SFC Releases Hedge Funds Guidelines

The Securities and Futures Commission (SFC) today releases the Hedge Funds Guidelines and the related Consultation Conclusions.

The Hedge Funds Guidelines set out the regulatory requirements for the authorization of hedge funds that are offered to the public in Hong Kong. It will be incorporated into the Code on Unit Trusts and Mutual Funds as Chapter 8.7. With the Hedge Funds Guidelines in place, the SFC expects that the Hong Kong public can start buying hedge funds by the third quarter of this year.

An overwhelming majority of respondents to the public consultation that ended last December supported the proposal to allow hedge funds to be marketed to the public in Hong Kong. Respondents generally believed that the formulation of clear guidelines would facilitate market development and benefit investors by offering them access to a broader range of investment products.

A majority of the respondents supported a market segmentation approach via the setting up of minimum subscription thresholds for different types of hedge funds. That said, respondents recognized that investor protection could not be achieved by merely setting minimum subscription thresholds. Most respondents agreed on the need to set sufficiently high entry standards to ensure suitability of fund managers but considered that some flexibility should be allowed given that the hedge fund industry is still in its early stage of development in Hong Kong.

Alexa Lam, SFC's Executive Director of Intermediaries and Investment Products, said: "The SFC is committed to accommodating market changes and facilitating investors' access to a wider range of investment products. Hong Kong will be one of the first few jurisdictions in the world to allow public offering of hedge funds."

In developing the Hedge Funds Guidelines, the SFC has opened the way to deregulate outdated rules that inhibit competition and innovation in the funds management industry. Hedge funds may be risky products. However, there is increasing retail interest in alternative investments. Provided there are adequate structural safeguards and proper disclosures, and investors understand the nature and risks before they invest, they should be given a wider choice of products. Informed choices for investors will bring forth a broader and deeper market for the benefit of all.

"We will continue to maintain close dialogue with the industry and seek ways to enable Hong Kong to continue to grow as Asia's premier fund management center," Lam added.

The SFC follows a "total approach" in considering hedge funds as public investment vehicles. Aside from having a set of product guidelines, the SFC will have regard to the importance of the education process for the buyers and sellers of hedge funds. The SFC will launch a series of investor education programs in the coming months to enhance investors' understanding of hedge funds. Investors are reminded that hedge funds are not a "sure-win" product and the risks inherent in hedge funds may be different from those in traditional funds. Investors should consider their own financial circumstances and the suitability of hedge funds as part of their overall investment portfolio. On the other hand, financial intermediaries are also reminded of their obligations to assess whether hedge funds were suitable for their clients.

Copies of the Hedge Funds Guidelines and the Consultation Conclusions are available at the SFC Office, on the SFC website (www.hksfc.org.hk) and the FinNet communication network.

Notes to Editor: Major features of the Hedge Funds Guidelines and highlights of the key conclusions are set out in the Appendix

Appendix

The key features of the Hedge Funds Guidelines and the issues arising from the consultation are summarized below. The references in brackets refer to paragraphs in the Consultation Conclusions paper.

(a) Market Segmentation vs. Full Public Offering [paras. 18-30]

Although some respondents were in favour of a full public offering, most of the respondents opted for a market segmentation approach and supported the use of a minimum subscription threshold for different fund categories. On the basis of the comments received, the SFC adopted segmentation via the following minimum subscription thresholds:

(b) Entry Requirements for Management Company [paras. 33-47]

There was tremendous support for the guidelines to set sufficiently high standards to ensure suitability of the fund managers, including the requirements for suitable internal controls and risk management systems and for the fund to be managed in an acceptable inspection regime*. In addition, having considered the comments received regarding the risk profiles of different categories of hedge fund managers, the SFC adopted the following entry requirements:

* The current list of acceptable inspection regimes includes the Commission des Operations de Bourse (France), Bundesaufsichtsamt fr das Kreditwesen (Germany), Central Bank of Ireland (Ireland), SFC (Hong Kong), The Commission de Surveillance de Secteur Financier (Luxembourg), Financial Services Authority - Investment Management Regulatory Organization (UK) and the Securities and Exchange Commission (US). For details, please refer to Appendix A2 of the Code on Unit Trusts and Mutual Funds.

(i) Single hedge fund manager

Minimum US$100 million AUM (Asset under Management) for the amount of assets that follow hedge fund strategies plus five years' general experience in hedge funds strategies with at least two years' experience in the same strategy as the proposed hedge fund.

(ii) Fund of hedge funds (FoHFs) manager

Minimum US$100 million AUM for the amount of assets that follow hedge fund strategies plus five years' general experience in hedge funds strategies with at least two years' experience as a FoHFs manager.

(iii) Managers of the underlying funds of FoHFs

No AUM requirement but at least two years' experience in the relevant investment strategies, provided however that up to 10% of the net asset value of a FoHFs may comprise of underlying funds managed by investment personnel with less experience.

(c) Fund of Hedge Funds (FoHFs) [paras. 79-89]

In general, most respondents favoured the authorization of FoHFs. Respondents argued that retail investors should be able to rely on the FoHFs managers to act on their behalf to play the role of "sophisticated investor" in selecting and monitoring the underlying hedge funds and their managers. Hence, the regulatory focus should be on FoHFs managers rather than the underlying funds. Respondents were generally in favour of some diversification rules on FoHFs.

Bearing in mind the need to strike a balance between market facilitation and investor protection, the SFC adopted the following:

(i) to place reliance on the FoHFs manager* to perform suitable due diligence in the selection of the underlying hedge funds and fund managers. In this regard, the FoHFs manager must submit a plan to the SFC to explain its due diligence process for the selection of the underlying funds and how it proposes to monitor the activities of the underlying fund managers;

*Provided that the FoHFs manager satisfies the qualification requirements and is based in an acceptable inspection regime.

(ii) to require the FoHFs to invest in at least five underlying funds, with no more than 30% of its total net asset value invested in any one underlying fund;

(iii) to allow FoHFs to invest in non-SFC authorized funds subject to additional requirements on experience of the managers to the underlying funds;

(iv) to require the offering documents of FoHFs to insert additional risk disclosures that some or all of the underlying funds and their fund managers may not be subject to the regulation of the SFC and that such funds may not be subject to rules similar to those of the SFC that are designed to protect investors;

(v) to require the underlying funds of a FoHFs to appoint independent trustees/ custodians to perform the safe-keeping function; and

(vi) to impose rules against the retention of rebates (whether in cash or in kind) from the underlying funds and the double-charging of fees by the FoHFs manager and its connected persons.

(d) Performance Fees [paras. 74-78]

There was general support for the "high-on-high"* or "high watermark" calculation basis. The SFC maintained the current "high-on-high" calculation basis for performance fees. Despite the demand for greater flexibility on the frequency of payment (e.g. quarterly payment) of performance fees, the SFC believes that an annual payment frequency is in line with the long term investment objective often projected by investment funds and hence should be adhered to. Nevertheless, the SFC relaxed the "high-on-high" and annual payment requirement for underlying funds of FoHFs, provided that the offering document of the FoHFs gives a summary of the bases of how performance fees are calculated and paid by the underlying funds.

* A performance fee can only be paid if the net asset value per unit/share exceeds the net asset value per unit/share on which the performance fee was last calculated and paid. The rationale of the "high-on-high" principle is that the manager should not be entitled to a performance fee unless it can demonstrate absolute improvement in performance and not simply because the fund outperforms a particular benchmark.

(e) Dealing [paras. 65-69]

Having regard to the submissions, the SFC maintained the original proposal that there should be at least one regular dealing day per month. However, the SFC relaxed the requirement on the payout period for redemption proceeds (between the receipt of a properly documented request for redemption and the actual payment to investor) by allowing for the necessity of notice periods. Hence, a 90-day payout period is required.

(f) Valuation [paras. 90-94]

The SFC considers that it is the responsibility of the management company to ensure that investments of the scheme are fairly valued in accordance with generally accepted accounting principles and industry's best practices. Onus is placed on the management company to demonstrate that its valuation agents possess sufficient know-how and experience in dealing with hedge funds. On the basis of the monthly dealing rule, valuation would need to be done at least on a monthly basis. In addition, the offering document is required to disclose the full particulars of the valuation methods, the valuation frequency, the identity of the valuation agent and its qualifications.