Pragmatism underpins cautious approach to UK retail market
At a breakfast meeting with senior Bank of England officials in the wake of this summer's credit crunch, Jon Moulton, a prominent private equity investor, had to explain what a CLO was. It is alarming that innovation in financial derivatives appears to have been so swift that some central bankers do not understand collateralised loan obligations.
With the redistribution of risk through securitisation leaving 'experts' struggling in its wake, some question the Financial Services Authority's proposals to allow retail investors wider access to hedge funds - many of whom use complex portfolio management techniques.
'The problem with hedge funds is that there is no definition, they can be anything they want,' says Justin Urquhart Stewart of Seven Investment Management. 'Put that proposition in front of an individual private investor and you have the opportunity to create absolute chaos.' Such concerns have grown following the difficulties experienced this summer by a number of hedge funds - not only those with direct exposure to credit derivatives, but also those following seemingly unrelated investment strategies. In the first week of August, for example, contagion spread from credit derivatives to quantitative equity funds.
Judging the hedge fund industry on the basis of one crisis period, however, would be unfair. Indeed, while concerns prior to this summer focused on the potential for hedge funds to create systemic risk, the crisis has instead highlighted the shortcomings of investment banks. It is always possible to point out individual spectacular failures, but Dan Waters, director of retail policy at the FSA, has gone on record to say that hedge funds may be less volatile than standard authorised funds.
The inevitability of a wider range of investment products entering the retail market has been recognised by the FSA. EU regulations - the Product Directive of UCITS III - permit mainstream funds aimed at retail investors to include certain types of derivatives and fund of hedge funds. Other EU jurisdictions - France, Italy, Spain, Germany and Ireland - have introduced retail-focused fund of hedge funds. UK private investors can already gain access to hedge funds by direct investment in offshore funds, although traditionally this has been the preserve of high net worth individuals, or by investing in listed hedge funds. The development of lower-cost hedge fund replication products has added a further dimension to the growing popularity of absolute return strategies.
Sensibly, the FSA wants to bring products aimed at retail investors under its jurisdiction, so that it can offer an appropriate level of consumer protection. The regulator has been studying the question for some time, first canvassing opinions back in 2002. The current proposals were set out in March 2007 in Consultation Paper 07/6 on Funds of Alternative Investment Funds (FAIF). After receiving feedback, a policy statement is expected in the early part of 2008.
The FSA proposes to introduce retail-oriented FAIFs into the existing regulatory regime for Non-UCITS Retail Schemes (NURS). The principle change to the regulations would be to lift the existing 20 per cent investment restriction into unregulated investment schemes by NURS, which would allow the development of onshore funds of hedge funds. The proposed FAIFs would be UK domiciled and their investment portfolios subject to regulation, but would be allowed to invest up to 100 per cent of their assets into unregulated schemes such as hedge funds and private equity.
A policy statement and final rules were expected from the FSA before the end of 2007. Outstanding tax issues, however, which are still under discussion with HMRC and which were brought more sharply into focus with the proposed changes to capital gains tax in the autumn pre-budget statement, prompted the regulator to announce a postponement in mid-November.
Regulations governing the taxation of investments in offshore funds originally grew up as a response to investors' attempts to avoid punitively high rates of UK income tax in the 1970s. Legislation was introduced under which gains on any investment in an offshore fund would be treated as income and taxed accordingly, unless the fund achieved distributor status.
The stipulations for distributor status are not well suited to the structure of hedge funds. The fund must distribute at least 85 per cent of its income under UK accounting rules and invest not more than 5 per cent of its assets in other non-distributing funds. An offshore fund of funds would struggle with the second criterion. The 85 per cent distribution is designed to prevent investors rolling up income within the offshore fund. But for a hedge fund that turns over its positions far more frequently than a long-only fund, this requirement would effectively amount to a need to distribute trading profits. Hedge funds are interested in attracting a global investor base, of which the UK market is just one part; therefore the vast majority have not pursued UK distributor status.
'Of a universe of about 12,000 hedge funds, probably less than 20 have UK distributor status,' says Peter Astleford, partner at international law firm Dechert LLP. 'If UK retail investors put money into unregulated alternative investments - mainly hedge funds - they will be investing in a universe of funds without distributor status, so will have an income tax liability.'
While UK authorised funds enjoy an exemption from tax on capital profits, income profits are taxable. Unless the tax rules are to be different for FAIFs, profits on investment in a hedge fund made by a FAIF would be likely to be taxed. A second layer of taxation would then apply when the investor sells its interest in the FAIF, making FAIFs an inefficient form of investment as compared with offshore funds of hedge funds.
Unfortunately, altering the rules to achieve a level playing field between onshore and offshore investments is not straightforward. 'There are significant problems with all the foreseeable ways to change the current regime to make a UK FAIF scheme tax appropriate,' says Fiona Sheffield, tax partner at Ernst & Young. 'Each potential change has a prejudicial effect on another type of product.' This suggests that the FSA's early New Year timetable for announcing the new rules may prove optimistic.
There is greater cause for optimism on offshore funds ability to achieve distributor status. 'HMRC has made clear indications, both in the consultation document (on offshore funds) and in the pre-budget report that they are going to make it easier for offshore funds to obtain distributor status,' says Ms Sheffield.
At the same time as the Inland Revenue is exhibiting a more pragmatic approach, Gordon Brown is proposing to make distributor status far more attractive - although, paradoxically, this is an unintended consequence of his efforts to remove some of the tax privileges enjoyed by private equity. The Chancellor proposed in the pre-Budget report to introduce a flat 18 per cent rate of capital gains tax - compared with current maximum rates between 40 and 24 per cent depending on eligibility for taper relief. The gap will widen between investments in funds taxed as income and those as capital gains. 'If by achieving distributor status the tax rate for UK investors in offshore hedge funds is cut to 18 per cent from 40 per cent then more funds will have an incentive to apply for that status,' says Dechert's Mr Astleford.
Demand for greater exposure to hedge funds is clear, as is the willingness of the regulator and the tax authorities to accommodate this trend in a sensible controlled fashion. Less clear is whether there will be sufficient appetite from funds of hedge funds to meet retail demand with suitable FAIF products.
According to a survey of fund of funds by AIMA only a minority would be interested in the retail market. 'For those funds that are part of a larger organisation with an established distribution network it would make evident sense to add additional retail-based hedge fund products,' says Emma Muggeridge of AIMA. The majority of managers surveyed, however, only intend to address sophisticated institutional investors and are not particularly interested in retail customers. 'Oversimplification does not lend itself well to the hedge fund business,' says Robin Bowie, chairman of Dexion Capital. 'It's a good idea for people to have hedge funds in their portfolio, but only if they know what they are doing and are properly advised.'
Appetite from funds of funds for the retail sector will also depend on the extent of product regulation that the FSA applies to FAIFs and what restrictions are made on redemptions and lock-up periods. The final details will not be known until the FSA releases its policy statement in the first part of 2008 - tax negotiations with the Inland Revenue permitting.
The pragmatic response of the FSA to growing popularity of hedge funds and the regulator's belief in principles-based regulation are grounds for optimism that a workable solution can be found. This should allow funds of hedge funds access to a broader range of eligible investors and to maximise investor numbers.
In turn, the UK retail customer will gain exposure to sophisticated investment techniques with less volatile returns than many of the long-only products currently available to them.
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