Ever since the first impact of the global financial crisis, both international and domestic regulators have been announcing changes to hedge funds, which would aim at improving disclosure and investor protection. Where are we now? Janine Mace reports.
When an investment sector finds itself under the regulatory spotlight around the world, life can be tough.
Just ask hedge funds. In the wake of the global financial crisis (GFC), Australia and international regulators have been focusing on the sector due to heightened concerns about investor protection, market integrity and systemic risk.
This is despite recognising hedge funds were not responsible for the financial crisis.
As the Australian Securities and Investments Commission (ASIC) commissioner, Greg Medcraft, acknowledges, “it remains unclear what role hedge funds did play … and they may well have been more victims than villains”.
However, this has not stopped regulators acting.
In November 2008, the G20 called for greater oversight of hedge funds and referred the issue to the International Organisation of Securities Commissions.
It published a 2009 report, Hedge Fund Oversight, which called for hedge fund registration, better oversight and investor disclosure, greater regulatory information sharing and regulatory principles around fund liquidity and redemption policies.
In addition, the Dodd-Frank Act in the US and the European Union’s Alternative Investment Fund Managers Directive have imposed very prescriptive regulations on hedge funds.
These initiatives represent a major change in direction according to Nikki Bentley, a partner at Sydney law firm Henry Davis York and chair of the Alternative Investment Management Association’s (AIMA) regulatory committee.
“It seems overseas regulators have gone to the other extreme from pre-GFC and changed quite dramatically from hedge funds being unregulated to being closely supervised.”
She says the regulatory focus in Australia “is not a huge change as hedge funds have always been regulated like any financial product,” but admits the rapid and sweeping reform of the local financial services industry is making life more difficult.
“There is a lot of regulatory change in the industry coming through – such as the Future of Financial Advice and MySuper reforms – and that is causing further uncertainty,” Bentley notes.
ASIC takes a look
For Australian hedge funds, a key development has been the February 2011 release of ASIC’s Consultation Paper 147 Hedge Funds: Improving Disclosure for Retail Investors.
It sought feedback on disclosure enhancements aimed at ensuring retail investors have the necessary information to make informed decisions about hedge funds.
The paper also discussed how the proposed disclosure guidance would interact with the tailored product disclosure statement (PDS) requirements for simple managed investment schemes.
According to Medcraft, ASIC believes the use of “diverse investment strategies, complex structures and use of leverage, short selling and derivatives” by hedge funds means they can “pose more diverse and complex risks for investors than traditional funds”.
The hedge fund industry has consulted closely with ASIC on CP147 during 2011, and a final regulatory guide is expected this year.
Most industry observers are relaxed about the likely outcome of the consultation process.
“We don’t expect the regulatory interest to have a major impact on the sector as most of it is about increased disclosure, which is good for retail investors – especially the improved PDS and fee information,” explains Lonsec senior investment analyst, Deanne Fuller.
Bentley agrees the regulatory focus is a positive move. “The hedge fund industry is very supportive of increased disclosure and is generally supportive of ASIC’s approach and feels it was very good.”
Chris Gosselin, chief executive of hedge fund research firm Australian Fund Monitors, is another who sees the consultation process as valuable.
“ASIC wants to make sure the industry is transparent and all investors are treated efficiently and fairly,” he says.
“It needs to regulate so consumers are informed and therefore protected, and so that if a fund breaks the rules it is regulated appropriately.”
However, an enhanced disclosure regime may result in higher fees. “All the extra information is available in standard industry documentation – so it is not a major impost, but it could lead to increased costs from an expanded PDS and other documentation,” Fuller points out.
While AIMA supports the ASIC initiative, it believes the regulator should have gone further. “The industry felt enhanced disclosure should apply more broadly to other complex products as well,” Bentley explains.
Gosselin agrees a more wide-ranging approach is required. “ASIC also needs to regulate the research industry so its reports are quantifiable, rather than based on a view of the potential performance [of hedge funds].”
Although the sector is largely comfortable with the ASIC consultation, Bentley says there are still some issues to be thrashed out.
“The industry is pleased there will be a carve-out for hedge funds from the shorter PDS regime. However, there is still uncertainty on what a hedge fund is and how it will be defined in the legislation,” she explains.
“ASIC is still grappling with how it will apply its enhanced disclosure approach, and we expect to see another draft regulatory guide and further industry consultation.”
International regulatory developments
While the local interest by regulators has been relatively benign, overseas the scrutiny is a different story. The EU Directive, in particular, has caused considerable angst in the hedge fund sector.
“AIMA globally spent a lot of time on it, as there was increasing concerns about what was proposed and it became a very public and political debate.
"The European system is very different, but it created huge concerns for Australian managers wanting to raise money in Europe,” Bentley explains.
“However, there will now be a time lag before it comes in and it is less strict than it initially was.”
The US reforms are also causing heartburn.
“In the US, the huge volume of regulatory change created huge uncertainty and this had an impact on many hedge fund managers. The local industry is still digesting what the regulatory changes will mean for their operations.
"For example, previously there was an exemption for overseas managers marketing to a US investor, but now they need to be registered,” Bentley says.
The introduction of the Volker Rule – which restricts US banks from making certain kinds of speculative investments – is also having an impact on the sector.
“We are seeing the start of the implications of the introduction of the Volker Rule on banks’ proprietary desks,” Bentley notes.
“This may lead us to see new boutiques being started by professionals previously working on the banks’ proprietary desks. We are seeing a bit of activity in that area.”
If these regulatory developments were not enough, the rollout of the new Foreign Account Tax Compliance Act (FATCA) regime by the US Government is set to make life even more challenging for hedge fund managers.
From 2013, the legislation imposes significant new information reporting and withholding requirements on foreign financial institutions such as Australian banks and hedge funds receiving US-sourced income.
“Most large financial institutions will have to make system changes, and the risk is it may lead to FATCA rules and standards legislation being rolled out in other countries,” Bentley explains.
