In September last year, the Australian Securities and Investments Commission (ASIC) released a new regulatory guide, RG 240 – Hedge Funds: Improving Disclosure which included a definition of a ‘hedge fund’. ASIC then established benchmarks and disclosure principles that should be included in Product Disclosure Statements (PDSs) for hedge funds. There are a number of interesting ramifications for the investing community.
Hedge funds and non-vanilla investments in general are a difficult area for regulators. By nature, this is a heterogeneous group of funds with vastly different characteristics. If regulators become too prescriptive the rules may not apply well to particular strategies or structures. However if they fail to establish appropriate standards then uninformed investors are at risk of unexpected poor outcomes. It is a tricky tightrope on which to walk.
Hedge fund definitions
RG 240 was initially released for consultation and the final version appears to have taken into consideration the feedback received. ASIC defines a hedge fund in two ways:
- The fund itself is promoted by the responsible entity as a ‘hedge fund’, or
- The fund exhibits two or more of the following five ASIC-defined characteristics:
i. Complex investment strategy or structure
The fund aims to generate returns with a low correlation to equity and bond indices, or invests through three or more interposed entities (or two or more interposed entities if at least one of the entities is offshore) where the responsible entity has the capacity to control the disposal of the products or two or more of the interposed entities. As an example think of a domestic fund that invests into an offshore structure over which the responsible entity has some sort of control
ii. Use of leverage
The fund uses debt to increase exposure to financial investments
iii. Use of derivatives
The fund uses derivatives, other than for the dominant purpose of:
- managing foreign exchange or interest rate risk, or
- more efficiently gaining an economic exposure to an investment, through the use of exchange-traded derivatives referenced to that specific asset, but only on a temporary basis (i.e. less than 28 days). An example of this would be using futures to gain exposure to equity markets following a large inflow, and subsequently replacing these exposures with actual stock positions
iv. Use of short selling
The fund engages in short selling
v. Charge a performance fee
The responsible entity (or investment manager) has a right to be paid a fee based on the unrealised performance of the fund’s assets.
The definition is interesting. There are likely to be some cases where investment managers who consider themselves more traditional investment managers may now find themselves a hedge fund under ASIC’s definition. An interesting case study is a number of funds managed by the very popular and successful Platinum Asset Management. The FAQ part of their website states,
“Is Platinum a Hedge Manager? No. We only partially hedge our share holdings with short sales and will generally have net long positions of 50% or more.”
However their PDS discloses that they do take some short positions and that there is the option to charge a performance fee. Under ASIC’s definition, they tick at least two out of the five criteria boxes and would be viewed as a hedge fund. Another example is the now-common equity income funds which may use derivatives and potentially meet ASIC’s definition of a complex investment strategy. PDSs need to be updated to reflect these changes by 22 June this year.
Increased disclosure
ASIC is not necessarily attempting to portray hedge funds as poor or even exceedingly risky investments. Rather, it suggests that hedge funds are more complex in terms of understanding the risks and features and the role they play in a diversified portfolio. ASIC believes investors need greater disclosure for such products, including:
- investment strategy: detail of the strategy and 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, fees through the structure
- valuation of assets: include location and 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: policy and limits
- withdrawals: disclosure around withdrawals and associated risks.
ASIC calls these 'benchmarks and disclosure principles' and 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 PDSs which do not provide sufficient disclosure.
What are the ramifications for different market participants?
Direct investors have the opportunity to be better informed. Following hedge fund losses such as Astarra Strategic Fund and Basis Yield Alpha Fund, it is understandable why ASIC wants to see better investor information. Question marks remain over the ability of non-financially educated investors to understand the risks even with this additional information, but financial education remains an ongoing industry challenge.
Financial planners may discover that they have exposed their clients to funds which may be subsequently re-defined as hedge funds. Do they have to change their statement of advice? Will PI (professional indemnity) insurance bills be higher for financial planning groups who include hedge funds on their approved products list? If they change client portfolios as a result there may be capital gains tax realisations.
Institutional investors such as super funds should be the least affected as they either have an internal investment team or an external asset consultant which should be professionally assessing each individual investment on its merits.
Finally, it is the actual underlying investment managers (or hedge fund managers) who may be the most affected. They may feel that 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).
Undoubtedly ASIC would have considered all these issues and felt that the possibly unfavourable implications for some in the investment community were more than offset by the overall improvement in disclosure for end investors.