This guest column is written by Ian Hamilton, the founder and chief executive of the IDS Group, a specialist administration company that administers over R60 billion in hedge funds, private equity and unit trust funds. Hamilton warned the Financial Services Board seven years ago about the dangers of the Relative Value Arbitrage Fund.

In 2009, I sounded a warning to pension fund trustees at their annual convention about unregulated alternative investment schemes, following the collapse of Bernie Madoff’s US$50-billion fraud. Many of Madoff’s investors were smart people who believed that what turned out to be a Ponzi scheme was a legitimate hedge fund.

I asked whether this could happen in South Africa. It has – with the potential estimated loss of R1.8 billion in the Relative Value Arbitrage Fund (RVAF), which, no doubt, will also be shown to have been a Ponzi scheme masquerading as a hedge fund.

I sounded the following warning to pension fund trustees with reference to the hedge fund industry: “While there are safeguards (regulated service providers) in place, not all hedge fund purveyors follow these requirements to the letter. There are still some that do not utilise prime brokers or third-party administrators, because neither of these are regulated requirements. Trustees should question such managers and obtain satisfactory answers as to why these best practice procedures are not followed.”

It seems that, following the tragedy involving the purveyors of the so-called hedge fund RVAF, this warning should have been issued to the general public. But it must also be said that the general public is not the market that the South African hedge fund industry seeks to attract.

Why would you want to invest in unregulated investments? The reason is that your investments should be diversified if possible, either to enhance returns or to reduce risk.

Unfortunately, the choice of “regulated” investment products in South Africa is very restricted, because local financial regulations have not kept pace with many international trends and product offerings. But as long as you follow some simple rules when making investments, you can avoid the Ponzi and other dubious schemes that float around in all financial markets.

Start with your financial adviser. Your adviser must be registered with the Financial Services Board (FSB) as a financial services provider (FSP) or a representative of an FSP. You can check this with ease on the FSB’s website, www.fsb.co.za

Your adviser must disclose what commission/fees he or she will earn from selling you a product. The higher the commission/fee, the more likely that something is not right – good investments do not need high commissions, because they can almost sell themselves. Accept that many advisers will sell the product that pays the highest commission, and the more dubious the product, the higher the commission.

The other issues you should check are:

* Product endorsement. Stay clear if the financial adviser is part of an established financial institution but the product that he or she offers or suggests is not endorsed by that institution.

* The investment manager. Investment managers, whether they are the traditional unit trust fund manager or a hedge fund manager, must be approved and licensed by the FSB.

* The investment product. Alternative investments, such as hedge funds, are unregulated, unless they are held in a collective investment scheme, such as a unit trust fund, or a life assurance policy.

A hedge fund should follow the best practice guidelines set out by international bodies such as the London-based Alternate Investment Managers’ Association. These guidelines are:

– The segregation of things such as the investments (your capital) and bank accounts from the investment manager. These should be under independent control to reduce the potential for the manager to steal your investment.

– The appointment of an independent and well-known third-party investment administrator whose role is to value the portfolio regularly and provide this information to the investor.

The investment manager may also have to ensure that the assets are segregated.

Third-party investment administrators are subject to regulation by the FSB. Again, this information is on the FSB’s website.

– The use of a prime broker (in the case of a hedge fund) to execute all the trades on behalf of the investment manager. A prime broker places deals, seeks third parties for scrip lending and borrowing, and arranges leverage if required. Prime brokerage is a service provided by regulated financial institutions, such as banks, that have suitable balance sheet support.

– Custodian. A custodian holds the assets (your investments) in trust whether they are in cash or other assets. The custodian acts on the instructions of the investment manager as to where the investments should be made. Again, custodians tend to be major banks and are used in conjunction with the prime broker. Custodians are also regulated by the FSB.

RVAF met none of these conditions for investor protection, and Herman Pretorius was not licensed by the FSB. If Pretorius had come to my company or any other administrator, he would not have passed the first hurdle.

These rules can be applied equally to other non-hedge fund types of investments. Although the investment product may not be set up in a regulated structure, the South African market has regulated service providers to ensure that your money is well looked after.

It must be noted that an unregulated product is not an illegal product. It is a Ponzi scheme that claims to be an unregulated product that is illegal.

Investors in non-mainstream products must be aware that they must do a bit more homework before investing. Is this too much to expect if you are seeking higher returns? Your “wealth and health” should always be treated in the same manner: for all important decisions, get a second opinion.