Hedge-Fund Danger Alert as Canada Prepares for Retail Investors

Depending on where you stand, hedge funds either expose investors to unnecessarily high risks and costs or they give people the opportunity to diversify and profit from volatility, reports Bloomberg.

That’s the basis of a tussle in Canada, where the leading investment-industry watchdog opposes rules that would allow man-in-the-street investors to move into hedge funds and other alternative products such as commodities and derivatives, perhaps as soon as next year. Financial institutions say retail participation is a no-brainer.

“A move from a regulatory perspective to allow retail investors access is a good thing and we’re keen to see that happen,” said Paul Taylor, chief investment officer at BMO Global Asset Management, which oversees about C$320 billion ($249 billion). “We’d like to give clients exposure to strategies offering very good returns” compared with their risk, he said.

Canadian regulators are proposing to loosen the rules on hedge-fund participation after pressure from fund managers and investment advisers. The desire to ape the far larger industry in the U.S. is another incentive. Firms see Canada’s C$40 billion hedge-fund sector easily doubling in size within a few years by attracting new investors and siphoning money from passive strategies such as exchange-traded funds. Investor protection groups, on the other hand, sense a money grab.

‘No Evidence’

“This initiative is largely driven by the industry’s desire to generate more fees rather than retail investor demand,” said Marian Passmore, director of policy at the Toronto-based Foundation for Advancement of Investor Rights. “There’s no evidence from the regulators that retail investors will be better off when most will have difficulty understanding the different characteristics and risks.”

Under the new system, hedge funds will be open to retail investors provided they adhere to certain standards, including offering daily liquidity, filing a prospectus and publishing interim and annual results -- similar to the so-called liquid alternative products in the U.S., the U.K. and Europe.

Canada’s current laws limit hedge-fund investing to institutions or accredited individuals with incomes of more than C$200,000 a year or a net worth of C$1 million.

“Hedge funds typically offer less liquidity and disclosure while charging aggressive fees, all things that would generally turn off most retail investors,” said David Stowell, professor of finance at Northwestern University’s Kellogg School of Management in Evanston, Illinois. Many Canadian hedge funds will be “willing to make concessions to induce retail investing,” he said.

Sifting Responses

Canadian Securities Administrators, formed from regulators from each of the country’s 10 provinces and three territories, is overseeing the rule change. Kristen Rose, a spokeswoman for the Ontario Securities Commission, which is part of the group, said regulators are still sifting through responses from an industry consultation. She said it’s too early to determine when the looser regulations might be implemented.

Hedge funds are potentially exposed to much higher risks than some other investments because they can seek to profit from falling markets as well as betting that stocks will rise. The most notable Canadian failure occurred in 2005, when regulators shut Toronto-based Portus Alternative Asset Management Inc., whose co-founders siphoned off more than C$100 million, some of it sent to Israel to buy diamonds.

The biggest challenge of retail participation is to ensure financial advisers fully understand the products and can help individual investors keep the risks under control, said Michael Burns, a lawyer at McMillan LLP in Toronto.

This sentiment was echoed by FAIR’s Passmore, who said the industry needs more training to understand the products and advise clients once it opens up to ordinary investors.

Industry Push

The push for retail hedge funds comes partly from investment advisers, who see pension and endowment funds such as Yale University in the U.S. using them to boost returns at a time of near record-low interest rates, said Hanif Mamdani at RBC Global Asset Management. He helps oversee about C$7 billion as the firm’s head of alternative investments.

“There really is value for clients to pursue non-traditional funds in terms of tailoring their risk-adjusted returns,” Mamdani said from Vancouver. “Canada is under-represented in the hedge-fund industry.”

Two Ancient English Statutes A…