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Clients need hedging, hedging needs diligence


Date: Tuesday, May 9, 2006
Author: Steven Lamb, Advisor.ca

This article is courtesy of www.advisor.ca

With many of the world's equity markets pushing historic highs, it may be prudent for many investors to re-examine the long-only strategy which has served them so well over the past few years.

As with any industry, high-profile problems may have tainted the public's perception of the hedge fund industry, despite the numerous success stories in this little understood space in the market.

Never mind the clients, many advisors remain uncertain of the industry. Even if they understand the structure of a product, selling it to clients may be an uphill battle, especially if it appears to be a bet against a roaring market.

Steve Kangas, president of Blumont Capital, acknowledges that it is difficult to persuade clients to take money off the table, given the gains from taking a long-only equity position. He likens this to the telecom and Internet bubble of the late 1990s, with investors unwilling to trigger a capital gain.

But he says Canadians are bound to catch up with the rest of the world in their appetite for hedge funds.

"More and more people are becoming interested in these kinds of assets," he told the audience at IFIC's Fifth Annual Compliance Forum on Monday in Toronto. "It's a little tough in the Canadian market right now, where we have record markets in the last three years...but how long do you want to keep your clients exposed (to the commodities rally)?"

Most advisors would agree that even if they understand the basics of the seminar, it might be difficult to take a product manufacturer at their word. Kangas says advisors have to "jump in with both feet" and educate themselves on the inner workings of more complicated alternative investments.

"I don't believe that you can get, through a seminar, what a lot of the hedge fund strategies are," said Kangas. "(But) the ones that have the most knowledge are the manufacturers."

The manufacturer's educational seminars can play an important part of the overall due diligence process, but it is only one component.

Due diligence must be tailored to the dealers' own situation, but should start with a written and standardized process a process which must be strictly followed, says Terry Ford, national compliance officer at Partners In Planning Financial Services.

A preliminary review should be held to determine whether the product in question is actually new, or simply a modified version of an existing product.

The detailed due diligence review should be conducted by a group, pulling staff from different departments at the dealership, including sales, IT, operations, but also bringing in members of the compliance and legal teams.

"Having compliance and legal involved at the early stages of this process will allow them to be considered a co-developer, as opposed to coming in late in the process and being considered more of a roadblock," Ford said.

The legal and compliance teams can also provide advance warning of any training the sales force will be required to undertake in order to meet regulatory and licensing requirements.

At PIP, the group then submits a detailed report for formal review by the senior management. It's up to this review group to set terms and conditions of suitability for the product in question and a detailed report should follow that committee meeting.

"Certainly there is no substitute for suitability review and analysis," he said. "Simply considering the product being sold to accredited investors is not in and of itself an indication of their sophistication."

The fifth and final stage of due diligence is the post-product review, which should take place six to 12 months after the product is launched, assessing performance and any changes in the market conditions that could affect the product.

Ford says PIP extends diligence beyond the approval process, to ensure suitability at the point of sale as well. Once the product has been approved for the shelf, compliance officers should contact clients who decide to invest in it, just to ensure they understand the risks involved.

Sales reps are required to attend the courses offered by the manufacturer, to ensure they understand the goals and processes of the product and to give them the opportunity to question the aspects they don't understand. Ford says his reps must also hold the CFP designation or have at least completed the CSI hedge fund course.

Of course, there is always the chance that an approved product will end up in the hands of the wrong client, so Ford makes sure that his E&O carrier covers every new product before it is added to the shelf.

Key Questions

Due diligence is all about asking the right questions and getting the right answers. Ford offered a partial list of some of the most important questions:

  • What is the structure of the product?

  • How is it offered (prospectus, offering memorandum, or information statement)?

  • Which regulator has jurisdiction over it?

  • What regulatory rules must be followed to offer the product?

  • Who is this product intended for?

  • Who should it not be offered to?

  • What are the objectives of the product?

  • What are the risks?

  • Do the returns justify these risks?

  • Are there less risky alternatives already available?

  • Are the costs and fees appropriate? Are they transparent? Are they comparable to similar investments?

  • How is compensation handled?

  • What conflicts exist in compensation and how are conflicts addressed?

  • If you are relying on third party analysis, what are their qualifications?

  • What training will the sales force need?

  • What is the complexity of the product? Will it impair the transparency or affect suitability?

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com