In a welcome development for the hedge fund industry, it may soon be possible to market retail hedge funds to the public. This is according to proposals published by the National Treasury and the Financial Services Board (FSB).
Although hedge funds are currently not directly regulated under South African law, indirect regulation results in hedge funds only being available to a select group of experienced investors. This has limited the size of the local hedge fund industry which is estimated at R31 billion, compared to US$ 2 trillion for the global hedge fund industry.
Hedge funds have been much maligned since their inception but the level of scrutiny and criticism has increased since the financial crisis. At the same time, there has been a global democratisation of hedge fund strategies with members of the public increasingly interested in investing in hedge funds.
In South Africa, these two developments have led to increased regulatory scrutiny of the industry. New legislation is proposed to firstly deal with the systemic risk to the financial system that hedge funds are perceived to pose and to make regulated hedge fund type products available to the South African public.
These two issues form the focus of the "Framework for regulating hedge funds" that the National Treasury and FSB published for comment in September 2012.
The way forward for hedge funds
South African fund entities are currently regulated under the Collective Investment Schemes Control Act (CISCA) whereas managers and other providers of financial services are regulated under FAIS.
According to the proposed framework, hedge funds will be added as a new category of collective investment scheme under CISCA. Two categories of hedge funds will be available:
- "Restricted hedge funds", which will be more lightly regulated and may only be offered to a restricted investor base of "qualified investors" who invest pursuant to private arrangements. This category seems to be little more than a clarification of the current regime.
- "Retail hedge funds", which may be marketed to the public and are subject to a greater degree of regulation, including publication of a plain language key investor information document, a requirement to offer 14-day liquidity and prescribed prudential requirements.
Government intends introducing the changes in two phases: an initial, interim phase involving the declaration of a new category of CIS under CISCA and a second phase involving more detailed amendments to CISCA.
The proposed framework contains measures intended to address the risks that traditional hedge funds are perceived to pose, namely:
- The risk posed to the public - hedge funds are an increasingly popular investment but they are seen as risky for inexperienced investors.
- The risk posed to the financial system - hedge funds are perceived to pose a systemic risk to the financial system which regulators seek to address by collecting and collating information from the funds.
Addressing the risks to the public
The ability to set up retail "hedge funds" that can be marketed to the public is certainly a positive development for the hedge fund industry.
However, as has been the case with similar legislation in the European Union and elsewhere, the retail hedge fund in South Africa is subject to certain regulation, notably prudential requirements, which prevent the implementation of a true hedge fund strategy.
One of the key drivers of the returns generated by hedge funds is their ability to invest in practically any investment, and the restrictions implied by a regulatory overlay inevitably have an impact on performance. Experience in Europe has shown that there is a significant performance gap between regulated "hedge funds" and true hedge fund strategies. Because they are technically not true hedge funds, these regulated entities that adopt hedge fund-like strategies are now normally referred to as "alternative funds".
Protecting against systemic risk
There is some controversy surrounding the role of hedge funds in the financial crisis, with many commentators expressing the view that hedge funds stabilised the crisis and noting that not a single hedge fund had to be bailed out.
The framework is based on the opposing viewpoint that although hedge funds did not cause the financial crisis, they played a role in exacerbating it. In this regard, South Africa has made a commitment at the G20 to enhancing the regulation of the hedge funds which form part of the "shadow banking system".
The framework proposes to achieve this by monitoring systemic risk build-up in hedge funds through regulations requiring the funds to report to the FSB on a regular basis.
Whilst efforts in this regard are laudable, it is questionable whether hedge funds currently pose a significant risk in South Africa. The smallest of the top 5 South African banks holds deposits about 18 times larger than Treasury's estimates of the total size of the entire hedge fund industry.
The advantages and drawbacks of the new framework
The proposals hold the following advantages:
- The regulatory framework should help to demystify hedge funds and give further legitimacy to hedge fund strategies.
- All service providers to hedge funds, including investment managers, administrators and prime brokers, will be regulated under CISCA . The requirement to involve third-party service providers will improve governance and ultimately enhance the protection of investors through additional checks and balances.
- Enhanced regulatory certainty may lead to reduced setup costs. Although hedge funds tend to be bespoke arrangements, structures and fund documentation will inevitably become more standardised. Operating costs will almost certainly come down as volume increases and service providers structure dedicated products.
At the same time, the new framework maintains fundamental misconceptions about what a hedge fund is. Hedge funds are an investment strategy, not an asset class. CISCA regulates funds on the basis of what they invest in (a CIS in securities or a CIS in property). A hedge fund is characterised by how it invests. As such, creating a new class of CIS under CISCA implies that hedge funds are a type of investment rather than a way of investing.
Furthermore, the traditional South African regulatory definition of a hedge fund as an investment which had the potential of incurring greater losses than the aggregate market value of the portfolio is perpetuated in the new proposals. This is a far broader range of collective investment schemes than which the traditional definition of a hedge fund covers and will mean that some fund managers who are not operating true hedge funds will need a hedge fund licence.
The result is that a host of funds that are not traditionally thought of as hedge funds will be deemed to be a hedge fund. The contradiction between the licensing of the fund entity and its strategy may be difficult to explain to investors. Taking the lead from the EU , in our view, the framework should refer to "alternative investment funds" rather than hedge funds.
Although prudential requirements for regulated alternative funds are inevitable, further detail is required to assess the practicality of the proposals particularly in regard to the liquidity requirements.
Another area of concern is that the tax treatment of hedge fund portfolios under the framework is uncertain.
The prospect of alternative funds that can be marketed to the public is a welcome step for the local fund industry.
While this is praiseworthy, it is arguable that the domestic hedge fund industry is currently too small to pose a significant risk to the South African financial system. Industry watchers would also welcome more debate about the classification of hedge funds and the practicality of the proposed prudential requirements.
The limits that will be imposed on these regulated structures take them outside the realm of traditional hedge funds and as a result they should, in our view, be referred to as alternative funds rather than hedge funds.
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