New hedge fund rules may require health warnings

Date: Monday, September 17, 2007
Author: Gerald Saacks, Busrep.co.za

 The Financial Services Board (FSB) has just published the long-awaited hedge fund regulations, but what exactly do they mean?

Firstly, it is important to note that the regulations regulate only the hedge fund management firm and the qualifying individuals on its staff, rather than products for the unit trust or pension fund market.

Secondly, rather than define a hedge fund by its characteristics - difficult due to the multitude of strategies followed - the FSB has focused on the unique risks of these alternative investments on the advice of the Investment Management Association of SA (Imasa).

Unlike investors in traditional, long-only investments, investors in hedge funds can lose more money than their initial capital investment.

Consequently, the FSB has used this as a basis for defining hedge funds, in effect including any strategy that could result in losses greater than a fund's market value.

Two strategies that could result in these types of losses are cited: leverage (gearing) and net short positions, which can be illustrated in the following ways:

n Leverage: you start with an initial investment of R100 and use this to buy a futures contract with an effective exposure of R1000.

You have essentially put down a 10 percent deposit and are geared 10 times. Should the market on which your future is based - say the all share index - go up by 25 percent, your contract would be worth R1 250. So if you were to close your future contract you would show a net profit of R250.

But should the market fall 25 percent, your future contract will be worth only R750, resulting in you having to pay in an extra R250 - in effect losing R250.

n Net short positions: you sell shares in company B to the value of R200. Your investment strategy hopes that company B's share price will fall in the next few days. Should the value of B fall to R150 you could buy the shares at R150, making yourself a nice profit of R50, as you have already locked in the selling price of R200.

However, should the price rise to, say, R300 when you need to deliver, you would be forced to buy at R300, making a loss of R100. The higher the price, the more your loss, which could in theory be infinite.

Because of these potential higher risks, the FSB requires all aspirant hedge fund managers to apply for a special type of licence that needs a higher hurdle than for traditional managers. This covers a higher level of educational requirements and experience, as well as greater internal controls.

It seems from the questions on the application form that the FSB is concerned about risk management independent from the fund manager, as well as the valuations of unlisted instruments.

The FSB has indicated that it will do on-site visits at all firms applying for a hedge fund licence - which did not happen when investment managers were approved to run traditional funds.

It is anticipated that when hedge funds are marketed, comprehensive health warnings will be required.

These will warn would-be investors about the extra risks they might face in their potentially speculative investment.

Because of gearing, hedge funds can quickly make spectacular profits or spectacular losses, so it is crucial that investors understand these risks.

Imasa has recommended more than 20 such warnings, some of them generic to all hedge funds, while others are specific to a fund's strategy or structure.

Imasa has also recommended a number of risk disclosures that should be made available to prospective clients before investing and thereafter on a monthly basis.

These include the number of "losing" days to "winning" days, the largest daily loss and the ratio of average losses to average profits.

These regulations form part of the Financial Advisory and Intermediary Act and will come into force in less than six months, making hedge fund managers who do not get FSB approval potential criminals.