Scrutiny for hedge funds

Date: Wednesday, November 1, 2006
Author: Theresa Tedesco and Duncan Mavin, Financial Post

Spurred on by concerns voiced by U.S. regulators, a committee of Canadian senators is set to begin probing the murky world of hedge funds and their effect on the economy and investors.

The Senate's standing committee on banking, trade and commerce will conduct three days of hearings, beginning today in Ottawa, to determine whether enough oversight of hedge funds exists in Canada and whether they should be regulated.

This comes as a result of a two-day, fact-finding visit to New York last month.

"Our committee is concerned that both Canadian investors and consumers, as well as financial investors, could be at some risk when it comes to the burgeoning and relatively unregulated hedge fund sector," said Senator Jerry Grafstein, committee chairman.

In recent years, hedge funds have become enormously influential in financial markets around the world.

Basically, hedge funds are large pools of money invested with the intention of generating a specific return, regardless of conditions in the financial markets. They offer higher rates of return than conventional mutual funds and have attracted investments from the country's major banks and pension funds.

Hedge funds have become increasingly popular around the world, controlling sums estimated at more than US$1.3-trillion, and are growing at a rate of about 30% a year.

"It's an absolutely mushrooming industry now and everyone is jumping into it thinking that's where the money is," said Senator Mac Harb.

"This is the only industry that is not regulated and nobody really knows what goes on. It's a huge problem in Europe and the United States and we want to find out if we have similar problems in Canada."

During a trip to New York last month, the Canadian senators apparently got an earful during 26 hours of meetings from officials from the Federal Reserve Bank of New York, the New York Stock Exchange, the Manhattan District Attorney's office and Wall Street investment firms.

"We found these things were growing like weeds everywhere and they are running wild," said Senator David Angus, deputy chairman of the Senate committee. "They told us we were well-advised to look at them in Canada."

Mr. Grafstein, who said he is "open-minded" about the issue, nonetheless expressed concern about the exposure Canada's major banks, pension funds and mutual funds have to hedge funds.

"Everyone is flocking to the higher yield," he said in an interview. "My major impulse about this is that hedge funds are a great boon for a booming market, but what happens when the market drops 30, 50 or 70 points?"

Others agree.

"This is an area that's been crying out for some direction," said Richard Powers, assistant dean at the Joseph L. Rotman School of Management at the University of Toronto.

Even David Dodge, the governor of the Bank of Canada, encouraged the senators to conduct an "investigation" into the role of hedge funds last week, even though the funds "do not pose a financial stability systemic problem at this time."

Hedge funds first gained notoriety in 1998, when U.S. fund Long-Term Capital Management almost collapsed because of a bad loan in Russia.

More recently, calls for greater regulation in the United States intensified after the implosion of Amaranth Advisors LLC, a hedge fund that lost nearly US$6.5-billion in one week in September.

The U.S. Federal Reserve, the U.S. Securities and Exchange Commission and British regulators have all given hedge fund regulation high priority in the wake of Amaranth's collapse. The Connecticut-based fund lost about 65% of its value in one week after a series of trades on the fluctuating natural-gas market worked against the fund.

The SEC's director of enforcement, Linda Chatman Thomsen, announced her organization would begin reviewing hedge fund activity. And Timothy Geithner, president of the Federal Reserve Bank of New York, called for regulators to examine whether banks and securities dealers are demanding hedge funds back up their activities with enough capital to cover themselves if deals go wrong.

Unlike other types of investments, there are currently few rules to protect hedge fund investors in Canada and other financial markets.

Fortunately, many hedge funds have been profitable in recent years, so investors have not been adversely affected by the lack of regulation in the industry, Prof. Powers said.

However, he said, when investments go sour, "there's very little authority to command when information goes public that would at least alert investors where there are possible issues."

"You can bet that they [the Senate committee] will make recommendations to try to tighten up the industry," he said.

The Senate committee said it has concerns about "systemic risk, the lack of consumer education about hedge funds and the qualifications of those individuals who are both managing these funds and investing Canadians' money in these hedge funds."

Mr. Harb said the lack of transparency "is a problem that needs to be addressed quickly."

He said hedge fund industry representatives will be asked to provide testimony during the hearings to explain the challenges they are facing. Other witnesses include officials from the securities commissions in Ontario and Quebec and from the federal Department of Finance.

The Senate committee is expected to make recommendations early next year but Prof. Powers expressed concern about the length of time it will take for the committee to produce a detailed report.

"These things tend to move at a glacial speed," he said. "I wouldn't expect to see anything soon."

ttedesco@nationalpost.com; dmavin@nationalpost.com