Hedge funds look at marketing promises

At those hearings, the IDA’s Paul Bourque said: “The expansion into retail markets heightened our concerns about several aspects of hedge fund products including the applicability of securities laws exemptions used; marketing practices by both hedge funds and dealers; conflicts of interest; high levels of fees and charges, some of them not transparent; the ability of hedge fund managers to meet expectations raised by their marketing; and the lack of disclosure of hedge fund operations and financial affairs.”

For his part, AIMA-Canada’s chair Jim McGovern says “We thought there was a need for this in the marketplace.” But he cautioned that AIMA is not a self-regulatory body but a trade association. Nevertheless, “We we do strongly encourage AIMA Canada members to consider them when developing promotional materials and procedures for the distribution of their products.”

Accompanying the guidelines is a 10 question checklist (with three or four subordinate questions for each topic) intended for consumers and advisors; it will be included in Advocis’s Best Practices manual, as well as available on the AIMA-Canada website.

Among the checklist questions: “Is there a qualified individual or team that evaluates hedge funds and principal protected notes for your financial advisor?” and “What relevant hedge fund experience does the hedge fund or hedge fund-of-funds manager have?” Other questions concern whether past performance numbers are actual performance or pro-forma numbers, how often can the investment be redeemed, and what the fee structure is, including advisor compensation.

The guidelines, entitled “A Guide to Sound Practices for Disclosure and Promotion of Alternative Investments in Canada”, cover three broad areas: regulation, disclosure requirements for offering documents and marketing guidelines.

Manager Registration

“There is a misunderstanding that hedge funds aren’t regulated,” says Gary Ostoich, AIMA’s legal counsel. Fund advisors, for example, must be registered, generally as investment counsel and portfolio manager. Also, trading has to take place through a registered dealer, and trading, the guide notes, is broadly construed to include marketing activities.

Against that backdrop, Ostoich notes, the U.S., where the hedge fund industry has generally opposed registration, is simply “coming up to speed to where Canada is.”

Although the majority of alternative investments are sold to accredited investors as private placements — and so they escape National Instruments 81-102 and 81-105, which define mutual funds and how they can be sold — hedge funds that qualify as privately offered mutual funds are subject to NI 81-106, which specifies continuous disclosure practices.

On disclosure in general, the guide recommends that offering documents — both offering memoranda used in private placements and information statements used for principal-protected notes offered by financial institutions, place investor interests first and foremost, using plain language that provides full, true and plan disclosure.”

“We can’t force disclosure,” explains Tris Lett, deputy chair of AIMA-Canada. “No one can.” Still, the disclosure guidelines, which cover such things as a fund’s investment strategy and leverage as well as how to subscribe, how the net asset value is calculated and how to redeem, “are just common sense, Lett says, adding, “they are in plain English and that’s how we’d like members use them.”

Then there is marketing, which the IDA has been especially critical of, arguing there’s a good chance in a principal-protected note that an investor will only recover the principle, thanks to underlying fees. Andrew Doman, chief operating officer at Abria Funds, likens the marketing principles to those laid out in NI 81-105, the mutual fund sales document.

The marketing guidelines include advisor compensation as well as co-op marketing, third-party compensation and registration; performance reporting as well as the manager’s fee schedule so that gross and net returns can be evaluated.

In a series of appendices, the guidelines also cover the information that should be included in an offering memorandum and information statement, and a risk acknowledgement form for the investor that includes an acknowledgement of fees paid for the investment.

“This is not an “all-encompassing list,” McGovern notes. He also acknowledges that the best practices in the world will not prevent a “bad apple” from happening. And the problems at Portus — primarily a compliance issue, at least from the public information, says McGovern — and at Norshield have acted as a “wake-up call” that in the short term has damaged investor confidence.

He suggests that if advisors have to pass a course to sell labour funds, that they should do the same with hedge funds. But in the end, the future of the industry will depend on head-office buy-in, and whether they devote the resources to providing due diligence on alternative products.

The guidelines are the distillation of peer pressure in the industry, on the industry, adds Ostoich. He doesn’t see the regulators moving to recast the exempt-securities regime for private placement products — including tax shelters, private equity. Meanwhile, principal-protected notes fall under federal purview. If those regulations become too onerous, he says, that industry could disappear.

Copies of the guidelines and checklist can be obtained at AIMA-Canada.

Filed by Scot Blythe, Advisor.ca, scot.blythe@advisor.rogers.com.

(06/14/05)