The National Treasury has put forward a proposal to distinguish hedge funds from other collective investment schemes (CIS), saying the R120bn industry needs to be given room to grow.
Should the proposal be passed into law, hedge funds will no longer fall under the tax definition of collective investment schemes.
In a discussion document published on Wednesday, the Treasury indicated that it plans to establish a distinct regulatory framework for hedge funds under the Conduct of Financial Institutions, to operate independently of the existing CIS framework in securities.
The aim is to highlight the unique characteristics of hedge funds and differentiate them more precisely from CIS, allowing for greater alignment between the tax and regulatory treatment.
“Given the systemic and significant size of the ‘vanilla’ collective investment schemes in the securities industry (R3.3-trillion), the options try to provide certainty on the tax treatment to reduce systemic risk and encourage continued savings, which is important for economic growth and household resilience,” said the Treasury.
“The role of hedge funds is somewhat different. They play an important role in funding innovation and providing liquidity to the market. However, they can be leveraged and shorted. They are designed for more sophisticated investors, which use hedge funds as an active part of a high risk, high return investment strategy.
“That said, the industry is still very small. Returns are low. The National Treasury and Financial Sector Conduct Authority can use the regulatory framework to encourage the development of the industry while ensuring stability and the protection of consumers. It is sensible to also treat hedge funds differently from a tax perspective as they are not collective investment schemes in essence.
“This option would remove hedge funds from the CIS regulatory regime, which would automatically remove the tax treatment and take out many of the funds where the revenue versus capital distinction is most at question.”
The Treasury estimates the value of the hedge funds sector at about R120bn, equivalent to less than 2% of GDP. It noted that while this was relatively small, the hedge funds were a vital component of the legal investment vehicles that support savings and investments. Their activities in derivatives contributed significantly to creating market liquidity.
Previously, hedge funds were available only to institutions and wealthy investors. Today, retail and qualified investors have the opportunity to invest in hedge funds.
The Treasury announced in 2015 that hedge fund operations would fall under the legal framework of CIS. The government is now considering reversing that decision.
“There is a common assumption that hedge funds provide outsize returns, however, the data does not support this. Of the 69 hedge funds that have been in operation for five years, only five have delivered annualised returns of greater than 15% per annum, while 20 have delivered returns of between 10% and 15%, and 18 have provided returns of between 5% and 10%. There were 18 hedge funds that delivered negative returns, highlighting that these investment vehicles are inherently risky,” it said.
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