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The working group set up by the AMF in April 2007 and chaired by Philippe Adhémar, a member of the regulator's Board, today published its report, entitled "Assessment of the regulatory framework for funds of hedge funds in France and potential avenues of improvement ".
The report's findings and recommendations were prepared on the basis of input from the market practitioners participating in the working group, together with information gathered through an industry consultation last spring and contributions from the academic community.
Background
The working group was asked to evaluate and adjust the French framework for funds of hedge funds (FoHFs), also known in France as "ARIA III" funds. Keeping in mind that FoHFs are the main channel through which retail investors access hedge funds, the aim is to make sure that the French framework is competitive without compromising investor protection, in accordance with commitments under the AMF's "Promoting Better Regulation" approach.
The working group took on this assignment at a time when:- alternative investment management and its techniques are becoming increasingly prevalent in retail products, as evidenced by CESR's recent ruling making hedge fund indices eligible for UCITS;
- other countries, like Germany and the UK, have introduced reforms geared to creating or modifying their domestic frameworks for FoHFs;
- the underlying hedge funds of these vehicles may still be exposed to significant risk (witness the events surrounding the Amaranth fund and other recent failures).
Principles-based regulation
The group recommends moving from a regulatory approach in which the eligibility of underlying funds is determined on the basis of binary ("yes/no") eligibility criteria to a framework founded on principles covering the key operational and organisational procedures of target hedge funds, their legal status, rules for segregating and valuing assets, and external controls.
A natural consequence of this approach must be to:- capitalise on the contribution made by FoHF programmes of operations approved by the AMF;
- establish a solid due diligence framework for fund managers. For this reason, one of the main regulatory challenges is to ensure a secure and effective process for selecting and monitoring underlying funds, based on a qualitative and quantitative analysis of fund specifications and risk exposure.
Management companies are made more accountable under the recommendations, and the way in which they exercise their accountability will be closely monitored and supervised by the AMF and other participants in the chain. Accordingly, the report clarified managers' commitments to depositaries and reiterated the key role of statutory auditors.
The group's proposals, put out to public consultation until 19 November 2007, will help to make hedge funds more transparent to markets and investors, a stated goal of the AMF and the French government. The due diligence procedures carried out by managers will be more relevant and more effective in making FoHFs secure if the hedge funds involved are subject to standardised transparency obligations that are more precise and clearly delineated.
Technical adjustments to ensure that France's framework is competitive
The report proposes offering new options to ARIA III fund managers, like authorising investments in funds of funds and hedge fund derivatives. It also recommends expanding the French framework to include gate provisions, a technique used to organise fund liquidity in exceptional circumstances where underlyings are highly illiquid. Specific requirements are attached to these adjustments, however, to ensure that investors are properly informed and protected.
Reaffirming the system of investor protection
The working group believes that funds of hedge funds can play a useful part in diversifying financial investments, because adding FoHFs to a portfolio can boost its return, provided the risks associated with this kind of investment are properly understood.
Mindful of the unique risk/return characteristics of these products, the group proposes maintaining the safeguards in place for retail investors, i.e., a minimum investment threshold of €10,000, and a diversification requirement for underlying funds, although the group has lowered the minimum number of underlying funds from 16 to 10 or so.
These funds are also required to be transparent about their fees, in the same way as standard funds of funds. These disclosures must include information about total fees, including those earned by the underlying hedge funds. The report also noted that the fund prospectus should provide clearer information about the kind of risk indicators used by the manager in the selection process and give a clearer picture of the product's risk/return profile.
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The report was presented on 4 September 2007 to the AMF Board, which is putting out the group's recommendations to public consultation until 19 November 2007. The AMF will use these recommendations as a basis for preparing possible proposals to amend AMF’s General Regulation.
The recommendations may also be used to guide the AMF's position in international discussions on alternative investment management, particularly in talks concerning the creation of a European FoHF.
