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ASIC’s focus on hedge funds may miss bigger picture

After a long consultation period, ASIC has amended its regulatory guidance relating to hedge funds (RG240) to focus on “… those funds that pose more complex risk to investors”. I discussed ASIC’s previous version on improving hedge fund disclosure in Cuffelinks on 1 April 2013. Many others raised concerns, with the prize for the most colourful title going to Mallesons with their, “Who’d be a hedgie? Could new reforms regulate hedge funds out of existence?”

Since then, ASIC continued to extend relief from the disclosures required under RG240 and in October 2013 released an updated version, to commence from 1 February 2014. ASIC Commissioner Greg Tanzer was quoted as saying, "Our changes will benefit the industry by relieving some lower-risk funds from the more extensive disclosure obligations imposed on a hedge fund under RG 240." From this comment the intention of the disclosure is evident: to create more extensive disclosure obligations for hedge funds, thereby protecting potential investors.

Revisions in ASIC’s updated version

What are the changes? The updated version of RG 240 makes only subtle changes to the definition of a hedge fund, in response to feedback from some groups that want to avoid this label. The broad definition of a hedge fund remains (full details here), namely a fund which promotes itself as a ‘hedge fund’ or one that exhibits two or more characteristics of hedge funds, the five characteristics being: complexity of investment strategy or structure, use of leverage, use of derivatives, use of short selling and charging of a performance fee.

The changes in the updated RG240 only apply to the descriptions of these characteristics:

  • under the characteristic of ‘complexity of investment strategy’, benchmarking to a blend of traditional market indices (such as traditional multi-asset class funds) is now excluded as a characteristic of a complex investment strategy
  • under ‘complexity of structure’, ASIC has clarified the definition of interposed entities (ASIC views too many interposed entities involved with the end product as a characteristic of a hedge fund) to relieve those parties using an authorised investment vehicle in a foreign jurisdiction
  • under ‘use of derivatives’, ASIC now does not consider the use of exchange-traded derivatives where the notional derivatives exposure does not exceed 10% of a fund’s net asset value as a defining characteristic of a hedge fund.

Extra disclosures for ‘hedge funds’

As discussed in my previous article, if a fund is deemed to be a hedge fund then it faces more significant disclosure requirements in the areas of:

  • investment strategy: detail of the strategy, exposure limits
  • investment manager: increased disclosure around key staff, qualifications, background, employment contracts
  • fund structure: detailed disclosure around the structure of the fund and service providers, and fees through the structure
  • custodial: valuation, location and custody of assets, custodial arrangements, and a list of all instruments and markets traded
  • liquidity: description of liquidity policy and any illiquid positions
  • leverage: disclosure of leverage and possible ranges
  • derivatives: a fair amount of disclosure required
  • short selling
  • withdrawals: disclosure around withdrawals and associated risks.

These areas of disclosure are what ASIC calls benchmarks and disclosure principals. ASIC advises that every PDS for a hedge fund should meet these disclosure requirements. However a responsible entity can adopt an ‘if-not-why-not’ approach where they do not disclose on a particular issue and clearly explain why they didn’t disclose and the risks this may create for investors. Of course ASIC may choose to not approve PDS’s with insufficient disclosure.

Will RG 240 work? If the objective of ASIC is to avoid repeats of the types of losses we saw with Astarra Strategic Fund and Basis Yield Alpha Fund, then RG 240 will assist but will not guarantee repeats of these events. ASIC’s model is to seek disclosure and then leave the rest to the (now presumed to be informed) investor. The investor can choose to use or not to use this additional information. Lack of investment knowledge and the behavioural biases that exist in investing will undoubtedly ensure future disasters.

What are some of the consequences?

Financial planners may ‘discover’ they have clients invested in hedge funds. Do they have to change their Statement of Advice? Will PI (professional indemnity) insurance bills be higher for financial planning groups which include hedge funds on their approved products list? If they change client portfolios as a result, there may be capital gains tax realisations.

The underlying hedge fund managers will be most affected. Some of the disclosures affect their ability to run their business (for instance they have to list key people and outline some details of their employment contracts), raise assets (the financial planning community may be deterred from recommending hedge funds) and protect their investment strategy (disclosure of instruments and use of leverage may give competitors some insight as to their strategy). I am not overly concerned about any changed perception of the hedge fund industry – it is full of complex products.

My main concern is that the term ‘hedge fund’ is used as the parking bay label for complex investments. The complementary set of investment products to those defined as ‘hedge funds’ will contain many investments which are complex. People may incorrectly regard investments which are not hedge funds as not being complex. Consider just a few: geared share funds, the range of equity income funds that use derivatives, new-age total return balanced funds, the more flexible fixed income and cash funds, the list goes on ... There are complex funds all around yet they may not be labelled as a hedge fund.

Better to focus on ‘complexity’

In my submission to ASIC for RG 240, I suggested that instead of focussing on hedge funds there was a one-off opportunity to focus on investment product complexity itself. Instead of defining hedge funds, ASIC could define complexity (for example a ‘complex’ investment may only require one of the five characteristics listed above), and disclosures appropriately designed. Funds could then label themselves as they like and ‘hedge fund’ would not be held out as the area where all the complex investments funds reside.

This type of approach would take the stigma out of complexity. These ‘complexities’ are usually used for a positive reason – to enhance returns or manage risks - but also highlight that extra consideration is required by investors. Investors would become more aware that many products have elements of complexity to them. It would also reduce ‘regulatory arbitrage’ where the provider designs a product to avoid being caught under particular regulations. Finally, as new products and categories are created, there is an over-arching definition of complexity that would catch these products rather than ASIC having to develop specific guidance.

Overall, while RG 240 will assist investors to be more aware when they are considering a hedge fund investment, I can’t help but feel it is an opportunity lost in terms of the bigger picture of investor protection in a world of complex investments. 

 

David Bell’s independent advisory business is St Davids Rd Advisory. David is working towards a PhD at University of NSW.

 

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