The Investment Dealers Association of Canada has issued a report outlining its concerns about the hedge fund industry and recommending ways to tighten possible regulatory gaps.

The report notes that the expansion of hedge funds into retail markets has heightened concerns about several aspects of these products, including:

  • marketing practices used by both hedge funds and dealers;
  • conflicts of interest;
  • high levels of fees and charges, some of them not transparent;
  • the ability of hedge fund managers to meet expectations raised by their marketing;
  • the lack of disclosure of hedge fund operations and financial affairs;
  • the applicability of securities laws exemptions they use.

The IDA recommends:

  • developing guidelines on proper practices for referral arrangements;
  • restricting IDA members from conducting securities-related activities in an affiliate with a limited market dealer registration when such activities could be conducted by the IDA member;
  • reviewing guidelines 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 these standards need amendment;
  • re-issuing the advisory to firms reminding them of the prohibition on “off-book” transactions;
  • issuing an advisory to firms as to their responsibility to conduct due diligence on products recommended to clients.

The study was researched and prepared in response to a request by the IDA member regulation oversight committee on Jan. 19, and was presented on April 13. It notes that, 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,” the report says.

“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,” it says. “Relatively good returns, meaning better performance than the market, have become less important than absolute returns.”

And, it notes, hedge funds are marketed as the answer to that demand: “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, which now account for approximately 50% of the $14.1 billion of hedge fund assets in Canada.”