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Hedge fund rules lack teeth; sector rife for potential conflicts: report

Regulatory body calls for review

Canada's growing hedge fund industry lacks sufficient regulation and is rife with potential conflicts of interest and poor disclosure, says a report released yesterday by the Investment Dealers Association of Canada.

The lack of proper oversight "results in the inability to detect fraud and other misconduct at early stages, and the opaque nature of the industry could certainly attract fraudsters and other market malefactors," the IDA said in the report.

It called for a review of current regulations governing hedge funds in order to "bring hedge fund products being offered to the retail investor fully within the regulatory process."

Paul Bourque, the IDA's senior vice-president of member regulation, said the main purpose of the study was to examine the size of the hedge fund industry and the nature of its products. "We're just trying to stay ahead of an issue and work with the [provincial securities] commissions to fill any regulatory gaps that are identified," he said in an interview. The IDA is the self-regulatory body for Canadian brokerage firms.

Hedge funds are private pools of money that are supposed to make money regardless of how stock markets behave. They are lightly regulated and typically have been limited to wealthy clients. However, in recent years they opened themselves to average investors.

The IDA report noted the explosive growth of hedge funds, particularly those aimed at retail clients. Canadian fund assets grew to $14.1-billion last year, a 39-per-cent increase from the previous year. Pension plans hold another $11-billion in hedge funds and nearly $2-billion more is invested by Canadians in offshore funds.

More than half of the $14.1-billion is represented by companies that sell so-called "principle protected notes." Those notes, usually backed by a bank, make it easier for retail investors to invest in a hedge fund because they guarantee the principle investment. The report said the notes often have to be held for up to 11 years and there is no guarantee the underlying hedge fund will make any return. "The risk that investments locked in for as long as 10 years will earn a zero return is no small risk to a retail investor," the report said.

It also raised questions about the fees in these funds and said many charges are not fully disclosed. Performance fees for managers are typically 20 per cent of the fund's profits.

Hedge funds also have several potential conflicts of interest, the IDA said. While individual portfolio managers are registered with regulators, fund companies are not. This raises issues of compliance, improper oversight and a general lack of safeguards.

In the United States, the Securities and Exchange Commission will require most hedge funds to be registered next year. That is expected to bring greater disclosure about how the funds operate and the value of their holdings. The issues surrounding Canadian hedge funds needs "to be addressed in Canada as it recently was by the SEC in the United States," the report said.

James McGovern, chairman of the Canadian chapter of the Alternative Investment Management Association, welcomed the scrutiny of the industry. He said the association has already come up with business practice guidelines and is in the process of developing disclosure guidelines. "This is just reiterating what the solid practitioners in the market do anyway," said Mr. McGovern, who is chief executive officer of Arrow Hedge Partners Inc., a Toronto-based company.

Mr. McGovern said the industry has been hurt by the bad publicity surrounding Portus Alternative Asset Management Inc., which collapsed last March, and Norshield Asset Management Ltd. which has suspended redemptions.

"For people in the industry, I would say it's challenging," he said. "But the upside is that if people actually sit down and look at this, and analyze it properly, there's a real role for hedge funds."

© 2007 The Globe and Mail. All rights reserved.

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