Regulatory Analysis of Hedge Funds - Investor Voiceinvestorvoice.ca/Research/IDA_HedgeFunds_18May05.pdfRegulatory Analysis of Hedge Funds May 18, 2005 Hedge Fund Working Group Louis

Regulatory Analysis of Hedge Funds

May 18, 2005

Hedge Fund Working GroupLouis Piergeti (Chair)

Maysar Al-SamadiLarry Boyce

Jon CockerlineRichard Corner

Alex Popovic


TABLE OF CONTENTS 1. PREFACE ........................................................................................................................................................1 2. EXECUTIVE SUMMARY .............................................................................................................................2

DEFINITION ........................................................................................................................................................2 EXPANSION INTO THE RETAIL MARKET..............................................................................................................2 ISSUES AND CONCERNS ......................................................................................................................................3

3. RECOMMENDATIONS ................................................................................................................................4 RECOMMENDATIONS FOR IDA ACTIONS ............................................................................................................4

4. CHARACTERISTICS OF HEDGE FUNDS ................................................................................................5 5. EVOLUTION OF HEDGE FUNDS...............................................................................................................7

EARLY DEVELOPMENT .......................................................................................................................................7 GROWTH IN THE 1980S AND 1990S.....................................................................................................................7 CURRENT STATISTICS ON HEDGE FUND INVESTMENT ........................................................................................8

6. THE CANADIAN HEDGE FUND LANDSCAPE .......................................................................................9 SIZE....................................................................................................................................................................9 TYPES OF HEDGE FUND PRODUCTS IN CANADA ...............................................................................................10 GROWTH TREND BETWEEN HEDGE FUNDS AND PUBLIC MUTUAL FUNDS ...........................................................10

7. PRINCIPAL-PROTECTED NOTES...........................................................................................................12 GRAPHIC ILLUSTRATION OF THEORETICAL GROWTH OF PPNS TO MATURITY ...................................................13

8. BENEFITS AND RISKS OF HEDGE FUNDS...........................................................................................14 BENEFITS..........................................................................................................................................................14 RISKS................................................................................................................................................................14

9. REVIEW OF HEDGE FUND REGULATIONS ........................................................................................15 PRODUCT OFFERINGS FOR HIGH-NET-WORTH AND INSTITUTIONAL INVESTORS (EXEMPT MARKET) ...............15 PRODUCT OFFERINGS FOR THE GENERAL INVESTING PUBLIC (RETAIL MARKET) ............................................15 REGISTRATION OF HEDGE FUND MANAGERS ...................................................................................................16 DISCLOSURE.....................................................................................................................................................16 REPORTING.......................................................................................................................................................17 FINANCIAL STATEMENTS..................................................................................................................................17

10. REGULATORY ISSUES..............................................................................................................................19 CONFLICTS OF INTEREST ..................................................................................................................................19 ROLE OF A FUND MANAGER.............................................................................................................................20 PRIME BROKERAGE ..........................................................................................................................................21 FEE STRUCTURES .............................................................................................................................................22 TRANSPARENCY OF RISKS, VALUES AND RETURNS..........................................................................................23 DISTRIBUTION ..................................................................................................................................................25 ACCREDITED INVESTOR RULES ........................................................................................................................26 INCENTIVE FEES ...............................................................................................................................................27 OFF-BOOK TRANSACTIONS ..............................................................................................................................28 LACK OF REGULATORY OVERSIGHT.................................................................................................................28 IDA MARGIN RULES FOR HEDGE FUND PRODUCTS ............................................................................................28


11. LIMITED MARKET DEALER REGISTRATION ...................................................................................30 IDA MEMBER AFFILIATES WITH LMD-ONLY REGISTRATION ..........................................................................30 IDA MEMBERS AFFILIATES WITH DUAL REGISTRATION INCLUDING LMD REGISTRATION..............................31

12. DISTRIBUTION OF HEDGE FUNDS........................................................................................................32 IDA MEMBER ACTING AS “MANUFACTURER” .................................................................................................32 IDA MEMBER ACTING AS AGENT IN A DISTRIBUTION ......................................................................................34

13. IDA POTENTIAL SUPERVISION ISSUES AND CONCERNS..............................................................36 RECOMMENDATION OF HEDGE FUND PRODUCTS .............................................................................................36 PROPRIETARY HEDGE FUND PRODUCTS ...........................................................................................................36 HEDGE FUNDS OPERATED BY RR.....................................................................................................................36 PROMOTIONAL MATERIALS..............................................................................................................................37 TRAINING .........................................................................................................................................................37

14. RECOMMENDATIONS ..............................................................................................................................38 RECOMMENDATIONS FOR IDA ACTIONS ..........................................................................................................38 PROVINCIAL SECURITIES REGULATION ............................................................................................................40

APPENDIX A – COMMON FRAMEWORK TO CLASSIFY HEDGE FUND STRATEGIES ..................................................41

APPENDIX B – DEFINITION OF HEDGE FUND STRATEGIES .......................................................................................42

APPENDIX C – HEDGE FUNDS BY FUND SIZE .............................................................................................................43

APPENDIX D – COMPARISON BETWEEN PUBLIC MUTUAL FUNDS AND POOLED FUNDS..........................................45

APPENDIX E – ACCREDITED INVESTOR RULES .........................................................................................................46

APPENDIX F – NEW CANADIAN CONTINUOUS DISCLOSURE RULES FOR INVESTMENT FUNDS (NI 81-106) ............50

APPENDIX G – FEES/HURDLE RATE/LOCK-UP ..........................................................................................................51

APPENDIX H– LIMITED MARKET DEALERS ..............................................................................................................52

APPENDIX I – AIMA – GUIDE TO SOUND BUSINESS PRACTICES ..............................................................................53


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1. PREFACE

The primary purpose of this report is to examine hedge fund activities in Canada and the involvement of

IDA Member firms or their affiliates in such activities, and to identify any regulatory arbitrage or “soft

spots” in securities legislation and regulations governing the business.

The study was researched and prepared in response to information requested by the IDA Member

Regulation Oversight Committee (MROC) on January 19, 2005, and presented on April 13, 2005.

The paper includes:

• a discussion of the characteristics and evolution of hedge funds;

• a review of the Canadian hedge fund landscape in terms of participants and asset size;

• a review of securities laws and regulations relating to the exempt market;

• a review of the differences between publicly issued mutual funds and private hedge funds;

• a review of hedge fund investment strategies;

• a review of principal-protected notes;

• an analysis of the involvement of IDA Members and/or their affiliates in hedge fund activities;

• a review of IDA margin rules as they relate to hedge fund products;

• a discussion of regulatory and/compliance issues; and

• recommendations.


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2. EXECUTIVE SUMMARY

Definition

“Hedge fund” is a generic term used to describe investment pools generally sold privately but sometimes

publicly offered under prospectus in which the fund advisor has the ability to trade a wide range of

investments, using a variety of investment strategies, with the objectives of generating profits and

protecting principal. Hedge funds generally aim to earn positive absolute returns with low volatility

through strategies that make use of financial instruments and tactics not typically available to the same

extent to mutual fund managers, for example derivatives, short selling, swaps and leverage.

Expansion into the Retail Market

Unlike mutual funds, hedge funds operate under exemptions from securities distribution laws.

Theoretically, that limits their investor base to the sophisticated and affluent investors that are capable of

protecting their own interests. However, there has been a widespread move into retail distribution of

hedge funds or hedge fund related products in Canada and elsewhere. In the study, the term “retail” refers

to investors other than those normally referred to as “professional,” “qualified” or “sophisticated

investors.”

The attraction for retail investors resulted from the bear market, which prompted many investors to look

for investment managers who know when and where to invest, and work within a format that allowed

them to do so. Relatively good returns, meaning better performance than the market, have become less

important than absolute returns (i.e., not losing money, especially when the market falls). Hedge funds

are marketed as the answer: vehicles that have provided generous returns during all stock market

environments and thus as excellent diversifiers to an all equity portfolio.

The result has been explosive growth in hedge fund assets under management in Canada.

One of the most popular retail products has been principal protected notes (PPNs), which now account for

approximately 50% of the $14.1 billion of hedge fund assets in Canada.


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Issues and Concerns

The expansion into retail markets has heightened concerns about several aspects of hedge fund products,

including:

• applicability of securities laws exemptions used;

• marketing practices by both hedge funds and dealers;

• conflicts of interest;

• high levels of fees and charges, some of them not transparent;

• ability of hedge fund managers to meet expectations raised by their marketing; and

• the lack of disclosure of hedge fund operations and financial affairs.


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3. RECOMMENDATIONS

The following are key recommendations arising from this study in respect to IDA Member firms.

Recommendations for IDA Actions

1. Re-issue the advisory to all Members reminding them of the prohibition of “off-book” transactions.

2. Develop industry guidance as to acceptable practices for referral arrangements.

3. Issue an advisory to all Members as to their responsibility to conduct due diligence on products

recommended to clients.

4. Review guidelines or standards regarding disclosure, conflicts of interest and internal controls for

IDA Members acting as manufacturer, advisor, manager and distributor of hedge funds or pooled

funds and determine whether such standards need amendment.

5. Restrict IDA Members from conducting securities-related activities in an affiliate with a limited

market dealer registration when such activities could be conducted by the Member.


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4. CHARACTERISTICS OF HEDGE FUNDS

“Hedge fund” is a generic term used to describe investment pools generally sold privately but sometimes

publicly offered under prospectus in which the fund advisor has the ability to trade a wide range of

investments using a variety of investment strategies with the objectives of generating profits and

protecting principal. Hedge funds aim to earn positive absolute returns with low volatility using strategies

(referred to as alternative investment strategies) that make use of financial instruments and tactics that are

not typically available to the same extent to mutual fund managers, for example, derivatives, short selling,

swaps and leverage.

Hedge funds can take long and short positions, use derivatives and leverage, arbitrage and invest in

almost any situation in any kind of market where the manager sees an opportunity to achieve positive

returns. In Canada hedge funds are structured in a variety of ways including limited partnerships, limited

liability companies and unit/mutual fund trusts.

The compensation structure of a hedge fund manager differs from that of a traditional manager. Many

hedge fund managers derive the bulk of their compensation from fees related to positive fund

performance, in contrast to traditional fund managers whose compensation is based on assets under

management.

The following are generally considered the three main hedge fund product categories:

• Stand-alone hedge funds – Funds whose returns are dependent on the investment decisions of a

single hedge fund manager.

• Pure fund of hedge funds – Funds that invest in units of other hedge funds with multiple

underlying managers.

• Principal-protected products – Funds or other financial instruments offering retail investors the

opportunity to participate in the returns of an underlying hedge fund, but with a guaranteed return

of their original investment at maturity.

Within each product category, hedge fund managers use a multitude of strategies. Hedge fund strategies

can be classified in a variety of ways: process or strategy, asset class, geographical location, industry

sectors, or return drivers.


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Following are the three main hedge strategy classifications relative to market exposure.

• Relative value hedge funds or market neutral – Attempt to profit by exploiting irregularities or

discrepancies in the pricing of related stocks, bonds, or derivatives. For example, convertible

arbitrage managers often simultaneously take long positions in a company’s convertible bonds,

preferred shares or warrants that they believe to be undervalued, and short position in its common

shares that they believe to be over valued. They aim to profit as the market ultimately recognizes

the mis-pricing and corrects.

• Event-driven hedge funds – Seek to profit from unique, particular events such as mergers,

acquisitions, bankruptcies, stock splits, and buybacks. These strategies revolve around capturing

trading profits that are often available when extraordinary events create considerable price

volatility.

• Directional hedge funds – Speculate on anticipated movements in the market prices of equities,

fixed-income securities, foreign currencies, and commodities. In Canada, the common strategy of

this type is long/short equity.

Appendix A outlines the most common classification system, based on the hedge fund’s strategy and

asset classes, and the various types of hedge fund risks.

Appendix B provides common definitions for hedge fund strategies.


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5. EVOLUTION OF HEDGE FUNDS

Early Development1

Hedge funds existed as early as 1949, but not until 1984 did they begin to gain widespread attention. The

pioneer in the evolution of hedge funds is Alfred Jones. He wanted to create a fund that offered

protection in a falling market, while achieving superior returns over the long run. Jones’ model was

based on the premise that performance depends more on stock selection than market direction. He used

two speculative tools – short selling and leverage – and merged them into a conservative strategy for

investing in both rising and falling markets.

Jones believed that in rising markets one could buy stocks that would rise more than the market, and sell

short stocks that would rise less than the market. In falling markets, one could buy stocks that would fall

less than the market, and sell short stocks that would fall more than the market. By balancing these

strategies, Jones believed that his fund could yield a net profit in both rising and falling markets. In fact,

during the 1950s and 1960s, Jones’ hedge fund consistently outperformed the best equity mutual funds.

Jones set up his fund as a general partnership with performance-based fee compensation, and invested his

own capital in the fund. The fund was converted into a limited partnership in 1982.

Jones’ success led many new hedge fund managers to enter the marketplace, and by 1968 there were

approximately 200 hedge funds in the US, including those managed by George Soros and Michael

Steinhardt. However, during the 1960s bull market, many hedge fund managers decided not to follow

Jones’ model, as they ceased selling short but continued to lever their long positions. Many of these

funds did not survive the bear market of the 1970s. Meanwhile, Jones’ hedge fund continued its success

during the 1970s, and over time he hired other stock pickers to autonomously manage portions of his

fund. In 1984, Jones created a “fund-of-funds” by amending his partnership agreement to reflect a formal

fund-of-funds structure.

Growth in the 1980s and 1990s

The growth in the hedge fund industry accelerated in the 1980s and 1990s. During this time, an increase

in new financial vehicles and changes in technology facilitated the development of sophisticated

investment strategies without the need for backing by large investment houses. In addition, performance-

based incentive fees and low barriers to entry for new funds led highly skilled entrepreneurial investment

professionals to leave large investment houses to start up their own hedge funds. Some of these managers

1 Source: AIMA Canada Hedge Fund Primer (pg. 1-2)


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had initial financial backing from their former employers, and many invested their own capital in their

funds.

During the 1980s, most US hedge fund managers did not register with the Securities and Exchange

Commission (SEC). They were therefore prohibited from advertising and relied on referrals to grow their

assets. During this period European investors also recognized the advantages of hedge funds, resulting in

the establishment of tax-efficient offshore hedge funds.

Growth was fueled by exceptional performance from a number of star managers, some earning compound

returns in excess of 30% through both rising and falling markets.

By the end of the 1990s, hedge funds were attracting money from multiple parties, including high-net-

worth individuals, private banks (mostly European), US endowments and foundations, insurance

companies, pension plan sponsors and funds-of-funds.

Current Statistics on Hedge Fund Investment

Tremont TASS Research has conservatively estimated global investment in hedge funds at US $615.4

billion at the end of 2004. Other industry measures have indicated that the global total was close to $1

trillion.

In March 2004, Merrill Lynch and Cap Gemini Ernst & Young reported that as at December 2003, 73%

of high-net-worth investors in the US (those with financial assets in excess of US $1 million) held hedge

fund investments.

The following chart depicts the growth in numbers of hedge funds in the US between 1949 and 2003.

1949 1968 1984 1991 2003

Number of funds

Hedge fund eras

“Obscurity” “The dark ages” “The renaissance”

1

200

68

2,100

7,500


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6. THE CANADIAN HEDGE FUND LANDSCAPE

Size

In a recent study, Investor Economics2, a Toronto-based research firm, estimated on a conservative basis

that there were $26.6 billion in Canadian hedge fund assets as at June 2004, broken down as follows:

• Canadian pension plan assets: $10.9 billion

• Canadian sponsored—Canadian assets: $14.1 billion3

• Canadian sponsored—offshore assets: $1.6 billion

The $14.1 billion in Canadian sponsored—Canadian assets funds represent an increase of 39% over one

year. Total assets expanded almost six times over the past four and a half years, for an average compound

growth rate of 46%. The report also indicates that worldwide, hedge funds continue to climb with very

strong investor appetite and may approach US $1 trillion in 2004. The study notes that hedge fund

sponsors have worked hard to attract business from pension plans – just as defined pension plan sponsors

have been seeking ways to reduce their exposure to stock market volatility.

Pure funds of hedge funds and principal-protected products account for 71% of the Canadian asset funds.

Of this amount, principal-protected products represent 54.7% of the total assets. Virtually all the “non-

guaranteed” principal component of principal-protected products, the portion invested in hedge funds, is

put into pure funds of hedge funds.

The increase in hedge fund investments in the past few years was driven primarily by the lower

performance of traditional asset classes, and by investors’ desire to diversify and lower their risk

exposures. This trend is in line with other parts of the world. However, unlike the more mature US and

European markets, general awareness (on the part of both institutional and individual investors) in Canada

of alternative investments, and hedge funds in particular, has until recently been low.

The Investor Economics study also showed that hedge funds are highly concentrated in Canada, that is, a

large proportion of hedge fund assets are held in a small number of funds or managed by a small number

of managers. More than 68% of hedge fund assets reside in 24 funds that hold more than $100 million

each. They account for $9.6 billion of the $14.1 billion in assets. Most of the other 167 hedge funds held

less than $25 million. (Statistics showing the breakdown of assets by fund size and investment style can

be found in Appendix C.)

2 Investor Economics – Hedge Fund Report, Volume 2, Winter 2005 3 Consisting of 191 funds and various structured note products with $10.5 billion in Canadian managed hedge fund assets and $3.6 billion in principal-protected assets.


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Types of Hedge Fund Products in Canada

Investor Economics conducted its first study of the Canadian hedge fund landscape in 2003, focused

primarily on individual investors in Canada. It found that because of their principal-repayment feature and

a low minimum investment, most Canadian individual investors have favored guaranteed fund-of-funds-

linked notes backed by highly rated international banks, resulting in their much higher assets under

management than the other two product types. Many series of the same product can be offered, further

contributing to growth in assets. As the investment is generally locked in for a number of years, the

average asset level will continue to increase as new investors’ funds are added to the locked-in base.

The study also found the following statistics:

• PPNs linked to hedge funds have the largest average size – $68 million. Each series issue of a

PPN represents a separate financial instrument and security, so the average decreased due to the

offering of many new series. Next in size were pure funds-of-funds at $44 million and stand-

alone hedge funds at $39 million;

• Funds holding $100 million or more represented 80.6% of the PPN assets, 56.2% of the fund-of-

fund market and 52% of the total stand-alone funds;

• $7.7 billion (or 55.1%) of the total $14.1 billion in hedge fund assets in Canada were managed

using opportunistic strategies which have a high exposure to market risk;

• Directional/opportunistic style strategies are used by the greatest number of funds – 102 of the

191 funds (approximately 53%);

• 78.2% of all stand-alone funds use directional/opportunistic strategies;

• The PPN segment is dominated by directional/opportunistic strategies. This represents $4.0

billion or 51.8% of total PPN assets.

In summary, the Canadian hedge fund landscape is skewed toward directional/opportunistic funds with

the greatest concentration of total fund assets invested in PPNs. Given the high concentration of assets in

PPNs, their characteristics will be further described in Section 7 of this report.

Growth trend between hedge funds and public mutual funds

It is useful in understanding the magnitude of growth of Canadian hedge fund assets to compare it to the

growth of traditional mutual fund assets. Canadian hedge funds have experienced strong growth while

asset growth for traditional mutual fund has stagnated, as illustrated in the following chart4.

4 Source: Investor Economics – Hedge Fund Report, Volume 2, page 53.


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Mutual fund companies have had a relatively weak showing in the hedge fund market because they have

not generally been sponsors of the pure funds of hedge funds and principal-protected products that have

held strong appeal for advisors and clients.

Those mutual fund companies entering the hedge fund arena have tended to favour long/short equity

strategy funds. While this might be the most obvious market opportunity for them, these funds have

tended to perform poorly during weak markets, especially those with a long bias.

Another reason is that potential conflicts of interest deter mutual funds companies from simultaneously

offering mutual funds and hedge funds. One conflict arises when a mutual fund manager is long a security

while the hedge fund manager is short; another arises in the potentially conflicting compensation

structures for firm managers – long-only managers receive management fees while hedge fund managers

receive both management and performance fees. Some firms have chosen to move forward and manage

the conflicts, while others have chosen not to enter the hedge funds arena.


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7. PRINCIPAL-PROTECTED NOTES

Canadian hedge fund investments are concentrated in PPNs because of their characteristics and exempt

product status under securities legislation. Under section 35(2)1 of the Securities Act (Ontario) (the Act),

dealer registration is not required to trade in bonds, debentures and other evidences of indebtedness of or

guaranteed by a Schedule I or II Bank, trust or loan corporations, insurance companies, credit unions or

caisse populaires registered under appropriate legislation.

PPNs, which have the principal of the original investment guaranteed by the above financial institutions,

qualify as exempt securities under the Act. They are like guaranteed investment certificates (GICs)

except that the income component is linked to the performance of a fund of hedge funds. As exempt

securities, they are not subject to the accredited investor exempt distribution rules. PPNs can be sold to

any investor for any amount by any entity (whether registered as a dealer or not). However, unlike GICs,

the Canadian Deposit Insurance Corporation does not consider PPNs to be “deposits” and therefore does

not cover losses in the event of the insolvency of the bank or trust company that issued the guarantee.

The following are general characteristics of PPNs that are linked to hedge funds and their guarantee:

• The notes constitute direct unconditional obligations of the bank;

• The notes are issued on an unsubordinated basis and rank equivalent to other unsubordinated debt

of the bank;

• The notes are not deposits insured by the Canada Deposit Insurance Corporation Act.;

• The issuer guarantees 100% of the original investment if the notes are not redeemed prior to

maturity;

• The issuer may leverage up to 20% to 50% of the net asset value of the investment.

The following example illustrates the principal guarantee of a PPN:

When an investor purchases a $100 PPN; the issuer invests up to $70 (or higher for products with shorter terms to maturity) of the original investment in cash or securities to guarantee the principal and swaps the remainder to a fund of hedge funds in return for its economic performance5. In effect, $70 represents the discounted market value of an investment in a residual type debt instrument (no coupon rate) that matures at par value. The remaining $30 is invested in a fund of hedge funds, the growth of which determines the investor’s return or lack of it.

There is no guarantee that the investor will earn any positive returns on the original investment. There is

only the guarantee that he or she will recover 100% of the original investment, but only if the notes are 5 An alternative to the swap is to buy a call option that is based on the returns of the underlying hedge. Here the swap amount of $30 is replaced by the premium paid on the call option. Both vehicles achieve the same objective: to participate in the upside return of the hedge fund based on its performance over the duration of the note.


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held to maturity. If the customer redeems prior to maturity, he/she can realize real capital losses on the

investment.

Graphic illustration of theoretical growth of PPNs to maturity

While PPNs may fit within the current definition of exempt securities, they include significant risks to

investors that directly contradict the apparent rationale for making them exempt in the first place – that

such products are simple and low-risk because of the financial stability of the issuer or guarantor. The

risk that investments locked in for as long as 10 years will earn a zero return is no small risk to a retail

investor, and is difficult to quantify given the characteristics of hedge funds discussed in this paper.

The OSC has recognized in the 1999 Task Force Report on Debt-Like Derivatives that similar products

should not be treated the same as traditional exempt products. The CSA should re-open the issue with a

view to seeing how hedge-fund related products can be analogized to those dealt within the Task Force

Report and to taking action to revise and implement its recommendations as appropriate for PPNs.

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8. BENEFITS AND RISKS OF HEDGE FUNDS

The following is a list of benefits and risks associated with hedge funds or pooled funds:

Benefits 1. Low correlation to traditional asset classes.

2. Risk minimization – Many hedge funds attempt to minimize risk.

3. Absolute returns – Hedge fund managers seek to achieve positive or absolute returns in any market,

not returns that beat a market index, which is the goal of many mutual funds.

4. Potentially lower volatility and higher returns.

Risks 1. Limited regulatory oversight due to exempt nature of their distribution.

2. Manager and market risk – The performance of a hedge fund is almost entirely dependent on the

manager, unlike that of mutual funds whose performance reflects general performance of the market.

3. Complex investment strategies – Hedge fund managers may deviate from established strategies into

directional strategies carrying more risk.

4. Liquidity constraints – Most hedge funds have lockup provisions, i.e., periods during which the initial

investment can not be redeemed.

5. Incentive fees – In addition to management and admin fees, hedge fund managers charge an incentive

fee based on performance.

6. Tax implications – Implications vary depending on the structure of the fund.

7. Use of short selling and leverage strategies. 8. Business risk relating to the capitalization of the company and whether the manager has any

experience running a business. 9. Lack of transparency and no mandated disclosure on financial or other operations.


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9. REVIEW OF HEDGE FUND REGULATIONS

Canadian investors can access hedge funds through a number of avenues including managed accounts,

pooled funds and derivatives. The appropriate product structure depends on numerous factors including

tax considerations and the prospective investors to whom the product can be marketed. Differences are

many and this section includes a comparison between hedge funds and publicly issued mutual funds. (A

summary of differences can be found in Appendix D.)

There are in fact few similarities between publicly issued mutual fund and private hedge funds. They

include the fact that both are pooled investments that may have front-end or back-end sales commissions;

both charge management fees and both can be bought and sold through investment dealers.

The following are the salient features of hedge fund regulations in Canada:

Product Offerings for High-net-worth and Institutional Investors (Exempt Market)

Hedge fund offerings restricted to the exempt market are often structured as managed accounts or pooled

funds. A managed account allows a hedge fund manager to invest, on a discretionary basis, on behalf of

the investor according to the terms of an investment management agreement between the parties. One of

the drawbacks of a managed account is that it requires a large investment in order to implement the

chosen trading strategies agreed upon by the parties.

An alternative is to invest with other investors on a pooled basis in a fund established by the hedge fund

manager. Such pooled funds are usually structured as limited partnerships or trusts.

Product Offerings for the General Investing Public (Retail Market)

Regulatory restrictions include the need for a prospectus, and prohibitions or restrictions on certain

investment strategies. If a hedge fund permits redemption of its securities at the net asset value, it may be

a mutual fund under securities law.

Retail mutual funds are subject to rules that prohibit the use of leverage or short selling by the fund

manager6.

In order to avoid the mutual fund investment restrictions, a hedge fund may be structured as a closed-end

fund offered to retail investors by prospectus. In order to provide liquidity to investors, closed-end funds

6 Except for commodity pools, which are considered a special type of mutual fund that can use leverage and engage in short selling using derivatives. Unlike conventional mutual funds, commodity pools must be sold pursuant to a long-form prospectus and there are additional requirements for mutual fund salespersons.


16

are often listed on the Toronto Stock Exchange (TSX). The listing also allows retail investors to gain

access to the fund through the secondary market.

However, as described above, the most popular retail product using hedge funds is PPNs.

Registration of Hedge Fund Managers

Anyone trading in or engaged in advising on securities is subject to the registration requirements of

securities law. For a hedge fund, this means that the portfolio manager must be appropriately registered

as an adviser or be able to rely on an exemption from adviser registration. Registered advisers are subject

to numerous regulations related to proficiency, record keeping and capital. Portfolio managers not

resident in a jurisdiction may have limited registration exemptions available to them. However, in some

cases, it may be necessary for the fund to have an adviser registered in the local jurisdiction.

Trading in securities can include marketing activities, not just buying or selling securities of the fund. As

a result, it may be necessary for the fund manager to obtain dealer registration even if it is not in direct

contact with potential investors.

Exemptions from registration are generally available when a prospectus exemption exists (i.e., in the

circumstances described below). However, in Ontario and Newfoundland and Labrador, if an entity (for

our purposes, the hedge fund manager) is in the business of trading securities as principal or agent, even

exempt securities, it is acting as a "market intermediary" and must be registered as a dealer. Those

dealing solely in exempt securities generally obtain registration as a Limited Market Dealer.

It is important to note that an entity incorporated as a hedge fund manager and solely responsible for the

administration and financial affairs of a hedge fund, but which does not market or distribute fund shares

or other instruments to investors, does not require registration.

Disclosure

Hedge funds in Canada are sold primarily in the exempt market, that is, without a prospectus. There are

three commonly used prospectus exemptions, as follows:

• Minimum Investment Exemption – Sales to investors who make a prescribed minimum

investment. The prescribed minimum is not the same in all provinces and territories, ranging from

$97,000 to $150,000, and there are specific restrictions in each jurisdiction. (See Appendix E for

a summary of Canadian provincial securities commission rules relating to minimum investment

and accredited investor exemptions.)


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• “Accredited Investor” Exemption – Sales to sophisticated investors, although sophistication is

usually defined by available means. Entities such pension funds, trust companies and

corporations with net assets of at least $5 million usually fall within the definition. Individuals

may be accredited investors if they own (alone or together with a spouse) financial assets

exceeding $1,000,000, or if they have net income before taxes exceeding $200,000 (or $300,000

if combined with that of a spouse) in each of the two most recent years and have a reasonable

expectation of exceeding the same net income level in the current year. Once again, the rules are

not consistent between jurisdictions. A “fully managed account” (managed by a registered

portfolio manager for an investor) is an accredited investor in all provinces and territories,

although in Ontario the exemption is not applicable to a purchase of an “investment fund.” A

fully managed account can invest in any type of security (except an investment fund in Ontario)

in any amount.

• Offering Memorandum Exemption – All jurisdictions, except Ontario and Yukon, provide an

exemption from the prospectus requirement if the issuer delivers an offering memorandum to

investors in the prescribed form and within the prescribed time. If this exemption is relied upon,

there is no minimum amount or any qualifications for investors purchasing. An offering

memorandum may also be the primary disclosure document provided to investors in conjunction

with either the minimum investment exemption or the accredited investor exemption. An offering

memorandum provides investors with a right of action for rescission or damages against the

issuer if it contains a misrepresentation. It is possible that securities regulators may deem any

kind of offering materials provided to prospective investors as an “offering memorandum” if they

fall within the definition in the applicable securities legislation.

Reporting

Once a hedge fund completes the sale of securities pursuant to a prospectus exemption, a report of trades

must be completed and filed with the appropriate regulators. A report of trades sets out the name and

address of the issuer (or seller), the name(s) of the investor(s), a description of the securities, the date and

the particulars of the trade(s), such as the number of securities sold and the purchase price.

Financial Statements

Although hedge funds that are not sold pursuant to a prospectus are not reporting issuers under securities

law, they may still have financial statement reporting obligations if they fall within the definition of

“mutual fund” in certain securities legislation (notably Ontario). Some jurisdictions require that mutual

funds established under local law file interim and annual financial statements, even if they do not


18

distribute securities pursuant to a prospectus. Unless an exemption exists, statements must be filed in

electronic format on the System for Electronic Document Analysis and Retrieval (SEDAR). Once filed on

SEDAR, the financial statements are available to the public on the internet. Many hedge funds and

pooled funds have obtained exemptions from filing financial statements on the condition they continue to

prepare these statements and send them to their investors. The requirement to prepare financial

statements does not apply to hedge funds that are not structured as mutual funds, for example, most PPNs

do not fall within the definition.

On March 11, 2005, the CSA released National Instrument 81-106 – Investment Fund Continuous

Disclosure (NI81-106) in final form. NI 81-106 and its related companion policy and forms must first go

through the rule approval processes of each CSA jurisdiction and are expected to come into force on June

1, 2005. Investment funds with financial years ending on June 30 will be the first that must comply with

the new requirements. (See Appendix F).

NI 81-106 will affect reporting issuers that are mutual funds, exchange-traded funds, commodity pools,

scholarship plans, labour-sponsored investment funds, split-share corporations, certain deferred sales

financing and flow-through share limited partnerships, and closed-end funds. Privately-offered mutual

funds (pooled funds) will be required to follow new rules except in Alberta, BC, Manitoba and

Newfoundland). Reporting requirements set out in NI 81-106 do not apply to privately-offered non-

redeemable investment funds, those not redeemable on demand because of an initial lock up period,

typically six months to one year.


19

10. REGULATORY ISSUES

Conflicts of Interest

Hedge fund managers can play multiple roles not normally permitted to mutual fund managers. The

following is a typical structure of hedge fund service providers, together with their roles and relationships.

The significant difference from public mutual funds is that hedge funds are not required to have an

authorized bank or trust company act as custodian for fund assets. In many cases the hedge fund manager

also acts either directly or indirectly through an affiliate as trustee and may hold the underlying fund

assets as custodian. This raises internal control and governance issues because of the inherent conflicts

between the roles and the lack of safeguards the separation is intended to achieve.

Legend: GP: General Partner MFD: Mutual Fund Dealer IC/PM: Investment Counselor/Portfolio Manager LMD: Limited Market Dealer

Executing Broker

Trustee / GP

FundSERV

Electronic Process Clearing and Settlement of trust and LP units

Market Intermediaries

Investment Dealer LMD ICPM/LMD (dual registration) MFD/LMD (dual registration)

Clients

Accredited Investors/ Minimum Exempt Purchase ($97K - $150K)

Securities Registrant)


Investors

Security Exempt from Prospectus IDA Member (multiple roles)


Non-Regulated EDP Utility

Same or Related Company

Fund Manager (Admin) Trustee or GP

Fund Advisor ICPM and LMD

Non-Securities Registrant)


Custodian

Hedge Fund (Trust or

Limited Partnership)


20

Role of a Fund Manager

It is relevant to note that many hedge fund managers are not, in fact, securities registrants. To the extent

that this business function is done in a separate company related to the fund advisor the conflict of interest

risk increases as there may be no direct regulatory oversight over the functions performed by the fund

manager. For example, unless proper internal controls and governance are in place in the management of

the fund, there is a bias to overvalue securities held in the fund and thereby overstate the fund’s NAV –

which is the basis on which compensation is determined for both the related fund advisor and manager.

To fully understand the extent of the activities and role that a fund manager (sometimes referred to as a

fund administrator) plays, the following are many of its primary functions:

• calculating the NAV and the NAV per share or unit (See below under Transparency of Risks,

Values and Returns);

• keeping the accounts and financial records;

• preparing the annual audit file and liaising with the auditor;

• liaising with the fund advisor, the custodian, the brokers and other service providers;

• liaising with prospective investors and sending out the offering documentation;

• calculating, confirming and arranging payment of all subscriptions, redemptions, fees and

expenses, and arranging for the payment of all dividends or other distributions, if required;

• maintaining the statutory books and records;

• acting as registrar and transfer agent, handling the registration of shares and liaising with

shareholders with regard to subscriptions, redemptions and transfers;

• carrying out anti-money laundering due diligence with regard to investors;

• acting as company secretary, responsible, amongst other things, for arranging board meetings,

calling the annual general meeting and preparing board minutes;

• maintaining a copy of the share register at its office and, if the administrator is not resident in the

domicile of the fund, ensuring that the original share register is held in the registered office in that

jurisdiction; and

• ensuring that the fund complies with the terms of its offering memorandum.

Based on the inherent conflicts of interest arising from the multiple roles associated with hedge fund

activities through entities under common ownership and management, regulatory jurisdiction and

oversight of non-registered fund managers is an issue that needs to be addressed in Canada. The issue has

been highlighted in the recent Portus Alternative Asset Management Corp. (PAAM). An OSC


21

Temporary Order dated March 15, 2005 made reference to PAAM as the registered fund advisor and

Portus Asset Management Inc. (PAM) as the unregistered fund manager. The court appointed receiver,

KPMG, in court filings described the affairs of PAM and PAAM to be so “intertwined that the court

should deal with them on a consolidated basis.7”

Because of the inherent conflict of interest arising from multiple roles associated with hedge fund

activities through entities under common ownership and management, regulatory jurisdiction and

oversight of non-registered fund managers is an issue that needs to be addressed in Canada as it recently

was by the SEC in the United States.

Prime Brokerage

A major conflict is inherent in the relationship between hedge funds and the prime brokers that cater to

them. Prime brokers provide trade execution, settlement, custody, loan facilities, performance

measurement, research, and even client referrals. Catering to hedge funds has become big business.

According to one estimate, hedge funds provide $10 billion annually, or more than 7% of Wall Street’s

reported revenue, through trading commissions alone. The Economist pegs the revenue at $15 billion, and

profits at $6 billion. In addition, fees for loans, back office clearing, and even “matchmaking” (client

referral) run into the billions of dollars.

The potential for conflict of interest is clearly illustrated in a recent NASD arbitration award to investors

in a hedge fund marketed by CIBC World Markets in the US. In this case, the aggrieved investors argued

that CIBC did little or no due diligence on the fund, sold to clients, that was part of a hedge fund group

known as Red Coat. CIBC marketed Red Coat to its clients, and shared in the management and

performance fees (¼ of both). Red Coat also steered stock-trading commission to CIBC, creating a “quid-

pro-quo” relationship that called into question the objectivity of the brokerage firm in dealings with its

clients8.

Soliciting portfolio transaction business in return for mutual fund sales is specifically prohibited in

Canada under section 6.1 of NI 81-105. While this prohibition applies only in respect of mutual funds,

dealers should be aware that by analogy, the IDA would consider this improper behavior with regard to

hedge funds.

7 Court File 05-CL-5792 – Third Report of the Receiver, page 4(h) 8 “CIBC Learns Costly Lesson in Hedge Funds”, Globe and Mail, February 22, 2005


22

Prime brokerage also raises concerns about potential abuse of soft dollar practices within the hedge fund

world. According to The Economist, hedge funds pay (on average) four to five times more for execution

than mutual or pension funds.

The fees to be earned from prime brokerage have also been cited as a motivator for dealer facilitation of

market timing in mutual funds by hedge fund clients9.

Fee Structures

Related to the conflicts of interest issue is the fee structure of hedge funds. A recent article in The

Economist, “The New Money Men,” described hedge fund fees as follows:

A hedge fund is “a compensation scheme masquerading as an asset class”. Whereas the average mutual fund charges 1% or 2% of assets, and smart buyers can pay a fraction of that, hedge funds charge 1% or 2% plus a big slug of profits, typically 20%, but often more. One well-known, but secretive, fund based on Long Island is reputed to charge 5% of assets plus 44% of profits. Another leading fund charges no maintenance fee but 50% of profits. An industry consultant says he has seen a new fund that will receive 80% of any excess above a guaranteed return linked to a well-known index. Even these huge costs do not really reflect what investors pay, since most hedge funds agree to conduct business through a prime broker, which extracts fees through stock– and bond-lending charges, as well as trading costs based on the fund's net asset value10.

PPNs also have complex fee structures. In addition to the fees levied by the fund-of-funds most often

used as underlying investments, these products require complex structuring in order to guarantee the

return of the investor’s principal. The fees may include:

• performance fees (which may range between 18 and 20%);

• management fees based on assets under management (usually 2%);

• commission to salespersons (commonly set at 4%);

• swap agreement fees;

• advisory fees;

• servicing fees to custodians; and

• commissions to prime brokers for trade execution.

The only fees normally disclosed in the offering memorandum for PPNs are the performance fee,

management fee and commission. All other fees and expenses are imbedded in the program and are not

disclosed to the investor. As noted above, some of these fees may be paid to affiliated companies of the

9 McCallum, James B., “Market Timing: A tale of systemic abuse and executive malfeasance,” Journal of Financial Regulation and Compliance, Vol. 12, No. 2, pp 172-173. 10 “The New Money Men,” The Economist, February 17, 2005, page 63.


23

hedge fund manager. The IDA has already received applications from affiliates of hedge fund managers

seeking to establish IDA Members whose primary function will be to execute trades on behalf of the

hedge funds and retain part or all of the commission revenue that was otherwise paid to third party

dealers. This would represent an added revenue source for the group of companies controlled directly or

indirectly by the fund manager.

Furthermore, with a fund-of-funds there may be two or more levels of fees – those of the fund-of-funds

and those of the funds in which it invests.

As noted above, only about a third of the original investment is actually invested in the underlying hedge

fund or fund-of-funds to generate absolute returns; the larger component is invested in low risk assets to

secure the guarantee upon maturity. All the expenses and fees that the fund manager must cover (some of

which are transparent and others not) in order to generate a reasonable return on the whole investment

result in the majority of PPNs being invested in hedge funds with aggressive or opportunistic strategies.

The hedge fund industry argues that its fee structure is a superior model for the investor, the largest part

being performance based. It can be argued, to the contrary, that this structure constitutes an additional

risk factor because the risk is asymmetrical: the manager shares in the winnings but not the losses. The

asymmetry gives the manager an incentive to take undue risks, including extensive use of leverage,

particularly where the manager is still guaranteed some compensation through other fees whatever the

performance.

Most hedge funds use a system known as a “high water mark” in calculating the incentive fee payable

each year. For example, if the fund loses 20% in a given year it must recoup that amount before the

manager receives an incentive fee. In some funds this high-water mark resets each year; in others it is

perpetual. There have been a few high profile cases in which funds experienced heavy losses and, due to

the existence of a perpetual high water mark, the manager simply closed the fund and distributed the

remaining capital to investors. The manager had no more interest in even trying to recoup investor losses

because of the unlikelihood of ever earning performance fees.

(A summary of performance fee and lock-up features of Canadian mutual funds can be found in

Appendix G).

Transparency of Risks, Values and Returns

Many hedge fund managers view their investment strategies as proprietary and are reluctant to disclose

their positions for competitive reasons. While this is certainly understandable, it raises concerns about the


24

ability of investors to assess investment risks and of dealers to conduct the necessary due diligence to

ensure the suitability of a particular hedge fund investment.

The high levels and lack of transparency of fees have not prevented hedge fund offerings from finding

investors, suggesting a relative lack of sophistication of many investors, accredited or not. It is, therefore,

unlikely that such investors are any more deterred by the lack of transparency of intended investment

strategies, risks and actual investments held.

Another transparency issue, also involving potential conflict of interest is the discretion that hedge fund

managers have in valuing their holdings. A recent Economist article dealt with the issue as follows11:

The largest area of transgression, and one that is almost certain to arise more in the future, is the incorrect valuation of securities held in funds. All securities are, to some degree, hard to price. The less liquid they are, the harder this becomes and hedge funds specialize in illiquid securities. Even if a hedge fund wants to value its portfolio correctly, it could make mistakes. If it had other motives - and because compensation is a multiple of returns this cannot be ruled out—disaster could follow…

Last December, William Donaldson, chair of the SEC, pushed through new regulations for hedge funds. Funds will have to register, meaning they will have to acknowledge their existence and submit to inspection by the SEC of their books and records. It would be no surprise if a series of announcements were to follow about hedge funds re-pricing their assets downwards and also, perhaps, reviewing how much they charge for compensation (the details of performance bonuses are complex and there is an assumption that they are mostly resolved in favour of managers).

Calculation of returns is also an issue, as it includes the basis on which a manager might earn its

performance fee. In a 2004 study12, Burton G. Malkiel of Princeton University examined the claim of

managers of funds-of-funds that they can form portfolios of the best hedge funds and that such funds-of-

funds provide useful investments for individual investors. He concluded that “hedge funds are far riskier

and provide much lower returns than is commonly supposed.” He also noted with regarding to pricing

and reporting:

In this study, we have shown that reported hedge fund results are substantially upward biased. The practice of voluntary reporting (and backfilling only favorable past results) causes some reported hedge fund indexes to be substantially upward biased. Moreover, the substantial attrition that characterizes the hedge fund industry results in substantial survivorship bias in the returns of indexes composed of any currently existing funds. Correcting for such bias we find that hedge funds have lower returns and are riskier than is commonly supposed. Moreover, the reported low correlations of hedge fund returns

11 “The New Money Men,” The Economist, February 17, 2005, page 65. 12 Burton G. Malkiel and Atana Saha: “Hedge Funds: Risk and Return”, Working papers, Princeton University and Analysis Group, December 1, 2004, pp 25-26.


25

with standard equity indexes is at least in part an artifact of hedge fund pricing that may sometimes rely on stale or managed prices. Even after correcting for such bias, however, hedge funds do appear to offer investors an asset class that is less than perfectly correlated with standard equity indexes.

With regard to risk, he noted:

[H]edge funds have been shown to be extremely risky in another dimension. The cross-sectional variation and the range of individual hedge fund returns are far greater than is the case for traditional asset classes. Investors in hedge funds take on a substantial risk of selecting a very poorly performing fund or worse, a failing one. The industry is characterized by substantial number of failures. Moreover, while selection of risk can be somewhat mitigated by investing in diversified “funds-of funds”, we have shown that these diversified funds perform much less well than the industry as a whole.

Finally, he noted the effects that the rapid growth of hedge funds may have:

Finally, we must wonder whether the substantial flow of funds into the hedge fund industry will tend to reduce returns significantly in the future. When only a limited amount of capital is pursuing arbitrage opportunities between about to merge corporations or between different securities of an individual company, even believers in reasonably efficient markets imagine that limited profit opportunities may exist. But as enormous streams of investment funds enter the field, it is reasonable to assume that such opportunities will be attenuated. Thus, the very success of the hedge fund industry in attracting funds is likely to make hedge fund investing a less profitable investment strategy in the future.

Distribution

The Investor Economics Hedge Fund Report notes that of 72 selected sponsors, 33 use proprietary

networks, 24 use intermediaries, and 15 use both. Money managers dominate the list of those doing

direct distribution. Most offer stand-alone funds and deal primarily with their high-net-worth clientele. It

also noted that one group is generally reluctant to enlist the aid of intermediary advisors because they are

now content with their level of asset growth and do not wish to have referral fees eroding their revenue.

Deposit-taking institutions also figure prominently in direct distribution as their branch networks, private

client units and brokerage firms offer a natural outlet for their proprietary creations. This is how

principal-protected notes issued by banks achieved great success in distribution.

Mutual fund companies figure prominently among sponsors using intermediary distribution, building on

the longstanding relationships they have established with dealers and advisors. Independent sponsors

such as Arrow, BluMont and Tricycle lack their own distribution networks and thus use intermediaries.

The sponsors using both channels are hedge fund managers who have typically developed mass-market

PPNs for broad distribution, and who have the infrastructure required to support intermediary advisors.


26

Accredited Investor Rules

Each province sets the minimum exempt purchase amount in its securities legislation or regulations, as

well as the definition of "accredited investors" for whom no minimum purchase amount is required. (See

full details in Appendix E.)

One specific aspect of these rules that deserves closer regulatory scrutiny relates to a hedge fund manager

that is a registered Investment Counsel/Portfolio Manager (IC/PM) and enters into discretionary money

management agreements with its clients. In all provinces except Ontario, the IC/PM can rely on the

“fully managed account” category of accredited investor and invest in any security in any amount for

those fully managed accounts. In Ontario, this exemption is not available if the fully managed account is

purchasing an “investment fund” in which case the minimum purchase amount of $150,000 or the client

being an accredited investor in his/her/its own right applies.

To illustrate the complexities and inconsistency amongst provinces of the accredited investor rules and

minimum purchase amounts in the exempt market, one need only examine the recent Portus case. Here,

clients referred to Portus Alternative Asset Management Corp (Portus) – an IC/PM – were required to

open fully managed accounts, and the IC/PM then used these accounts to purchase Portus’ hedge fund

products (exempt from prospectus) for amounts less than the prescribed minimum (e.g., $150,000 in

Ontario). It is not clear how or whether Portus relied on the “fully managed account” category of

accredited investor in Ontario, as the Portus product issued as trust units qualified as an investment fund.

It is not known whether Portus relied on the exemption for registration under OSA section 35(2) granted

to PPNs as the Portus product was issued by a non-financial institution as trust units.

Outside of Ontario, Portus may have been entitled to rely on the fully managed account category of

accredited investors and permit purchases by customers (that did not otherwise qualify as accredited

investors) for amounts less than the prescribed minimum for exempt purchases in the respective

provinces. This case clearly demonstrates the inconsistency as to how the exempt market rules are applied

amongst provinces in Canada and the need to harmonize them and, in so doing, consider the attendant

risks where the IC/PM is affiliated with the product manufacturer or distributor.

In this respect, on December 17, 2004, the CSA published for comment proposed National Instrument 45-

106 Prospectus and Registration Exemptions, together with related forms and a companion policy

(National Exemption Rule). The National Exemption Rule, in large part, continues the existing exempt

distribution regime, which was modified in various ways throughout Canada several years ago. In general

terms, it will allow exempt trades to occur without a prospectus or the involvement of a registered dealer.


27

The most commonly used exemptions will continue to be available, but now in a significantly more

uniform manner.

For example, the accredited investor exemption will continue, but the categories of accredited investor

will be largely uniform across Canada, including the minimum purchase exemption for distributions of

any type of security. In Ontario, this means that investment funds such as hedge funds or pooled funds

will no longer be subject to the minimum purchase amount of $150,000 if purchased by an accredited

investor.

In light of the recent issues involving Portus, the CSA needs to carefully reconsider this National

Instrument Rule amendment, and the use of the fully managed account category of accredited investor in

allowing IC/PM affiliates of hedge funds to effect purchases with no minimum amounts to investors who

do not otherwise qualify as accredited investors themselves.

Another issue in the distribution of hedge funds highlighted in the Portus case, is the referral of clients by

registered investment or mutual fund dealers. Portus may claim that it was not obligated to ensure the

suitability of hedge fund investments for the referred clients because the referring dealers, probably

holding other assets for the clients and having a broader picture of their needs, would only send those

clients for whom such investments are suitable. The dealers likewise may claim that they were acting

solely as referring dealers and were not involved in the specific trades, and as Portus’ IC/PM arm is

registered, it was required to ensure the suitability of any hedge fund investments by the clients.

Ordinarily, a referral results in the dealer or IC/PM to whom the referral is made taking the client and

conducting its own suitability assessment in order to manage the client’s investments. However, it is

arguable that when the referring dealer is compensated for sending a client for the sole purpose of buying

a specific product the IC/PM and its affiliated hedge fund manager have to offer, that dealer has an

obligation to ensure the suitability of the product. Otherwise, the client can easily conclude that both

parties are ensuring suitability when neither may be.

Incentive Fees

In a 2002 article, “Beware of Hedgehogs,” Canadian Business magazine observed that hedge funds in

Canada are offering to share their incentive fees with advisors who steer clients into their funds, creating

at the very least the appearance that independence and objectivity have been compromised. Furthermore,

hedge funds offered variable compensation – a practice that mutual fund regulations have stopped. These

practices only heighten the conflict of interest concerns.


28

Off-Book Transactions

Mutual fund trades conducted “off-book” continues to be problem with some IDA Member firms, but has

not been found to be a systemic problem as it was with the whole securities industry in the mid-1990s.

However, “referrals” to hedge fund manager/IC/PM groups to purchase specific products share all the

characteristics of off-book transactions, and consideration should be given to applying the same record-

keeping rules to them.

Lack of Regulatory Oversight

The hedge fund industry makes the claim that “unshackling” the manager from regulatory oversight is

advantageous to the investor. The opposing view is that the broad license afforded the hedge fund

manager is a significant risk factor.

The regulatory issue, particularly with respect to PPNs, is whether these types of investments, with locked

in maturity periods of as long as 5 to 11 years, little or no certainty of positive returns, minimal disclosure

and minimal assessment of suitability, should continue to be sold to small retail investors on an exempt

basis, without even the asset and income backing of an accredited investor.

Lack of oversight also results in the inability to detect fraud and other misconduct at early stages, and the

opaque nature of the industry could certainly attract fraudsters and other market malefactors.

IDA margin rules for hedge fund products

• Hedge funds

As with mutual funds, pursuant to IDA Regulation 100.2(f)(ii), only hedge funds that are sold by

prospectus are margin eligible. There are very few hedge funds that are sold by prospectus. Those

hedge funds that are sold by prospectus with a per unit price in excess of $2.00 attract a 50% margin

rate and therefore qualify for 50% loan value.

• Principal-protected notes

There are no specific IDA margin requirements for PPNs.

Exchange traded PPNs automatically qualify for a 50% margin rate by virtue of being listed. Margin

rate rulings have also been issued for both listed and unlisted PPNs. The rulings have permitted PPNs

issued by qualifying corporate financial institution issuers to be margined as corporate residual debt

instruments, whereby regulatory value is given to the residual debt portion of the note and no value is


29

given to the return portion of the note. As a result, the margin rate for a typical five-year corporate

PPN ranges from 40 to 45%13 which equates to a 55% to 60% loan value rate.

To date, there have been no rulings issued for non-exchange traded PPNs whose performance is

linked to hedge fund performance.

• Hedge fund credit risk requirements

Hedge funds (either trusts or limited partnerships) having at least $100 million in assets under

management that can be verified by annual audited financial statements, may be treated as an

acceptable counterparties for purposes of security lending and borrowing activities and settling trades.

As a result, the credit risk associated with hedge funds that qualify as acceptable counterparties is

determined on a market value deficiency basis (comparing market value of collateral held to market

value of amounts receivable from the hedge fund). All other hedge funds are treated in the same

manner as retail clients for credit risk purposes.

13 The value of the residual debt position of a $100 investment in a five-year PPN is currently approximately $70. The margin required on the residual debt position is 10.50% (1.5 x 7.00% for 3 to 7 year maturities) or $7.35. The results in regulatory loan value percentage of 62.65% [($70 – $7.35)/$100] or conversely and margin of 37.35%. Most Member firms use house rates between 40 to 45% to avoid detailed margin calculations on a daily basis.


30

11. LIMITED MARKET DEALER REGISTRATION

Anyone in Canada engaged in trading in or advising with respect to securities is subject to the registration

requirements of securities law. While in other provinces the exemptions under which hedge funds are

sold are total – that is, they provide an exemption to any registration requirement – in Ontario and

Newfoundland a “market intermediary” (as defined in the regulations) that trades as principal or agent, in

the exempt market is required to register as a Limited Market Dealer (LMD) unless it is registered as a

full dealer. IDA Members are registered as investment dealers and can trade in the exempt market under

their investment dealer registration. Mutual fund dealers can only distribute mutual funds and Registered

Advisors (IC/PMs) are not registered to trade in securities and must therefore obtain a LMD registration

in order to trade securities in the exempt market.

Directors and officers of LMDs must also register with the Ontario Securities Commission (OSC) or

Newfoundland Securities Commission as appropriate, but there is no requirement for the registration of

salespersons and no proficiency requirements for officers, directors or salespersons.

Furthermore, most of the investor protection sections of the Ontario registration requirements that apply

to other dealers do not apply to an LMD. (See specific sections outlined in Appendix H.)

LMDs are considered market participants, which gives the OSC the right to carry out compliance audits

of their operations. Each registrant must provide a copy of a signed letter of direction to the applicant's

auditors authorizing them to act at the request of the OSC to conduct an audit of the applicant's books, the

expenses are by the applicant.

However, despite the registration requirement, there is little or no substantive regulation and active

oversight of LMDs.

IDA Member Affiliates with LMD-only Registration

The primary concern of IDA staff regarding LMD-only affiliates is that they could be used to conduct

exempt business with clients off the books of the Member and outside the regulatory scrutiny of the IDA,

while using the cachet offered by the affiliation to suggest that the business is being done under normal

SRO regulation.

In a recent study conducted by the IDA, it was found that 56 IDA Members have affiliates with LMD

registration in Ontario, 43 of which have another category of registration such as IC/PM or mutual fund

dealer.


31

Of the remaining 13 Member firm affiliates having LMD-only registration, seven are inactive or their

businesses do not in fact require LMD registration and one is resigning from IDA membership. Further

analysis is being done on the business models of the remaining five firms that carry out securities related

business activities through an LMD-only affiliate.

Based on this review, there is not widespread use by Members of affiliates with LMD-only registration

and therefore there are minimal regulatory gap concerns of the type described above.

IDA Members Affiliates with Dual Registration including LMD Registration

As noted above, there are many IDA Member firm affiliates with dual mutual fund dealer and LMD

registration. Since its inception as an SRO, the Mutual Fund Dealers Association (MFDA) has prohibited

its members from conducting any LMD activities involving the dealer’s registered persons through a

separate affiliated entity. As much of the activity of the LMD involves the sale of limited partnership

units, this activity is again subject to the regulatory jurisdiction of an SRO and therefore does not raise the

regulatory gap issues regarding books and records and compliance.

Unlike IDA or MFDA Members, IC/PMs are under the direct regulation of provincial securities

regulatory authorities. To the extent that IC/PMs may also conduct LMD activities, the securities

commissions have direct regulatory jurisdiction over such registrants. To the extent that there are

differences in regulation and active oversight of exempt market related activities between provinces and

between SROs, there is the possibility of regulatory arbitrage.


32

12. DISTRIBUTION OF HEDGE FUNDS

IDA Member Acting as “Manufacturer”

Several Member firms act as manufacturers of private mutual funds or stand-alone hedge funds.

In some of these cases, the IDA has discovered that the firms have multiple roles, such as portfolio

manager, administrative manager, custodian and distributor. From a financial compliance perspective, the

IDA has conflict of interest concerns with respect to some of these structures.

The following illustration shows the relationship(s) of a Member acting as a hedge fund manufacturer:

Trustee/General Partner/Indemnifications

In the course of examinations of Members, the IDA Financial Compliance Department identified some

firms that manage stand-alone hedge funds, acting as a trustee of the fund, as well as advisor and fund

manager (i.e., administrator of records, etc.).

A trust is a legal relationship of one person (trustee) with respect to another person (beneficiary) in

respect to holding of property. A trust is not a separate legal entity but trust relationships are often

identified in particular circumstance, including securities legislation, as though they were separate legal

persons. The trustee of a mutual fund is typically evidenced by declaration of a trust made by the trustee.

IDA Member (multiple roles)

Executing Hedge Fund

(Trust or Limited

Partnership)

Security Exempt from

Prospectus

Clients


Trustee (or General Partner) Fund Manager (Administrator)

If set up as a trust must register as a Trust Company or apply for exemption 213(3)(b) from Ontario T & L Act

Separate Affiliate (Non-securities registrant)


Custodian

Fund Advisor

Investment Dealer


33

A Member firm would sign a trust declaration either declaring itself to be a trustee or accepting the

appointment of another person (a settlor) as trustee for the duties and with powers described under the

declaration of trust. The trustee is empowered to issue securities in the form of trust units to purchasers

(beneficiaries) who have the rights and liabilities associated with the trust units. In this capacity trustees

are often referred to as issuer trustees as opposed to trustees who merely hold property on behalf of others

or who act as indenture trustees for the issuance of debt securities on behalf of third party corporations or

other entities. These kinds of trusts are usually created for commercial purposes – as opposed to personal

trusts arising under a will, for instance – and a mutual fund trust is often referred to as a commercial trust.

Typically, the terms of a trust declaration for a mutual fund trust would provide for the delegation of the

management and administration of the trust affairs to another person. If the trustee has the administrative

resources to perform those duties they may remain with the trustee. The important role of managing the

trust's portfolio assets is usually delegated directly, or by sub-delegation, to advisers who do not hold the

assets but who have the authority to direct their investment.

The trust property administered by a mutual fund trustee usually comprises a portfolio of securities of

which the trustee is the legal owner and the holders of the trust units have an undivided beneficial interest

in the portfolio as represented by the trust units. The property held in the trust is not usually held in the

possession of the trustee itself, a third party institutional custodian is engaged for commercial and

regulatory reasons unless the trustee happens to be a qualified custodian itself. For public mutual funds,

the custodian must be a bank or trust company that is separate from the mutual fund manager. In the case

of a hedge fund, there is no requirement to have a qualified and separate entity act as custodian. In most

cases, the prime broker of the hedge fund, as a service, also acts as custodian for those fund assets which

the fund advisor at its discretion directs the prime broker to hold, for purposes of facilitating trading,

settlement and financing.

As indicated above, because a trust is not a separate legal entity distinct from its trustee, any person acting

as a trustee is liable for all of the obligations of the trust as well as being the legal owner of all of its rights

and assets. Because the Member as the trustee is, in law, the mutual fund itself, the IDA Member’s role is

analogous to that of an issuer of securities rather than the conventional role of a Member carrying out

brokerage and principal trading activities. As a result, a Member acting as trustee of a mutual fund

(including pooled funds) undertakes risks to the Member itself and the Association’s membership credit

ring that are not currently addressed in the IDA regulations. On that basis, it would be difficult for the

IDA to justify permitting its Members to act as fund trustees without appropriate changes to the IDA rules

to mitigate or quantify the risks.


34

It is relevant to note that the role of trustee and fund manager (administrator) are not separable roles under

securities legislation. In order to provide commercial trust services, a Member acting as a mutual fund

trustee would be required to either be registered as a trust corporation14 or obtain an exemption from the

securities commission. This would apply whether or not the mutual fund trust units are distributed to the

public through a prospectus offering or privately.

An IDA Member cannot act as trustee of a mutual fund (including pooled funds) in Ontario unless it is

registered as a trust corporation or is exempt from such registration pursuant to section 213(3)(b) of the

Ontario Loan and Trust Corporation Act. In the latter case, a Member must both: (1) manage a mutual

fund trust and (2) be approved by the OSC to act as the trustee of the mutual fund trust without

registration as a trust corporation.

Pursuant to By-law 6.7, acting as a trustee is considered a non-securities related business activity and

must be done in a separate legal entity distinct from the IDA Member. The IDA has not knowingly

permitted or approved any Member to act as trustee for a mutual fund (including pooled funds). Where it

is discovered that a Member is doing so, the IDA has required that it be separated from the activities of

the Member. As required by securities legislation, any entity set up as a trustee of a fund must not only

obtain securities commission exemption from trust company registration but perform the functions of

fund manager.

In the case of a Member acting as general partner of a limited partner that has issued limited partnership

units, IDA By-law 100.14 states: “No member shall provide directly or indirectly, any guarantee,

indemnity or similar form of financial assistance to any person unless the amount of the guarantee,

indemnity or other assistance is limited to a fixed or determinable amount and margin is provided for by

the Member.”

Where it is discovered that a Member is acting in the capacity of a general partner or providing any third

parties with indemnifications, the IDA has required the Member to remove itself from any

indemnification and/or reorganize its structure so that the general partner is a separate legal entity apart

from the Member.

IDA Member acting as Agent in a Distribution

14Section 213(1) states that no person other than a registered corporation shall conduct or undertake or transact in Ontario the business of a loan or of a trust corporation. This includes act as a trustee in respect of any service it provides to the public unless pursuant to 213(3)(b) a body corporate that manages a mutual fund trust and that is approved by the Ontario Securities Commission to act as the trustee of the mutual fund trust.


35

To enable private investors, through an investment dealer or mutual fund dealer/limited market dealer (to

invest in a hedge fund), the hedge fund manager or administrator may elect to subscribe to the services of

FundSERV15.

FundSERV is the electronic communication network used by dealers and fund companies in Canada to

send and receive fund orders and funds for the settlement of trades. A dealer acting as agent enters an

order on its back office system and through FundSERV and the hedge fund manager or its administrator

receives and processes the order. FundSERV works on a net settlement basis so that both orders and

redemptions are combined, resulting in only one payment to either the hedge fund manager’s trust

account or to a Member’s operating bank account16.

The hedge fund manager is ultimately responsible for accepting investors in the hedge fund. Appropriate

procedures should be in place to ensure that only qualified investors, under the hedge fund manager’s

policies and applicable securities law requirements, are accepted. If the hedge fund manager has

contracted the screening of investors to an administrator, the manager should ensure that appropriate pre-

screening procedures are in place at the administrator and should regularly obtain records of subscriptions

and redemptions for review. This will enable the hedge fund manager to monitor and manage its cash

flow requirements. The hedge fund manager should also maintain an investor listing or database

evidencing its due diligence to ensure that it has satisfied itself that investors qualify as purchasers under

available securities exemptions. These would include documentation establishing an investor’s status as

an “accredited investor,” “eligible investor” or “sophisticated purchaser” as applicable. Where dealers or

other sales intermediaries are involved at the point of sale, the dealer must understand the legal

qualifications that must be met by investors in the relevant jurisdiction. The dealer also must have

appropriately drafted investment applications and risk acknowledgement forms (where necessary) to

document each investor’s qualifications and consent to the investment.

It should be noted that some Members sell hedge funds only from a recommended list, and many restrict

their hedge fund offerings to funds-of-funds and structured notes.

15 Most structured notes are distributed through FundServ due to the large fees demanded by going through a syndicate or investment banker. Syndication route can easily cost up to 7% of the capital raised, whereas the FundServ route is far cheaper. An industry source estimates that 80% of structured notes are distributed via FundServ, with the balance being done through syndication. 16 CIPF is a securities industry protection scheme designed to cover customer losses in the event of an insolvency of an IDA Member firm. As a result, securities regulations do not require investment dealers to maintain separate trust accounts for un-invested customer monies. The MFDA does not currently have a similar insurance protection scheme and its mutual fund dealer members are required to maintain separate trust accounts on behalf of their customers.


36

13. IDA POTENTIAL SUPERVISION ISSUES AND CONCERNS

Recommendation of Hedge Fund Products

Some Members restrict Registered Representatives (RRs) to selling hedge funds from their recommended

list. This ensures that the fund has gone through a due diligence process. Other firms have dedicated

hedge fund analysts to review and recommend hedge funds. Dedicating an analyst to hedge fund

products provides RRs with product support and information.

Given the difficulties of assessing hedge fund products, Members should establish sufficient internal

controls designed to ensure that hedge funds offered for sale to their clients have undergone an

appropriate due diligence process.

Proprietary Hedge Fund Products

Some Members have offered proprietary hedge funds products. Such cases involve the same potential

conflicts of interest as other proprietary products. The sponsoring firm should ensure that it sets high

standards of disclosure and has appropriate internal controls to ensure accurate valuation and reporting.

Furthermore, Members should not close down poorly performing funds solely because of the likelihood

that the firm will not ultimately earn a performance fee. Firms should continue to give appropriate

attention in such cases to earning the best possible result for their clients.

Hedge Funds Operated by RR

In several cases RRs have themselves established or operated hedge or pooled funds. In one such case

they explained that they believed they could tailor funds to the needs of their high-net-worth clients in

ways not available in the market. They own the management company but hire outside IC/PMs to do the

management. The relationships are disclosed to and acknowledged in writing by the clients.

In one case, a senior officer of a Member used an internal portfolio manager to manage the fund. This led

to a high regulatory risk in that the ability of the portfolio manager to exercise independent judgment

appeared to be compromised.

While these kinds of situations are rare, there is nothing to say they are improper if appropriate controls

are put in place. Such controls should include, at the very least, senior management approval and

supervision, appropriate disclosure to the clients and independent investment managers.


37

Promotional Materials

Members may be using material and marketing items prepared by the hedge fund companies themselves.

Such literature may not have adequate disclosure or may not be a fair representation of the risks

associated with holding hedge fund investments.

Members should ensure proper review of any such literature distributed by the Member.

Training

Of particular concern to the IDA is any lack of understanding of products being recommended by

Approved Persons.

As part of proper controls and procedures over hedge fund products, a Member should educate and train

the relevant Approved Persons about the characteristics, risks, and rewards of each product before they

allow them to sell hedge funds to investors.

Since 2004, new Approved Persons have received a good introduction to hedge funds in a chapter of the

Canadian Securities Course, together with appropriate testing. As well, the advanced courses required to

be taken by retail registered representatives within 30 months of initial registration are expected to

include more advanced content and testing on hedge funds by the end of 2005.

For current registrants, any learning gap can be addressed through participation in continuing education

programs. Possible courses may include two continuing education courses under development by the

Canadian Securities Institute, with the advice of participants having a serious interest or business in hedge

funds. A substantial on-line hedge fund proficiency course is also offered.

It is the practice of some Members to require that the above courses be completed prior to selling any

hedge fund products. In other cases, Members have developed internal training courses.


38

14. RECOMMENDATIONS

Recommendations for IDA Actions

1. Re-issue the advisory to all Members reminding them of the prohibition of “off-book”

transactions.

Whether or not a reconsideration of the nature of certain referral arrangements is necessary, there has

been some suggestion that registered representatives have simply referred clients directly to hedge fund

managers for product purchases or sold hedge fund products in exempt trades with the trades being

booked only by the manager. The original notices on off-book transactions, Compliance Interpretation

Bulletins C-93 and C-106, were issued in 1996 and dealt only with off-book mutual fund transactions,

although the principles apply to all off-book transactions. These bulletins should be updated and the

applicability of their provisions to other kinds of instruments such as exempt products should be explicitly

described.

2. Issue industry guidelines as to acceptable practices for referral arrangements.

The IDA attempted to implement a referral arrangements by-law in 2002 but it was rejected by CSA staff

over the issue of commission splits as an acceptable form of compensation for a referral. The IDA

decided not to pursue the matter further. In rejecting commission splits, the CSA staff reversed the

position taken in the CSA Distribution Structures Position Paper, published in August 1999.

At present there are no specific rules on referral arrangements other than in Québec and BC, where the

securities commissions have local rules.

The Sales Compliance FAQ on the IDA website outlines the positions taken in the Distribution Structure

Position Paper and contains guidelines regarding disclosure and documentation that IDA staff believe are

a simple interpretation of existing requirements regarding secret commissions.

The IDA should consider issuing a notice containing these guidelines, although doing so may be seen as

an attempt to implement by other means a rule that the CSA has already rejected. The IDA should also

consider re-submitting its 2002 proposed rule to the CSA and requesting a discussion with the CSA

Chairs regarding the issue, given the unresolved differences of opinion between IDA and CSA staff. If it

does so, the guidance bulletin could be proposed as an interim step pending resolution of the

disagreement regarding the proposed rule.


39

3. Issue an advisory to all Member firms as to their responsibility to conduct due diligence on

recommended products.

As described in this report, the complexities of many hedge fund products make assessment of their

suitability difficult. Where a registered representative on his or her own decides to recommend a hedge

fund product to a client, even in an exempt transaction, the firm has a responsibility to ensure that the

recommendation is suitable. It cannot do so without sufficient knowledge of the product.

The IDA should issue a notice reminding Members of their responsibility in these situations, including

the responsibility to conduct due diligence on any product recommended to a client where its

characteristics, risk profile and merits may not be readily apparent.

4. Review guidelines or standards regarding disclosure, conflicts of interest and internal

controls for IDA Members acting as manufacturer, advisor and distributor of hedge funds or

public mutual funds and determine whether such standards need amendment.

There are already standards in place on a number of these issues, such as related and connected issuer

disclosure under provincial securities regulations and permissions and disclosures under the IDA

managed account provisions in Regulation 1300. Minimum internal control standards that cover the

safeguarding and custody of customer assets and pricing of securities are currently set out in IDA Policy

3. These requirements may be sufficient to deal with the issues regarding hedge fund products, but

should be reviewed in relation to industry published guidance such as “Guide to Sound Practices for

Canadian Hedge Fund Managers” published by The Alternative Investment Management Association

Limited in 2004, relevant sections of which are attached as Appendix 1.

They should also be reviewed in connection with the involvement of registered representatives in the

establishment of private investments funds so that disclosure and other conflict of interest provisions can

be made known to all Members. These could include requirements such as disclosure and client

acknowledgement of the relationships, the hiring of independent and appropriately registered managers,

heightened supervision for suitability and requirements or restrictions regarding the direction of portfolio

transactions through the registered representatives involved.

5. Restrict IDA Members from conducting securities-related activities in an affiliate with a

limited market dealer registration when such activities could be conducted by the Member.

This recommendation relates primarily to distribution of exempt products through LMDs. Enabling a

firm and its Approved Persons to place securities business through a much less regulated LMD allows


40

them to evade the direct investor protection provisions of IDA regulations while in effect trading on the

standing given by their IDA Membership. It would not necessarily be apparent to clients that they were

not receiving the benefit of the higher regulatory standards to which IDA Members are subject and

disclosure is not always effective in rectifying such a misunderstanding.

Provincial Securities Regulation

Hedge fund products, including related products directed at the retail market such as PPNs are exempt

from most regulatory requirements (such as securities registration and distribution by securities

registrants). As securities, they fall within the ambit of IDA regulations as to suitability, but not all

Members have that obligation in all situations. Furthermore, even in pursuing due diligence on hedge

fund products, dealers will have to contend with the risks resulting from conflicts of interest, complex

fees structures, lack of disclosure requirements, lack of controls on pricing and valuation and all the other

problems introduced by the lack of direct regulation of highly complex products.

The IDA believes that there should be a review of provincial laws, regulations and approaches and, if the

regulatory tools are not already available, development of amendments that will bring hedge fund

products being offered to the retail investor fully within the regulatory system. That review could

include such matters as the exempt product status given to PPNs issued by banks and similar products to

ensure a standard of fair dealing; distribution of hedge fund and other exempt products, particularly to

non-accredited or retail investors; definition of referral arrangements to determine whether some are acts

in furtherance of a trade; conflicts of interest of hedge fund managers that act directly or through

affiliates as a manufacturer, advisor, custodian and distributor of hedge funds and hedge fund products

with a view to implementing requirements to control such conflicts; and registration of hedge funds and

their managers and oversight of their activities.

APPENDIX A

41

COMMON Framework to Classify Hedge Fund Strategies

Low Market Exposure High

Source: AIMA Canada Hedge Fund Primer

Non-directional

1. Relative Value

Convertible Arbitrage

Equity Market-neutral

Fixed-income Arbitrage

3. Opportunistic

Equity Hedge (Long/Short)

Global Macro

Managed Futures

Emerging Markets

2. Event Driven

Merger (Risk) Arbitrage

Distressed / High-yield Securities

Directional

APPENDIX B

42

Definition of Hedge Fund Strategies

Convertible arbitrage Simultaneous purchase of convertible securities – such as convertible bonds – and short sale of a percentage of equivalent underlying shares in order to capitalize on a perceived discrepancy in prices

Distressed/High Yield securities

Investment in debt or equity of companies experiencing financial or operational difficulties, typically in bankruptcy. Attempt to take advantage of the fact that these securities sell at deep discounts.

Dedicated short bias The fund has a short net position (i.e., the fund has more short positions outstanding than it does long positions).

Equity Hedge (long/short)

Expect capital appreciation achieved via a long equity portfolio, while maintaining minimal exposure to general equity market risk via generally smaller short equity portfolio. Most long/short equity portfolios have a long bias.

Emerging markets Equity and fixed-income investing focusing on emerging markets around the world. Similar to emerging market mutual fund except it can use derivatives, short selling, etc.

Equity market -neutral Generate returns that do not depend on the direction of the stock market. Usually involves being simultaneously long and short equity portfolios of the same size.

Fixed-income arbitrage Profit from price discrepancies between related interest-rate instruments. High leverage of 10 to 100 times the capital employed is used. (Long-Term Capital Management lost billions of dollars using this strategy).

Global Macro

Rather than make investments on events that affect only specific companies, these funds make bets on major events affecting entire economies. They attempt to profit from changes brought about by shifts in government policy that alter interest rates, thereby affecting currency, stock, and bond markets.

Managed futures

Invests in listed financial and commodity futures markets and currency markets around the world. The managers are usually called Commodity Trading Advisors (CTAs). Use technical and statistical analysis of price and volume information to determine investment decisions. Trading decisions are therefore largely mechanical.

Merger or risk arbitrage

Usually involves taking a long position in the company being acquired (the target) and short position in the acquiring company.

APPENDIX C

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Hedge Funds by Fund Size

Total ($ Billion)

Share 1 Year % Growth

All hedge Funds 14.1 100.0% 39.9 Assets < $25 million 0.9 6.7 65.6 Assets $25 to $100 million 3.5 24.5 49.3 Assets > $100 million 9.6 68.4 34.1

Average asset size 73.0 million Median asset size 23.3 million

Stand-alone hedge funds 4.0 100.0% 61.2

Assets < $25 million 0.4 11.0 12.1 Assets $25 to $100 million 1.4 34.7 39.5 Assets > $100 million 2.1 52.0 90.1


Pure funds of hedge funds 2.4 100.0% 39.8

Assets < $25 million 0.2 8.5 52.7 Assets $25 to $100 million 0.9 37.1 26.0 Assets > $100 million 1.3 56.2 53.7


Principal-Protected products 7.7 100.0% 31.0

Assets < $25 million 0.3 3.9 -- Assets $25 to $100 million 1.2 15.4 91.1 Assets > $100 million 6.2 80.6 19.0

Average asset size 68.3 Median asset size 33.9

Source: Investor Economics – Hedge Fund Report, Volume 2, Winter 2005

APPENDIX C (cont’d)

44

Number of Hedge Funds by Fund Asset Size

Number of Funds

Share 1 Year % Growth

All hedge Funds 191 100.0% Assets < $25 million 107 56.5 2.9 Assets $25 to $100 million 60 31.9 41.9 Assets > $100 million 24 12.6 33.3

Stand-alone hedge funds 104 100.0%

Assets < $25 million 63 60.6 -10.0 Assets $25 to $100 million 31 29.8 47.6 Assets > $100 million 10 9.6 42.9

Pure funds of hedge funds 53 100.0%

Assets < $25 million 24 45.3 14.3 Assets $25 to $100 million 21 39.6 50.0 Assets > $100 million 8 15.1 33.3

Principal-Protected products 34 100.0%

Assets < $25 million 20 58.8 66.7 Assets $25 to $100 million 8 23.5 14.3 Assets > $100 million 6 17.6 20.0

Hedge Funds Products by Investment Classifications Total

($ Billion) Share Number of

Funds Share

All hedge Funds 14.1 100.0% 191 100.0% Relative value/market neutral 4.17 29.5 44 23.0 Event driven 1.69 12.0 27 12.0 Opportunistic 7.77 55.1 102 55.2 Other 0.45 3.2 19 3.2

Stand-alone hedge funds 4.0 100.0%

Relative value/market neutral 0.46 11.4 Event driven 0.34 8.4 Opportunistic 3.16 78.2 Other 0.03 0.6

Pure funds of hedge funds 2.4 100.0%


Principal-Protected products 7.7 100.0%


APPENDIX D

45

Comparison between Public Mutual Funds and Pooled Funds

Public Mutual Funds Pooled Funds

1 Regulation Highly regulated Less regulated

2 Reporting Issuer Yes No

3 Structure Set up as a trust or investment company Set up as a private trust, limited partnership or a trust

4 Disclosure High disclosure and transparency Less mandated disclosure

5 Documentation Sold by prospectus Usually sold by offering memorandum

6 Minimum purchase Small minimum investment Usually large minimum investment ($79,000 to $150,000 or reduced limit if accredited investor)

7 Performance objectives “Relative” return objective. Performance is usually measured against a particular benchmark

“Absolute” return objective. Fund is expected to make a profit under all market conditions

8 Investment strategy Limited investment strategy – take long positions – do not use leverage

Flexible investment strategies – take long and short positions – may use leverage

9 Reporting File annual audited financial statement and semi-annual statements

May be exempted from filing. No reporting requirements if privately-offered non-redeemable investment fund.

10 Net asset valuation Daily Weekly or monthly

11 Derivatives Can use derivatives only in a limited way

Can utilize derivatives in any way

12 Custodian Fund assets must be held by a custodian that is bank or trust company

No requirement to have a separate custodian

13 Liquidity Good liquidity Liquidity restrictions and initial lock up periods and/or penalties for early redemption

14 Settle on FundServ Yes Yes

15 Fund Manager Compensation Tied to assets under management (1-2%)

Tied primarily to performance (18-20%)

16 Distribution Investment dealer, discount broker or mutual fund dealer

Investment dealer or limited market dealer

17 Commission May include front end or back end charge + trailer fee to sales representative

Up front commission charge + trailer fee to sales representative

APPENDIX E

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Accredited Investor Rules

If you are resident in one of the following jurisdictions, you must purchase the following minimum

amounts indicated by province or territory unless the investor meets the criteria of an “Accredited

Investor.” There is no prescribed minimum for an accredited investor in all provinces except Ontario.

Ontario continues to require that the minimum prescribed purchase amount of $150,000 apply only to

investment funds (such as private mutual funds or pooled funds) unless the investor meets the criteria of

an “accredited investor.”

As a general “house rule,” most IDA Members set a minimum purchase amount of $25,000 so that the

commission earned on the transaction is economically feasible for the firm to process.

Alberta $97,000 NWT $150,000 BC $97,000 Ontario $150,000 (only applies to

investment funds) Manitoba $97,000 PEI $97,000 New Brunswick $150,000 Quebec $150,000 Newfoundland $100,000 Saskatchewan $150,000 Nova Scotia $150,000 Yukon $97,000 Nunavut $150,000

An "Accredited Investor" in Ontario includes:

(a) a bank listed in Schedule I or II of the Bank Act (Canada), or an authorized foreign bank listed in Schedule III of that Act;

(b) the Business Development Bank incorporated under the Business Development Bank Act (Canada);

(c) a loan corporation or trust corporation registered under the Loan and Trust Corporations Act (Ontario) or under the Trust and Loan Companies Act (Canada), or under comparable legislation in any other jurisdiction;

(d) a co-operative credit society, credit union central, federation of caisses populaires, credit union or league, or regional caisse populaire, or an association under the Cooperative Credit Associations Act (Canada), in each case, located in Canada;

(e) a company licensed to do business as an insurance company in any jurisdiction;

(f) a subsidiary entity of any person or company referred to in paragraph (a), (b), (c), (d) or (e), where the company owns all of the voting shares of the subsidiary entity;

(g) a person or company registered under the Securities Act (Ontario) or securities legislation in another jurisdiction as an adviser or dealer, other than a limited market dealer;

(h) the government of Canada or of any jurisdiction, or any crown corporation, instrumentality or agency of a Canadian federal, provincial or territorial government;

APPENDIX E (cont’d)

47

(i) any Canadian municipality or any Canadian provincial or territorial capital city;

(j) any national, federal, state, provincial, territorial or municipal government of or in any foreign jurisdiction, or any instrumentality or agency thereof;

(k) a pension fund that is regulated by either the Office of the Superintendent of Financial Institutions (Canada) or a provincial pension commission or similar regulatory authority;

(l) a registered charity under the Income Tax Act (Canada);

(m) an individual who beneficially owns, or who together with a spouse beneficially own, financial assets having an aggregate realizable value that, before taxes but net of any related liabilities, exceeds $1,000,000;

(n) an individual whose net income before taxes exceeded $200,000 in each of the two most recent years or whose net income before taxes combined with that of a spouse exceeded $300,000 in each of those years and who, in either case, has a reasonable expectation of exceeding the same net income level in the current year;

(o) an individual who has been granted registration under the Securities Act (Ontario) or securities legislation in another jurisdiction as a representative of a person or company referred to in paragraph (g), whether or not the individual's registration is still in effect;

(p) a promoter of the issuer or an affiliated entity of a promoter of the issuer;

(q) a spouse, parent, brother, sister, grandparent or child of an officer, director or promoter of the issuer;

(r) a person or company that, in relation to the issuer, is an affiliated entity or a person or company

(s) an issuer that is acquiring securities of its own issue;

(t) a company, limited liability company, limited partnership, limited liability partnership, trust or estate, other than a mutual fund or non-redeemable investment fund, that had net assets of at least $5,000,000 as reflected in its most recently prepared financial statements;

(u) a person or company that is recognized by the Ontario Securities Commission as an accredited investor;

(v) a mutual fund or non-redeemable investment fund that, in Ontario, distributes its securities only to persons or companies that are accredited investors;

(w) a mutual fund or non-redeemable investment fund that, in Ontario, distributes its securities under a prospectus for which a receipt has been granted by the Director (as defined in the Securities Act (Ontario)) or, if it has ceased distribution of its securities, has previously distributed its securities in this manner;

(x) a fully managed account if it is acquiring a security that is not a security of a mutual fund or non-redeemable investment fund;

(y) an account that is fully managed by a trust corporation registered under the Loan and Trust Corporations Act (Ontario) or under the Trust and Loan Companies Act (Canada), or under comparable legislation in any other jurisdiction;

(z) an entity organized outside of Canada that is analogous to any of the entities referred to in paragraphs (a) through (g) and paragraph (k) in form and function; and

(aa) a person or company in respect of which all of the owners of interests, direct or indirect, legal or beneficial, are persons or companies that are accredited investors.


48

An "Accredited Investor" in all jurisdictions other than Ontario includes:

(a) a Canadian financial institution, or an authorized foreign bank listed in Schedule III of the Bank Act (Canada),

(b) the Business Development Bank of Canada incorporated under the Business Development Bank of Canada Act (Canada),

(c) an association under the Cooperative Credit Associations Act (Canada) located in Canada or a central cooperative credit society for which an order has been made under subsection 473(1) of that Act,

(d) a subsidiary of any person or company referred to in paragraphs (a) to (c), if the person or company owns all of the voting securities of the subsidiary, except the voting securities required by law to be owned by directors of that subsidiary,

(e) a person or company registered under the securities legislation of a jurisdiction of Canada as an adviser or dealer, other than a limited market dealer registered under the Securities Act (Ontario) or the Securities Act (Newfoundland and Labrador),

(f) an individual registered or formerly registered under the securities legislation of a jurisdiction of Canada, as a representative of a person or company referred to in paragraph (e),

(g) the government of Canada or jurisdiction of Canada, or any crown corporation, agency or wholly owned entity of the government of Canada or a jurisdiction of Canada,

(h) a municipality, public board or commission in Canada,

(i) any national, federal, state, provincial, territorial or municipal government of or in any foreign jurisdiction, or any agency of that government,

(j) a pension fund that is regulated by either the Office of the Superintendent of Financial Institutions (Canada) or a pension commission or similar regulatory authority of a jurisdiction of Canada,

(k) an individual who, either alone or jointly with a spouse, beneficially owns, directly or indirectly, financial assets having an aggregate realizable value that before taxes, but net of any related liabilities, exceeds $1,000,000,

(l) an individual whose net income before taxes exceeded $200,000 in each of the two most recent years or whose net income before taxes combined with that of a spouse exceeded $300,000 in each of the two most recent years and who, in either case, reasonably expects to exceed that net income level in the current year,

(m) a person or company, other than a mutual fund or non-redeemable investment fund, that, either alone or with a spouse, has net assets of at least $5,000,000, and unless the person or company is an individual, that amount is shown on its most recently prepared financial statements,

(n) a mutual fund or non-redeemable investment fund that, in the local jurisdiction, distributes its securities only to persons or companies that are accredited investors,

(o) a mutual fund or non-redeemable investment fund that, in the local jurisdiction, is distributing or has distributed its securities under one or more prospectuses for which the regulator has issued receipts,

(p) a trust company or trust corporation registered or authorized to carry on business under the Trust and Loan Companies Act (Canada) or under comparable legislation in a jurisdiction of Canada or a foreign jurisdiction, trading as a trustee or agent on behalf of a fully managed account,

(q) a person or company trading as agent on behalf of a fully managed account if that person or company is registered or authorized to carry on business under the securities legislation of a jurisdiction of Canada or a foreign jurisdiction as a portfolio manager or under an equivalent category of adviser or is exempt from registration as a portfolio manager or the equivalent category of adviser,


49

(r) a registered charity under the Income Tax Act (Canada) that, in regard to the trade, has obtained

advice from an eligibility adviser or other adviser registered to provide advice on the securities being traded,

(s) an entity organized in a foreign jurisdiction that is analogous to any of the entities referred to in paragraphs (a) through (e) and paragraph (j) in form and function, or

(t) a person or company in respect of which all of the owners of interests, direct or indirect, legal or beneficial, except the voting securities required by law to be owned by directors, are persons or companies that are accredited investors.

APPENDIX F

50

NI 81-106 AT A GLANCE

Financial Statements Management Report of

Fund Performance Summary of Investment

Portfolio AIF

Public mutual funds [redeemable on demand, subject to NI 81-101 and NI 81-102]

Prepare and file annual audited within 90 days of financial year-end and interim within 60 days of end of most recent six-month period File first annual audited statements within 120 days of year-end File first interim statements under NI 81-106 for first six-month period after the first financial year-end for which new annual statements prepared

Prepare and file annual and interim at same time as financial statements [Form 81-106F1] File first interim management report for the six-month period after the financial year-end relating to the first annual management report Send first annual management report to all registered and beneficial security holders by the filing deadline, with an explanation of the new disclosure requirements

Prepare, but not file, as at 3-month and 9-month financial quarter-ends [Item 5 of Part B of Form 81-106F1] and post to Web site, if any, within 60 days of quarter-end. Include total net asset value as at end of period Prepare first quarterly summary as at 3-month or 9-month financial quarter-end ending on

Prepare and file NI 81-106AIF within 90 days of financial year-end, if no current SP File first AIF under NI 81-106 within 120 days of applicable financial year-end

All other investment funds that are reporting issuers [exchange-traded funds, closed-end funds, certain deferred sales financing and flow-through partnerships etc.]

√ as for public mutual funds √as for public mutual funds √ as for public mutual funds √ as for public mutual funds, if no current long-form prospectus

Privately-offered mutual funds [pooled funds] **NI 81-106 does not apply to pooled funds in Alberta, BC, Manitoba and Newfoundland NI 81-106 does not apply to privately-offered non-redeemable investment funds

√ as for public mutual funds, but exempt from requirement to file with regulators if specified one-time notification made and investors receive statements**

Does not apply Does not apply Does not apply

APPENDIX G

51

Fees/Hurdle Rate/Lock-up Performance FeesJUNE 2004.

Stand-alone Fund of Principal All Hedge Hedge Funds Hedge Funds Protected Products Fund Products

Fee not disclosed 3.80% 30.20% 20.60% 14.10%

Fee less than or equal to 10% 4.80% 41.50% 41.20% 21.50%

Fee between 10% and 20% 1.10% 9.40% 8.80% 4.70%

Fee equal to 20% 86.50% 18.90% 11.80% 54.50%

Fee greater than 20% 3.80% 0 17.60% 5.20%

Source: Investor Economics

• Performance fees comprise the most significant portion of Hedge Fund manager remuneration,

with nearly 60% of hedge funds charging a performance fee of 20% or more

Number of Hedge Funds by Hurdle Rate June 2004.

Stand-alone Funds of Principal AllHedge Funds Hedge Funds Protected Products Hedge Funds

Hurdle rate not disclosed 4 16 7 27

Performance fee with hurdle rate 33 6 5 44

Performance fee with No hurdle rate 67 31 22 120Source: Investor Economics

• Majority of Hedge Funds do not incorporate a Hurdle Rate, the minimum annual return that a

fund must achieve before performance fees apply.

Funds with a Lock-up Period Funds with Early Redemption Fees

Lock Up Period Number of Funds Early redemption fee level Number of Funds

30 days 5 5.00% 336 months 6 4.00% 2

1 year 13 3.00% 91.5 years 2 2.50% 12 years 3 2.00% 32

1.70% 1Source: Investor Economics 1.00% 11

0.0375% 1Source: Investor Economics

• Excluding principal protected products, only a few hedge funds have lock up periods.

• Early redemption fees, sometimes as high as 5%, are common.

APPENDIX H

52

Limited Market Dealers

Below is a brief summary of the relevant sections of OSC Regulation 1015 that do not apply to a Limited

Market Dealer:

107 - Maintenance of a minimum amount of free capital;

108 - Maintenance of bonding or insurance;

109 - Notification of changes in bonding or insurance;

110 - Requirement to participate in an investor compensation fund;

111 - Requirement to enter into a subordination agreement (upon the request of the commission);

112 - Financial statements and reports have to be reported upon by an acceptable person, unless

an application pursuant to s. 147 to be exempted to file annual audited financial statements;

113 - Maintenance of books and records;

116 - Separation of client's securities (prohibition on inter-mingling of securities);

117 - Segregation of client accounts;

118 - Client's free credit balances are to be maintained in a separate trust account;

120 - Client's free credit balances with respect to commodity futures trading accounts;

121 - Permitted transfer of client's free credit balances between security accounts and commodity

futures trading accounts;

123 - Provision of "Statements of Account" to clients.

APPENDIX I

53

AIMA – Guide to Sound Business Practices

Foreword The Canadian Hedge Fund market has witnessed rapid growth over the past three years. As a response to this growth, The Alternative Investment Management Association (AIMA) established a Canadian chapter in March of 2003 that now boasts over 50 corporate members. AIMA Canada is part of the global "non profit" association based in London, UK with over 600 corporate members worldwide. AIMA’s primary objectives are to increase investor education, transparency and promote due diligence as well as to work closely with regulators to better promote and monitor the use of alternative investments. With rapid global growth of the hedge fund industry, the need for Hedge Fund managers and their service providers to provide sound professional services as well as increased transparency has never been greater.

On August 30, 2002, AIMA, in conjunction with leading European industry participants released the "Guide to Sound Practices for European Hedge Fund Managers" (the "European Guide") which has proved enormously popular. Given its success, a Canadian version of the European Guide (the "Guide") has now been prepared. The Guide provides an overview of the many issues that should be considered by a Hedge Fund manager who manages funds in Canada, but is not intended to set out definitive standards or an exhaustive list of requirements that could serve as a benchmark against which conduct should be assessed. There is no substitute for professional advice in managing a hedge fund business.

A number of individuals have extended considerable time and effort in preparing the European Guide and this Guide and their valuable input is acknowledged in Appendix 1 and 2. It is intended that this Guide will be reviewed on a regular basis so its value to the industry does not depreciate. To this end, comments should be sent to:

[email protected]

Jim McGovern Chairman, AIMA Canada March 1, 2004

8 The Alternative Investment Management Association Limited, 2002, 2004 All rights reserved. No part of this publication may be reproduced in any material form (including photocopying or storing it in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without written permission except in accordance with the provisions of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency. Application for permission for other use of copyright materials including permission to reproduce extracts in other published works shall be made to The Alternative Investment Management Association Limited. Full acknowledgement to authors, publisher and source must be given. Warning: The doing of an unauthorised act in relation to a copyright work may result in both a civil claim for damages and criminal prosecution. AIMA CANADA | Sound Practices for Canadian Hedge Fund Managers

APPENDIX I (cont’d)

54

2.2.6 INDUCEMENTS AND SOFT COMMISSIONS

Inducements and soft commissions can be offered to Hedge Fund managers from a variety of sources. Care should be taken to ensure that inducements do not create unacceptable conflicts of interest or influence the Hedge Fund manager against acting in the best interest of its clients.

The practice of using soft commissions (or soft dollars) to pay for certain investment related services is permitted by some regulators, subject to a number of rules. Hedge Fund managers seeking to pay for investment-related services in this way should ensure that the service itself is a documented legitimate softing service of which clients have been made aware. In Ontario, soft dollars arising out of portfolio commissions may only be used by a Hedge Fund manager for order execution services and investment decision-making services as defined in the applicable policy. There are also limits on a Hedge Fund manager directing portfolio trades to, or at the request of, dealers who distribute the Hedge Fund manager's funds.

Any other forms of inducement, given to or received by Hedge Fund managers or their employees, should be monitored to ensure they are appropriate in the circumstances and not likely to unduly influence the judgment of the recipient. Hedge Fund managers should consider adopting the sales practices prescribed in National Instrument 81-105 Mutual Fund Sales Practices. This rule, which applies to most mutual funds offered by prospectus in Canada, limits the types of compensation paid to dealers, as well as imposing restrictions on marketing and other sales practices.

2.2.7 CONFLICTS OF INTEREST

The Hedge Fund manager should be aware that potential conflicts of interest might exist or develop. Where they do exist or develop, the Hedge Fund manager should ensure they are reviewed by the senior management of the Hedge Fund manager and by those people responsible for the compliance function. Hedge Fund managers may want to consider constituting a review committee, independent of the Hedge Fund manager, to review conflicts.

Once reviewed, the Hedge Fund manager should ensure such conflicts have been either appropriately dealt with or eliminated and disclosed to the relevant parties if this is considered to be necessary or is required by applicable law.

Hedge Fund managers should also ensure that they observe any relevant provisions of securities legislation concerning conflicts or interest and the management of investment funds.

2.2.8 PERSONAL TRADING

The Hedge Fund manager should adopt a personal trading policy that ensures that conflicts of interest between staff and clients are effectively managed. The easiest way to avoid conflicts of interest is for a Hedge Fund manager to prohibit personnel from trading on their own account in securities which they analyze or in which they invest for clients. Indeed there are perceived benefits for all if staff are encouraged to invest instead in the client Hedge Funds themselves, thereby aligning their interests with those of their investors. However this may not be appropriate or possible in all circumstances. Providing adequate controls exist, personal trading may be permitted. Hedge Fund managers may want to consider the personal trading requirements set out in the Code of Conduct and Standards of Professional Conduct of the Association for Investment Management and Research (AIMR) and the Code of Ethics Guidelines for Personal Investing of The Investment Funds Institute of Canada (IFIC).

For all personal account dealing the Hedge Fund manager should have:

i. written policies and procedures communicated to and accepted in writing by all employees and reviewed and accepted on an annual basis;

ii. pre-clearance and hard copy confirmation records of relevant transactions; and

iii. monitoring and analysis of all personal dealings by a person competent to ensure proper management of the potential conflicts involved.

APPENDIX I (cont’d)

55

6.8 Conflicts of Interest Potential or perceived conflicts of interest can exist at the FOF level when:

i. principals and employees of a FOF (or the FOF manager) invest directly in the underlying Hedge Fund;

ii. different FOFs managed by the same FOF manager invest in the same underlying Hedge Funds; or

iii. management and/or performance fees are rebated to the FOF manager by the underlying Hedge Fund manager and the rebate is not passed on to investors.

These conflicts may arise because Hedge Funds typically have capital constraints. The difficulty in placing funds with or removing funds from a Hedge Fund manager may cause real or perceived advantages by those making these decisions when compared to the FOF investor.

A FOF manager can avoid these conflicts through the development of proper and consistent policies and proper disclosure to its investors.

Documents

Regulatory Analysis of Hedge Funds - Investor Voiceinvestorvoice.ca/Research/IDA_HedgeFunds_18May05.pdfRegulatory Analysis of Hedge Funds May 18, 2005 Hedge Fund Working Group Louis