South African hedge fund managers can soon look forward to operating in a fully regulated industry in 2014, but with this regulation comes good news and bad news.
Draft regulations recently published by National Treasury and the Financial Services Board (FSB) include hedge funds under the existing Collective Investment Schemes Control Act (CISCA) and provide a positive outcome for investors and managers.
Resolving industry uncertainty
Although hedge fund managers have long been regulated under the Financial Advisory and Intermediary Services (FAIS) Act, the draft regulations bring to a close a long period of uncertainty regarding the regulation of hedge fund products in South Africa.
The process to expand the scope of oversight over hedge funds, resulted in National Treasury and the FSB proposing in 2012 that the regulatory framework for hedge funds take effect through CISCA. The final regulations will be realised in terms of CISCA and the intention is to finalise these by mid-year.
The benefits of regulation
One benefit of being fully regulated is that hedge funds, as a strategy, are likely to become more mainstream and accessible, having previously mainly been the preserve of institutions and high net worth individuals. The ability to offer hedge funds in a unit trust environment will enable the broader retail market access to these strategies.
The challenge for the industry in this regard will be to maximise potential inflows from smaller investors attracted by the reassurance of buying regulated products.
The new regulations distinguish between retail and qualified hedge funds. Retail hedge funds will have stricter prescribed guidelines, with regards to risk parameters and liquidity, to ensure investor protection and will be available to the general public.
Qualified funds will only be available to select investors who have the necessary knowledge and experience, or through an approved financial services provider with a minimum investment of R1 million.
Besides increased investor protection, the regulations are also intended to assist regulators in monitoring systemic risk.
The dangers of regulation
Stronger regulation, however, is likely to place upward pressure on costs and hedge fund managers will be challenged to contain expenses in the face of more stringent compliance and monitoring requirements.
The proposed regulations have a big focus on risk management and compliance monitoring with regular reporting to both the registrar and investors. This will require additional resources and, in some cases, independent service providers.
Some of the reporting requirements are for at least quarterly disclosure to investors, including information on the sources of leverage employed in the portfolio, the methodology for stress testing, counterparty exposures, as well as the total expense ratio, amongst others.
In addition, reports to the regulating body each quarter will need to include a full list of gross and net assets, as well as all positions in the portfolio, and risk management measures employed relating to market, liquidity, counterparties and derivatives.
Risk management important
Risk management will be the responsibility of managers who will be required to document and review policies and procedures at least annually. The risk management function will also need to be performed by a resource that is independent of the investment committee.
Over the year ahead, the hedge fund industry could benefit from the positive impact of new regulations promoting integrity and enhanced transparency, which in turn could lead to inflows from a previously untapped market. According to the Novare Investments Hedge Fund Survey, assets in the South African industry reached R42.2 billion last year, a new all-time high.
Where strategies are concerned, equity in both long and short funds continued to dominate the local hedge fund industry with 52.5% of assets managed within this strategy. The second largest strategy is fixed income hedge housing 15.7% of total industry assets, followed by multi-strategy with 9.0% of industry assets.
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