Hedge fund regulations will boost retail investors’ access and lower costs, Deloitte says

National Treasury’s decision to regulate hedge funds in the same way as collective investment schemes will help improve the public view of hedge funds while at the same time giving retail investors access to a wider array of trading strategies and instruments than are currently available via unit trusts, says Deloitte.

As of 1 April 2015 new regulations were promulgated where hedge funds are now governed under the sphere of the Collective Investment Schemes Control Act (CISCA). Consequently, these investment vehicles were into two types: Retail Hedge Funds (RHF) and Qualified Investor Hedge Funds (QIHF). RHFs are regulated more strictly without any minimum investment requirements, while QIHF, which typically require minimum investments of R1 million, are only accessible to investors who can demonstrate a sound knowledge of financial markets.

Angela Costandius, Deloitte’s Cape Town-based financial services audit manager, says one of the biggest impacts of the new regulation will be that South African hedge funds, which have an estimated combined assets under management of R83 billion, will now be required to appoint a management company to oversee operations, in addition to their administration and asset management arms. Collective Investment schemes are required by law to have an administrator, asset manager and management company. Hedge funds were traditionally divided into an administrator and asset manager but have until 30 October 2016 to comply with new regulations, which for one, requires the appointment of a management company.

“We are seeing the vast majority of hedge funds in South Africa are looking to outsource their Management Company functionality, which is likely to lower cost and increase the admin input required from the hedge fund. The fund managers in the South African market are typically CFA’s and actuaries – to take on an additional admin load within their hedge fund structure would decrease the time for them to do what they’re good at – creating returns,” says Costandius.

“The other positive aspect to the regulation is that it will open up the world of hedge funds to retail investors, thereby giving them access to a wider range of assets, such as larger limits of unlisted investments, as well as sophisticated trading strategies like short selling. At this stage, unit trust fund managers may not borrow money to invest; neither may they short the market.”

Short selling involves selling a security that the seller does not yet own at an agreed price based on the belief that the price of that security will fall below the specified price by the time the transaction occurs. That allows the seller to pocket the difference and make a profit.

“Hedge funds have the advantage in that they have a greater array of trading strategies available to them in order to enhance returns for their investors,” says Costandius. “If they think a certain asset price is going to decline they can devise a strategy to try and profit from that whereas all a unit trust portfolio manager can really do is sell out of that asset.”

Leverage, or borrowing certain instruments to trade them on financial markets, can also be used by hedge funds to take positions in certain assets without actually having to own them. This puts them in a rather unique position in that they don’t have to pay securities transfer tax (STT).

“There is obviously a bit more risk associated with these highly sophisticated trading strategies but potential returns are higher,” says Costandius. “At the same time hedge funds are able to be a lot more agile.”

She says the perception of hedge funds as operations run by investment ‘cowboys’ is largely unfair as retail funds in particular have stringent restrictions on what their asset managers can invest in as well as limits on leveraging. Hedge fund managers are required to be licensed with the Financial Services Board and the risk within the funds is also closely monitored by CISCA.

“While it remains to be seen whether retail investors in South Africa take strongly to the new accessibility to hedge funds, we foresee strong growth in the sector,” says Costandius. “Most of the large hedge fund players already have ready-for-launch retail platforms and the remainder of the large players are expected to be fully compliant with the new regulations by the end of February. Most boutique hedge funds are setting up retail platforms as well, so there is a vast array of options available to individual investors.”