FSA warns IFAs as retail investors get wider access to alternatives

The FSA has today unveiled a new regime allowing UK retail consumers to invest in funds of hedge funds and other alternative investments but has warned advisers they must understand the products before making a recommendation.

Funds of Alternative Investment Funds' (FAIF) can invest up to 100% of their assets into other collective investment schemes and the new rules allow the products even greater flexibility as to the proportion of assets in particular types of underlying scheme. For example, a FAIF could invest up to 100% of its assets in a selection of hedge funds based in non-EU countries.

However, following its consultation paper on FAIFs, published in February 2008, the FSA has built additional consumer protection measures into the regime which comes into effect on 6 March 2010.

This includes requirements that FAIF managers carry out initial and ongoing due diligence to determine the assets in the underlying scheme are held by a third party independently of its manager. They also need to check the valuation of schemes within a FAIF and the maintenance of a fund's accounting records are segregated from the scheme's investment management process.

However, the FSA has told advisers that despite the robust due diligence requirements introduced for providers, they must also feel comfortable with the products before advising clients.

"We do not expect intermediaries to repeat this due diligence themselves, but we would expect an intermediary to understand a FAIF they plan to distribute.

"Intermediaries should also understand how a FAIF may differ from other
investments or collective investment schemes with which they are already familiar."

As part of its policy statement, the FSA has provided a Factsheet for advisers on FAIFs (Annex 1 of the policy statement) which includes a list of questions advisers should ask before recommending the vehicles.

These cover areas such as risk, borrowing, the nature of the underlying schemes, whether due diligence is properly carried out by the provider and if sufficient information is provided in the literature.

Under the new regime, FAIF managers can wait 185 days before paying redemptions, but they must explain redemption procedures clearly to investors. Gearing will be limited to 10% as the FSA says high borrowing levels can result in increased risk.

The regulator will review the rules after implementation, and does not rule out re-writes once the EU's Alternative Investment Fund Management directive takes effect later this year.