Our Research posts are about the latest academic research and this week we have a guest post:
SOUTH AFRICAN HEDGE FUND REGULATION – THE GOOD, THE BAD, AND SOME CONTROVERSIAL VIEWS
by Francois van Dyk (Unisa)
It seems as though South Africa is aiming to become one, if not the first jurisdiction to formally impose regulations on hedge funds, as the National Treasury and Financial Services Board (FSB) suddenly, but not surprisingly issued a proposed regulatory framework on 13 September 2012.
Although hedge funds are still considered to have no formal, universal definition, it generally refers to amongst others the following:
- A pooled investment vehicle which is organised privately and administered by professional investment managers.
- An investment instrument that provides different risk/return profiles compared to traditional shares and bond investments, thus they are by definition alternative.
It is also imperative to note that hedge funds, unlike mutual funds (better known as unit trusts in South Africa) are not dependent on the direction of the financial markets in which they invest for performance – as hedge funds have a very low correlation with the direction of financial markets. The proposed framework defines a hedge fund as a collective investment scheme whose portfolio uses any one or more of the following investment strategies:
- short positions; or
- derivative positions for the purposes of enhancing returns or to protect the assets against market exposures.
The purpose of the proposed regulatory framework is to provide a framework on the proposed regulation of hedge funds, as the proposal is to regulate and supervise certain hedge fund structures under the existing Collective Investment Scheme Control Act, 2002 with the creation of a new and separate category for hedge funds as a collective investment scheme. The proposed framework goes further by stating that the intention is not to regulate hedge fund financial service providers but to regulate hedge funds as a special collective investment scheme.
In essence, the proposed framework does not really divulge a great deal, as at this stage the proposed framework is still very much a work-in-progress as it is still in the consultation phase. So, at this early stage the framework as set out for public comment is merely publicly announcing the intention of the South African regulatory authorities to formally regulate hedge funds.
It is quite difficult to delve into all the areas and details that the proposed framework covers in a short blog post such as this, so we won’t go there, but one interesting and also somewhat questionable, yet still clever twist is that the proposed framework is proposing that a distinction be made between two types of hedge funds with regard to the regulatory approach, namely restricted and retail funds.
From the above there is, however, quite a clear distinction between the manner and severity in which the regulatory authorities want to regulate the two different fund categories, and this is for good reason – mainly investor protection, and particularly protection to the retail investor (the general public). In addition, the reporting requirements set out for the restricted fund category is a plus on all levels. The reasoning behind why the regulations are attempting to create two categories in which retail funds are split from restricted funds (which are only available to the qualified investors) is firstly because the level of interest in hedge funds continues to rise. Also, hedge funds are also becoming more aggressive in raising their public profiles, and mutual funds (unit trusts) are becoming more aggressive in using the mutual fund (unit trust) format to deliver hedge fund strategies to a broader audience.
The reason why hedge funds are the centre of investors’ attention is as these funds aim to deliver consistent returns in any market condition while also generally being uncorrelated to the returns of traditional asset classes (shares, bonds). Hedge funds thus offer a greater level of portfolio diversification when combined in an investment portfolio alongside traditional asset classes.
So, let me turn the question of hedge fund regulation on its head by asking if regulations or supervision is really wanted and or required? Prior to sharing some somewhat controversial or alternate views regarding this question I must state that I am all for regulation as its primary purpose is to stabilise and strengthen the financial system (which ultimately influences all individuals).
Firstly, it should be kept in mind that regulation is not static, as it changes in response to changes in the financial environment, in response to crises, and in response to the activities of special interest groups. The Long Term Capital Management (LTCM) debacle, for example, was an especially important crisis (in terms of hedge funds). In the immediate aftermath of that crisis, there was a widespread sense that “something should be done”. There was also widespread fear within the hedge fund community that “overzealous regulators” would implement new rules that would create huge administrative burdens, destroy returns, and ultimately turn an excellent business into a terrible business. These fears turned out to, by and large, unjustified. Regulators in the US also quickly realised that the hedge fund community is very difficult to police on a regular basis. After the crisis atmosphere eased in the US, it became clear that LTCM crisis was largely caused by excessive leverage. The truth is that leverage is an activity that takes place between well informed, consenting parties and LTCM was able to borrow too much money only because the banks and the brokers were willing to lend too much money. In the aftermath of the crisis, the major institutions tightened up their lending practices and the regulators have increased the level of surveillance. In the post-LTCM period there was also much discussion about vastly increased reporting requirements.
Then there is the moral-hazard issue – prudent investors know that investing is a risky business. So, if investors begin to think that the regulators have reduced the level of investment risk, they will become overconfident and misjudge the level or risk. The result is bound to be some sort of blow-up down the road. The basic syndrome here is the same as what was observed with portfolio insurance in the mid-1980s – if you think your equity portfolio is protected against loss, then you will have a higher exposure to equities that you would otherwise. The late stages of the recent bull market presented a similar moral-hazard issue as some investors developed too much confidence in the wizardry of Alan Greenspan, as some individuals thought that equity investing had become totally safe thanks to the magic of the Federal Reserve. That faith led to patterns of behaviour that guaranteed that the boom would eventually become a bust.
It is said that regulators walk a fine line – regulation is designed to protect the financial system at large and to protect the small investor. At the same time, however, it is of utmost importance that investors be reminded that investing is risky. Some companies need to go bankrupt, and some investors need to experience large losses. Failure keeps the sense of risk alive, and the sense of risk is what ultimately keeps the system sound. It’s when people stop worrying that thing go really wrong.
So, to conclude my somewhat controversial views, “more regulated” does not mean “less risky”. The mutual fund (unit trust) industry is more highly regulated than the hedge funds industry, but there are many high-risk mutual funds (unit trusts) and a good number of risk-averse hedge funds.
The Regulation of Hedge Funds in South Africa: a proposed framework can be obtained at: http://www.treasury.gov.za/comm_media/press/2012/2012091301.pdf