Hedge funds - to regulate or not to regulate

When it comes to hedge funds, the watchful gaze of regulators seems never to be far behind, as Janine Mace writes. 

Related: Are hedge funds set for a revival of fortunes?

In the wake of the GFC, regulators around the world have viewed hedge funds suspiciously over concerns about their potential to pose ‘systemic risk’ and their lack of transparency. 

Regulators have studied them closely and continue to introduce new regulatory frameworks designed to keep them in check. Despite the concern, little evidence of problems has emerged so far. 

In fact, the Australian Securities and Investments Commission (ASIC) gave local hedge funds a largely clean bill of health in a report released in September. 

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ASIC concluded Australian hedge funds have “quite limited levels of leverage and concentration, suggesting that they pose little systemic risk to the financial system as a whole.” 

It also noted hedge funds have a “very important role to play in the Australian financial system and globally, particularly in providing innovative products and strategies to help investors manage their investment portfolios and their risks”. 

The industry anticipated this would be the result, according to Nikki Bentley, honorary legal counsel for the Alternative Investment Management Association (AIMA) Australia and a partner at Henry Davis York.

“The ASIC report on systemic risk was not expected to show it had found a problem, so now we expect to see less focus on hedge funds by the regulators.” 

Although Australian regulators may be comfortable, those at a global level still remain concerned. The International Organization of Securities Commissions (IOSCO) published its latest survey of hedge funds in late October and noted data limitations were preventing global regulators from making an assessment of the possible systemic risks.  

The report noted the limitations “prevented definitive conclusions” on the risk to the financial system and said IOSCO would continue to promote the international collection of comparable hedge fund data by regulators. 

Costly interest 

The price of all this ongoing regulatory interest is not small either. 

Hedge fund managers are being forced to make significant investments in their firms’ infrastructure to comply with new global requirements, with a recent survey finding the industry had already spent more than US$3 billion on compliance costs.  

According to The Cost of Compliance, a new report produced by AIMA, the Managed Funds Association and KPMG International, the average spend on compliance was at least US$700,000 for small hedge fund managers, US$6 million for medium-sized funds, and US$14 million for large hedge fund managers.  

In releasing the report, AIMA CEO Andrew Baker, noted the potential for rising costs to lock new hedge fund managers and strategies out of the industry. 

“The results of this global survey show the industry is serious about building its operational infrastructure for regulatory compliance. But it is important that regulation does not raise barriers to entry to the industry. Next generation managers are an important source of new ideas and talent,” he says. 

Chris Gosselin, CEO of specialist hedge fund research firm Australian Fund Monitors, agrees regulatory interest comes at a high cost. “The industry is more transparent than 10 years ago, but it can be a significant burden on costs.”  

Although Australian hedge fund managers welcome regulatory oversight, many believe the continuing interest does not accurately reflect the current situation – particularly in light of the re-regulation occurring in the global financial services industry. 

As Paul Chadwick, Australian chapter chairman of AIMA, notes: “The ongoing level of regulatory interest is spread right across the financial sector – and especially the banks – and this has changed the ability of hedge funds to do some things.” 

Stifling industry growth 

Even at a local level, well-intentioned reforms like the Investment Managers Regime (IMR) risk stifling the development of the hedge fund industry and the introduction of innovative strategies for Australian investors. 

“From a regulatory perspective, the development of the IMR is stopping global hedge funds from setting up here and stopping Australian hedge fund managers managing  overseas money. We cannot be globally competitive,” Bentley says. 

“Australia can’t dictate to the world how hedge funds will work globally and the regime has complicated it, so it is not achieving the objectives set for it. It is missing the big picture of being able to grow the industry.” 

According to Chadwick, the fine print of the IMR is “crippling” and he agrees it will restrict growth of the Australian hedge fund industry.

“If the regime was less restrictive, more big hedge fund managers would employ more local talent and this would lead to greater local interest and a bigger industry for the financial services sector.” 

Another challenge for the hedge fund industry is ASIC’s push for greater retail disclosure. In October it released an updated version of Regulatory Guide 240 Hedge Funds: Improving disclosure, which changes the characteristics prompting a registered managed investment scheme to be classified as a hedge fund. 

According to ASIC commissioner, Greg Tanzer, the changes will benefit the industry by “relieving some lower-risk funds from the more extensive disclosure obligations” imposed under RG240. 

“This will also benefit investors by more clearly differentiating hedge funds from other types of managed investment schemes so that they can better understand and assess these products,” he says.  

This is a welcome step, notes, Lonsec senior investment analyst, Stewart Gault. “It will not solve the labelling problem, but it will give planners and investors greater clarity on complex products and the risks involved.” 

RG 240 represents an attempt to define what a hedge fund is, to try to ensure more complex strategies have more disclosure, he says.

“However, often the more complex ones had it already. The question is around the products sitting in the grey area who never marketed themselves as a hedge fund and which use derivatives or shorting and complex legal structures. These will be smoked out by RG240 and forced to prove greater clarity.” 

According to Chadwick, ASIC has been very consultative and the industry is very pleased with the result. 

“Hedge funds were originally set up for sophisticated investors, but retail investors wanted access too, and this has led to a focus by regulators to protect retail investors. Appropriate governance needs to be set up to guide retail investors if they invest.” 

Not everyone is convinced the extra detail required under RG240 is needed. 

“ASIC has updated its guidance considerably with increased detail, so it is inevitable that it leads to more complexity,” Gosselin says. 

He believes the requirement for greater transparency has been increasing over the past seven years and most Australian hedge funds are now quite transparent about their holdings and how their strategies work. 

“This is a double-edged sword. For funds that are providing transparency and meeting all the compliance requests investors could make, it is not a problem, but the minority which are not complying or have poor governance are affecting everyone. It is the minority that creates a problem.”