Yeo Lian Sim: Hedge funds - a mainstream alternative
Keynote address by Ms Yeo Lian Sim, Deputy Managing Director (Market Conduct) of the Monetary
Authority of Singapore, at the Hedge Funds World Singapore 2002, Singapore, 19 September 2002.
* * *
Good morning, Ladies and Gentlemen
A decade of controversy and rapid growth
Ten years ago this month, speculation that Europe's Exchange Rate Mechanism (ERM) would be
realigned gained momentum and the British pound came under intense pressure in the foreign
exchange markets. The rest, as they say, is history.
Hedge funds have come a long way since the Sterling attack. They have been linked to other
instances of market turmoil, like the Mexican Peso meltdown in 1994-95 and the Asian financial crisis
of 1997-98. Studies have revealed little evidence that hedge funds were mainly responsible for those
episodes. But their participation is not in dispute.
Also in 1998, we saw the near collapse of Long Term Capital Management and its subsequent
recapitalisation by a consortium of banks brought together with the help of the New York Fed. The
incident raised questions about the risks that large and highly leveraged hedge funds pose to systemic
stability.
It was to address these concerns that the Financial Stability Forum (FSF), of which Singapore is a
member, set up a working group on Highly Leveraged Institutions (HLIs). In March 2000, the group
issued a sobering reminder: institutions that provide leverage to HLIs must improve their counterparty
risk management and hedge funds need to enhance their disclosures.
Along with these developments, or some say in spite of them, the hedge fund industry has continued
to grow from strength to strength. There are now about 6,000 hedge funds worldwide, managing more
than US$550 billion. In 2001, some US$140 billion of new capital was invested into hedge funds. By
comparison, the entire industry was only US$20 billion in 19901.
While high net worth individuals remain the main source of capital, hedge funds are becoming more
popular among institutional and retail investors. Funds of hedge funds and other hedge fund-linked
products are increasingly being marketed to the retail market2. For example, ABN Amro launched the
first retail fund of hedge funds in Singapore last month.
There are a number of factors behind the meteoric rise in demand for hedge funds. The
unprecedented bull run in the US equity markets during the 1990s swelled investment portfolios. This
led both fund managers and investors to become more keenly aware of the need for diversification.
Hedge funds are seen as a natural "hedge" for controlling downside risk because they employ exotic
investment strategies believed to generate returns that are uncorrelated to traditional asset classes.
More recently, the bursting of the technology and telecommunications bubbles, the wave of scandals
that hit corporate America and the uncertainties in the US economy have led to a general decline in
stock markets worldwide. This in turn provided fresh impetus for hedge funds as investors searched
for absolute returns. As one commentator put it, "Where else are they going to put their money?"3.
And the maths is compelling. From 1987 to 2001, the Hennessee Hedge Fund Index posted
annualised returns of 18%, higher than the S&P's 13.5%.
The growing demand for hedge fund products has wrought changes on the supply side of the market.
The prospect of untold riches has spurred on many former fund managers and proprietary traders to
strike out on their own and set up new hedge funds. This year's ranking of top 100 hedge funds by
Institutional Investor magazine included several funds founded by "Tiger Cubs", former employees of
Tiger Management. Investors now have a wide array of hedge funds to pick from, instead of only a few
prominent ones previously.
With hedge funds entering the mainstream and becoming respectable, an increasing number of banks,
insurance companies, pension funds and fund managers are investing in them. Some are also offering
their own hedge fund products to meet customers' needs, diversify their fee income and stem the
outflow of talented staff.
In short, the hedge fund industry has attracted a wider following in the last decade and is expected to
broaden its appeal further in the years to come.
Hedge funds in Asia
This trend is also evident in Asia, where hedge funds are starting to take off. According to AsiaHedge
magazine, some 150 hedge funds operate in Asia, of which 30 were established in year 2000 and
20 last year. Currently estimated at around US$15 billion, hedge fund investments in Asia are
expected to burgeon. Europe's experience in this regard is encouraging, with its hedge fund industry
quadrupling in size between 1999 and 20014.
Industry participants believe that Asia could be the next region of growth for the hedge fund industry.
Several factors support this view. Asian hedge funds currently account for a tiny slice of the global
hedge fund pie and a mere trickle of the total financial wealth of high net worth individuals in Asia5.
Demand for Asian hedge funds should increase as investors in the region build up a better
understanding of this new asset class.
The potential of Asian hedge funds is well-supported by fundamentals. From an investment
perspective, the volatility in the Asian markets in recent years has allowed long-short and other
strategic plays to outperform regional indices. The relative inefficiency of the regional markets also
presents arbitrage opportunities.
From a demand standpoint, US and European investors are expected to turn to alternatives in Asia as
capacity (and quality) in their home markets diminish. Further, the improving economic climate in
South East Asia should help foreign fund managers and investors to refocus their attention on the
region.
Hedge funds look set to play a larger role in Asia.
The role of hedge funds in Singapore
In Singapore, hedge funds form part of the expanding menu of products offered by the asset
management industry. This industry grew rapidly over the last ten years: assets under management
increased eightfold from just over S$35 billion in 1992 to more than S$300 billion last year. For the
reasons mentioned earlier, asset managers and investors alike are finding a place in their overall
strategies for alternative investments including hedge funds, commodities and real estate. (Of course,
judging by concerns about Singaporeans over-investing in property, one wonders whether real estate
can indeed count as an alternative investment here.)
That aside, hedge funds can contribute to the development of Singapore as an international financial
centre in a number of ways. First, as evidenced in other major financial centres, hedge funds can
attract a mix of supporting professionals such as fund administrators, prime brokers and product
specialists skilled at structuring new instruments. Other positive spinoffs include fund of hedge funds
managers and consultants, who can add value to investors in the areas of hedge fund selection and
allocation among different fund strategies.
Second, hedge funds can lead to more wide-spread use of innovative financial instruments and the
development of cutting-edge technical and investment skills. Unit trusts typically go long-only on listed
equities, bonds and cash. In comparison, hedge funds, with their broad investment mandates, can
employ a selection of designer instruments and creative investment strategies and face little (if any)
restrictions on what they can hold.
Third, hedge funds can add to the liquidity and efficiency of our capital markets. The contrarian
instincts of hedge fund managers provide liquidity and help curtail unsustainable asset bubbles. By
seeking out arbitrage opportunities, hedge funds also improve the information flow and, consequently,
the efficiency of the market. Further, specialist hedge funds that invest in unlisted stocks and unrated
bonds facilitate fundraising by small, relatively unknown companies.
Singapore's regulatory approach
Singapore's approach to regulating hedge funds is risk-focused and differentiated, balancing the potential benefits
with the risks that hedge funds could pose to the financial system.
Hedge fund managers are regulated like any other fund manager that manages third-party funds in
Singapore. Small or boutique fund managers, that manage funds for accredited investors6, are subject
to less stringent licensing requirements because investor protection concerns are less acute. Smaller
firms, with fewer than 30 qualified investors7, are exempted from licensing. Hedge fund managers
should find such operating structures conducive, as they are typically small outfits managing funds for
a limited number of institutions and high net worth individuals.
MAS applies the same risk-focused and differentiated approach to the marketing of hedge funds. MAS
does not regulate offers of collective investment schemes and hedge funds to professional and
institutional investors in the financial sector as these investors are adequately skilled to evaluate for
themselves the investment characteristics of hedge funds. Similarly, financial institutions can offer
hedge funds to sophisticated investors on the strength of an offering memo.
MAS' regulatory oversight of the marketing of hedge funds is focused on retail investors. Retail
investors may not be familiar with the differences between a hedge fund and a typical collective
investment scheme. In particular, key aspects such as legal structure, investment objectives, trading
strategies and fees may not be fully appreciated. Unlike unit trusts where a growth fund usually invests
in stocks and an income fund in bonds, there is no simple correlation between investment style and
asset exposure for hedge funds. Hedge funds also tend to be leveraged and can trade in derivatives,
whereas traditional funds have limited scope for borrowing and dealing in derivatives.
Further, retail investors may be lulled into thinking that hedge funds are low risk investments based on
studies showing hedge fund returns to be less volatile than mutual fund returns. Such statistics must
be carefully considered especially since hedge fund returns are anything but normally distributed.
Indeed, they are negatively skewed and exhibit high kurtosis. A fat-tail event, such as the Russian
default in 1998, was enough to scuttle any profits Long Term Capital Management might have
projected with its elaborate models.
Retail investors may not realise that hedge funds also display other characteristics that make them
riskier than traditional funds. For one thing, hedge funds have an average life span of 3.5 years, with
one-third of newly-established funds folding before those three years are up primarily due to poor
performance8. Further, hedge funds are usually subject to a lock-up period and, after that, fixed
redemption windows, unlike unit trusts which are typically redeemable every trading day.
This is not a preamble to a blanket prohibition on the marketing of retail hedge funds. Retail hedge
funds will continue to be permitted under a comprehensive regulatory framework. MAS' approach is to
balance investor needs and investor protection on three pillars - enhanced disclosure, enabling
regulation and enlightened investors.
To enhance disclosure in prospectuses for offers of investments (including hedge funds), Part XIII of
the SFA which came into effect in July this year introduced new prospectus checklists, prospectus
registration procedures and advertising regulations. A prospectus must contain all material information
that a reasonable investor would require to make an informed investment decision, such as the
investment objective and specific investment risks of a fund, the fees and charges, and the track
record of the fund manager.
For the market to exercise discipline on prospectus disclosure, prospectuses that are lodged with MAS
are posted on the MAS web-site for public comment for a minimum two weeks. We view this as an
advance in speed and efficiency. As a safeguard, MAS may refuse to register a prospectus if it does
not satisfy the disclosure requirements or if its registration is not in the public interest. If a prospectus
is found to be misleading or deficient after it has been registered, MAS can serve a stop order on the
prospectus to prevent further issuance or sale of securities to the public.
Following a public consultation in August, MAS will issue comprehensive retail hedge fund guidelines
by year-end that will include, among other things, a requirement for some specific information to be
disclosed in both prospectuses as well as marketing materials. In particular, the material differences
between the hedge fund offered and traditional funds. Also the fees and charges. For funds of hedge
funds, the method of achieving diversification must be disclosed.
Turning to the second pillar - enabling and flexible regulation, the new guidelines aim to align our
hedge fund regulations with international best practice, so that well-managed hedge funds from
established markets can be offered in Singapore.
A key development is to distinguish between single hedge funds, funds of hedge funds and capital
protected hedge funds. Recognising that features such as diversification and capital protection would
reduce the risk of investing in a hedge fund, MAS will introduce a lower minimum initial subscription of
S$20,000 for funds of hedge funds. No minimum subscription will be required for capital protected and
capital guaranteed hedge funds. Single hedge funds may continue to be offered to retail investors with
a minimum initial subscription of S$100,000.
To maintain professional standards, retail hedge funds must have at least two executives who each
have a minimum of five years' experience in managing hedge funds. In addition, managers should
have at least three of those five years of experience managing funds of hedge funds if they offer this
product.
Redemptions of retail hedge funds need only be made once every quarter. This is an accepted
international practice. Managers who want to provide for more frequent redemptions are free to do so.
Redemption procedures should be prominently disclosed.
To facilitate the entry of foreign funds of hedge funds, there will be a flexible diversification rule. The
rule will require any fund of hedge funds to be diversified either across 15 hedge fund managers or by
having not more than 8% of its assets allocated to a single hedge fund manager.
This would enable foreign funds of hedge funds to benefit from an earlier liberalisation introduced by
the SFA in July this year, which allowed all recognised foreign funds (including hedge funds) to be
offered directly to Singapore investors instead of only through feeder funds previously. For a foreign
fund to be recognised by MAS, the foreign offeror needs only to register a foreign company in
Singapore and appoint a representative to act as a liaison for investors. The fund and its manager
should be from a jurisdiction with acceptable regulatory standards.
While providing for direct offers of foreign funds into Singapore, the alternative feeder fund structure is
still available. A Singapore fund of hedge funds can therefore feed into a foreign fund of hedge funds.
Such alliances could benefit from the Singapore manager's access to local investors as well as the
foreign manager's working relationships with other hedge fund managers. Structures that involve a
foreign fund of hedge funds feeding into other funds of hedge funds will also be allowed with good
reason and disclosure of all relevant fees and charges.
Work has also begun on the third pillar - enlightened investors - which is an essential element of a
disclosure-based regulatory regime. The Financial Advisers Act (FAA), which will become operational
on 1 October, will create a class of financial advisers who can advise and inform investors on a whole
range of investment products. These financial advisers would be able to promote public awareness of
more sophisticated products such as hedge funds.
As part of the regulatory regime under the FAA, a new code of conduct will be issued shortly to
provide guidance on the standards of conduct expected of all persons who provide financial advice
(including exempt financial advisers like banks and insurance companies). The standards will cover
specific responsibilities with regard to hedge fund products such as explaining product features and
risks, as well as making investment recommendations to clients. The new regulatory framework under
the FAA is expected to raise the quality of advice on investment products and, along with that, investor
sophistication.
Within MAS, a new division has been set up to provide an overview of investor education efforts
across the financial sector. In other financial centres, having a strong community of well-informed retail
investors has helped in developing the sophistication of the financial markets. This is what we would
like to see happening in Singapore. MAS will work closely with the industry to identify gaps and study
ways of enhancing investor education in Singapore.
The industry itself also has a major role to play. Given the untapped potential in the market, there is
much to be gained, whether at the individual firm or industry level, by being more active in educating
investors about the nature of hedge funds, their contribution to an overall wealth management
strategy, and the merits of different products. Only by winning and maintaining the trust of investors
can the hedge fund industry seize the unique opportunities that are opening up in Singapore and the
region.
For its part, MAS will maintain its calibrated approach towards the regulation of hedge funds and
hedge fund managers. MAS will also continue to build on the three pillars of enhanced disclosure,
enabling and flexible regulation and enlightened investors to establish sound regulatory standards for
the industry and foster market development. In each of these areas, we will need to work closely with
industry players like yourselves. I consider this conference to be a useful step in promoting such
cooperation.
Thank you.