMarker gathered some of the top names. They spoke about the growing interest of foreign investors in Israeli hedge funds, but they also complained about the lack of consistent regulation. On the one hand, there are rules that make it difficult to compete with foreign hedge funds; on the other, the relatively lax regulation there is making foreign investors wary of giving their money to Israeli managers.

“The government is doing everything it can to destroy our activities,” says Uri Hershkovitz, CEO and partner in in the Sphera Fund, which with $260 million under management is Israel’s biggest hedge fund and is controlled by businessman Mori Arkin.

Hershkovitz says the Tax Authority puts Israeli hedge funds at a disadvantage to their overseas counterparts. “In contrast to investors in U.S. hedge funds, who only pay capital gains tax when they sell an asset, Israel investors are required to pay tax at the end of every calendar year, even if they’ve sold nothing,” he explains. “This alone is enough to drive foreign investors away from Israeli funds. It has nothing to do with malice, just a lack of thought-out policy.”

Another issue that distresses Hershkovitz is the fact that the Bank of Israel uses foreign banks to manage the country’s foreign currency reserves. “Let’s compare the performance of Citibank or Deutsche Bank, which manage Israel’s currency reserves, with that of Bank Leumi or Sphera. I’m telling you that both Leumi and I could eat them alive. Why don’t they do something to encourage the Israeli industry?” he asks. “If there’s one industry here that can grow, it’s management of global financial assets. It’s an area where we are very strong and are very well known globally.”

Nir Peleg, a partner and CEO in the $35 million Kryptonite Fund, agrees that Israel has a large talent base on which to build a much bigger industry, pointing to the fact that foreign financial services companies are constantly in search of veterans of the Israel Defense Forces’ 8200 intelligence unit who can develop for them securities trading strategies based on algorithmic models. “Israeli is known worldwide as a leader in algo-trade. Foreign investors see the potential here of finding the genius who can create the next money machine,” he says.

 Reluctant investors 

 One of the disadvantages of operating in Israel for hedge funds is the absence of regulation. In contrast to mutual funds, which are answerable to the Finance Ministry’s commission on capital markets, hedge funds are not supervised by any particular body, one of the principal reasons why foreign investors are reluctant to let Israelis manage their money. Managers are realizing that if the industry is going to grow, it will need to become more transparent.

 “The person who best understands the role of regulator is the investors,” says Yitzhak Raab, founder and CEO of Tzur Management, which provides services to the hedge fund industry. Investors, he says, are requiring more and more information be put into fund prospectuses and are paying attention to every small detail.

“Three years ago, we were getting telephone calls from clients asking who is your prime broker?” Hershkovitz recalls, referring to the company that provides trading services to funds. “We said UBS. They would ask us what happens if UBS goes bankrupt? So we added another prime broker, Morgan Stanley. It’s a demand that originated with the clients. Today even if I wanted to steal money from an account, I can’t because two prime brokers are watching over me.”

In addition, he says, every one of Sphera’s fund has its own prospectus, in which is details the level of levering in the fund, which sectors it is investing in and the extent of exposure to the capital market and to stocks.

Leumi’s Tzidon says that despite any prospectus a fund may issue, the industry still suffers from a lack of transparency. “The source of the problem is over-information. You can’t explain everything to an ordinary investor. People who invest in a mutual fund canny understand what the fund does. With hedge funds, the situation is different. Investors don’t always know what the fund is doing − therefore it’s not suited for the retail world,” he says, referring to small investors.

NIS 1 million to get in

Itamar Eden, a partner and investment manager for Kryptonite, says a hedge fund is appropriate for anyone with liquid funds in excess of NIS 1 million to invest for the medium to long term. Kryptonite’s minimum for accepting new clients is NIS 1 million, but some funds will accept no less than $1 million. 

Hedge funds employ a strategy aimed at producing returns in every arket situation. To do this they need to make use of a wide range of financial instrument and leverage themselves generously, all of which are rarely if ever used by mutual funds. Raab, who conducted research on 34 Israeli hedge funds, says he found five broad strategies employed by them. “The biggest segment of the market uses the long-short strategy in shares,” he says. “Every stock purchase in hedged by a short sale of another stock, generally speaking in the same industry.”

The fourth is known as “event driven,” and is based on exploiting situations such as a company going bankrupt. The fifth is one that employs elements of two or more of the others, he says.