Regulation expected to encourage investment in hedge funds

The long awaited regulation of hedge funds in South Africa, released last week by the National Treasury and the Financial Services Board (FSB), is a positive outcome for investors and hedge fund managers alike.

Hedge funds have been declared collective investment schemes from 1 April 2015, with regulation including market conduct guidelines to ensure cost-effectiveness and standards on leverage.

According to Eugene Visagie, Portfolio Manager at Novare Investments, the objective of regulation is to protect investors and to assist with monitoring systemic risk, while promoting the integrity of the industry and encouraging financial market development.

“Despite a misconception that hedge funds invest in risky assets, South African funds invest in similar instruments to unit trusts, bonds and equities for example, but they have more flexibility when it comes to deploying financial instruments. Using strategies like short selling, leverage, concentrated investments and derivatives, hedge funds are able to use alternative methods to extract alpha from financial markets.

“One of the main benefits of including hedge funds in a balanced portfolio is that a hedge fund can have a long or short exposure to the market, allowing it to profit from both rising and falling markets. This means investors are able to use hedge funds as a risk reducing strategy while delivering absolute returns,” said Visagie.

On the investment merits of hedge funds, he commented: “Hedge funds typically exhibit lower correlation with financial markets, which can reduce overall portfolio volatility if used in combination with other more traditional asset classes.

“One of the main advantages of the new regulation is that a broader investor base will be able to access these portfolios.”

Regulation incorporates a two-tiered approach, with retail hedge funds open to any investor and qualified funds, with less cumbersome regulation, only available to qualified investors. Retail hedge funds will be subject to stricter investment guidelines as well as more frequent reporting to ensure stronger investor protection.

On the two-tiered approach, Visagie said that amongst the differences between retail and qualified investor hedge funds is that the former are subject to stricter liquidity requirements and risk parameters, while qualified funds have less stringent but fitting requirements.

“Investment guidelines will include hedge funds not exceeding gross exposure of 200%. Much of the domestic hedge fund industry is focused on equities and we expect that the majority of equity long/short strategies and equity market neutral strategies will be able to fit within the prescribed guidelines.

“A clear distinction is also made with regard to the liquidity offered to investors. Retail hedge funds will offer a maximum notice period of a calendar month to facilitate redemptions, with qualified funds offering a maximum of three calendar months.

“The regulation has a big focus on risk management and compliance monitoring with regular reporting to both the registrar and investors. Some of the reporting requirements include regular disclosure to investors, including sources of leverage, the methodology used for stress testing, counterparty exposure as well as the total expense ratio,” said Visagie.

Reporting to the regulator will 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, counterparty and derivatives risks.

The risk management function will need to be performed by a resource that is independent of the investment committee.

Additional independent oversight is also required, and regulation stipulates that the board or the trustees of hedge funds include independent directors or trustees.