A move by the Financial Services Board (FSB) to restrict how retirement funds invest in hedge funds has drawn the ire of the hedge-fund management industry, which says the proposed measures contradict the existing requirements for the registration of hedge funds as collective investment schemes.
The proposed measures are contained in a draft notice published by the FSB and signed by Rosemary Hunter, the deputy executive in charge of retirement funds.
The draft notice outlines amendments to the prudential investment guidelines for retirement funds, which are contained in regulation 28 of the Pension Funds Act (see “More about the restrictions”, below). Effectively, the proposed amendments will limit retirement funds to investing in the more conservative, retail class of hedge funds, as defined in regulations issued under the Collective Investment Schemes Control Act (Cisca).
The period for the public to comment on the amendment closed last week. The FSB has undertaken to publish all the comments it receives and its response to them before it takes further action.
In February 2015, then Finance Minister Nhlanhla Nene announced that all hedge funds – which were unregulated investments – would have to register as collective investment schemes in terms of Cisca and adhere to that Act.
In April last year, regulations issued under Cisca required all new hedge funds to register as collective investment schemes and gave existing hedge funds 12 months to register. The regulations provided for hedge funds to be classified in two broad categories:
* Qualified investor hedge funds (QIHFs), which are available only to institutional investors, such as retirement funds, and financially sophisticated individuals. QIHFs are not as tightly regulated as hedge funds for retail investors.
* Retail investor hedge funds (RIHFs) are open to ordinary investors, but they can have fairly high minimum investment amounts. They are more strictly regulated than QIHFs and cannot take as many investment risks.
The regulation of hedge funds followed changes to regulation 28 of the Pension Funds Act four years ago allowing retirement funds to invest up to 10 percent of their assets in hedge funds.
Ian Hamilton, the head of IDS Fund Services, the largest hedge-fund administration company in South Africa, says the FSB’s proposed measures will result in a bureaucratic muddle and possibly in retirement funds deriving inferior performance from hedge-fund investments.
In simple terms, they will result in retirement funds paying more for insurance against market volatility, while receiving less cover against downside market volatility.
He says the purpose of allowing retirement funds to invest in hedge funds is to reduce their exposure to volatile markets. The proposed amendments come “at the very time that markets are volatile and hedging is required”.
Hamilton says the proposed measures require QIHFs to comply with the same derivative structures as retail hedge funds, “which are governed by a far more restrictive mandate”.
He says the restrictions may make it necessary for all the applications for registration as a QIHF to be withdrawn and amended. In the case of IDS, this would affect more than 50 applications.
Jurgen Boyd, the FSB’s deputy executive in charge of collective investment schemes, says that to date the FSB has received applications from 19 management companies to register 33 collective investment schemes, comprising 283 individual hedge fund portfolios with a total of R93 billion under management. There are 21 applications to register collective investment schemes as QIHFs, while 12 are for registration as RIHFs.
Hamilton says: “If the notice is not withdrawn, it will be at least six months before an orderly transition to regulated funds can take place because of the uncertainty it has now created. We will have to wait for the FSB to collate the submissions with the proposed new regulations and reply to the industry on the submissions. This is something that takes months.”
Hamilton says the “silliness” of the proposed measures is highlighted by the fact that retirement funds were allowed to invest in unregulated hedge funds before hedge funds were required to register in terms of Cisca.
The Association for Savings and Investment SA (Asisa) is among the parties that have provided the FSB with comments. Asisa says it does not want to comment publicly until the FSB has had time to consider its comments.
The FSB declined to comment on Hamilton’s criticisms.
MORE ABOUT THE RESTRICTIONS
The proposed restrictions on how retirement funds may invest in hedge funds mirror and add to the hedge fund regulations that were issued under the Collective Investment Schemes Control Act (Cisca).
The proposed restrictions, which were issued in terms of regulation 28 of the Pension Funds Act, limit retirement funds to investing in hedge funds regulated by Cisca. Currently, retirement funds can invest in unregulated hedge funds.
Tony Christien, the deputy chief executive in charge of hedge funds and general operations at IDS Group, says the main proposed amendment to regulation 28 restricts hedge fund managers’ use of derivatives. “This requirement in essence limits pension funds to investing in retail hedge funds,” he says.
Christien says another proposed amendment places “onerous requirements” on retirement funds to monitor hedge funds’ compliance with Cisca.
He says although the proposed changes to regulation 28 will make it almost impossible for retirement funds to invest in qualified investor hedge funds (QIHFs), they do not address important issues, such as retirement funds’ use of segregated mandates (stand-alone hedge funds) and their investments in foreign hedge funds.
Cisca limits both QIHFs and retail investor hedge funds (RIHFs) to using securities and derivatives listed on registered securities exchanges. It also limits the percentage of a fund’s assets that may be invested in a single security. These limits apply to all collective investment schemes, to reduce the risk of the scheme incurring a major loss if a single underlying investment fails.
The Cisca conditions that apply specifically to QIHFs include the following:
* Only “qualified investors” may invest in QIHFs. A “qualified investor” means any person or entity (such as a retirement fund) that invests a minimum of R1 million per hedge fund and that has demonstrable knowledge of and experience in financial and business matters that would enable the investor to assess the merits and risks of a hedge fund investment, or that has appointed a financial services provider with demonstrable knowledge and experience to advise the investor about the merits and risks of a hedge fund investment;
* There are restrictions on the investment strategies that a fund may use, to ensure that investors will not suffer losses greater than the value of their investment or contractual commitment to the fund;
* Fund managers must set a “value at risk”, which is a measure of the maximum expected loss in a portfolio over a specified period of time; and
* Funds must have sufficient liquidity (cash and assets that are easy to sell) to enable the manager to pay out investors within three calendar months of an instruction to disinvest.
The requirements for RIHFs include:
* Funds must be sufficiently liquid, so that the manager can pay out investors within three calendar months of receiving an instruction to disinvest. A unit trust fund must be able to pay out an investor within 48 hours, but because of the contractual nature of derivatives, there is a constraint on when the underlying investments of a hedge fund can be cashed in.
* The fund manager is limited to borrowing up to 10 percent of the value of a portfolio for liquidity purposes.
* Managers may borrow against the fund’s assets only for investment purposes, when borrowing funds for taking short positions or engaging in derivative transactions with counterparties (see “What is a hedge fund?” below).
* Gearing (borrowing to invest) is restricted to a maximum of 20 percent of the total net asset value of the portfolio.
* Managers must report to the Financial Services Board monthly, within 14 days of the end of the month, all long and short positions in the portfolio, reflecting the market value and the effective exposure and value of each of the underlying investments.
* Funds may not invest in immovable property, a portfolio of a QIHF, or a private equity fund.
* A fund’s exposure to derivatives may not exceed the net asset value of the portfolio.
WHAT IS A HEDGE FUND?
Hedge funds are similar to unit trust funds in that investors’ money is pooled and used to buy securities, such as shares.
The main difference between a hedge fund and a unit trust fund is that hedge funds have more flexibility in the financial instruments and investment strategies they can use, and they can borrow money against their assets to enhance returns (although this can also result in more losses).
Hedge funds are typically more risky than most unit trust funds. They also tend to be more expensive than unit trust funds, which reduces returns.
Hedge funds use different strategies to achieve returns, from trading in stressed debt to finding small gaps in the prices of securities. The regulations issued under the Collective Investment Schemes Control Act (Cisca) prescribe which strategies regulated hedge funds can and cannot use.
A common strategy, which is permitted by Cisca, is investing long/short with the aim of producing superior returns whether investment markets are up or down. This strategy involves buying some securities long and selling others short. Buying long means to buy a security (bond or share) and hold it in the hope that it will gain in value.
When a manager shorts a security, it borrows (rents) shares from another investor and sells the shares in expectation that the price will drop. When the price drops, the manager buys back the shares at a cheaper price and returns them to the original owner, making a profit on the difference between the selling and purchasing price (less the rental).
Hedge funds have many risks. The Cisca regulations mitigate, but do not remove, these risks, which include:
* Liquidity risk. Contractual or market conditions often make it difficult for hedge funds to sell their underlying investments. In extreme market conditions, liquidity problems can result in the collapse of the fund.
* Pricing risk. It can be very difficult to value the assets in a hedge fund at a particular time.
* Counterparty risk. Hedge funds tend to deal with other parties in purchasing derivatives, borrowing securities and gearing (borrowing). There is a risk that a counterparty may fail to meet its commitments, which will have a knock-on effect for the fund.
* Short-squeeze risk. The securities required for a shorting contract are not available.
* Financial squeeze. The fund manager is unable to borrow, or cannot borrow at an acceptable interest rate, frustrating the manager’s investment strategy.
* Timing risk. The manager makes the wrong market calls.