Various regulators around the world have attempted and struggled to come up with a definition for ‘hedge funds’. ASIC and the Australian Treasury have recently grappled with this task. The definition affects Australian hedge fund issuers but is having unintended consequences for some other fund managers.
Various regulators around the world have attempted and struggled to come up with a definition for ‘hedge funds’. This task has been before ASIC and the Australian Treasury, as they devised a definition for hedge funds to exclude them from the shorter product disclosure (SPDS) regime and to introduce enhanced disclosures for hedge fund offerings to retail clients. The definition affects Australian hedge fund issuers but is having unintended consequences for some other fund managers.
Why is it necessary to define a hedge fund − what is at stake?
A hedge fund is an investment fund and until now, there has not been a need to distinguish between hedge funds and other types of funds.
Since 22 June 2012, funds that are simple managed investment schemes will generally need to comply with the SPDS requirements. Some hedge funds are also simple managed investment schemes since the definition of a simple managed investment scheme is based on a liquidity test, rather than a complexity test.
In an announcement on 22 December 2011, the Minister for Financial Services and Superannuation, the Hon Bill Shorten, reiterated that complex products, such as hedge funds would be excluded from the SPDS requirements, until they can be fully considered in light of the intent of the SPDS regime.
There was uncertainty for many product issuers for quite some time leading up to the SPDS effective date until ASIC released Class Order 12/749 (Class Order) on 18 June 2012 as neither ASIC nor Treasury had given any indication of what the exemption would cover or how hedge funds would be defined. Under the Class Order, hedge funds can not opt into the SPDS regime. For those hedge fund issuers that have already transitioned to the SPDS regime before the commencement date of the Class Order, the responsible entities have until 31 January 2013 to revert back to the long form PDS.
In addition, ASIC is also focusing on hedge fund disclosure to retail clients and has released two consultation papers, Consultation Paper 147: Hedge funds: Improving disclosure for retail investors and Consultation Paper 174: Hedge funds: Improving disclosure - Further consultation in February 2011 and 2012 respectively, incorporating a draft regulatory guide on hedge fund disclosure. Like other products that ASIC considers to be complex, it is requiring issuers of hedge funds to include additional information in the product disclosure statements on a list of benchmark topics or disclosure principles (or otherwise explain why they have not included the information). Some of these enhanced disclosure requirements are particularly onerous for hedge fund issuers and it is questionable whether the prescribed additional information would be useful to investors when making a decision to invest or withdraw from a fund. It is proposed that hedge funds will need to meet the enhanced disclosure requirements from 1 March 2013.
Can a fund be a ‘hedge fund’ if it doesn’t hedge?
Before we consider ASIC’s definition of a hedge fund, it is interesting to consider whether the term ‘hedge fund’ is even an appropriate description.
‘Hedge fund’ is an expression believed to have been first applied in 1949 to a fund managed by Alfred Winslow Jones. Mr Jones’s private investment fund combined long and short equity positions to ‘hedge’ the portfolio’s exposure to movements in the market. Many hedge fund managers still use this principle but many other hedge fund strategies do not include ‘hedging’.
The type of investment strategies and techniques that hedge fund managers adopt are many and varied. Broad categories of hedge fund strategies include absolute return, global macro, directional, event driven and relative value (arbitrage). Some hedge funds have a particular investment focus such as a regional or geographical focus (Asian equities), particular type of industry (technology companies, power companies) or type of investments (commodities, derivatives). Many hedge fund portfolios will include investments in derivatives, swaps, futures and complex products and more risky techniques such as short selling and leverage. However, as hedge fund strategies and types of investments vary, it is extremely difficult to classify a fund based on these factors alone. In addition, the types of strategies deployed and the types of investments traded in hedge fund portfolios are constantly evolving.
Definition of hedge fund
The definition of a hedge fund under the Class Order is similar to the definition in the draft regulatory guide on hedge fund disclosure, but not identical. We expect that the definition under the draft regulatory guide will be changed to align the definitions. We note that ASIC has incorporated many of industry’s submissions on the definition.
Under the Class Order, a hedge fund is defined as a registered managed investment scheme that:
- is promoted by the responsible entity using the expression and as being a “a hedge fund” or
- is covered by two or more of the following characteristics – certain investment strategies, use of leverage, use of derivatives for speculative purposes, use of short selling and charge performance fees.
The characteristics listed in (b) above in the definition of the Class Order are similar to those in the draft regulatory guide. However, ASIC has provided greater clarity on the specific characteristics. For example, ASIC has now clarified that investments in derivatives that are only used for managing foreign exchange or interest rate risks are not speculative and should not be included when considering whether the fund is a hedge fund. The concept of “dominant purpose” has also been introduced to some of the characteristics.
The approach of defining a ‘hedge fund’ by considering whether a fund has certain characteristics is adopted by other financial services regulators, including Singapore, Hong Kong and the United Kingdom. It is also worth noting that this approach is also adopted by the International Organization of Securities Commission (IOSCO). In the IOSCO final report on ‘hedge fund oversight’, published in June 2009, it noted that some characteristics to consider when defining a hedge fund include funds that have borrowing and leverage restrictions, significant performance fees, permit investors to redeem their interest periodically, co-investment by the investment manager and the use of derivatives. ASIC (in its draft regulatory guide) and IOSCO acknowledge that not all hedge funds will fit within this mould and possess all the characteristics listed above. It is interesting to note that other regulators, such as in United States, do not focus on the characteristics of the fund, but rather whether it is a ‘private fund’ - by focusing on how the fund is promoted and the investors in the fund.
It has to be acknowledged that defining ‘hedge fund’ is difficult and ASIC has clearly given extensive consideration to this issue. However, there is a danger in adopting the ‘characteristic’ approach in defining a ‘hedge fund’ as there may be some funds that possess two or more of the characteristics but would not generally be considered hedge funds. A particular funds’ mandate may permit it to enter into long and short positions (such as a 130/30 fund) or invest in derivatives and use leverage (such as a standard real estate investment trust) but may not be generally considered a ‘hedge fund’. There is a real risk that some funds that are not traditionally considered hedge funds, may fall within ASIC’s hedge fund disclosure web.