The Guidelines are contained in Chapter 8.7 of the Code on Unit Trusts and Mutual Funds and were published in May 2002. The objective of the HF Guidelines is to regulate hedge funds that are offered to the retail public in Hong Kong. Given their retail nature, SFC-authorised hedge funds are required to comply with specific disclosure requirements and implement structural safeguards in accordance with the HF Guidelines. Hedge funds not offered to the public do not fall under the jurisdiction of the HF Guidelines.

Since the launch of HF Guidelines, the SFC has authorised 13 hedge funds. Five are single hedge funds and the remaining eight are funds of hedge funds (FoHFs). As of 31 March 2005, the total net asset size of the SFC-authorised hedge funds was about US$1.2 billion.

In view of the rapid development in the hedge funds industry, the SFC considers it desirable to revise the HF Guidelines in order to enhance the regulatory regime for SFC-authorised hedge funds.

Mrs Alexa Lam, SFC’s Executive Director of Intermediaries and Investment Products, said: “We seek to adopt a more pragmatic approach on individual assessment of hedge fund applications to ensure that the right balance is struck between market facilitation and investor protection.”

The proposed revisions to the HF Guidelines aim to serve three key objectives:

(1) strengthen the assessment criteria of managers of SFC-authorised hedge funds, and provide greater flexibility in recognising the experience of fund manager’s key personnel;

(2) enhance the measures for safeguarding investors’ interest and the level of transparency; and

(3) codify existing practices of the SFC in authorising hedge funds and provide additional guidance to the interpretation of the provisions in the HF Guidelines.

Says the SFC:

'The hedge funds industry is a skill and resource intensive industry. In view of the rapid market development especially the increasing use of complex investment strategies and investments in non-traditional asset types by hedge funds managers, the SFC proposes to take a holistic approach in reviewing the acceptability of a manager for SFC-authorised hedge funds in that not only does a manager have to have two key personnel with the requisite experience, the manager as a firm must also demonstrate that there are the necessary internal systems, resources and risk management process in place to manage the hedge funds business.'

Under the SFC proposals, each of the two key personnel must have at least two years’ specific investment management experience in hedge funds out of a total of five years’ experience. The rest of the experience can be made up of general experience in a wide spectrum of activities related to hedge funds strategies, such as experience in proprietary trading, securities dealings or funds selection.

The SFC proposes that additional disclosure be made in specific areas relating to the operation of SFC-authorised hedge funds. These include the calculation of performance fees chargeable by managers, the risk management process and the relationship between the funds and their prime brokers. The SFC also proposes to make it mandatory for all SFC-authorised hedge funds to have independent valuation.

“Investment units are priced, and are purchased and redeemed by retail investors on the basis of the valuation of the fund. The manager’s fees are also based on this valuation. Therefore, it serves a key function of investor protection that the fund is independently valued,” Mrs Lam said.

To provide further guidance on the application of the authorisation requirements, the SFC proposes to insert practical notes in the revised HF Guidelines to reflect the existing regulatory practices. For example, in view of the potential risks to investors, direct proprietary trading by a FoHF is not allowed in general as this may affect the overall risk profile and investment objectives of the FoHF or even result in a spillover of liabilities to the fund as a whole. This prohibition is proposed to be codified as a note to the HF Guidelines.

The SFC also invites comments on two specific proposals for the revision of the HF Guidelines:

(1) The lowering of the current minimum subscription level for SFC-authorised single hedge funds from US$50,000 to US$30,000; and

(2) The relaxation of the current restriction imposed on the level of collateralisation to prime brokers for SFC-authorised hedge funds.

Mrs Lam said: “Investor’s interest always comes first when we regulate investment products for public offering. Hedge funds may be exposed to higher risks due to rapid market movements and volatility of various asset classes. As such, hedge fund managers should ensure that they have taken the necessary measures to control all risks involved in managing their hedge funds. Distributors of hedge funds are also expected to fully understand the investment risks involved in the products to avoid any possible mis-selling to the public. Investors should assess the product’s suitability before investing in hedge funds.”

“The proposals are intended to help increase the transparency of SFC-authorised hedge funds so that investors are better informed when making their investment decisions. In addition, the codification of our existing practices in the authorisation of hedge funds is intended to assist the market practitioners in seeking authorisation of their hedge funds,” Mrs Lam said.

The one-month consultation will end on 30 June 2005. Following the consultation, the SFC will prepare a consultation conclusion document to summarise the views expressed by the respondents and set out the final revised HF Guidelines. The revised HF Guidelines will be incorporated into the Code on Unit Trusts and Mutual Funds, and is expected to take effect in the second half of 2005.