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Hedge Funds and Financial Markets in Africa and USA

Introduction

This paper investigates issues involved in financial markets in both Africa and North America and what is fast becoming a global economic village as countries are becoming interconnected and economies becoming more and more converged. Financial markets in North America are more juxtaposed and epitomized than anywhere in the World and it sets the case for the African markets to follow suit. However, African Markets should be warier and learn from the mistakes that have been made by the markets in the west. In today’s markets, the volatile nature of stock markets all around the world has engrossed a lot of interest in public, academic and policy circles. It has been argued by academicians that the value of corporate equity depends on the health of the economy. The use of information on financial fundamentals has been shown to assist market traders and analysts to better manage their portfolios. The role of policymakers in both financial markets can also manage the economy which means further developing the equity markets to become more efficient by organizing variables that impact the markets (Bekaert 402).

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Studies that have been done mostly concentrate on developed markets. Though in the recent past there has been more and more research on financial markets in Africa and stock markets in emerging economies. African markets have risen substantially. Proof of this is illustrated by total capitalization for Africa which has doubled from a figure of US $113,423 million to the US $244,672 million. Financial markets in Africa have shown significantly improved performance and returns have increased considerably. However an issue that should be noted is that stock markets in Africa countries are small and largely lacks liquidity that can be found in most financial markets in the developed countries. Despite all these weaknesses, African markets are momentous in influencing the general trend in corporate and economic growth (Bekaert 408).

The importance of stock markets as financial conduits for savings and investment is fast becoming the norm all around the world and in particular, African countries. Where the financial market in the US is mature, we are seeing African markets undergoing major reforms to match markets in the west. These have been taking place for the last two decades. Economic and political stability has therefore become more and more important for financial and economic growth in African countries. This is in addition to coming up with better investment plans. Thus effects of Volatility in both markets can thus be controlled and reduced by conducting further examination on how uncertainty in market variables lead to the general growth and effect on both African and North American economies.

Statement of the problem

Financial Markets be improved in Africa just as it is developed in the US? There has been a general perception that financial markets in African nations are backward and that the same path taken by advanced countries can best be applied to the development of financial markets in Africa. What scholars and other people should realize is that changes are already being instituted and that the environment surrounding the financial markets in Africa is so much different from what is being experienced in the west. One fact that we must recognize is that Africa has a set of different cultures; hence we cannot put up a blanket policy over the financial markets in the continent. Thus we need to realize and come up with new strategies that can be applied to the continent instead of following the same path and solutions that were followed by advanced markets.

One tool that can be introduced to spur growth across African markets is hedge funds. We dwell on how to best introduce hedge funds in that African market and hence this will not only develop new interest into the African market but will also bring in new investments.

Research Questions

  1. What is the state of financial markets in Africa?
  2. What is the difference of financial markets in Africa when compared to those of the West?
  3. What Financial Instruments can we introduce in order to spur growth?

Literature Review

As of 2006, the number of stock markets in Africa numbered twenty in total. This is a small number when taking to account that there are 54 countries in Africa. Markets that were established recently included the stock market in Uganda and Mozambique. From 2006 up to now 2010, the number of stock markets has increased dramatically and most of the African countries have stock markets with South Africa being the most developed. The South African stock market is the only one that offers derivatives. Other markets are quickly following suit. Total market capitalization has increased dramatically from US$281.7 billion in 1996 to US$932.8 billion in 2006.This has been in part due to the inflow of investment funds as fund managers are in search of high potential returns and greater diversification of risks (Smal 72). Market capitalization in individual markets may be seen as low when compared to more advanced financial markets. An exception to this would be the Johannesburg Securities Exchange (JSE). The JSE exhibits better market indicators when compared to larger emerging markets.

Methodology

The research will dwell on Hedge funds as a means of developing African financial markets with a keen eye on learning from past mistakes committed in other developed markets. We have seen recently that hedge funds can become financial weapons of mass destruction if strict regulations are not put in place.

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Financial Markets in Africa

Having a population of over 700 million people, Africa is demographically one of the expanding markets in the world. This growth is only rivaled by the Asian continent. Nonetheless, there is very little information on African markets. This is in part due to generalization and bland assumptions which have thus far subjected strategic and academic thinking, this is especially true when discussing about West African countries. This has resulted in partial knowledge about the rapid changes that are currently taking place and the resultant impact on the financial processes. Different approaches have been postulated in the expansion of frontiers in regard to knowledge. Many people including scholars and policymakers in the west have erroneously adopted a “third world countries” mindset, assuming that all the financial markets are at the beginning stage of the same development passageway as that followed by the developed countries. This has brought out the perception that a game of catch-up is in play and the same market evolution patterns that were seen previously in advanced economies will be replicated in the African emerging markets. There has been a general concern that financial markets are in danger of becoming alienated from other financial markets of the world. The total scale of the region’s socio-economic drawbacks has tended to contribute to widespread Afro-pessimism among businesses and scholars who have researched on financial markets. A good example of this is how a recent meeting by top stakeholders and fund managers came up with recurrent views that included thoughts such as: Africa is very unstable politically and economically, markets are exposed to high-risk investment climates, there is a low level of management education amongst the fund managers in Africa, consistent depository information sources are absent. These are some of the divergent views that are being held by managers in western countries. While these views have just a glimpse into African financial markets, changes have been taking place such that there have been factual errors in interpreting environmental signals. This has been done repetitively and unless there are continuous monitoring systems are put in place (Smal 99). The fact of the matter is that African market environment is rapidly transforming and investors willing to make committed and long-term commitments are expected to reap attractive rewards. As the trends have shown lately, there is a new “scramble for Africa” that is currently ensuing driven by insightful investors who are looking for ways to diversify their portfolios as they prepare for the prospect of lower returns in more advanced financial markets such as in the US. The World Bank estimates growth that may surpass percent per annum through the region. Although political and economic forces continue to instigate the factors driving financial market changes in Africa. There are perceived and real threats or impediments from country to countries such as insecurity of economic rights, trade restrictions and complex regulations. These same forces have put policy turnaround in danger among governments. Policymakers have instituted distinct reforms that are bringing changes. These reforms can be categorized as:

  • Reform from government-dominated economic order towards market-based system.
  • A shift away from political conflicts to reconciliation and social rehabilitation

Countries that have shown aggressive development in terms of market capitalization such as South Africa, Botswana and Mauritius have long records of political democratic rule. More recently, there have been noticeable changes in West African countries such as Benin, Ghana, and Mozambique where there has been a resurgence in the culture of democracy. As much as we may talk of democracy being the key to success in African financial markets, there are also some countries that display the parallel nature between political and economic liberalization. These countries include, Congo, Sierra Leone.

Results

Hedge Funds

The growth in number and popularity of hedge funds has encouraged the Financial Services Authority, (FSA), the chief regulator in the UK financial markets, to address the issue of whether these non-retail funds should be subjected to regulation. If yes, the FSA believes that retail hedge funds would have to fit within the existing authorized collective investment scheme regime, and be subject to the same disclosure and financial promotion requirements. At present, hedge funds cannot be authorized collective investment schemes (Smal 67).

Our view is that a halfway house would be appropriate, that is to permit wider marketing but with a stronger regulatory requirement. For instance, suitability tests for hedge funds could be made more stringent so that they cannot be sold to “widows and orphans” while tougher risk warnings and disclosures should be required (Smal 90). In any event, it seems unlikely that hedge fund managers will want to change fundamentally their operations to market to the public but more probable that existing retail managers would want to create hedge funds to extend the funds they can offer to their existing customers (Bekaert 405).

What are hedge funds?

There is no legal definition of the expression “hedge fund”. The term is loosely used to describe investment funds that have an absolute return objective with flexible investment guidelines and the ability to use speculative high-risk hedging techniques such as derivatives and leverage, as well as long and short selling. The word “hedge” or “hedging” is usually used to describe a strategy to offset investment risk. This does not necessarily mean that the fund will use all of these techniques, merely that these strategies are available to them.

Why are hedge funds popular?

The nature of the investments made by hedge funds demands active management. The use of sophisticated techniques such as short-selling or trading in derivatives means that the fund manager can maximize the profits from the underlying portfolio and speculate on equities and securities not held by the fund. Hedge funds are seen as having the ability to make money in both bull and bear markets and, though correlated with the equity markets, hedge funds are to some extent insulated from equity market fluctuations because of the secondary market nature of many of their investments.

Traditionally, notwithstanding the usually substantial minimum investment requirements, private investors have invested in hedge funds. However the signs are that institutional investors are now investing in this sector. Hedge funds are seen as being high risk but with the potential for a high return and this explains why they are generally non-retail products. However, an investor is usually “locked-in” to the hedge fund for a minimum period, so there may be little liquidity for investors.

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Hedge fund vehicles

The fund may be structured as any type of non-UK vehicle, as the UK tax regime is not favorable for hedge fund structures. The most popular vehicles are non-UK open-ended limited liability companies and limited partnerships. In the former case, investors will receive shares in return for their investment and the company will be operated by a separate management company. The liabilities of the shareholders in the fund will be limited to the amount of their shareholding. In the case of a limited partnership, the investors will become limited partners in return for their investment, with little or no power of management (Nelson 480). The general partner of the limited partnership will operate the limited partnership itself or appoint a manager to do so Consequently general partners are usually established as limited liability companies. The liability of the limited partners in the fund will be limited to the number of their contributions to the fund (Senbet.25)

The manager or general partner of the fund usually receives about 20 percent of the profits, in addition to the fixed management fee, which is usually around 1 percent per annum of the assets under management. Obviously this incentivizes the manager though it may also mean that the manager is more willing to take bigger risks in the hope of greater returns.

Structuring the hedge fund

The structure of the hedge fund will depend on many considerations, and these will include:

  • Tax – the hedge fund may be established in a tax haven and so take advantage of favorable tax rates and other concessions.
  • Regulatory issues – the fund may choose to be established in a jurisdiction with a particular level of regulation.
  • Investors – if the fund’s potential investors are mainly US-based, the considerations will revolve around US tax issues and the probable preference of US investors for a US fund vehicle.
  • Marketing – consideration will need to be given as to whether the fund can legally be marketed under the laws of each particular investor’s country.
  • Employees – as the fund will be actively managed, the operator needs to attract and maintain sufficient high-quality staff. Incentives to attract staff may include a profit or equity share in the fund.
  • Investment – the fund may be looking to invest specifically in a particular geographical region or financial sector so time zones may have an impact and this will have a bearing on where the fund will be established.

Tax issue

There will be several important tax considerations, ranging from where the fund will be domiciled to where the fund management company is domiciled. This will be important as, potentially, large fees can accrue to the fund manager.

For example, if the UK fund manager is to receive the remuneration for the services it carries out this will need to be paid to it in the UK. Performance fees cannot be accumulated in an offshore vehicle unless that offshore company is performing a real role and has sufficient substance.

To keep the fund outside the UK tax net, the fund must be centrally managed and controlled offshore. Consequently, a majority of the board directors must be non-UK residents and board meetings should be held outside the UK. Finding suitable people to act as directors may be time-consuming and expensive.

Documentation

The principal documents required to establish the fund include:

  • The constitutional documents of the fund vehicle.
  • The constitutional documents of the fund manager.
  • Investment Management Agreement between the manager and the fund.
  • Custodian Agreement between the manager (of fund) and the custodian.
  • Administration Agreement between the manager and the administrator.
  • The offering memorandum of the fund.
  • Subscription agreement or deed of adherence to the partnership for the investor to take a share in the fund.
  • Prime brokerage agreement.

Prime brokers

Prime brokers (usually large international investment banks) provide all the services for a funda one-stop-shop. Hedge funds appoint prime brokers to minimize operational, accounting and administration issues and to cut down on costs through consolidated financing. These considerations are especially important for hedge funds as the type of investments undertaken involve active management and the execution of many trades. Although a hedge fund may appoint a prime broker, it will still retain the right to execute trades with any number of brokers. It is important to ensure that prime brokers can clear and settle in the time zone of the hedge fund, and in every market and jurisdiction in which the hedge fund wants to trade.

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Hedge funds on US investors

There are many issues for US investors depending on whether the US investor is tax-exempt for US tax purposes. US tax-exempt investors may wish to invest in an offshore corporate fund to avoid US unrelated business taxable income (UBTI), whereas US tax investors cannot invest in an offshore corporate structure, which is regarded as a passive foreign investment company (PFIC), without being subjected to fairly harsh tax penalties. Frequently a fund manager will make the US and a non-US vehicle available (Loeys 90).

An offshore fund must comply with US securities law where it is offering securities to US persons. To avoid such requirements, the fund’s securities should be offered on a private placement basis, which means limiting the sale to 100 US investors, at least 65 of whom must be accredited, investors.

Case Study

FSA regulation of hedge fund managers

DP 16 observes that hedge funds are mostly based offshore as, because of the UK tax regime, the UK is not a domicile of choice. Therefore the FSA has no jurisdiction to regulate them, unless they are brought onshore. This makes the hedge funds themselves very difficult to regulate but a significant number of hedge funds are structured with UK managers. Some of the service providers to hedge funds, such as prime brokers, are also in the UK, as are many of the investors in the hedge fund. Thus, although the hedge fund itself is outside the jurisdiction of the FSA, the FSA does oversee the marketing in the UK and the regulation of the UK-based hedge fund managers and prime brokers, which are authorized persons. DP 16 is careful to point out that the FSA is confined only to the regulation of authorized persons, such as the manager, and this does not imply the FSA has any regulatory oversight over the hedge fund. The FSA believes that the current position is satisfactory and consistent with its objectives, powers and risk-based approach.

FSA regulation over the marketing of hedge funds in the UK

Hedge funds are unregulated collective investment schemes and may be marketed by taking advantage of the various exemptions under The Financial Services and Markets Act 2000 (Promotion of Collective Investment Schemes) (Exemptions) Order 2001 (SI 2001/1060), as amended; or the exemptions for authorized persons set out at Annex 5 to the Conduct of Business Rules, Chapter 3. This means hedge funds can be promoted to, amongst others, independent financial advisers, sophisticated entities, high net-worth individuals, sophisticated investors and those private customers who have opted to be moved up to intermediate customer status. However these are complicated options and there is no ability to promote to the general public. The FSA seems content with this position although there is a discussion on the promotion of hedge funds and whether the rules should be relaxed so that they can be promoted to the public. It was noted that IFAs sometimes promote hedge funds to their customers. DP 16 asks whether authorized funds such as open-ended investment companies or unit trusts should have hedge fund characteristics or whether there should be a separate regime for promoting hedge funds to the public, which would include allowing hedge funds to list in the UK. Listing of hedge funds would make dealing and trading by retail investors much easier.

The FSA plans to consult on a fundamental review of the collective investment sourcebook in the first quarter of 2003. Comments on DP 16 would assist in determining whether there was any demand, despite the practical difficulties, for bringing certain hedge funds within the authorized collective investment scheme regime (Levine 690).

Lessons from the US model

We believe that, for Africa to take full advantage of the demand for hedge fund products and to compete with the USA in the hedge fund industry, further significant change to the African regulatory model is necessary. The US hedge fund industry benefits from a regulatory environment that is conducive to managing and distributing hedge funds. As long as the hedge funds and separate accounts managed by a hedge fund manager total less than 15, most managers can obtain exemption as “private advisers” from the majority of the regulatory requirements of the Investment Advisors Act of 1940, while the Commodity Exchange Act provides rules only for those hedge fund managers that are registered as commodity pool operators or commodity trading advisers (Fama 270).

Similarly, most hedge funds are exempt from regulation under the Investment Company Act of 1940 and the Securities Exchange Act of 1934 providing they are not offered to the public and meet certain other criteria, principally about the number and nature of investors. Compliance with federal regulatory rules in most cases also achieves compliance with state rules and consequently US hedge fund managers can conduct business within a flexible regulatory environment which, for most managers, entails minimum regulatory oversight (Kent 78).

The existing US regulatory model for hedge funds is subject to change due to the introduction of the USA Patriot Act and the findings of the year-long SEC review of the hedge fund industry. The SEC has yet to announce the results of its review, but it is quite possible that most hedge fund managers will be required to register as investment advisers with the SEC, and that the accreditation standards governing eligible investors may be raised. However, while these changes are likely to result in additional regulations and potentially enhanced costs of compliance for hedge fund managers, they are unlikely to have a significant impact on the regulation of the hedge funds themselves or the ability of the managers to market the funds. The US model of “regulation with a light touch” seems to be here to stay.

We believe that, to compete with US hedge fund managers, the regulatory environment in Africa needs to continue to evolve and to move towards the US model with flexible regulation and fewer barriers to distribution (Bekaert 408). This means that European and national regulators must continue to harmonize the rules between countries by addressing the current regulatory barriers; however, the harmonization must be workable.

Harmonization in Africa is difficult to achieve, because, although regulators have common concerns about investor protection, in addition to regulatory differences, there are significant differences in the fiscal regimes in each country. Despite the creation of many pan-African government institutions and the advent of the Euro, each country still retains the right to levy its own taxes and this fact remains a key barrier to a true market (Arnold 17).

Conclusion

Hence we need to develop the African Hedge funds industry nationally as each nation has its own different sets of environmental variables that determine how fast their financial markets will grow. A blanket policy cannot be put into force as each nation is different from the others. Apart from this the guidelines of setting up hedge funds remain the same and the countries that decide to follow this path in the shortest means possible will reap maximum rewards.

Works Cited

Aggarwal, R. Exchange rates and stock prices: a study of the US capital markets under floating exchange rates, Akron Business & Economic Review, Vol. 12 pp.7-12. 1981.

Arnold, D., Quelch, J. New strategies in emerging markets, Sloan Management Review, Vol. 40 No.1, pp.7-20. 1998.

Bekaert, G. Time-varying world market integration, Journal of Finance, Vol. 50 No.2, pp.403-44. 1995.

Fama, E.F., Short-term Interest Rates as Predictors of Inflation, The American Economic Review, Vol. 65 No.3, pp.269-82. 1975.

Kent, Z. The Story of the New York Stock Exchange. Scholastic Library Pub. 1990.

Levine, R. International financial integration & economic growth, Review of International Economics, Vol. 9 pp.684-98. 2001.

Loeys, J. Volatility, leverage and returns, Global Market Strategy, J.P. Morgan Securities Ltd, London, 2005.

Nelson, C.R. Inflation and asset prices in a monetary economy, Journal of Finance, Vol. 31 pp.471-83. 1976.

Senbet, L.W. Financial sector reforms in Africa: perspectives on issues and policies, Version of paper prepared for the 17th Annual World Bank Conference on Development Economics (ABCDE), Dakar, Senegal, 2005.

Smal, M.M.The monetary transmission mechanism in South Africa, South African Reserve Bank Occasional Paper, No. 16. 2001.

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