Tighter regulation for hedge funds

14 Mar

Author: Bruce Cameron

Publications: iOL

Date Published: 14 March 2015

Hedge funds, which manage assets of more than R57 billion, mainly from retirement funds, will have to register as collective investment schemes by the end of March next year in terms of new regulations by National Treasury and the Financial Services Board (FSB).

This will result in far more protection for investors in hedge funds, which are currently unregulated. Until now, hedge fund managers have only had to register with the FSB as financial services providers.

The absence of regulation allowed things such as the massive Relative Value Arbitrage Fund scam, in which about 3 000 people invested about R2 billion in an unregulated fund posing as a hedge fund. The fund collapsed in 2013, when the person who ran it, Herman Pretorius, shot himself after killing his business associate, Julian Williams, after the FSB started a much-delayed investigation.

The regulations, which will be implemented from April 1, 2016, will require all new hedge funds to register in terms of the Collective Investment Schemes Control Act (Cisca), while existing hedge funds will have 12 months to register.

The regulations create two broad categories of hedge fund, each with different levels of regulation:

* Qualified investor hedge funds, which are limited to institutions, such as retirement funds, and very wealthy individuals who have large sums to invest. These funds are less rigidly regulated. Investors must be able to demonstrate to the fund managers that they have sufficient expertise to understand the workings and risks of hedge funds.

* Retail hedge funds, which are open to ordinary investors, although the minimum investment amounts are usually fairly high. They are more strictly regulated than qualified investor funds, and the risks they are allowed to take are more limited.

The new hedge fund regulations follow changes to regulation 28 of the Pension Funds Act four years ago that allowed retirement funds to invest significant amounts in hedge funds.

The regulations also come at a time when investors internationally are expressing greater caution about hedge funds, because of complexity, fraud, costs and poor performance. For example, in 2014, one of the world’s biggest retirement funds, the California Public Employees’ Retirement System, announced plans to start cashing in the US$4 billion it had invested with hedge funds, saying they were “too expensive and complex”.

The aims of the regulations are to:

* Provide investors in hedge funds with better protection;

* Assist in monitoring and managing systemic risk to the financial services industry;

* Promote the integrity of the hedge fund industry;

* Enhance transparency in the hedge fund industry, which traditionally has been ultra secretive; and

* Promote the development of financial markets.

The regulations state that hedge funds will be taxed on the same conduit basis as all other collective investment schemes, such as unit trust funds.

The conduit principle means that investors pay tax only when they receive returns. So any interest or dividend payments are taxed in the hands of the investor when they accrue; and income tax (if the investment is sold in less than three years) or capital gains tax apply to any gains or losses on the sale of an investment.

The regulations, in effect, accord hedge funds a special status in terms of Cisca. Unit trusts funds, which are also governed by the Act, cannot use the investment strategies and financial instruments that often form the backbone of hedge funds (see “What are hedge funds?”, below). For example, unit trust funds are not allowed to borrow to invest, nor can they use most derivatives.

But the regulations will not open the door to a “wild west”. There are strict controls, particularly in the case of retail hedge funds, on investment strategies, gearing and financial instruments.

The South African hedge fund industry grew its assets under management by R10.5 billion during 2014, ending the year with assets under management of R57 billion.

These assets are invested in 113 hedge funds, which are managed by 55 hedge fund managers (fund of hedge fund managers excluded).

‘WELCOME DEVELOPMENT’

The declaration of hedge funds as collective investment schemes by National Treasury and the Financial Services Board (FSB) is a welcome and long-awaited development, says Leon Campher, chief executive of the Association for Savings & Investment SA (Asisa).

Campher says Asisa partnered with National Treasury and the FSB for several years to regulate hedge funds, which had been pushing for clarity on product regulation.

“Generally, regulation assists with the growth and management of an industry, as it provides much- needed clarity to industry participants and investors alike. Consumers, whether they are institutional or retail, also find comfort in the fact that an independent body – the FSB – is overseeing the industry operations and structures that manage their investments,” Campher says.

He says that South African financial regulators accepted in 2007 that hedge funds needed some form of regulatory supervision. Initially, this was thought to be appropriate at only manager level, since hedge fund managers are held to higher experience standards, greater capital adequacy requirements and stricter qualifications than their “long only” peers. However, since the global financial crisis of 2008, South African and global regulators have been reviewing the situation.

REGULATIONS FOR QUALIFIED AND RETAIL FUNDS

Under the new regulations, general conditions apply to both retail and qualified investor hedge funds. For example, they are restricted in the main to using securities and derivatives that are listed on registered securities exchanges. There are also limitations on the percentage of a fund that may be invested in any one security. These limitations apply to all collective investment schemes, to reduce risk of a major loss if there was a total failure of a single underlying investment.

The specific conditions that apply to qualified investor funds include:

* They are restricted to “qualified investors”. This is someone who can invest a minimum of R1 million per hedge fund and who has demonstrable knowledge and experience in financial and business matters that enable the investor to assess the merits and risks of a hedge fund investment; or who has appointed a financial services provider who has demonstrable knowledge and experience to advise the investor about the merits and risks of a hedge fund. A qualified investor can be an individual or an entity, such as a retirement fund.

* There are limitations on investment strategies that expose an investor to a loss in excess of the value of its investment or contractual commitment to a fund.

* The fund manager must set a “value-at-risk”, which is a measure of the maximum expected loss of a portfolio over a specified period.

* Have sufficient liquidity (cash and easy-to-sell assets) that enable the manager to pay out investors within three months of an instruction to sell.

The specific requirements for retail hedge funds include:

* The fund must have sufficient liquidity to enable its manager to pay out investors within three months of an instruction to sell. A unit trust fund must pay out an investor within 48 hours, but, because of the contractual nature of derivatives, there are constraints on when the underlying investments of a hedge fund can be cashed in.

* The fund manager is limited to borrowing up to 10 percent of the value of a portfolio for liquidity purposes.

* The manager may borrow against the fund’s assets only for investment purposes, when borrowing funds for taking short positions or engaging in derivative transactions with counterparties (see “What is a hedge fund?”, below).

* Gearing (borrowing to invest) is restricted to a maximum of 20 percent of the total net asset value of the portfolio.

* Managers must report to the Financial Services Board monthly, within 14 days of the end of the month, all long and short positions in the portfolio, reflecting the market value and the effective exposure and value of each of the underlying investments.

* The fund may not invest in property, the portfolio of a fund for qualified investors or a private equity fund.

* If the portfolio includes derivatives, the manager must ensure that the fund’s exposure to derivatives does not exceed the net asset value of the portfolio.

WHAT IS A HEDGE FUND?

Hedge funds are similar to unit trust funds in that investors’ money is pooled to buy assets. The main difference is that hedge funds have more flexibility in the financial instruments and investment strategies they can use, and they can borrow money against their assets, to multiply returns (but they can also multiply losses).

Hedge funds should not be confused with hedging, which is an investment strategy to reduce potential losses.

Most hedge funds are more risky than unit trust funds. On average, they are far more expensive than unit trust funds, which reduces the returns.

Hedge funds use many different strategies to earn returns, from trading in stressed debt to finding small gaps in the prices of securities. Most of these strategies are not permitted in terms of the new regulations.

Most hedge funds, particularly more traditional ones, use what are called long-short strategies to provide superior returns, whether investment markets are rising or falling. These involve buying some securities long and selling others short.

Buying long means buying a security (bond or share) to hold on to it in the hope that it will increase in value.

Selling short is a bit more complex. The manager borrows (rents) shares from another investor and sells the shares in the expectation that the share price will drop. When the price drops, the manager buys back the shares at a cheaper price to give back to the original owner, making a profit on the difference between the selling and buying prices (less the rental).

There are many risks associated with hedge funds, which the regulations aim to reduce but do not eliminate. These include:

* Liquidity risk. It is often difficult to sell a fund’s underlying investments because of contractual or market conditions. In extreme market conditions, liquidity problems can cause a fund to collapse.

* Pricing risk. It can be very difficult to value the assets in a fund at a particular time.

* Counterparty risk. Hedge funds tend to deal with other parties when purchasing derivatives, borrowing securities and gearing (borrowing). There is a risk that a counterparty may fail to meet its commitments, which will have a knock-on effect on the fund.

* Short squeeze risk. This is the risk that the securities required for a shorting contract will not be available when required.

* Financial squeeze. This is the risk that a manager will be unable to borrow, or to borrow at an acceptable rate, frustrating the strategy followed by the manager.

* Timing risk. This is the risk that the manager simply gets it wrong.

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