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Hedge funds face scrutiny

Date: Monday, March 31, 2003

Securities regulators on both sides of the Atlantic Ocean are scrutinizing the secretive world of hedge funds amid concerns that smaller, unsophisticated investors are jumping into the market. Industry regulators in Britain last week decided not to allow retail investors greater access to these unregulated products. In the United States, the Securities and Exchange Commission announced last week that it will hold public hearings on hedge funds in May, a move that could signal plans to rein in the fast-growing $600-billion (U.S.) industry. The SEC said the two-day discussions will focus on how these funds are run and sold, and whether additional regulation is warranted. The Ontario Securities Commission also waded into the matter last month when it unveiled plans to review for the first time disclosure documents for all types of investment funds. But unlike its counterparts in the United States and Britain, the Canadian watchdog is not singling out hedge funds, nor seeking to impose new rules on the huge and lightly regulated industry. Hedge funds are investment pools that, as the name suggests, seek to hedge their bets or limit their risks through offsetting strategies, including short sales. (A short seller sells borrowed stock, hoping the price will fall before he has to replace it.) Unlike mutual funds, hedge funds can invest in the futures and commodities markets and borrow to magnify their gains, as well as sell stocks short to make money in a falling market. The industry has enjoyed explosive growth. Assets worldwide soared to $622-billion last year from $367-billion in 1997, according to Chicago-based Hedge Fund Research Inc. While there are no figures available for Canada, the domestic industry has also enjoyed rapid growth, according to Jim McGovern, chairman of the Canadian chapter of the London-based Alternative Investment Management Association. The chapter set up shop this month in Canada with 38 founding members, in response to the growing interest in policing the hedge fund sector. AIMA has offices in several other countries, including the United States, Hong Kong and Australia. "Anything the U.S. does affects Canadian players to some extent," Mr. McGovern said. "Many of the Canadian players have funds that are domiciled offshore as well," said Mr. McGovern, who is also chief executive officer of Toronto fund company Arrow Hedge Partners Inc. "We want to be in a position where we can represent the voice of the hedge fund industry to regulators." Traditionally, hedge funds have been reserved for institutions and rich investors, typically those with a minimum of $1-million in spare capital. They get little regulatory scrutiny because such individuals are considered financially sophisticated enough to look after themselves. But in recent years, new routes have opened up for retail investors. These include closed-end funds listed on the Toronto Stock Exchange and so-called fund of funds -- mutual funds that invest in hedge funds. These vehicles are luring thousands of first-time investors by offering far lower investment minimums than traditional hedge funds. For example, the BluMont Man-IP Series 1 Notes, which are managed by Man Investments Products, one of the world's largest hedge fund managers, are available at a minimum of $5,000. The Altamira Active Management GIC can be had for a minimum investment of $500. Both these products consist of a principal-guaranteed term deposit that offers returns tied to the performance of various hedge funds or strategies. Investors make money if the basket of hedge funds rises in value, and they get all or part of their money back if the funds drop in value. Gary Ostoich, a partner with Toronto law firm McMillan Binch LLP, said it makes sense for investors, both institutional and retail, to invest in alternative products such as hedge funds, even if the equity markets rebound. "Alternatives aren't the panacea," he said. "It's not like they're going to give you these great returns all the time. But they're not going to lose as much during an equity downturn." What regulators are debating, however, is just how actively retail investors should be in the hedge fund market. The Financial Services Authority in Britain concluded after an eight-month review that the rules governing the sale of these funds to retail investors should not be relaxed. Hedge funds and other investment advisers were not clamouring to sell these products to the retail market, the authority said. "Nor was there evidence of significant demand from retail investors," it said. For their part, SEC officials are concerned that hedge funds may act to the detriment of investors through short selling. SEC chairman William Donaldson said last week that he plans to take a "long, hard look" at the industry.