At a conference this Tuesday organised by Hong Kong's Securities and Futures Commission (SFC), executive director Andrew Proctor outlined the key points of a consultation paper on the regulation of hedge funds issued by the SFC.

The paper, issued at the weekend, aims to lay the ground rules for the authorization of local hedge funds to be made available to the investing public. Over the next six weeks, the SFC expects to receive a string of submissions from investors, fund managers, distributors and administrators commenting on the proposed legislation. The final date for comment is 7 December and all submissions are to be published on the SFC's website, the first time that the consultation process has been made public.

Addressing the conference, Proctor said the paper was likely to generate a "heated debate" as the SFC sought to regulate an industry that has a reputation for being opaque and secretive. "I want to make it clear that we are not anti-hedge funds. Like other investment vehicles and securities, they offer a viable alternative to investors," he said. "But there must be a way to protect investors from making the wrong decisions by ensuring that hedge funds meet certain disclosure and transparency requirements."

He said the SFC's biggest concerns in the public offering of hedge funds were an ignorance of the risks involved in investing in hedge funds, the inexperience of distributors who sell the products and the likelihood that investors would find themselves locked into the investments for longer periods than they were used to.

Proctor pointed to several sections in the paper that were likely to attract resistance from the industry. These included: the provision that fund managers should be responsible for educating third party distributors about their hedge funds; a standardised way of calculating performance fees; and the need for fund managers to release quarterly narratives on the performance and structure of their funds.

The paper places high importance on the suitability of management companies to operate a hedge fund. In order to qualify for authorisation, the SFC is proposing that hedge funds show a minimum investment track record of five years, have at least $100 million in assets under management, display suitable internal risk control measures and be operated by experienced investment personnel. 

Oddly the paper does not give a definition of a hedge fund and Proctor said "it was not going to be easy to work out what sort of product will be controlled by the regulations". The difficultly is the number of different investment styles that can be characterized as a hedge fund. He said guaranteed funds, funds of funds and hybrids would all come under the regulations.

While the paper calls for some sort of minimum investment limit on investing in hedge funds, the SFC will wait until the consultation process is completed before setting that limit. In June this year, the Singapore authorities passed a set of hedge fund guidelines setting a minimum subscription of S$100,000 for the public to invest in hedge funds. The Hong Kong regulations focus more on the "know your client" rule.

"Just because a person has a lot of money doesn't mean they understand the risks involved in investing in different securities," said Proctor. "Fund managers and their distribution agents should know enough about a client's circumstances to know whether they can handle the risk of investing in a hedge fund."

Delegates to the conference pointed out that many fund distributors, particularly those commercial banks in Hong Kong, were not regulated by the SFC, therefore making it difficult for the SFC to monitor the sale of hedge funds through these third parties. Proctor agreed with the point, saying that by the first half of next year new rules would ensure that banks were classified as dealers and investment advisers and fall under the same codes and practices as independent financial advisors.

Proctor concluded his address to the conference by saying the SFC would exercise discretion in the approval of hedge funds. He said the commission needed more expertise in alternative investments and would likely seek outside legal and financial advice when reviewing applications.

It is expected that the SFC will finalize its regulations for the public offering of hedge funds in the first quarter of 2002.