SA On Fast Track To Hedge Fund Regulation

Following lengthy discussions that kicked off in 2012, the Financial Services Board (FSB) and Treasury finally published the long-awaited draft regulations for SA hedge funds on April 16, 2014. Comments need to be submitted by May 23, 2014. The FSB intends to finalise the regulations before the end of the second quarter of this year, which would make SA the first country in the world to regulate hedge funds to this extent.

Various industry players, such as the Actuarial Society of South Africa, Association for Savings and Investment South Africa, the Banking Association of South Africa and the JSE, have given input during the period leading up to the publication of the draft. When finalised, the regulations will be effected through the Collective Investment Schemes Act (CISCA).

Definition of a hedge fund

In the proposal, a hedge fund is defined as a collective investment scheme that uses any strategy that could result in the portfolio losing more than its aggregate market value at any point in time. The main strategies used would be short selling and leverage.

To illustrate, an equity hedge fund, for example, is an equity portfolio that does at least one of two things:

1) engages in short selling by either selling overpriced individual shares it does not yet own, with the idea of buying the shares at a later stage when the price has dropped, or selling an index future (a proxy for all shares in the market or a particular sector) and thereby making a profit from the fall in share prices;

2) borrows money to buy shares with the idea of leveraging (amplifying) returns in excess of the borrowing rate.

Despite the emphasis on capital loss in the above definition, most hedge funds have a risk profile equal to or even lower than the typical long-only fund and provide stable inflation-beating returns over the medium to long term.

Your retirement fund may already be invested in hedge funds

Regulation 28, governing the rules around the instruments and asset classes in which retirement funds may invest, already allows investment of up to 10% in hedge funds. But it’s not yet possible to invest discretionary (non-retirement funding) money in a collective investment scheme that uses leverage, one of the strategies wielded by hedge funds.

Hedge fund managers are currently regulated; hedge funds are not

To obtain their special hedge fund (category IIA) license with the FSB, hedge fund managers are required to meet the fit and proper requirements of the FSB. This means that they need an unblemished track record of acting honestly and with integrity, have to be financially sound, and must meet the competence and the operational ability requirements imposed by the FAIS Act.

Hedge funds, however, are not yet regulated. The local hedge fund industry welcomes the regulation of the funds, and has, in fact, been self-regulating for a while. SA fund of hedge funds managers, for example, have been applying the industry’s best practice due diligence guidelines when selecting the underlying funds.

Expect the following changes

The proposals distinguish between a retail investor hedge fund and a qualified investor hedge fund, with qualified investors meaning anyone with a minimum investment amount of R1m and who can demonstrate knowledge and experience in financial matters or who have appointed an FSP with this knowledge and experience.  Retail hedge funds would have to comply with stricter regulation requirements than qualified investor hedge funds. All existing funds would have to be registered with the FSB in either of these two categories.

Once implemented, the following are a few of the aspects that will be regulated under CISCA:

• The hedge fund’s choice of administrator, trustee and prime broker
• The custody of assets
• The choice of risk manager, as well as the risk management policy
• The choice of counterparty to any derivative instrument and the extent of counterparty exposure
• Permitted assets and securities – and exposure limits to these assets
• The extent of leverage
• The valuation and pricing of the fund
• Fees
• Reporting to investors and the registrar
• The remuneration policy of a manager

We believe that there is a place for hedge funds in a balanced portfolio

Sanlam Investments’ Fund of Funds: Investment Core welcomes the proposed regulations. Given the investment freedom enjoyed by hedge funds, they are able to manage risk more effectively. Regulation will enforce transparency and stringent risk control, making these products more accessible to investors. Against this backdrop, we are happy to see the veil over hedge funds finally being lifted.