Does regulation mitigate hedge fund risk?
Under current legislation pension fund managers can invest a maximum of 2.5% of their funds’ assets in hedge funds. Such investments are classified as ‘other.’ This situation seems to be the crux of the local hedge fund industry’s drive for tighter regulation. The thinking runs on the lines: if we’re regulated then pension funds will, one day, be able to invest 15% to 25% of their assets in our industry. “Without a tight and well-run regulatory environment the industry is going to flounder,” said Robert Foster, chairman of the Alternative Investment Management Association (AIMA).
Foster was speaking at Blue Ink Investments’ Exploring the hedge conference held at Summer Place on 16 July 2009. He revealed that key stakeholders in the local hedge fund industry and the local regulators (National Treasury and the Financial Services Board) had been talking about regulating the industry for some time. The next meeting with the regulators is set for late August.
Global regulatory trends
Since the sub-prime crisis unfolded the world has been baying for improved financial services regulation. According to Foster the initial focus in the US was on ‘fixing’ the credit providers.” Banks emerged as the likely cause of the financial contagion, and were therefore singled out for special attention when policymakers discussed possible solutions to the problem. “In Europe the focus has been on a general clampdown on all financial services, from banks to offshore products,” said Foster. With attention thus diverted, hedge fund managers escaped the initial thrust of regulation, despite many pundits blaming the industry for the financial meltdown. In the next 12 to 18 months global regulators will undoubtedly tackle hedge fund industries on critical issues such as transparency. Foster believes that improved insight and understanding, particularly from regulators, would be good for the entire hedge fund industry.
But stakeholders in the UK have been vocally opposed to regulation. Although they have identified (and agreed upon) five key points that need to be resolved, they are unable to agree a way forward. These concerns include the need for greater macro-prudential oversight of systemic risks, greater transparency of risk data, consistency of short-selling regulation internationally, convergence of industry standards globally and authorization and registration of managers by their national regulators.
Meanwhile, back at home
The international hedge fund industry is divided into two camps. Some hope for a “completely unconstrained” environment while the rest prefer a regulated environment with impartial oversight. In South Africa most stakeholders are already subject to some form of regulation. Under the Financial Advisory & Intermediary Services (FAIS) Act, local hedge fund managers are regulated by, and have to register with the FSB. There are approximately 128 registered hedge fund managers, many of whom have already been subject to a second FSB audit. “It’s great to be in a proactive, cooperative relationship with your regulator,” said Foster. He believes this relationship will improve the environment for all stakeholders, including investors.
The next big step for the local hedge fund industry will be the regulation of hedge fund (and perhaps other alternative investment) products. The industry, with FSB consent, has already agreed to develop a Hedge Fund Product Regulation which will probably be housed in the Collective Investment Schemes Control Act (CISCA). A regulatory framework will be jointly developed by AIMA and the Association for Savings and Investments (ASISA) in cooperation with the FSB. “We would like to set the framework for the regulator to consider a wider berth for hedge funds to operate in,” said Foster, adding that a Final Regulated Product Proposal should be on the drawing board by year end.
Due diligence, risk management and separation of duties already exist in the local hedge fund space. Foster said the industry would push for formal recognition of its ‘self regulating’ nature, but admitted that regulation was essential to achieve the credibility already afforded other long-term savings vehicles, such as those housed in the collective investments and long-term insurance space.
Getting the balance right
There are a number of items that must be addressed through the regulatory framework. Perhaps the most important will be to strike a balance between industry trends locally and internationally. It won’t help to create a regulatory island in South Africa, thereby isolating our hedge fund industry from the rest of the world. Foster said the regulations would have to ensure effective risk management and reflect a clear understanding of risks across the industry. Separation of duties and elimination of potential conflicts of interest would also have to be addressed. Excessive regulation could post a major threat to product innovation. Foster noted that the innovative products tend to flourish in an unregulated environment. (We’re sure many FAnews Online readers wonder whether the disappearance of such products is necessarily a bad thing).
Regulators would also have to agree on appropriate levels of education for all stakeholders. A critical issue would be to what level the financial adviser – who deals with the ultimate beneficiary - would have to be educated.
Editor’s thoughts:
The hedge fund industry suffered massive losses through the financial crisis despite the range of alternative investment strategies available to hedge fund managers. Investors soon discovered that the spread of returns across hedge funds was as wide as that in other regulated funds. Do you believe that regulation creates a safer investment environment? Add your comments below, or send them to [email protected]
