Since the global financial crisis, product innovation is being seen in a new, less flattering light and as a growing challenge for regulators. That’s why the Ontario Securities Commission has recently decided it needs more input from the financial services industry to help keep the regulator up to speed on all of the changes taking place in the investment funds arena — and their implications for investors.

The OSC has now put together a new investment fund product advisory committee stocked with people from various parts of the fund industry, primarily those with extensive experience in product development. IFPAC also includes industry research guru Goshka Folda, senior managing director with Investor Economics Inc. ; and investor representative Marian Passmore, associate director with the Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada).

In recent years, there has been relentless proliferation of new retail investment products, including a stream of structured products, a resurgence in closed-ended funds and the mutation of exchange-traded funds into vehicles offering exposure to innumerable niches and investment strategies. This increase in variety and complexity may be a boon to certain investors, but novel products can also carry new, unanticipated risks.

Indeed, products that are devised to help spread risk, generate extra returns or create newly investible asset classes can lead to unforeseen consequences. The financial crisis helped reveal the dangers that can accompany financial innovation.

In late 2007, for example, inves-tors who thought they were holding safe money market vehicles found they were actually exposed to the risky U.S. subprime housing market. Before the trouble in the underlying assets emerged, no one was asking enough questions about what these products were and whether they were appropriate for retail investors.

Rhonda Goldberg, director of the OSC’s investment funds branch and head of IFPAC, says the decision to create the committee reflects the regulator’s need keep up with the increasing complexity and innovation in the fund industry: “The dynamic nature of the investment funds industry really requires us to adapt and respond to rapid product developments and trends, so the purpose of this committee is to try to stay ahead of emerging issues and anticipate risks that could affect investors.”

IFPAC will inform both the OSC’s development of policy, such as new rules, and its operational work (such as reviewing and approving new products and its compliance efforts). The committee also will contribute to the OSC’s evolving approach to regulation.

One of the consequences of the financial crisis, and the role complex products played in that crisis, is a regulatory rethink. Britain’s Financial Services Authority, for example, has declared that the traditional regulatory approach of simply relying on disclosure isn’t good enough. Instead, the FSA has decided to adopt a more interventionist strategy, including banning products it deems inappropriate for retail investors.

The OSC hasn’t gone that far, but is considering that it may have to embrace new approaches to regulation, too. The regulators’s latest statement of priorities, which sets out the regulator’s plans for the year ahead, observes: “Changes in products and market structures challenge the ability of traditional securities regulation to protect investors.

“In some cases, existing tools may be insufficient to monitor and respond to new developments within the limits of current regulation, and the OSC must find new ways to respond effectively. Traditional approaches to inves-tor protection alone, such as setting disclosure requirements and business conduct rules, as well as enforcement, are no longer sufficient.”

Whether this attitude will lead to radically different regulation in Canada remains to be seen. Meantime, the OSC is looking to lean more heavily on the fund industry to keep itself on top of product and market innovations — and on top of the possible impact by these developments on market fairness and investor protection. (As well as IFPAC, the OSC is also setting up a new advisory committee to keep up to speed with evolving market structure issues.)

IFPAC is slated to hold its first meeting at the end of September, and members plan to meet in person about four times a year. And although IFPAC will try to give the OSC an early start on emerging issues in the investment funds arena, in the meantime, regulators are already grappling with their share of existing regulatory issues in this space — and scrambling to bring the regulatory regime up to speed.
@page_break@Earlier this year, the Canadian Securities Administrators had announced that it is embarking on a project to modernize investment fund regulation and harmonize the regulation of different sorts of products (mutual funds, closed-ended funds and ETFs). Much of the existing regulation focuses on traditional mutual funds, which is by far the biggest fund category; but as other sorts of funds have become more popular, they have started to grab their share of regulators’ attention too.

The CSA points to product innovation and the increasing complexity of investment funds as its motivation for examining the existing regulatory regime to ensure that its “investor protection, fairness and market efficiency objectives are being met.”

For investor advocates, this also represents an opportunity for regulators to innovate — and they are encouraging regulators to embrace the FSA’s new philosophy that disclosure alone just isn’t good enough.

FAIR Canada’s response to the CSA modernization initiative says that while the advocacy group applauds efforts to improve the existing regime, it “cautions that any attempt to improve investor protection primarily through disclosure will be inadequate.”

Instead, FAIR Canada believes more fundamental changes in investment funds regulation are necessary, and it proposes that regulators adopt a principle requiring industry participants to put the best interests of their clients first — similar to a statutory fiduciary duty. The group also is calling for tougher conflict-of-interest prohibitions, more robust regulation of investment fund advertising, a comprehensive review of the exempt market (particularly the accredited investor rules) and tighter exempt-market regulation.

The CSA also is in the midst of overhauling the disclosure regime for investment funds. This is less a response to innovation by the industry and more an effort to revamp a regulatory regime that has seen the quality of disclosure degenerate by becoming increasingly dense and complex, to the point at which it’s ultimately ineffective for many investors.

Earlier this year, the CSA had introduced a new, streamlined disclosure document for mutual funds, known as Fund Facts, which aims to convey all the salient attributes of a fund in a brief, plain-language, two-page document rather than the bloated traditional prospectus.

In early August, the CSA proposed Step 2 of the new disclosure regime, allowing Fund Facts to take the place of prospectuses entirely. For now, the new documents are to be made available on fund company websites and provided to investors upon request. The CSA is now seeking to make Fund Facts the default disclosure document, with full prospectuses available on request.

Down the road, regulators intend to extend the new disclosure model to all investment funds, not just mutual funds, and to require delivery of the documents at the point of sale. (The current proposals would give firms two days after the sale to make disclosure.)

Both the scope and timing of disclosure documents have been the major issues of industry resistance that have discouraged regulators from making these changes sooner. (In fact, POS disclosure reform has been in the works since the late 1990s.)

So, while the CSA’s latest proposals make their way through the rule-making process, Goldberg indicates that the next step on this project is to develop a version of Fund Facts for other sorts of investment funds.

Yet, investor advocates are already voicing concerns with the Fund Facts documents. FAIR Canada, for example, has written to the OSC pointing out that some companies are not complying with their disclosure obligations; in particular, it claims, they aren’t making proper risk disclosure.

Goldberg says the OSC has heard this criticism and is taking a look at it: “Based on the feedback we’ve received, we intend to continue to consider the Fund Facts content. We will be looking further at the presentation of risk and the use of benchmarking.”

Nevertheless, she suggests, it’s still too early to get much of a read on how well the new regime is working. (The requirement to produce Fund Facts and make them available has only been in effect since July.)

But, she notes, the uptake by the fund companies, and the fact that the firms anticipate that clients will rely on Fund Facts as a decision-making tool, is encouraging to regulators so far. IE