New hedge fund regulations place more emphasis on risk management

"Investors and regulators are placing greater emphasis on risk management. For example, the recently published proposed framework for the legislation of South African hedge fund products says that all funds should have a risk management programme (RMP)," said Carla de Waal, head of Funds of Hedge Funds at Novare Investments.

"In the proposed framework issued by the National Treasury and Financial Services Board (FSB) there is a section dedicated to risk management, which incorporates disclosure of conflicts of interest, valuation, liquidity, segregation of assets, leverage and service providers like the auditor and compliance officer."

Risks must be specified

The framework proposes that the RMP covers, amongst others, risks relating to investment in unlisted instruments, the use of derivatives in the portfolio, and the trading process employed. With regard to the usage of derivatives, the hedge fund manager will need to specify the risks associated with the derivatives and how they will be managed.

"Keeping in mind that one of the objectives of the proposed regulatory framework is the prevention of systemic risk, hedge fund managers will be required to report on their counter party risk exposure. This is particularly important when a large proportion of portfolio assets are invested in over-the-counter instruments," De Waal said.

Reality and theory differs

With risks in the investment world ever changing, risk management processes need to be adaptable in order to add value. It is also important to understand the challenges of risk management, including that reality often plays out differently to theory, betas and correlations are not stable over time, and frames of reference may change. People, process, control, support are the four pillars of a successful risk management framework.

There are currently around R33.6bn in assets managed in South African hedge funds, most of which employ vanilla long/short strategies, like equity hedge, equity market neutral, fixed interest long/short, fixed interest arbitrage and multi-strategy, which is a combination of strategies across different asset classes.

"The South African hedge fund industry has been characterised by high self-regulatory standards in the absence of more formal regulation, although local hedge fund managers have been subject to Financial Advisory and Intermediary Services legislation since October 2007. Transparency is good, mainly as a result of funds of hedge funds being the largest investor group," she concluded.