UK retail distribution - boon or bane?

In March, the UK's Financial Services Authority (FSA) paved the way for retail funds of hedge funds (FoHF), or at least industry discussion on the topic. The UK market regulator stated plainly in its Discussion Paper 05/3 Wider Range of Retail Investment Products: Consumer Protection in a Rapidly Changing World: "Given the reality of the increasing penetration of 'wider-range' products in the UK retail market, the growing interest in the retail market in such products and our own preference for sound market-based solutions, we do not consider it sensible to continue to prevent the creation in the UK of FoHFs which can be marketed to the retail investor."

Any move to retail by the FSA would follow the lead mapped out by Germany's BaFin, and Switzerland's authorities, as well as those in Ireland and the Netherlands in Europe, and also Brazli's authorities in South America. In Luxembourg, retail investors can access FoHFs only if the FoHF has been approved by the local regulator. While France has not overtly said smaller investors can access funds of hedge funds, a minimum threshold of 10,000 tends in that direction in practice.

While not spelling out completely what conditions the UK FSA may impose on retail FoHFs, Clive Briault, managing director, retail markets at the FSA, did note "the funds would be subject to structural and operational safeguards including the requirement to have an independent depository."

The regulator added hedge fund managers providing products to the retail market would not have free hand in deciding who to include in their portfolios. "Fund(s) of hedge funds managers will not be able to invest into all hedge funds - there will be liquidity criteria, for example, in respect of the underlying funds. This should enhance investor protection while allowing increased investor choice," the FSA said.

The FSA's discussion paper on retail investment products identified three risks to consumers posed by the current suite of retail investment products, the regulator said, namely the following:

• Lack of consumer understanding of newer products;

• Confusion over the sales and distribution channels used; and

• Possible detriment caused by marketing prohibitions on certain unregulated funds.

Consequently, the FSA will also consult the industry on:

• Consumer education and awareness;

• Product provider responsibility, "examining the role that product providers and distributors play in ensuring customers are treated fairly, primarily through the provision and use of product information," and added;

• The FSA will soon be publishing a consultation paper on changes to the listing rules for investment entities, "designed to provide … greater choice in their selection of investment strategies, while maintaining appropriate standards of investor protection."

The $64m question - or $63bn in this case, as that was the aggregate AuM of FoHF managers we polled in April's edition - about fund providers' willingness to sell into the UK retail market received a mixed response, both on whether hedge funds were appropriate for retail distribution, and whether providers would enter that section of the market if allowed.

The FSA's March retail discussion paper came in a busy month for the FSA, as it also published a feedback statement to the accompanying Discussion Paper 05/4 - Hedge Funds: A Discussion of Risk and Regulatory Engagement.

Interestingly, the FSA focused in this second paper on hedge fund risks, focusing particularly on asset valuations and on side letters. These may be seen as pertinent to retail investors, particularly given that arguably retail would have greater difficulty ascertaining the methodology behind pricing of some hard-to-value or thinly traded instruments than might institutional investors in hedge funds, and retail investors may stand less of a chance getting side letters from hedge funds (even if their £7,000 lots were aggregated by the FoHF manager) than would either family office/HNWIs who could provide seeding capital to hungry managers, or institutional allocators who could provide larger sums.

With these topics in mind, for this month's tête-à-tête discussion, we asked five industry experts about the appropriateness of FoHFs for UK retail investors and how the industry may develop, and one legal expert on the use of side letters by hedge funds.

ian morley, dawnay, day olympia

Ian Morley, CEO at Dawnay, Day Olympia expressed some concern mass retail participation in FoHFs would have implications through the hedge fund world as an increasing body of invested assets originate from "non-sticky" sources.

Negative publicity and monthly losses will be amplified in importance as nervous investors shun volatility and react disproportionately to bad news, he says. He cautiously welcomed the prospect of funds of hedge funds (FoHFs) for retail investors, but also warned any move must not come at the cost of an increase of burdensome regulation. The regulatory framework needed to accommodate retail FoHFs should cover the sector in an intelligent way, he notes, and not issue detailed dictums as to what is or is not permitted.

harry wulfsohn, stenham advisors

Harry Wulfsohn, director at Stenham Advisors, said Stenham has no plans to enter the mass-retail market in the UK, although would continue using sophisticated wealth managers as one of its distribution channels. While the minimum investment threshold for Stenham products is $25,000, giving the affluent investor access, Wulfsohn noted the typical minimum actually allocated approached $100,000.

To distribute to retail, he says: "You really need to have a very wide IFA network. We don't have that kind of distribution network." Wulfsohn says the FSA was sensible to state useful risk and allocation parameters for retail products. "We would target the more sophisticated wealth managers rather than the mass-retail market."

adam fairhead, jp morgan am

We welcome proposals that will lead to further innovation in the UK funds industry - including retail FoHFs. However, UK tax will be a big issue with these proposals. The resolution of tax issues needs urgent attention, especially as we still have no tax clarity for UCITS III products two years after the FSA regulations came into effect. If we do get onshore FoHFs, it should be possible to get offshore funds recognised in the UK - that is, registered to be sold to retail investors - subject to them having the minimum organisational rules; for example, liquidity and diversification the FSA sets. Resolution would greatly facilitate the UK financial services industry extending its products and services as other centres are overtaking the UK as the preferred domiciles.

meera patel, hargreaves lansdowne

Meera Patel, senior analyst at retail investment broker Hargreaves Lansdowne in Bristol, says HL approves of retail FoHFs as a concept, but is proceeding very cautiously in providing access now. It has begun consultation and research into how to proceed in delivering FoHFs to retail investors. Advising the retail sector is already a minefield, she says, with advisors forced to know a little about a lot, raising concerns over how an advisor can recommend exposure to complicated underlying strategies. Diversification is key, but the principle of understanding your investments is more fundamental so single strategy FoHFs, or FoHFs exposed to only low-risk strategies, are an appropriate starting point, she says.

martin cornish, katten muchin rosenman cornish llp

My guess is that it will be the traditional UK retail houses that may see this as an extra product they could sell through their network. Some existing retail fund management groups have both management and distribution capabilities, while others may need to bring it in-house - such as Schroders buying New Finance. I would expect the initial products that would come out would be conservative, perhaps being sold on the basis that investors should not expect to participate in 100% of the potential upside, but equally should not be exposed to 100% of the downside either, and with limited or no leverage.

alex erskine, Appleby S&H (side letters)

Investors who have been issued side letters but are uncertain about their position should obtain legal advice on the validity or otherwise of the side letters and shares issued under them. If it's established the shares have been issued in breach of the bye-laws of the company, the investor must, at the very least, seek to obtain shareholder ratification of the side letter and the issuance of shares in relation thereto. An investor that successfully negotiates a side letter with preferential rights must ensure the shares being issued under the terms of the side letter are duly authorised to be, and are issued validly by the company in that manner. Alex Erskine, Appleby Spurling & Hunter