Hedge Fund Retailisation: New Era or False Dawn?

“Where are they when we need them?”

Originally published in the November 2008 issue

This year, the FTSE 100 index has fallen by a third and the HFR index of funds-of-hedge funds has fallen by 18.74%. So whereas the London (and global) stock market collapse heralded a deep recession, the hedge fund of fund numbers are in the ‘also ran’ category. Unsurprisingly, many of Britain’s retail investors would prefer to be ‘also rans’, rather than suffering heavier losses. And there was every expectation that opportunity would arise; that the Financial Services Authority would permit, even encourage, retail funds of hedge funds, to be offered in the UK from January. So where are they when we need them?

The FSA opened the debate around retail access to hedge funds in a Discussion Paper of June 2005. After feedback, it announced in March 2006 that it would launch a consultation exercise the following year. The rationale was clear. The distinction between traditional asset management and the hedge fund world is blurring all the time with long only funds emulating some techniques used by hedge funds to find alpha and on the flip side with some hedge funds adopting traditional structures and strategies as they get bigger and more institutionalised.

Secondly, retail investors want alternative investments, as they seek to diversify their portfolios away from a reliance on traditional asset classes.

Finding a way in
UCITS III is one way in and as the FSA pointed out in March 2006, retail investors can access listed funds of hedge funds, as well as structured products linked to hedge fund indices. Thanks to the internet, UK consumers can also purchase hedge fund products that are on offer in several other European countries. For example, Ireland introduced regulations allowing retail funds of hedge funds back in December 2002, the first European jurisdiction to do so. France’s Autorité des Marchés Financier issued new regulations at the end of 2004 on how hedge funds and hedge fund-like products could be marketed to investors, including retail . Germany introduced new rules allowing for the public distribution of funds of hedge funds. More recently, Spain launched an onshore hedge fund regime that allows for both domestic single manager funds, known as Free Investment Funds (FIF), and funds of hedge funds (FoFIF). The regulation went into effect in May 2006 (updated in March 2007). Given these market realities, the FSA determined it would be prudent and preferable to allow the establishment of UK onshore funds of hedge fund vehicles that would benefit from the protections offered by its authorised collective investment scheme regime.

In Consultation Paper 07/6 Funds of Alternative Investment Funds (FAIFs), published in March 2007, the FSA proposed allowing the introduction of a range of retail-oriented funds of alternative investment funds into the existing non-UCITS Retail Scheme (NURS) regime. To do this, the FSA proposed lifting the 20% investment restriction into unregulated collective investment schemes for NURSs, thereby enabling them to invest all their assets in other unregulated funds, such as hedge funds. The manager of the Fund of Alternative Investment Funds would then be responsible for selecting the underlying unregulated schemes, which the FSA hopes would provide consumer protection, since there would be an intermediary between the retail investor and the unregulated scheme.

Taxing complications
Comments on the consultation paper were due by 27 June last year, however, complications arising from the UK Offshore Funds Tax Regime have delayed matters. For example, one of the requirements of becoming a distributing fund under the current framework is that a fund cannot invest more than 5% of its assets in another offshore fund at any time in the period, acting as a barrier to funds wanting to invest in certain other funds.

To counter this, the UK Treasury announced in the 2007 Budget that it plans to modernise the regime to address the various tax barriers and simplify the requirements for funds wishing to obtain Reporting Fund status. Its discussion paper, in October 2007, proposed removing the relevant UK tax barriers to multi-tiered fund structures. On 22 February 2008, the FSA announced further progress confirming the policy of introducing retail-orientated FAIFs. However, before the final regime could be introduced, an additional round of consultation re master/feeder structures, repayment standards and due diligence guidance was inaugurated. This closed in May and the draft rules and Policy Statement should be published shortly although the current economic/financial environment may delay things. What the FSA’s final position will be remains to be seen. But while the potential regulatory change presents significant opportunities for managers, it also presents challenges, most notably in ensuring funds have, or implement, robust operational infrastructures.

Scalability will be a prime consideration. How popular funds of hedge funds will prove to be with retail customers is anyone’s guess at the moment. Nevertheless, those fund of fund managers and the underlying schemes with reliable and scalable IT platforms will certainly be best placed to take advantage of any surge in asset inflows.

For the underlying hedge funds, accurate, transparent and timely valuation practices will also be key. At a minimum, these will mean adhering to the International Organisation of Securities Commissions’ (IOSCO) Principles for the Valuation of Hedge Fund Portfolios, released in November 2007. And with FAIFs likely to be under an intense regulatory spotlight, there can be no room for sloppiness here.

Process automation is another central requirement. Any errors in transaction or performance data delay the fund managers’ trading decisions, since they must wait for corrections and an accurate picture of their positions. Likewise, the FAIF will not be confident their money is being managed properly if the information is not clear, correct and timely, and unless the underlying scheme can demonstrate it has its fund under control. In short, those hedge funds that can show they have scalable and robust operational infrastructures with a seamless integration of front, middle and back office technology platforms will be the ones best placed to succeed in this shifting regulatory environment and extraordinary financial environment – if and when the starting gun is fired.