Hedge funds in the crosshairs

30 May

Hedge funds have long been viewed as one of the more untouchable areas of the financial markets, and now 30,000 Canadian investors, along with a handful of pension funds, know why: Quite literally, they can’t touch their money.

More than $1.2-billion they invested in two domestic hedge fund companies has been frozen by securities regulators amid a wide-ranging investigation, and the investors don’t know when — or if — they will get all of their cash back. To make matters worse, regulators can’t even determine where all of their investments have gone.

The problems at Portus Alternative Asset Management Inc. and Norshield Asset Management Ltd. have trained a spotlight on what has become the fastest-growing segment of the Canadian financial market. With stock markets sagging and mutual funds engulfed in scandal, disillusioned investors have been flocking to hedge funds in droves, lured by the promise of minimizing their risks and making a return regardless of which way markets are moving.

But many observers fear that in this mad rush for stable returns, investors are sinking billions of dollars into an industry that is cloaked in secrecy, stacked with high fees and accountable to almost no one.

The growth has been explosive: In the past five years, Canada’s hedge fund industry has jumped sixfold to $26.6-billion, while the number of funds has ballooned to 191 from 46. Globally, hedge funds are now a $1-trillion (U.S.) business, and that figure is expected to almost double by 2008. Much of the boom is being driven by a massive infusion of pension fund money, as deep-pocketed investors such as the Ontario Teachers Pension Plan and Caisse de dépôt et placement du Québec increasingly look to hedge funds to help prop up their returns.

This, in turn, has spawned another set of concerns for governments and central banks around the world: Now that hedge funds are armed with significantly more clout, what kind of impact will they have on global financial systems?

“You can’t think of any other industry that manages $1-trillion in assets where reporting is not required and where there is such a lack of transparency,” said Dr. Atanu Saha, a Princeton University professor who has studied the hedge fund industry.

Industry players are used to these criticisms, and insist the complaints about secrecy are overblown. They point out that hedge funds are a vital source of trading liquidity and offer investors an alternative to conventional stocks and mutual funds.

“There are a trillion dollars in hedge funds and that is not a trillion dollars of stupid money,” said James McGovern, chairman of the Canadian chapter of the Alternative Investment Management Association (AIMA), and chief executive officer of Toronto-based Arrow Hedge Partners Inc.

“So people are investing in these things for a reason. Always follow the smart money and look at what are they doing with their money. That will tell you that the case for hedge funds is very good,” he added.

Funds avoided regulation

But recent scandals, coupled with the industry’s startling growth, have finally registered on the radar screens of securities watchdogs. For decades, hedge funds have managed to avoid regulation because they’ve been limited to rich clients, dubbed “accredited investors,” who are supposed to be sophisticated enough to weigh the risks. Now, however, with the industry targeting average investors, regulators say it’s time to implement rules and policies that will make hedge funds more transparent.

The Investment Dealers Association of Canada, a national self-regulatory body for the country’s brokerages, last week called for new laws to force retail-oriented hedge fund products out of the shadows and corral them “fully within the regulatory system.” It warned in a report that the current lack of oversight makes it difficult for regulators to detect misconduct in the industry and could make it a breeding ground for “fraudsters and other malefactors.”

Stan Beckers, a managing director at Barclays Global Investors in London who monitors hedge funds, says further regulation is inevitable as the industry gets bigger, regardless of industry lobbyists who claim this will drive up their costs and hurt their ability to make returns for investors.”This is just an immature, young industry where you have all of the disadvantages and the drawback of a young and immature industry,” said Mr. Beckers, referring to some of the recent hedge fund problems that have grabbed headlines. “I think most arguments against regulation are sort of rear-guard action fights. I can’t see any convincing or compelling arguments why this business should not be regulated.” Regulators are mainly concerned with how hedge funds sell their products to retail investors, and are raising red flags about such issues as misleading marketing practices and hidden fees.

According to a study by Investor Economics, a Toronto firm that has studied the industry, 14 per cent of hedge funds do not disclose performance fees for managers. These fees are typically 20 per cent of the fund’s profit, and are in addition to a charge of 2 per cent of assets. Mutual funds, by comparison, which are much more familiar to retail investors, charge a flat management fee and do not take an extra slice of the returns.

The promise of lucrative performance fees, coupled with surging demand for these products, is a major reason that so many hedge funds have been cropping up in the past few years. Almost anyone can set up one of these funds, and traders, disgruntled mutual fund managers, and other financial professionals have been pouring into the sector. There are an estimated 8,000 such firms in the United States today, nearly rivalling mutual funds in sheer numbers.

Poor returns in 2005

This influx of unseasoned managers has been blamed for the industry’s poor returns this year — hedge funds returned less than 1 per cent on average in the first quarter of 2005 and some funds were down by as much as 3 per cent. It has also been singled out as one of the reasons scandals have become more prevalent.

Part of the rationale for keeping retail investors on the sidelines of this industry is that hedge funds employ a range of complex trading strategies. These range from convertible arbitrage and other exotic derivatives to short-selling stocks — essentially betting that a company’s shares will decline in value. Hedge funds also borrow heavily, sometimes as much as six times their asset base, to bolster their investment power. This concept, known as leverage, is what precipitated the collapse of Long-Term Capital Management, a U.S. hedge fund that crashed in 1998 after the financial crisis in Russia. The fund’s implosion prompted the Federal Reserve Board to organize a $3.5-billion bailout by U.S. banks.

Nevertheless, hedge funds have found a novel way to reach the average investor: relatively new products known as “principal-protected” notes, securities that allow investors to get all of their original investment back at maturity, but do not guarantee any returns beyond that. At almost $8-billion (Canadian), the protected-note market is the fastest-growing segment of the Canadian hedge fund industry, and some are selling for as little as $500.

The notes have allowed hedge funds to sidestep “accredited investor” rules, which limit hedge funds to investors who make a minimum investment of about $150,000 or who have $1-million in assets (the rules vary by province).

Here’s how they get around it: Hedge fund companies sell investors a promissory note backed by a bank, which is essentially a bond linked to an underlying basket of different hedge funds, or “fund of funds.” Because the notes are similar to a bond or guaranteed income certificate, they can be sold to almost anyone. For hedge fund companies it’s an easy sell: investors have their principal guaranteed and still get to participate in the hedge fund sector.

Fee structure not clear

But the IDA and other critics say the note structure can carry high fees that are not always clearly disclosed. Even some industry players quietly acknowledge that it’s nearly impossible to make a decent return with some of these products.

In addition to the “2 and 20” structure for management and performance fees, investors can end up footing the bill for a dizzying layer of other charges. There are commission payments to salespeople, which can range between 4 and 5 per cent, along with swap fees to set up some of the protected-note products, costs for trading services, and advisory fees. As well as the top-level fee, the underlying managers of the individual “fund of funds” also get a slice of the action. Rarely are these latter costs disclosed.

In its report, the IDA questioned whether retail investors should even be allowed to tap into the hedge fund market through principal-protected notes. “The regulatory issue . . . is whether these types of investments, with locked in maturity periods of as long as 5 to 11 years, little or no certainty of positive returns, minimal disclosure and minimal assessment of suitability, should continue to be sold to small retail investors on an exempt basis,” the IDA said.

There are other loopholes in current regulations that the IDA wants addressed. For example, while an individual portfolio manager at a hedge fund must be registered with provincial regulators, the hedge fund company itself does not. Observers say this creates a host of potential conflicts of interest and prevents full disclosure of financial information. It also raises questions about whether fund managers are being adequately supervised.

The Ontario Securities Commission, which has plowed most of its resources into investigations of Portus and Norshield, is similarly wrestling with the sudden popularity of hedge funds. It is preparing to launch a review of so-called “limited market dealers,” a group of firms that sell complex products like hedge funds.

The OSC will ask these firms to fill out a questionnaire next month explaining their business structure, their processes for identifying accredited investors, and how they determine whether clients are suitable for a particular product. The regulator also plans to conduct some on-site reviews.

OSC enforcement director Michael Watson said the chief concern for regulators is whether investors are being steered to suitable products. Mr. Watson recently promised a crackdown on financial advisers and others who referred clients to Portus without properly understanding the nature of the hedge fund’s offerings.

The Securities and Exchange Commission is introducing new rules next year that will require more disclosure by hedge funds. The SEC said the move is needed to avoid potential “disasters” in the industry.

AIMA’s Mr. McGovern said the industry welcomes the scrutiny and added that the credible players are already following industry guidelines for best practices. More regulation isn’t necessarily the answer, he added.

“Just because something is regulated doesn’t mean it’s any good.”

Increased regulation, however, may be the cost hedge funds will have to pay if they want to crack the mainstream market and continue to attract less affluent investors.

Ordinary investors have already been burned by the Internet meltdown, and are now being bombarded with grim predictions on the fate of stock markets over the next decade. As they look for new ways to both minimize their risk and generate decent returns — independent of fickle market movements — investors and advisers have become more accepting of non-traditional investment strategies, says Investor Economics president Earl Bederman. Despite some recent hiccups, he doesn’t view the hedge fund boom as a flash in the pan.

“I think that alternative investments are part of the landscape,” he said. “They are here to stay.”

Beating the bushes for returns

The amount of money invested in hedge funds in Canada has grown dramatically over the past five years as Canadians abandon conventional products and seek ways to control risk. The number of hedge fund products has kept pace with that burgeoning demand.

ASSETS ($billion)

Dec. ’99 Dec. ’02 June ’03 Dec. ’03 June ’04

Stand-alone hedge funds 52.9% 29.2% 24.9% 24.0% 29.1%

Pure funds of hedge funds 24.2% 15.3% 16.7% 18.1% 16.0%

Principal-protected products 23.0% 55.5% 58.5% 58.0% 54.9%

$2.5 $8.6 $10.1 $11.9 $14.1*

-*Does not include $11-billion in hedge fund assets held in pension funds and $2-billion in offshore funds.

NUMBER OF HEDGE FUNDS

Dec. ’99 Dec, ’02 June ’03 Dec. ’03 June ’04

Stand-alone hedge funds 65.2% 63.6% 60.1% 58.6% 54.5%

Pure funds of hedge funds 23.9% 25.2% 25.2% 22.1% 27.7%

Principal-protected products 10.9% 11.3% 14.7% 19.3% 17.8%

NUMBER 46 151 163 181 191

Canada

Sprott Asset Management: Created in 2000 by Eric Sprott, the company manages close to $3-billion in assets, including about $600-million in a group of hedge funds. Those funds primarily use a “long/short” strategy.

Salida Capital Corp.: Salida gained publicity last year by pushing Penn West Petroleum Ltd. to convert into an income trust.

Polar Capital Corp: Established in 1991, Polar is among Canada’s oldest hedge fund companies and manages about $500-million in assets. The company has both multistrategy and long/short funds.

Leeward Capital Management: Created in 2001 by investment manager Brendan Kyne. Leeward manages about $400-million in assets.

J.C. Clark Ltd.: Founded in 2001 by John Clark, co-founder of Connor Clark & Co., it manages about $350-million. The company caters to institutions and wealthy clients as minimum investments run as high as $2-million.

Front Street Capital Inc.: Created in 1992 and co-managed by Frank Mersch, Front Street recently started a hedge fund that shorts or hedges a portfolio of income trusts. The company manages about $800-million in total.

Tricycle Capital Corp.: Created in 2000, Tricycle specializes in “managed future notes. ” The notes are backed by the Canadian Wheat Board and the returns are based on a portfolio of commodity contracts.

Scivest Capital Management Inc.: Founded in 1999, Scivest uses “quantitative analysis and mathematical optimization” to invest money in its funds. It caters primarily to institutions and manages about $200-million in assets.

BluMont Capital Corp: The five-year old company has almost $700-million in assets under management. BluMont’s chief investment officer is high-profile investment guru Veronika Hirsch.

Arrow Hedge Partners Inc.: Arrow Hedge manages about $450-million in assets through a variety of funds including several “fund of funds”. The company is run by James McGovern, former chief of BPI Financial Corp. (Canada).

World

Man Group PLC: London-based Man is one of the few publicly traded hedge fund companies. Man has $43-billion (U.S.) in total assets and about $12-billion in hedge funds.

GLC Partners: London-based company was created by Lehman Brothers in the mid-1990s and spun off in 2000. It manages about $13-billion (U.S.) in hedge fund assets.

Caxton Associates LLC: Based in New York, Caxton has about $12-billion (U.S.) under management. It is run by billionaire Bruce Kovner, who reportedly earned $600-million in 2002.

Vega Asset Management: Madrid-based Vega manages about $11-billion (U.S.) in hedge fund assets. The company raised eyebrows last year when it hired one of the founders of notorious Long-Term Capital Management.

Farallon Capital Management LLC: San Francisco-based firm manages about $11-billion (U.S.) in assets and has a reputation for secrecy.

By Paul Waldie and Sinclair Stewart

SOURCES: INVESTOR ECONOMICS, TD WATERHOUSE, COMPANY REPORTS

Source: Globe and Mail

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