Authorized hedge funds are governed by the SFC's Code on Unit Trusts and Mutual Funds.
What are the SFC's regulatory requirements on hedge funds?
The SFC adopts an authorization regime in which any category of fund, including hedge funds, should be authorised by the SFC before marketing to the Hong Kong public. In light of the use of alternative strategies and special risks undertaken by hedge funds, the SFC has set out specific requirements on fund managers' qualifications, amount of assets under management (AUM), risk management profile and internal control systems of the management company, information disclosure and other structural measures in authorizing hedge funds. The SFC also adopts a minimum subscription threshold to make hedge funds accessible to eligible investors only.
The requirements are detailed in Chapter 8.7 of the Code on Unit Trusts and Mutual Funds which is available on the SFC website.
Can any fund manager launch hedge funds for the Hong Kong public?
In addition to the requirements applied to traditional fund managers, the SFC, when assessing the suitability of the management company with regards to hedge funds authorization will also consider the following:
- Professional expertise - Key personnel of fund managers of single hedge funds and Fund of Hedge Funds (FoHFs) must have a minimum of 5-year general experience in managing hedge funds, at least 2 years of which is specific to the particular strategy applied in that hedge fund.
- Amount of assets under management (AUM) - There should be at least US$100 million AUM for fund manager of a single hedge fund or a FoHFs.
- Risk management and internal control systems - The fund managers should have proper, clearly written risk management and control procedures in place that are commensurate with their business profile and risk exposure.
- Appointments of representatives and agents - Other parties, such as administrators, custodians, prime brokers and valuation agents involved in the daily operation of hedge funds are required to have sufficient know-how in their own areas. The fund managers also need to provide adequate information and training to their selling agents to ensure they possess the relevant expertise in marketing hedge funds.
What are the investment restrictions on hedge funds?
The SFC adopts a "disclosure" approach, in that single hedge funds can define their own investment and borrowing parameters provided that sufficient and clear disclosure are available in the constitutive and offering documents.
FoHFs have to invest in at least five underlying funds, each of which can be an authorised or unauthorised single hedge fund, but investing in a FoHFs is not acceptable. In addition, each underlying fund cannot account for more than 30% of the total NAV of the FoHFs.
FoHFs claim to reduce their risk exposure via diversification. How can the SFC assure that FoHFs have carefully selected their underlying funds?
On top of the above diversification requirements, the SFC also requires a FoHFs manager to have a due diligence process in place for selecting underlying funds and monitoring their performance. In seeking authorisation, a FoHFs needs to submit a plan of its due diligence process to the SFC. You can refer to a summary of the due diligence process and explanation of the diversification strategy in the offering document.
Hedge funds were well-known for their mysterious approach in the past. Will SFC require more disclosure by retail hedge funds?
An authorized hedge fund is required to provide sufficient and clear information for investors to assess if it is suitable for them.
The offering document (commonly known as an explanatory memorandum or a prospectus) of a hedge fund offers details about the fund's investment strategies, dealing procedures and fee structure, etc. There are prominent risk warning statements in the front cover of a hedge fund's offering document, as well as on the application form and advertisements. Read them to understand the special risks undertaken by the fund.
Apart from publishing semi-annual and annual reports (a requirement for traditional funds), hedge funds also have to prepare quarterly reports. Hedge funds need to disclose their investment exposures (e.g. holdings of different classes of assets expressed in percentage terms with respect to NAV) in all these three types of reports, with more specific information about the top 5 positions in annual and semi-annual reports. To help investors monitor the funds' performance, quarterly reports must also incorporate a management commentary including a performance review supplemented with NAV, return and risk statistics and market outlook, etc.
Are guaranteed hedge funds subject to more regulations?
Apart from the regulatory requirements for hedge funds, guaranteed hedge funds also need to fulfill the requirements for traditional guaranteed funds.
Only a licensed banking institution, an authorised insurer or a financial institution of good financial standing and integrity and subject to prudential regulation can act as the guarantor of a guaranteed fund.
Moreover, a guaranteed fund is required to give details of its guarantor, the terms of the guarantee, the underlying investments and its risk exposure, such as investment and counterparty risks, in its offering document and advertisements.
All investments carry risks and guaranteed hedge funds are no exception. Unless the hedge fund in question has a legal guarantee attached to it, otherwise, nobody can give any assurance to the hedge funds' future performance or investment returns. Even then, investors should check the level of guarantee provided.