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Hedge funds to be regulated by the JSE

It’s no secret that hedge funds haven’t had the best reputation, particularly abroad. Not because of performance issues — they have frequently performed exceptionally well — but because the industry has been tainted by fraud convicts of the Bernie Madoff ilk, who have played fast and loose with investors’ money in a largely unregulated space, leaving clients with no recourse.

High-net-worth individuals have certainly lost a lot of money investing with hedge fund managers that haven’t always complied with their mandates, taking positions that have been at odds with clients’ wishes.

Understandably, institutional investors have been nervous to expose their clients to hedge funds — but this could now change, thanks to the JSE’s acquisition of Momentum’s Managed Account Platform (MAP).

Allan Thomson, head of derivatives trading at the JSE, says this platform is essentially a legal structure that will allow hedge funds to be managed by an independent agent.

This means that, although hedge fund managers will still take a position and invest on a client’s behalf, the assets will be segregated from the manager and are held by the platform, which will also risk manage the hedge fund managers’ positions and make sure they are fulfilling their mandates.

What’s changing here is the kind of compliance expected — hedge fund managers will need to play open cards and if they’re not in compliance the platform’s managers can step in.

In this sense, the platform is a risk management tool that takes away the potential for fraud and opaque trading. Trading activity will be closely monitored.

Since Parliament in unlikely to regulate the hedge fund industry any time soon, this level of oversight and regulation will make the industry credible to investors who would like to explore the investment opportunities afforded by hedge funds.

One must remember that hedge funds are not de facto risky and aggressive funds — some are relatively conservative. But the risk has been the opaque trading and sometimes questionable management.

However, a South African hedge fund manager, who declined to be named, said that there has been full transparency and independent risk oversight on all domestic hedge funds for some years already, pointing out that the local hedge fund industry is “light years ahead of its offshore counterparts in terms of disclosure to investors”. He argues that this is driven by the industry itself, not by regulation, and says it is hard to see how “more disclosure” would be possible.

Nevertheless, what the JSE is doing is minimising risk — as long as there is a chance that managers could in some way abuse a client’s mandate, additional oversight can hardly be a bad thing for the industry.

The JSE’s acquisition of this platform is an important world first, says Thomson. “Of course, what we can’t do is guarantee you’ll make money. That’s still up to the hedge fund manager. But you won’t see a local Madoff running off with your retirement funds. That simply can’t happen with this new, safe platform in place.”

What about pension fund exposure?
The National Treasury has just released another draft of the proposed amendments to Regulation 28 to the Pension Funds Act, in terms of which hedge funds are specifically provided for.

Treasury says that private equity and hedge funds can add value to a pension fund portfolio provided there’s no false reporting of asset exposures. This is good news because the MAP should take this particular risk out of the equation.

Institutional investors can invest up to 10% of their assets in hedge funds (up from the previous 2,5% allocation). Compliance is obviously important here because a hedge fund can’t comprise more than 10% of an investment fund’s total assets.

Note that Regulation 28 doesn’t regulate hedge funds — it simply says that some exposure can be good for capital growth and proposes guidelines for limited exposure. Regulation 28 has traditionally limited how retirement funds can invest in certain assets, because pensioners can’t afford exposure that’s too risky. At the same time, amendments have recognised that too little exposure to certain asset classes means that pensioners haven’t always enjoyed the best possible diversification and capital growth potential.

What will be important to investors
Investors will obviously want to make sure that disclosure of underlying assets will occur — MAP will need to monitor not just the legal form of the investment but whether or not funds are investing in equities in excess of what’s permitted by regulation, for example.

Regulation 28 has stipulated that there should be tight definitions of hedge funds and private equity funds to ensure that the exemption of the look-through principle is not abused (the look-through principle states that a fund can’t use as asset structure to circumvent regulatory limits — if an asset comprises less than 5% of the aggregate fair value of the assets of the fund, for example, then the fund need only disclose the categories of underlying assets making up the investment, and not the underlying asset).

It is here that MAP provides the additional benefit of monitoring mandate compliance, which should put investors’ minds at ease.

Investors will also want to know that their returns will be what their portfolio says they are. Actual fund returns and net asset value will be reported to investors daily as an indicative value and final returns will be reported to investors at month-end.

Read more news, blogs, tips and Q&As in our Smart Money section. Post questions on the site for independent and researched information

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