National instrument 81-107,
effective Nov. 1, provides for much-needed independent oversight of every investment fund that is a reporting issuer in Canada, including both publicly offered mutual funds and quoted funds listed on OTC markets. However, NI 81-107 does not go far enough. It does not include hedge funds and other alternative investment products. In our opinion, some increase in the level of independent oversight is required for the hedge fund industry, especially in light of recent scandals.

With an estimated value of $14 billion and continuing rapid growth in both size and popularity with institutional investors, the Canadian hedge fund industry is significant. As hedge funds are offered on only a private basis to accredited and institutional investors, regulation and disclosure requirements are significantly less stringent than for public mutual funds. That said, the fact that hedge fund investors have greater sophistication does not remove their need for protection. Transparency is key, and this could be achieved by some form of ongoing independent oversight.

One element of independent oversight would be a requirement for independent valuation of hedge funds. Currently, there is no such regulation in Canada. Although many smaller shops do delegate their valuations to third-party administrators, almost all the larger hedge fund managers perform this role internally. This can lead to huge problems for investors. For example, at most hedge funds and similar alternative investments, managers strive to produce a defined return — either a return that outperforms certain well-recognized market indices or an absolute return. If a manager is struggling, a temptation surely exists to add a few basis points to the present month’s performance and to try to make it up in the following month. And we all know where this leads.

The only required protection for hedge fund investors in Canada is the fund’s annual audit. In most cases, this would allow up to 15 months between a misstatement or act of fraud and its uncovering. Although 15 days is too long, 15 months is enough time to not only sail halfway around the world, but also to design and build the sailboat.

Another solution is clearly needed.

We can choose one of two avenues. All valuations must be reviewed by: an independent body, such as an investor risk committee, to oversee potential foul play; or be performed by an independent administrator. Let’s consider the costs of each.

It has recently been estimated that the annual cost of operating an IRC could start at $200,000 per mutual fund, and rise to seven figures for larger, active funds. If IRCs were required by hedge funds, a similar or potentially higher cost might apply because of more complicated investment transactions. This kind of fixed cost could kill a smaller hedge fund before it had a chance to grow.

On the other hand, fund administrators usually base their fees on assets under management. Funds of all sizes would find it more reasonable if a fund administrator took on some of these extra responsibilities.

To accomplish this, the Ontario Securities Commission could create a registration requirement for fund administrators. This would help ensure that fund administrators have the necessary processes and controls in place, and that the people behind the fund administration firm have the expertise to handle these extra responsibilities. Currently, a range of offshore jurisdictions require registration and sometimes licences to be granted by the relevant authority before a firm can provide fund administration services. There is no reason why a similar approach could not be adopted in Canada.

In addition, the following duties could be delegated to the fund administrator:

> daily/weekly/monthly NAV calculations;

> acting as authorized signatory on bank accounts while giving a restricted power of attorney to fund managers. This would ensure that fund managers can use the investor’s money only for trading purposes and they would not be able to send it to third parties without the administrator’s approval;

> monitoring the fund’s investments to ensure that it adheres to the investment strategy and there are no conflicts of interests.

A further consideration would be for fund managers or administrators to offer a Web-based resource that provides information on the positions held by a fund. This would ensure fund managers stay true to their investment objectives, as what they are trading will become completely transparent. And investors would be able to detect any duplication in their portfolios in real time, enhancing their personal risk-management abilities.

@page_break@Enhancements to the regulation and independent oversight of hedge funds are clearly needed. The wealth of investors and the industry’s sustainability depend on it. IE



Alex Chapman is director of operations at Mintz Fund Services Inc. in Toronto.