Following a year-long review, the FSA has concluded that funds of hedge funds are appropriate financial investments for the UK retail investment market.
The Financial Services Authority (FSA) yesterday issued two separate Feedback Statements on its previous discussion papers looking at hedge fund investing in the UK - DP05/3, 'Wider-range Retail Investment Products' and DP05/4 'Hedge funds: A discussion of risk and regulatory engagement'.
In its discussion paper on retail investment products, the FSA concluded that funds of hedge funds are appropriate financial investments for the UK retail investment market.
The FSA said it would to consult next year on widening the range of funds that can be marketed to retail investors to include new authorised funds of hedge funds.
This would enable retail investors, who are already gaining access to products with hedge-fund investment characteristics through a variety of means, to invest in products that would be subject to the FSA's regime for authorised collective investment schemes.
The funds would be subject to structural and operational safeguards including the requirement to have an independent depositary. In addition, the fund of hedge funds managers will not be able to invest into all hedge funds - there will be liquidity criteria, for example, in respect of the underlying funds. This should enhance investor protection whilst allowing increased investor choice.
Clive Briault, FSA Managing Director for Retail Markets, said: "Retail investors can currently gain access to products with hedge-fund investment characteristics through a variety of means, including listed funds of hedge funds, funds offered on the internet from European jurisdictions, structured products linked to hedge fund indices and funds under the UCITS III (Undertakings for Collective Investments in Transferable Securities) Directive.
"Given the reality of the contemporary retail market, it seems sensible to permit the marketing of funds of hedge funds through an authorised, onshore vehicle. These onshore funds of funds would benefit from the protections already in place for authorised funds.
"We also need to consider how we can help consumers to understand the features and risks associated with these products. Our consultation will also address these important issues."
The discussion paper on retail investment products identified three risks to consumers posed by the current suite of retail investment products. These were: lack of consumer understanding of newer products; confusion over the sales and distribution channels used; and possible detriment caused by marketing prohibitions on certain unregulated funds.
AIMA welcomes FSA's recommendations
The London-based Alternative Investment Management Association (AIMA), the global hedge fund and alternative investment industry association, welcomed the FSA's recommendation to allow UK retail investors to invest in funds of hedge funds.
It stated: 'Funds of hedge funds invest in single manager hedge funds. One of AIMA's primary goals is to educate the investment market on hedge funds. In this instance AIMA agrees with the FSA that fund of hedge fund managers are best qualified to select the most appropriate hedge funds for retail investors'.
Florence Lombard, Executive Director at AIMA, said: 'There is a common will shared by the industry and the FSA to optimise the investment environment for investors. The FSA has correctly concluded that retail investors should be given the opportunity to invest in market leading investment products that can deliver absolute return performance in all markets.'
Over the last number of years hedge funds have become increasingly mainstream with institutional strength controls and governance. AIMA has been encouraging the distribution of funds of hedge funds since the FSA's original DP16 hedge fund discussion paper in 2002. These funds are already marketed to retail investors in other European countries including France, Germany, Italy and Spain.
AIMA also welcomed the FSA's statement in its discussion paper on risk and regulatory engagement - DP05/4 - that hedge funds enhance market efficiency, increase liquidity, and that the FSA is committed to ensuring the UK remains an attractive place for hedge fund managers. The number of hedge funds managed in London has more than doubled between 2002 and 2005 and now represent 20% of the worldwide industry.
Lombard added: 'We are pleased that the FSA has acknowledged the growing importance of an industry which now manages more than USD 1.5 trillion in assets worldwide. Over the last few years hedge funds have been at the forefront of the development of the investment management industry, as managers seek new and innovative ways of generating returns for investors'.
The FSA's recommendations on regulation of hedge funds in the UK
Commenting on the FSA's feedback on DP05/4 - 'Hedge funds: A discussion of risk and regulatory engagement', Hector Sants, FSA Managing Director of Wholesale Business, said: "We continue to view hedge funds as a vital segment of the financial services industry. In particular they play a fundamental role in the efficient reallocation of capital and risk, and remain an important source of liquidity and innovation in today's markets.
"We are pleased that both the formal responses and our wider discussions confirmed that the risks we had identified from hedge funds to our objectives were the correct ones. As we have previously made clear our response is only a modest change in our regulatory approach.
"There are two principal areas of focus to our current supervisory work. Firstly, we will seek additional information from the hedge fund managers we regulate to enhance our understanding of their activities, which will better inform our supervisory approach. Secondly, we continue to urge firms to focus on the risks posed by asset valuations and side letters, which will remain an area of supervisory focus."
The FSA continues to view hedge funds as an important part of the financial services system providing a major source of liquidity and enhancing market efficiency. In DP05/4 the FSA identified what it saw as the risks posed to its objectives by hedge funds and outlined the steps it had taken to mitigate them and a number of further ways in which it could address those risks.
Additional FSA questions for hedge fund managers
In order to increase its understanding of the activities of those asset managers using hedge fund techniques, the FSA proposes to include additional questions to identify the firm's prime broker, third party administrator and the fund auditor in the Integrated Regulatory Returns that firms send to the FSA.
Additionally, two specific areas are the subject of supervisory focus. These are:
- Asset Valuations: hedge fund managers may be exposed to conflicts of interest as their remuneration is based on performance and assets under management. This may create an incentive to overstate the valuations it provides to administrators, who may not be able to challenge them. Themed visits are currently being carried out in this area and the findings will be known in the third quarter this year. The FSA has also sponsored an IOSCO project on valuing complex and illiquid assets in hedge funds; and,
- Side Letters: the failure by hedge fund managers to disclose that side letters have been granted to certain clients may result in some investors receiving more information and preferential treatment to other investors in the same share class. The FSA expects managers to ensure that all investors understand that a side letter has been granted and that conflicts may arise.
AIMA stated that it was pleased that 'the FSA is leading coordination of IOSCO's work on asset pricing for the hedge fund industry, to create principles-based guidelines. The FSA refers to a specific company that has withdrawn from the industry following fund over-valuation - not a member of AIMA'. The FSA stated that it will 'look to build on the work on good practice that has already been undertaken through trade bodies such as AIMA'.
This refers to AIMA's 'Asset Pricing and Fund Valuation Practices in the Hedge Fund Industry' April 2005 study, which puts forward 20 recommendations covering governance, transparency, procedures and pricing models. The second phase of work in this area is already underway and AIMA has recently established a global working group comprising hedge fund managers, administrators, investors and leading pricing specialists.
This issue of 'side letters' was identified by AIMA last year and an industry working group was established in October 2005, which is examining means of reducing the use of side letters - potentially by moving common issues into the fund's documentation.
Pdf copies of the feedback report to Discussion Paper 05/4 Hedge Funds: A Discussion of Risk and Regulatory Engagement and the FSA's feedback to Discussion Paper 05/3 Wider Range of Retail Investment Products: Consumer Protection in a Rapidly Changing World can be obtained from www.hedgeweek.com/hwreports.asp 
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