THFJ: What do you see as the major trends in retail hedge fund regulation at the moment?
There is currently a transatlantic rift going on, rather than the usual disagreement between the Anglo-Saxon countries and continental Europe which you usually see on hedge fund issues. In this case, in continental Europe you're seeing liberalisation on a number of fronts, while in the US they are raising the accredited investor thresholds, and are more concerned about retail access to hedge funds.
It was interesting to look at the recent G7 meeting, when the Germans were chairing that, and wanting to bring more regulation to hedge funds, and the UK and US were trying to push them back on that, whereas on the retailisation issue, continental Europe has been a lot more liberal than the US. For example Germany loudly trumpeted the introduction of its onshore regime for hedge funds in 2004.
You really need to think of a square with four quadrants when you're talking about retailisation and liberalisation. You've got the listed products, single hedge funds and funds of hedge funds, and then there are authorised funds, again single hedge funds and funds of hedge funds. The most interesting at the moment are the authorised funds of hedge funds, as the FSA are consulting on that, and are planning to allow them. If these are allowed, fund managers will be able to market them in railway stations and in newspapers alongside normal unit trusts.
Interestingly, a big reason Dan Waters [FSA Director of Retail Policy] gives for this liberalisation is to do with operational risk. I think one of the misconceptions people have is that hedge funds have more investment risk than a normal unit trust, but that's not necessarily true. Many kinds of hedge fund strategies, such as long/short, and in particular funds of funds, have a lower volatility than a straight equity unit trust would have. It's not actually about investment risk necessarily – what is more of an issue is operational risk. This is a way into hedge funds where the investor would have the protection of the depository which in turn would have responsibility for ensuring compliance with FSA rules, looking at valuations, and effectively fulfilling a role that the prime broker doesn't in the hedge fund world. The depository has obligations and rules laid down for authorised products which the custodian of an offshore hedge fund does not have. The FSA, rather than publishing detailed product regulation usually associated with this kind of regulation, has gone down much more of a due diligence approach. The fund of hedge funds manager has to do much more due diligence on the underlying managers in the fund, which is a very different approach. Again, there is emphasis on operational risk. The goal here seems to be to allow retail investors into hedge funds but to try and reduce operational risk.
THFJ: Will there be formalisation of this process of due diligence?
Yes, there is some guidance in the latest consultation paper. The depository is watching the fund of hedge fund manager, and the manager is doing the diligence on the underlying funds.
These products are likely to be brand led, so we expect it will quite likely be the big retail asset managers that will do this. The new funds will probably have lower fees than a typical fund of hedge funds, and the big risk will be mis-selling. The thing the retail asset managers will have to get right is their relationship with the intermediaries, the IFAs, educating them and projecting the treating-customers-fairly agenda.
THFJ: Do you think the issue of education is a big problem at the moment, given that the bulk of the UK IFA market is simply not properly informed about alternative investments?
Certainly marketing by the retail asset managers will be an important part of this. The whole difference between an authorised fund and a listed fund, is that with an authorised fund you can keep on marketing. With a listed fund of hedge funds, you are only able to market when you issue shares. How they mix marketing and education, both for the IFAs and their customers, will be an important part of it.
THFJ: When you say one of the big risks will be mis-selling, presumably you mean sales of funds to individuals who do not properly understand what the product is?
It means understanding the risk appetite of the client, and characterising the risk of the product in a way that they can understand.
THFJ: Do you think we may see retail funds of hedge funds from existing players who have previously only managed institutional or high net worth money?
The established retail asset managers will be the ones managing the FAIFs [Funds of Alternative Investment Funds]. The typical, West End, single managers will need to decide whether they want their funds to be in a FAIF, and whether they want to attract retail money that way, indirectly, and then they need to think about whether they can meet the due diligence hurdles, or will need to do some kind of operational risk review to prepare themselves for that.
THFJ: What sort of hurdles do you think they will be facing?
Valuations, the methodology used to calculate these, controls, governance, accounting, business continuity, risk management training and arrangements, liquidity levels, preferential terms such as side letters, and conflicts of interest. The largest single hedge fund managers which are chasing institutional money are having to raise their operational risk game anyway, so if they also decided they wanted retail money indirectly, via allowing their funds to be part of FAIFs, they're going to have the same pressure.
THFJ: Do you think managed accounts platforms will have a role to play in all this?
People running these platforms, the small number of firms that do them, will probably find it quite easy to manage a FAIF. The type of managers happy to be included on a managed accounts platform could well be the same type of managers happy to be included in a FAIF. That's logical.
THFJ: In terms of strategy, are underlying funds likely to be using long/short?
You can have a variety of strategies – that's one way of getting diversification. You can look at the breakdown of strategies in the hedge fund universe, or you could have specialist FAIFs, long/short equity for example. The big change in the rules is that you are no longer restricted to 20% of assets in unregulated schemes, you can now have 100%. Those unregulated schemes can invest inanything, real estate, private equity, the whole range of alternatives. The FSA is consulting on liquidity arrangements, and is suggesting a minimum of once every six months. One of the things managers will have to take into account will be the liquidity of the underlying funds. But FAIFs are only one aspect of retailisation. We have also seen the liberalisation of UCITS. This has led to a flurry of long/short equity and long/short bond-type funds. They are not true long/short, because you can't short securities in a UCITS fund, but you can buy derivatives which mimic shorting. The interesting one everyone is talking about at the moment is 13030 funds.
THFJ: Will such funds be successful in the retail market, or will they remain primarily institutional products?
I think a number of managers are looking at launching retail products, and are going to try to sell them. These will not be hedge fund firms, but retail asset managers.
THFJ: Are you seeing a lot of interest in 13030 structures from asset managers?
I think some retail asset managers will certainly test them out.
THFJ: What about 14040 or 12020 funds?
A typical long/short fund would be between 12020 and 13030, so I guess these will mimic that. I doubt they'll go 14040 for a retail product. You're trying to sell the long/short equity concept to retail, and there's already a successful long/short equity industry out there. A lot of these long/short managers are stock-pickers, basically. They're not into massive leverage, but they do like to have the option to go up to 30% short.
THFJ: How does this compare with the listed market?
The listed fund of hedge funds have been available for quite a while now. There was a flurry of activity when they first came about, and then there has been a new wave of launches in the last 12 months. Dexion have issued some more shares in theirs, which is the largest, and Goldman Sachs Asset Management launched a $500 million fund. It will be interesting to see whether that market continues, or whether people will switch to using FAIFs when they become available.
The listed market is hampered by the fact that you can't promote to private investors once the shares are in the secondary market, you can only really market in the offering stage. You could issue more shares, but there is limit to how many times you can do that, practically. There's a lot less scope to market to retail investors than an authorised fund.
Now we've got single listed hedge funds as well, with Brevan Howard's being the first to be UK-listed, after Marshall Wace listed theirs in Amsterdam. The FSA are consulting on having a unified regime here.There is still quite a difference of opinion on the listing regime between the traditional investment trust industry and the alternatives industry.
There are two chapters in the FSA listing regime handbook, and the search is on to find some kind of compromise. The alternatives industry is favouring a much more liberal set-up, while the investment trust industry is fearful of mis-selling, and a repeat of the splits scandal. It is a very sensitive area for the investment trust industry.
THFJ: Has the success of the retail regimes in France and Germany helped to usher the FSA towards issuing this consultation paper?
It is a factor. They do say in the consultation paper itself that they are aware that liberalisations have happened in Germany, Luxembourg, Ireland, and Italy. It is quite ironic really that the Germans have been quite liberal about this, whereas in other aspects of hedge funds they have been more critical. You can also sell funds under the e-commerce directive – those funds of hedge funds authorised in those jurisdictions can be bought over the Internet by UK customers.
THFJ: Is it possible that FAIFs could become passported for sale inthe EU in the near future?
Because they-re in the NURS regime, no. What we have in Europe at the moment is a patchwork of funds of funds regimes. None of them are passported at the moment. NURS means Non-UCITS Retail Scheme – it can-t be passported as a UCITS, but because it is a retail scheme it can be marketed to private individuals in the UK. It is what the FSA thinks is okay to market to retail customers, but not where there is an agreement in Europe. We then get into the debate of whether or not we need a fund of funds directive, a UCITS for funds of hedge funds, but there's no appetite for that kind of legislation at the Commission level. They have had an asset management consultation paper, and it didn't emerge from that.
THFJ: Do you think a minimum investment level will be set for the new FAIF?
That's not something the FSA seems to regard as a particularly effective means of regulation. I don't foresee that, and I don't think they've consulted on that.
THFJ: What about the tax issue?
The other interesting point is what the HMRC think of all this, and whether they will give their support in person. If they don't, it would just go the way of the QIS (Qualified Investor Scheme) regime, where very few were created. It was an institutional investor regime the FSA launched.
THFJ: How important is it to get HMRC approval for investment schemes?
It is crucial. They have got to make sure that the fund is not going to be taxed, and that the tax privileges of being an authorised fund can be sustained. It is a matter of record that the QIS regime was not successful, and that the tax issues were part of the reason. The FSA itself recognises the need to consult with HMRC and the Treasury.
THFJ: When can we expect to see the first FAIFs being made available to the public?
The consultation will end on 27th June, and they will probably issue a feedback statement in the autumn. I think it will be the beginning of 2008 at the earliest.
THFJ: Are retail fund groups properly set up at the moment to run these sorts of funds, or will they need to make additional changes, for example, new risk management systems?
Again this is the whole risk issue which the FSA does see, with mainstream asset managers making more use of derivatives and not having the operational framework in place. That's another thing they'll need to look at, and a lot of managers are bringing in outside advisors to look at their systems. That's the kind of thing we would do at Kinetic Partners.
THFJ: What attracted you to join Kinetic ?
As the FSA moves to more of a principles-based approach, regulation will be much more about peer group comparisons and industry standards and benchmarks, rather than a detailed rulebook. I think there will be a growing need for regulatory consultants, and there's now more emphasis on a broader range of risks. Managers now have to think about not just regulatory risk, but operational risks such as valuations. I'm from the investment management industry, so the attraction of Kinetic is that it's an investment management boutique. We do tax advice, we do audit, operational risk, and we provide regulatory advice, whereas the other specialist investment management consultancies tend to just focus on regulatory advice.