Canadian regulators, like their counterparts around the world, are trying to figure out the best way to deal with the growing appeal of hedge funds to retail investors. The result will probably be more rules and greater scrutiny for a segment of the investment industry that has so far thrived without it.

In the past few years, hedge funds have been stuck with the role of bogeyman of the capital markets. The industry has never escaped the shadow cast by the failure of Connecticut-based Long-Term Capital Management Inc. in 1998. The speed and magnitude of that firm’s collapse highlighted the potential for large, secretive, highly leveraged funds to spark a financial system failure.

Yet, the LTCM debacle did not kill off the hedge fund business. Rather, the industry has flourished. Although reliable data is sketchy, it is believed that there are now upwards of 9,000 hedge funds in the world, managing in excess of US$1 trillion.

Many of the funds are new to the game. Recent research sponsored by NBCN Prime Brokerage Services shows one-quarter of all Canadian hedge funds have been around for less than three years, and 33% for between three and five years. Only 17% of Canadian hedge funds have existed for at least 10 years.

Despite their popularity with some investors, hedge funds continue to wear the black hat. Germany’s deputy chancellor famously derided them as “locusts” that ruthlessly prey on companies and their workers. The funds spark envy and derision for their sometimes-extreme compensation. Rumours of a large hedge fund failure are floated from time to time, causing fear in the market. Genuine failures have been frequent enough to preserve the credibility of the concern.

Those fears and the rapid growth of this industry segment have made regulators take notice. In 2004, the U.S. Securities and Exchange Commission proposed a rule that would have brought hedge fund managers under greater scrutiny by requiring them to register. Last year, that rule was challenged in a U.S. court and thrown out. The SEC has subsequently indicated it doesn’t plan to press the issue. The concerns, however, have not disappeared.

In Canada, securities regulators have also been worried. Two years ago, the Investment Dealers Association of Canada published an impressive paper documenting the growing “retailization” of the hedge fund business. It illuminated some potential trouble spots — including the marketing of hedge funds to unsophisticated investors through principal-protected notes, and assorted concerns about suitability, transparency and a general lack of oversight.

Now, the Canadian Securities Administrators has published the results of its own review of the hedge fund space. And it finds many of the concerns are still valid. Several member commissions of the CSA — for example, the Ontario, British Columbia and Quebec securities commissions — conducted co-ordinated field examinations of 13 firms, including both hedge fund managers (fund manufacturers) and their portfolio managers/advisors. The regulators also examined funds’ disclosure documents and held consultations with various members of the hedge fund industry.

The review looked at a range of issues from custody to disclosure, valuation methods and distribution. In general, most of the problems the CSA identified have to do with disclosure and distribution.

The CSA found that transparency about the fees that funds charge can be lacking, and there was inconsistent disclosure among funds that are offered on an exempt basis rather than through a prospectus. It also voiced concerns about the quality of performance reporting, which was found to be inadequate and inaccurate in some of the marketing materials it reviewed.

In terms of distribution, the CSA also found issues relating to referral arrangements in Ontario and B.C. It reiterated concerns about the use of PPNs to sell hedge funds, noting investors may not understand what they are buying, that the products are very complex and that there may be suitability and disclosure issues.

Despite its concerns, the CSA concluded that, overall, the current regulatory regime is able to oversee the hedge fund market effectively.

Nevertheless, changes are coming.

The biggest change will affect all fund managers, not just hedge fund managers. The CSA plans to introduce its own requirement for managers to register. It is expected that this will be proposed in March as part of the regulators’ overall registration reform project.

@page_break@Requiring the registration of fund managers as well as portfolio managers will give regulators greater oversight of the managers, and it will impose minimum standards in terms of proficiency, operational capacity, capital requirements and an obligation for managers to manage their conflicts of interest.

It will not, however, bring managers under the ambit of other fund-related rules — such as the mutual fund sales practices rule or the investment fund governance rule — unless they are already covered by these rules by virtue of their structure, says Leslie Byberg, manager of the investment funds branch at the Ontario Securities Commission in Toronto.

Byberg says manager registration will create some entry-level requirements for those who want to be in the money-management business. It will also create more detailed reporting obligations and authorize regulators to ensure that managers are adhering to the minimum requirements.

In addition to imposing registration requirements on all fund managers, the RRP will stake out a position on referral arrangements. The CSA is continuing to study the PPN issue. David Wilson, chairman of the OSC, indicates that it hopes to publish a position on PPNs within the next three months, although, he concedes, it may take longer.

Although hedge funds are receiving plenty of scrutiny and generating lots of chatter, it appears they won’t face onerous new rules in the short term. The RRP promises to be a large undertaking and history suggests that significant rule review projects tend to go through multiple comment periods and often take years to implement. Similarly, a resolution of the issues raised by the use of PPNs to package hedge funds appears some way off.

The big — but unanswered —question is why it has taken regulators so long to pay more attention to hedge funds. Most of the issues about which the CSA says it is concerned were brought to light by the IDA report almost two years ago.

In the meantime, investors continue to buy products that aren’t captured by current regulations, in the case of PPNs, and that pose some fairly fundamental problems. Many investors who are buying these complex products are unsophisticated, with little understanding of the underlying investment risks or the associated fee structures. While investors probably won’t lose a bundle on the products because their principal is protected, they may face an enormous opportunity cost if, after several years, all they have to show for their investment is the return of their principal.

The downside of slow-moving regulators isn’t limited to the impact on investors. Some manufacturers have also complained that uncertainty about acceptable referral structures has crimped their businesses, as risk-averse dealers are understandably wary about entering into arrangements that may carry regulatory risk.

Eventually, it appears, regulators will have to take a stance on these issues and other matters that have yet to be explored. Wilson says the CSA notice reflects the current state of its efforts to grapple with the growth of hedge funds. But the report doesn’t mark the end of its work.

Indeed, the notice indicates that the CSA is also interested in hedge fund valuation issues, a topic that is also being examined at the global level by the International Organization of Securities Com–missions.

Securities regulators in the U.S., Britain and parts of Europe have also recently taken up the question of hedge fund borrowing — and whether the firms lending the funds capital to make highly leveraged bets are ensuring the funds have sufficient collateral to cover a possible big default.

There are some fears that as hedge funds grow they will become the kind of client a firm can’t turn away because the funds generate huge revenue through their active trading and heavy borrowing.

The emergence of hedge funds from their origin as shadowy products that only the very wealthy could afford into a more mainstream retail product is certainly drawing regulatory attention. Hedge funds have yet to shed their outlaw image, but the intensified scrutiny of regulators could drag them further into polite society, whether they want it or not. IE