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Pragmatic hedge fund supervision – a near reality

23 April 2014 George Cavaleros, Deloitte & Touche

Regulatory supervision of the R 45-odd billion South African hedge fund industry – which, depending on the strategy followed, returned approx. 4.7 % to 27 % to investors during 2013 – recently took a step closer to finalisation with the release by National Treasury and the Financial Services Board of draft regulations for public comment. These follow the issue of a proposed regulatory framework for hedge funds during September 2012 and subsequent comments received on the proposals from interested parties.

The draft regulations, which stem from South Africa’s G20 obligations, aim to protect hedge fund investors, manage systemic risk and promote the integrity of and transparency in the hedge fund industry. They also focus on the regulation of hedge fund products. Currently hedge fund managers are regulated under the Financial Advisory and Intermediary Services Act (FAIS).
 
The authorities have taken what can be considered a pragmatic and flexible approach in achieving their objectives by allowing for two types of hedge funds, both of which will fall under the ambit of the Collective Investment Schemes Controls Act (CISCA), the same legislation that regulates collective investment scheme portfolios in South Africa.
 
The first type, the Qualified Investor Hedge Fund (QIHF), is aimed at so called "qualified investors” who are either experienced in investment matters or who have appointed experienced FAIS registered advisors to assist them and who have a minimum hedge fund investment budget of R 1 million. Institutional investors are also included in this category.
 
QIHFs can only be marketed to qualified investors and will not be available to the general public.
 
The second type, the Retail Investor Hedge Fund (RIHF), is aimed at the retail market and is available to all potential investors, especially individuals who are interested in hedge fund exposure.
 
While the draft regulations provide for certain general rules and principles that are applicable to all hedge funds, e.g. the principle that an investor cannot lose more than the invested capital, the specific provisions relating to RIHFs are more onerous and provide for more regulatory safeguards than those affecting QIHFs. In the case of leverage for instance, QIHF managers have the flexibility to determine their own leverage levels, subject to certain disclosures, while gross exposure by RIHFs is limited to 200% of the fund’s net asset value. Regarding permitted investments, RIHFs are subject to investment exposure limits, while QIHFs are not restricted in the same way.
 
This "regulatory differential” follows the regulator’s view that qualified investors are generally more investment savvy than their average retail counterparts, allowing them to better appreciate hedge fund mechanics and the risk return profiles of investments in the hedge fund universe.
 
Hopefully these regulations will assist in changing the perception held by many potential investors that hedge funds are "toxic "or high risk investments that should be avoided as they could be value destructive. It is true that investors have lost money in the hedge fund space. Some losses have been due to hedge fund investment manager errors and operational risk management failures, but many were probably a function of speculative investing and the selection of funds whose profiles were at odds with investors’ investment strategy and risk tolerance.
 
The reality is that hedge funds, due to their characteristics, have a useful role to play in a well-constructed portfolio. These include their low correlation to other investments resulting in portfolio diversification, the stabilisation of returns and the reduction in volatility. On the negative side, their fees are generally high.
 
It is expected that the tax regime for both types of hedge funds will be similar to that applicable to unit trusts and their investors. Distributions made by hedge funds will be taxed in the hands of the investors depending on their tax status. Capital Gains Tax will also accrue to investors who meet the necessary requirements.
 
The proposed regulations do however raise many potential questions. Will the cost of supervision, investor protection, transparency, and reporting have the effect of increasing costs, thereby reducing returns? Will the steps introduced to reduce risk, e.g. exposure limits for RIHFs, limit the hedge fund manager’s ability to generate the most appropriate returns? How will the retail industry, which has a lot to gain from a cash inflow perspective, respond to the regulations and how far will it go in pursuit of retail clients? Are the retail industry distribution channels sufficiently skilled and effective to enable fair marketing of RIHFs? Will the industry be able to attract sufficient new cash flows to create RIHFs that are sustainable in the long term?
 
The proposed transition period of one year from the promulgation of the regulations to enable managers, administrators and hedge fund investment managers to comply with the regulatory requirements will prove challenging and costly. In many instances, risk management and compliance functions and tools will have to be enhanced and formalised, data sources tested to assess whether they are capable of complying with the reporting requirements, contracts and mandates checked for suitability and regulatory registration in terms of CISCA finalised. Some participants will have to evaluate whether existing systems and retail platforms require any modification. 
 
The upside of all this alignment to the regulations is the continued strengthening of the industry’s infrastructure to become more efficient and better able to respond to investor demands.
 
One can argue that the expected regulatory burden may be distraction. Actually, retail investors will have much needed access to hedge funds with different strategies capable of delivering uncorrelated risk- adjusted returns. They also create opportunities for hedge fund investment managers, to profitably respond to the expected increased investor appetite for hedge funds and to develop new strategies to meet new needs. These are clear short to medium term benefits.
 
What is not clear at this stage is the long term impact and implications of these regulations on investors and the hedge fund industry.
 
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