Australian Regulator Warns Pensions Industry On Hedge Funds

LawAndTax-News.com, Hong Kong

14 March 2003

The Australian Prudential Regulation Authority (APRA) recently warned the retirement industry about its concerns over the use of hedge funds as an investment choice. APRA is the prudential regulator of the financial services industry including banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, friendly societies, and most members of the superannuation industry. It currently regulates $1.5 trillion in assets for 20 million Australians.

APRA General Manager, Mr Wayne Byres, said that hedge funds were growing in popularity because they ostensibly offer the potential for greater diversification in asset classes and absolute returns for less risk at a time when market returns were down. “What is becoming obvious, however, is that while some hedge funds are professionally managed and regulated, they can still lead to significant losses in a relatively short space of time, particularly where gearing is used,” he said.

“Events in the late 1990s have shown that even the most carefully constructed investment strategies are not fool-proof and significant losses can be generated in a relatively short space of time where large, illiquid positions are involved”.

APRA’s main concerns are that hedge funds rely heavily on a single strategy, with broad delegations for the use of gearing and derivatives, and on a single individual to execute the investment management process; and are characterised by relatively short trading history and/or an absolute return rather than a benchmark return.

“APRA expects trustees to address a number of issues and analyse the risks inherent from an investment perspective before taking the decision to allocate a percentage of a portfolio into a hedge fund,” Mr Byres said.

Some of the questions APRA says trustees must ask in relation to hedge funds include:

• Is the hedge fund a regulated entity? What are the disclosure requirements of the fund and what legal jurisdiction is the fund subject to, and is that legislative environment comparable to the Australian system?
• Has the trustee developed confidence in the adequacy and robustness of the fund’s resources and risk management systems?
• Has the trustee assessed, and formed confidence in, the integrity of key service providers of the fund such as the prime broker, dealers, auditors, legal advisors and external administrators?
• What is the level of due diligence performed on the underlying fund manager, especially where the investment is via a fund of hedge funds structure? Has external professional advice been taken?
• What is the level and frequency of reporting received by the trustee from the fund? For example, if the fund is an equity long/short strategy, are short and long positions disclosed to the investor? Are the number and value of positions disclosed? Is the level of gearing reported? Will the extent of reporting from the fund enable the trustee to manage and monitor the level of risk inherent in the fund’s portfolio?
• What disclosure statements are trustees receiving from hedge funds with respect to the use of derivatives? Is the derivative charge ratio disclosed? Does the use of derivatives adhere to APRA Circular II.D.7?
• How are hedge funds classified in the fund’s investment strategy in terms of asset classes? That is, does an investment in a hedge fund represent a component of equities or is it classified into a separate asset class?
• Is there a lock-up period for the investment in the hedge fund? Can the investment be redeemed within an acceptable period of time? What is the regularity of the fund striking a unit price?
• What benchmarks do trustees utilise to measure the risk weighted performance of a hedge fund? Are performance fees set at realistic levels?
• Is the trustee confident that the hedge fund will not impair the ability of the trustee to comply with reporting obligations to Australian regulatory bodies, including APRA?

Mr Byres added: “Trustees who are unable to answer all of the above questions need to seriously reconsider whether they have made an informed and appropriate investment decision on behalf of their members.”

“If APRA is not satisfied that an investment in hedge funds is to the benefit of fund members, it will step in to protect their interests,” he said.

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