The role of the OSC in Portus

Date: Friday, May 13, 2005
Author: Terence Corcoran- Financial Post

With only a few weeks to go before he leaves the helm of the Ontario Securities Commission, you would have thought David Brown would want to check out on a moral high note. It was surprising, therefore, that one of his final public speeches -- delivered on Tuesday to the Toronto CFA Society -- turned into an indecent public flogging of investment advisors over the Portus hybrid hedge fund fiasco.

A lot of stray dogs probably need to be shot over Portus, a few of which might even be hanging out at the OSC. Where were the regulators when the creators of these products brought them to market? What role did existing regulation play in making Portus's products, based on hedge funds, so alluring to small investors? What about the financial institutions that had roles in marketing the plans? Was this a fraud or simply a rocky investment model that in fact made no sense from the start? As Mr. Brown put it himself, the complexity of the Portus investment instrument "and the lack of regulatory compliance by Portus has made it difficult for investigators to understand this product after months of forensic accounting."

Setting an example through all of this has been ManuLife Financial, which has come forward to accept responsibility by offering to reimburse investors hurt by its operations. So far the OSC has yet to admit to any responsibility, direct or indirect. Despite its massive regulatory power, expanding budgets and constant production of rules and laws, the OSC is blind to what went on and accepts no responsibility for whatever Portus did.

Maybe the OSC doesn't need to admit to anything at this point, but it is certainly out of line to single out investment advisors as the sole culprit. "So what could have accounted for [Portus's] tremendous sales record?" asked Mr. Brown. "Perhaps there is only one particular feature to speak of -- high up-front fees and trailer fees for referrals."

That's it? More than 26,000 investors turned over $750-million to Portus solely because advisors were paid fees? This is convenient for the OSC, which has been riding the fund fee issue for more than a decade, with absolutely no benefit to investors. Rather than take a hard look at the regulated investment environment that created Portus, Mr. Brown has decided to take a quick, cheap shot at a dead hobbyhorse.

Far more interesting and sophisticated would be an examination of the role of regulation in creating demand for Portus and the other hybrid hedge products. The analysis by Miklos Nagy on this page goes a long way to explaining the success of the Portus products, one that has little to do with fees. The fees, moreover, are no more of a sales incentive than exist with regular mutual funds.

The high fees for Portus's hybrid hedge product exist in part because, under regulation, the real hedge fund products with low fees are not available to small investors. Retail investors are cut off from the real market by regulations that make it illegal to sell hedge funds to people who have incomes and net worths below certain regulated limits. That's where the high potential returns (and risks) lie. Small investors who wanted to get in on the burgeoning hedge market had no choice, and when the Portus style instruments came along, the small investor responded.

Regulations have a high price in the market. A big part of that price is to lull investors into believing that the market is safer and less risky than it actually is. Many small investors, ignorant of risk, should not be in these markets, but the air of confidence created by regulations draws them in. Failures then land on investors as stunning surprises. At that point, the regulators walk away from the victims and turn to imposing new regulations and lay the foundation for more stunning disasters in the future.