Hedge funds, long accused of a string of misdemeanours, from fuelling the 2008 global economic meltdown to being the investment vehicle of choice for fraudsters, are about to have their wings clipped in South Africa. National Treasury and the Financial Services Board (FSB) this week published a proposed regulatory framework for these funds.

Mainstream hedge funds aim to profit from both good and bad market conditions. They also use strategies that can be very high risk.

Until now there has been no regulation of South African hedge funds, apart from a requirement for hedge fund managers to be registered as financial services providers in terms of the Financial Advisory and Intermediary Services Act.

Hedge fund managers and consultants have been hard-selling their products to retirement funds since the easing of restrictions on alternative investments (contained in the prudential investment requirements of regulation 28 of the Pension Funds Act).

However, draft regulations have been published that will place a responsibility on retirement fund trustees to exercise special care before their funds invest, and once their funds have invested, in hedge funds.

The draft regulations released this week propose the creation of two categories of hedge funds, each with different levels of regulation. These are:

* Restricted hedge funds. In terms of the proposals, these funds may not be sold to the general public. They will be made available only to investors – including wealthy individuals and retirement funds – that conduct at least 10 significant transactions on securities markets every three months. The minimum amount that an investor will be able to invest in a single fund is R1 million.

Restricted hedge funds will not be subject to strict regulation but will have to register with the FSB. The funds will have to submit annual returns to the FSB, mainly so that the regulator can assess their gearing (borrowing to invest, which can multiply returns, as well as losses).

* Retail hedge funds (including funds of hedge funds). These funds will be open to wealthy individuals and institutional investors. The minimum investment amount in a single fund will be between R50 000 and R100 000.

It is proposed that retail hedge funds will be regulated more strictly than restricted funds by the addition of a section to the Collective Investment Schemes Control Act (Cisca), which regulates unit trust funds and mortgage participation schemes.

Cisca allows the investments of many investors to be pooled and managed by collective investment scheme management companies, subject to very tight regulation.

A key proposal is that an investor in a retail hedge fund cannot be liable for more than the amount invested in the fund. In other words, the most you can lose is all your capital. Any additional losses incurred as a result of gearing will be to the account of the fund manager.

Other special conditions proposed for retail hedge funds are:

* The underlying investments will be limited to securities and money market instruments listed on an exchange or a regulated market and the derivatives of those instruments. Retail funds will not be allowed to invest in commodities whereof the physical delivery is possible, property, private equity or non-financial indices. However, they will be allowed to gain exposure to these opportunities through financial indices (for example, exchange traded funds). There will also be limits on how much a fund can invest in a single security or derivative.

* The assets of a fund must be held by a custodian or trustees and not the fund manager.

* There must be full disclosure of conflicts of interest and how the conflicts will be limited, particularly where funds of hedge funds share fees with the underlying funds.

* A fund’s underlying assets must be valued by an independent valuator, with unit prices provided daily. If the underlying assets are unlisted instruments, the fund’s trustees must approve the valuation methodology.

* A fund must hold sufficient cash for investors to be paid out within 14 days of giving notice of their intention to withdraw.

* Fund managers must hold capital as assurance against potential losses.

* A fund must draw up a risk management programme, which must specify the types of derivative instruments that will be used, their level of risk and their purpose.

* Leverage will be limited to double the net assets held by a fund.

* There must be a high level of disclosure to investors through the provision of a key investor information document.