Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 10 - Evidence - Meeting of November 8, 2006
OTTAWA, Wednesday, November 8, 2006
The Standing Senate Committee on Banking, Trade and Commerce met this day at
4:10 p.m. to examine and report upon the present state of the domestic and
international financial system (study on hedge funds).
Senator Jerahmiel S. Grafstein (Chairman) in the chair.
The Chairman: Gentlemen, thank you very much for waiting. I am
delighted that you have come to join us this wonderful day in the life of
The Standing Senate Committee on Banking, Trade and Commerce was in New York
last month to discuss a number of issues with the committee's mandate, one of
which is the hedge funds, a sector valued anywhere from $1.5 trillion to $3
trillion in assets globally. Based on the information we have received, we
understand that in Canada it is now somewhere between $40 billion and $50
billion. We have the 2004 numbers but we have not been able to coagulate the
most recent numbers. There has been a tremendous rise in hedge funds.
Given the size and scope of our trading relationship with the United States
and the integrated nature of aspects of our economies, the priority must be
given, from our perspective as a committee, to global and North American
financial stability. It is imperative that we, as policy-makers, try to
understand what is happening not only in Canada but also in the United States,
because our two markets are so integrated.
During our discussions with U.S. regulators and representatives of the
financial services sector, hedge funds emerged as a key issue and one that
members of the committee agree requires further study by us given the recent
high profile hedge fund failures and the increasing number of investors, both
sophisticated and now retail, indirectly using this financial tool. The Canadian
hedge funds, as I said, were estimated at $26 billion in 2004 but, based on
other numbers we have received, they have increased at a compound rate of 30 per
cent each year. That is my estimate. Canadian hedge funds are now somewhere
between $40 billion and $50 billion, perhaps higher.
We heard about hedge funds during our recent study on consumer issues in the
financial sector. We recommended at the time the appointment of an eminent
person to review appropriate regulatory oversight of hedge funds. Nevertheless,
key questions remain regarding the extent to which, if at all, and how these
types of financial products should be regulated and supervised in order to
protect the consumers and the stability of domestic and global markets.
Today we welcome Mr. Stephen J. Kangas, president of BluMont Capital; Mr.
Christopher Guthrie, president of Hillsdale Investment Management Inc. and Arun
Kaul, chief operating officer. We also wish to welcome Mr. Guthrie's two sons,
who are here to listen to their father tell senators about this important aspect
of the economy. We want to welcome both William and Caleb as part of our very
astute audience. Thank you very much for coming here this afternoon, gentlemen.
Tell us how you would like to proceed.
Christopher Guthrie, President, Hillsdale Investment Management Inc.:
We have approximately seven minutes each between the two of us and also for Mr.
Kangas. I will go first, my esteemed partner will pitch in and Mr. Kangas will
follow up with part of the industry we do not cover.
Mr. Guthrie: Thank you for the introduction; that was very sweet.
I will be referring to a Power Point presentation, which you should have in
front of you. This is what I will be walking through for seven minutes.
By way of introduction, you have here between Mr. Kaul and myself between 19
and 20 years of experience at running what we call long-short equity, which is a
subclass of hedge funds, one of the more conservative types of hedge funds. When
we began our firm 10 years ago, we were pioneers in the field. There was little
regulation and infrastructure. There were few fund administrators to help us and
few resources on the Investment Dealers Association, IDA, side for stock loan.
It was a primitive set up when we first began. We did a lot of teaching to fund
administrators on how to do accounting for hedge funds. Roll forward 10 years
later and now the industry has matured and is beginning to code itself and find
its way as a main asset class for investments. The two of us had the good
fortune of starting doing quantitative equity management, which allowed us to
train other managers at the time in our previous employ.
On page 3 of our presentation, you will see that we currently manage $330
million, which in the world scope of hedge funds is very small but in the scope
of the Canadian market probably places our firm in the top 10 amongst asset
managers of manufacturers — which is the word for those who actually manage
hedge funds — of hedge funds in Canada.
We are a member of AIMA, the Alternative Investment Management Association
Limited, with which I know you have had dealings before. It is our industry
association. In one of the appendices, I included five or six pages describing
their purpose. They may or may not get a chance to come here to speak with you.
They represent 72 members in Canada who are hedge fund managers, providers,
buyers and administrators.
We currently have 16 people in our firm, which is what it takes to do our job
correctly. The type of people that we use to manage money in hedge funds would
be mostly mathematics grads, computer scientists, risk management professionals,
people skilled in trading, technical analysis, audit, accounting, marketing,
compliance and finance, to give you an idea of what it takes to manage hedge
funds correctly. Most of our strategies are currently focused in North America.
In terms of distributing our services, we currently have five pooled funds
that we distribute to Canadian residents and two pooled funds that we distribute
to non-Canadian residents, being offshore product that either Japanese or even
U.S. residents can participate in. We also manage segregated accounts for
pension funds directly. We do not sell to retail investors through prospectus,
nor do we participate in principal protected notes, issues you are grappling
with here. We are not much help on those two issues.
On page 5 of the brief, we indicate a particularly important viewpoint on
what hedge funds can contribute to investment management and as well to the
economy. The first point is the most important. What hedge funds can offer to
investors is a consistent and customizable risk profile. The first sentence
turns the world a bit on its head. The flexibility in the use of leverage and
instruments leads to enhanced risk management. It would be impossible for us to
do what we do without using leverage and without doing it in the structure of a
hedge fund. Our objective is to align our risk with the investor's risk. It
enables us to specify, to target risk budgets. It is in this way that hedge
funds actually lower systematic risk. It is an important component. I have seen
some of your transcript struggling with the systematic risk. On hedge fund side,
we would come down importantly on the fact that hedge funds are unique enough by
virtue of their construction that, as a group, they very rarely pose any
systematic risk, certainly nothing compared to other asset classes, which are
dealt with in the next two points.
A more consistent return profile, hedge funds have the ability to create
consistent return profiles that are different from what we are typically used to
or where we are a victim of the business cycle or the asset cycle or the bubble
cycle. Typical asset classes have extreme dislocations. These things can rarely
be avoided and they are never one person's or one industry's fault. They just
happen. Why do Japanese equities go up for six years and then go down for 20
years? Why does Nortel go up and down like a yoyo? Why is Calgary real estate 20
times more expensive than it was? In our opinion, these are systematic risks and
they are not necessarily due to hedge funds.
The third point is true diversity and asset allocation. Over time, markets
have become more sophisticated, and we can now buy pre-packaged Turkish
equities. We can participate in all kinds of markets in an efficient manner. The
diversification that used to be available by participating around the world is
no longer available. Our markets are now linked like they were never linked
before. Systematic risk appears to be accumulating in traditional asset classes,
not necessarily in hedge funds. I have by appendix small presentations that we
put together showing the data on how asset classes are becoming more correlated
to one another. European stocks and U.S. stocks are trading essentially in
precisely the same patterns.
The fourth point is better matching of liabilities. It is important on the
pension side, in particular for many of our clients who are struggling to meet
either long-term, fixed or low-risk liabilities, to have an option other than
bonds, especially in this environment where bond yields are quite low. I know
senators have touched on this, but the Canada Pension Plan does have a fairly
active program of what they call "active overlay,'' which is a hedge fund, by
any other name, inside its program. These are not new things to all
sophisticated participants in the market.
We also thought it was important to highlight that we are extremely regulated
by a number of different forces already. On slide 6 we refer to investors,
service providers, regulators and the public. In particular, regulators now have
additional resources that they never had 10 years ago; I believe the Ontario
Securities Commission, OSC, is now a large, profit-making venture. They have
resources to audit and to control like never before, and to come here and
present, which they have done.
I am highlighting the points that I deemed important to address. On slide 7,
we have the blind trust comment. In our case, because we are registered and all
our products, although exempt, are still in the public eye, we are governed by
our offering documents; by subscription agreements; by due diligence, which is
onerous and extensive and much more than in the regular asset-management space;
by monthly reporting to clients; and by audited financial statements for our
funds that hold every asset in the funds every six months. I brought, in
appendix, a statement that a client of ours would receive on a monthly basis,.
The Chairman: Thank you. I do not mean to interrupt, but we would be
curious about the offering memorandum that you mentioned. Perhaps you could send
us some examples. We would like to see what is being offered and, therefore,
what the investors can rely upon if something happens.
Mr. Guthrie: That is a good question, and I did not bring one.
The Chairman: You can give us a random sample subsequent to this
Mr. Guthrie: Yes, we can send you one subsequent to this. It is a
great place to start looking because a great deal of information is disclosed in
those offering documents. In our case, the process of developing an offering
document is capital intensive, requiring hours of legal fees, which is why I did
not include one today for public disclosure.
The Chairman: There are a number of lawyers at this table, so we
understand the intensity of that, and we do not have a conflict of interest.
Please, send them along to us so that we can take a look.
Senator Goldstein: We have a great appreciation of trade union
principles when it comes to legal fees.
Mr. Guthrie: They do not seem to be coming down.
Senator Goldstein: Good.
The Chairman: This committee is highly cost efficient; our costs are
Mr. Guthrie: On slide 8 I have shown some of the matrix of oversight
that we have. In Canada we have created a large, robust matrix of oversight.
There are investors and service providers in a general sense, and there are
quite a few of them to a traditional hedge fund that are important to know
about, such as prime brokers and custodians. "Prime broker'' is the term used
for a hedge fund custodian, which allows you to borrow shares to affect your
short-selling or your margin. All large IDA firms have prime brokers and are
making a tremendous amount of money. The key is that they provide oversight and
it is their capital. Under IDA regulations, margin is constrained and it is not
possible to borrow more than IDA regulations allow.
Fund administrators, such as Citigroup Canada, Royal Trust, Citco Group or
CIBC Mellon. Traditional custodians, who have added to their arsenal of
products, are fund accounting arms that allow us to count the assets, in our
case on a daily basis, and distribute those net asset values to the public or to
I believe that you have had all of the regulars here. They now have resources
and, from a personal perspective, we spend a great deal of time interacting and
having them in our office. The audit process that the OSC goes through is
extremely extensive and lasts one to two months, depending on how many people
are involved. It takes place once every two or three years depending on your
risk as a firm. All investment council portfolio managers have been audited in
Ontario at least once, and perhaps a second time.
In Canada we have the concept of proficiency requirements, which the U.S. has
not added yet to their registration. Under the Ontario Securities Commission
registration, you have to be seen as proficient, which involves a CFA course and
a large standard-of-practice handbook that governs all of our behaviour on a
regular basis. There are annual audits, semi-annual audits and regulations, so
it is fairly large. I mentioned the CFA designation, and some of the other
market exchange regulations of which we are a part. As well, there are the
one-offs that still linger: FINTRAC, the Financial Transactions and Reports
Analysis Centre of Canada, for money laundering; PIPEDA, the Personal
Information Protection and Electronic Documents Act; and various other policies.
Regulators come through the office or monitor websites to ensure that those
policies are in place. We are in frequent contact with regulators.
The public provides a degree of review because our asset classes are posted
in the newspapers on a weekly basis.
I will pass it over to Mr. Kaul. We thought it would be useful for the
committee to look at the hedge fund industry to understand how the hedge fund
asset pie fits inside the investable asset pie. We brought some market sizes
with respect to derivatives and other instruments to give you an idea how small
Arun Kaul, Chief Operating Officer, Hillsdale Investment Management Inc.:
I am working from Appendix 5, which you should have in your notes. The table
shows the relative size of all assets globally. Gathering data is one of the
challenges in the industry. Various providers track hedge funds and the assets.
It is a self-reporting industry so there is a fair range of data available.
The Chairman: Is this data on the first page indicating the relative
size of the hedge fund market?
Mr. Kaul: Yes, that is the page to which I will speak. The intent is
to show the relative size of the hedge fund industry vis-à-vis the financial
markets. The data we are using on the hedge fund space is from Hedge Fund
Research, Inc., a firm based in Chicago. They had the estimate of industry
assets at U.S.$1.1 trillion as of the end of 2005.
The Chairman: The last material we received was from Senator Arlen
Specter Hatch who was at least then head of the Senate Judiciary Committee in
the United States. In a hearing in June 2006, the reference we heard was that
the amount was $1.5 trillion to $3 trillion. There is a big difference between
$1.5 trillion and $3 trillion, but those were the numbers that he had received
last June. If the assets total $1.1 trillion as of 2005, and assuming there is
an accumulated increase of one third, that would hit the lower number of his
Mr. Kaul: Gathering the data is a challenge. I would suggest to
senators that there is a great deal of double accounting in the industry in the
sense that funds of funds, that would track their numbers, also own single
managers, who would track their numbers too. Thus, there is double accounting.
Funds of funds are approximately one third of the assets in the industry.
If you tried to define hedge funds, it would be difficult to reach a
consensus. I have not seen anything as high as $3 trillion in the data that we
follow. The advantage of this firm is that they have been around for 15 years
and have had a stable and consistent categorization of hedge funds.
The other issue that comes into play is that hedge funds use leverage. When
individuals report their assets, even in the hedge fund industry, there is no
agreement on what is leverage and what is not. Many people use leverage but do
not call it leverage. There is room for determining the real asset number. For
now, we have used $1.1 trillion. I will provide some perspective on the growth
of the industry. In 1990, the annualized growth rate was approximately 25
percent. Over the last five years, the annualized growth rate has been
approximately 15 per cent at the global level.
Many participants now are non-U.S. based. Going back 10 or 15 years, the
advantage the industry had was that it was largely U.S.-based, which made the
reporting easier. Now there are hedge funds that are based globally, for
instance in Europe, the Middle East, Australia and emerging markets. It is more
difficult to gather the numbers. It is possible that it is higher than this.
Having said that, when you put it in context, it is still a fairly small
The total market cap of global equity markets is around $41 trillion. This is
data from the World Federation of Exchanges and is, again, for the end of 2005.
Hedge funds are under 3 per cent of global equity markets.
The U.S. bond market is larger than the U.S. stock market from a market cap
perspective. If you put stocks and bonds together, you are looking at roughly $3
trillion against $80 trillion for traditional assets of stocks and bonds. If you
look at the derivatives market, the notional value today is greater than $300
trillion. Hedge funds are certainly involved in derivatives, but they are by no
means the main participants in terms of the derivative market globally.
The Chairman: If you compare the growth of the overall market of $41
trillion, at what rate has it been growing per year? I see your number is 35 per
cent. We have been given anywhere from 15 per cent to 30 per cent, but let us
take 25 per cent as a compound rate for hedge funds, per se. What is the growth
of the overall market?
Mr. Kaul: That is a good question. Certainly, the last three or four
years it has been fairly high.
The Chairman: Has it been higher than 10 per cent?
Mr. Kaul: Yes, 10 per cent to 15 per cent is reasonable.
The Chairman: Would it be fair to say that it is between 10 per cent
and 12 per cent?
Mr. Kaul: That is probably reasonable. I would adjust it by saying
that more countries are participating in the global public markets. Thus, the
growth rate is probably higher if you add in the new emerging markets as new
companies that were never listed before. Take Chinese IPOs for example. The
growth rate is probably higher in some regions. Normal equity growth of 10 per
cent to 15 per cent is reasonable to use with certain regional exceptions.
From a Canadian perspective, the data everybody is quoting is from
Investor Economics from June 2004. That is approximately $26 billion in
Canadian assets. That breaks down through hedge funds, funds of funds and also
single hedge fund providers like ourselves.
According to the Canadian Pension Fund Directory, a publication
produced through Rogers, Canadian pension fund assets are around $800 billion.
According to their reports, they have roughly a 1 per cent exposure to hedge
funds, which is about $10 billion. They are self-reporting. That is the largest
1,000 pension plans in Canada.
Mutual fund assets as measured by IFIC, the Investment Funds Institute of
Canada, are around $570 billion. IFIC is a self-reporting organization. Some
firms have left, so that number is probably understated.
Looking at derivative assets in Canada, the Montreal Exchange representatives
quoted $600 billion. Thus, I am using that number for derivatives in Canada.
The point simply is that if you look at hedge funds as part of the global
marketplace, they are not very large in terms of the asset size. When you look
at hedge funds specifically, we ask that they be treated in the context of their
overall size in the marketplace.
Trading activity is a different point. However, we did not bring any
statistics with regard to that. Certainly, the trading activity would have a
different bias because hedge funds will typically tend to trade a bit more. That
is the context on the data. The derivative data we have is from the Bank for
International Settlements. Most of this data is publicly available on all their
Mr. Guthrie: The sheer magnitude of the size of the other asset
classes means that if you try to regulate the content of one of them, the others
just swamp the effort. We have to try them all or none. It is impossible to
squeeze one asset class while others thrive in an unregulated environment. In
the case of most of these assets, that is how they are.
Mr. Kaul: In some cases there might be competition between a pension
fund or an investment bank and a hedge fund for the same type of strategy. The
investment bank, which is not precluded from running a particular strategy,
could run a strategy and a hedge fund may not be able to if they were so
restricted. Again, they would be doing the same thing.
To touch on systemic risk, which is the next page, it is important to
differentiate between stock-specific risk or non- systematic risk and actual
systemic risk. The issue here is that stock-specific risk is diversifiable. The
main point is that as long as investors can diversify their risk, then you have
an active and properly functioning marketplace.
I want to make reference to Amaranth because it has come up. The Amaranth
loss is better viewed as stock specific or issuer specific as opposed to
systemic in the sense it is really just an issuer-specific issue. The challenge
with hedge funds is that there is tremendous latitude on what they may or may
not want to invest in. The investor, the regulator and the policy-maker may have
a harder time knowing exactly what the exposures are. Again, if you see that as
non- systematic risk, then the real risk is that as long as there are many
participants in the marketplace who are free to invest as they want, then you
have a fairly stable market with individuals on both sides of the trades.
The point with Amaranth is that you could look at other traditional
investments and have losses that were greater than that, and these investment
products are readily available. For example, look at Nortel as a stock. It had a
35 per cent decline in one week in September 2000. That was roughly a
$46-billion loss for the stock for that one week. The two should be viewed as
the same, i.e. issuer-specific risk, both diversifiable, as long as the investor
The only area that is not regulated is the specific content of the strategy.
From our perspective there are no rules in terms of how we want to design the
strategy, which we think is a great benefit of the area because it allows
investors to choose exactly what they may or may not want. It could be a risk
budget. It could be someone as aggressive as an Amaranth or someone with a more
consistent or non-diversified approach. Many of those features are available in
the marketplace today.
With that I will pass it over to Mr. Guthrie to conclude.
Mr. Guthrie: We have our opinion. Obviously, we have stated most of
From our perspective, over a 10-year cycle in Canada, regulations have grown,
matured and have become a positive force on the industry. Some of the stuff we
have recently seen out of the OSC has a vision as to how to regulate. There is a
lot of research going on. They have resources now which they did not have 10
years ago. We have to give them time to continue their job. In our opinion, they
are doing a fairly good one.
Deficiencies are being addressed one by one on the distribution side. They
are certainly being addressed by that matrix of parties, the IDA, the OSC, the
exchanges, et cetera.
Sophisticated investors drive the largest part of the market. In this case,
the growth of hedge funds at the institutional level will soon swamp whatever we
can sell on the retail side. It is smaller already in Canada. Institutions are
getting into it at an ever increasing rate. We do not worry too much about them,
unless the risks are clustered.
We do like cost-benefit work on all regulations. This industry is probably
the most competitive industry in the world. That is a little self-serving,
perhaps. It is hard to think of others where people go in and out of business
based purely on their raw processing power as quickly as hedge funds start and
stop for reasons of obvious public performance.
In Canada, we have a small, nascent industry that is just getting started and
is now competing on a global scale, particularly with the reduction of the
Canadian content and the elimination of the Canadian content restriction. We are
now facing competition from the mammoth global investment management firms. Any
help we can get in terms of our regulation vis-à-vis the others would be much
appreciated. It is a different slant on regulation. There is no reason why we
have to have the tightest or most constrained market necessarily, if we think
the industry is worth supporting. It is not just the hedge funds but the whole
investment management industry in this case that faces a large quantum shift in
the next few years.
The U.K. is now reworking the whole principle of regulation to be
principle-based. When you get to the size and the complexity of the instruments
we have, you have to leave prescription and go to principle and just enforce a
universal principle, either distribution or content or know-your-client,
whatever it is, rather than trying to set up rules for these asset classes where
people jump from one regulatory regime to another to arbitrage the advantages
Stephen J. Kangas, President, BluMont Capital: Like my colleagues
here, I appreciate our opportunity to speak in front of the senators on an
important issue. I know a slight profile on BluMont was provided. I want to
update you a bit on who we are and who I am relative to that, and then I will
talk about our products, because in the mosaic we are probably an additional
interesting piece of your review in that we target our focus completely on
private client investors, whereas many of the managers like Hillsdale or Front
Street Capital are more institutionally oriented to some extent. We have
structured products, including principal protected notes. Hopefully we will have
plenty of time to comment.
To add to the corporate profile that you took from our website, we are one of
the largest if not the largest retail hedge fund company in Canada. Our focus is
entirely on providing hedge fund portfolios in a variety of different packages
through financial advisers, both those licensed under the Investment Dealers
Association, what we call IDA members, also known as stockbrokers, and those
under the Mutual Fund Dealers Association, also known as financial planners.
That is our primary audience, and their clients would be high net worth clients,
in some cases small institutional clients and in other cases more what we or
marketers would categorize as the mass affluent — those who may not qualify as
being rich but are well on their way and have significant RRSP dollars and are
clearly concerned about their portfolios for the future.
BluMont is a publicly traded company. We are on the venture exchange of the
TSX. Our parent company, which owns 55 per cent of us right now, although it has
a tender offer to take up some of the public shares, which expires tomorrow
evening, is another publicly traded company called Integrated Asset Management.
It is one of Canada's leading alternative asset management firms, not just hedge
funds. It is involved in other areas not on the topic list here, including real
estate, private equity, private debt, and all of the things that institutions
use to diversify their portfolios.
As the second paragraph of that corporate profile points out, we offer
innovative products designed to provide enhanced diversification, which is one
of our main selling points, and potentially higher returns than may be provided
from traditional equity and bond investments. There are about 40 employees in
The Chairman: You have both mentioned this, but it might be
elucidating to the committee if you told us what your average rate of return net
to your investors was in the last five years. That would be net of deposit, net
Mr. Kangas: We always report net of all fees. Veronika Hirsch's
portfolio — I am thinking off the top of my head here — is about 13 per cent, 14
The Chairman: Is that over the last five years?
Mr. Kangas: Over the last five years. Some more recent portfolios are
principal protected notes, which I am sure we will have a lot of discussion on,
with Man Investments have been doing high single digit returns — which is below
their long-term average and something we are hoping they will be working on to
improve — but around 8 per cent, 9 per cent, 10 per cent net of fees, including
the fees for the principal protection.
The Chairman: Mr. Guthrie, we should have asked you that question. I
do not mean to interrupt Mr. Kangas, but it has been an ongoing issue and it
would be of interest to get a fuller picture. What would be your average rate of
return for your clients? We are talking about your firms.
Mr. Guthrie: Most firms that survive would not have a 40 per cent
return. This is where we come from. Most of our work would lead to a variety of
products, so our returns would be somewhere between 2 per cent for our worst but
most conservative approach and up to 20 per cent on an annualized basis for a
more aggressive approach.
Senator Massicotte: I have a supplementary question on that. What is
your percentage leverage of your funds when you say per cent of return? Give me
percentage leverage also for your fund.
Mr. Kangas: In our offering memorandum with Veronika Hirsch as our
lead long-short manager, she has the ability to go up to 150 per cent leverage.
Senator Massicotte: What was the average?
Mr. Kangas: It has rarely been that high. At the most it would be 115
Senator Massicotte: Is that of the funds under management?
Mr. Kangas: Of her portfolio.
Mr. Guthrie: We typically would run $1.40 long and 80 cents short,
which is $2.20 on $1 of equity.
Senator Massicotte: Help me, chairman, what did he say?
The Chairman: What he said was, as I understand it, you asked him the
question of his leverage and he gave a number which I did not quite get for his
Senator Angus: You asked him for a percentage.
The Chairman: He asked him for a percentage of leverage, and the first
number was supposed to be the equity and the second number was to be the
percentage of leverage on that equity. It is1to 3, is it not, roughly?
Mr. Guthrie: The industry is clustered into less than $3.
The Chairman: Roughly 1 to 3. That is the way I read it.
Mr. Guthrie: That is it, 1 to 3, one being none.
The Chairman: Okay, we can move on. I am sorry, Mr. Kangas, we are
just trying to pick up information as we go along.
Mr. Kangas: That is understandable.
As I mentioned, we and our parent company are publicly traded, which means we
are a reporting issuer, which puts a different standard over our overall
corporation than some of the other, private firms. I have brought our most
recent annual report, which is almost a year old now because our year end is
September 30, and a quarterly financial statement from June 30.
We are like the managers you have met. Veronika Hirsch is a registered
portfolio manager, also known as investment counsellor portfolio manager or
ICPM. Our company is also registered as a mutual fund dealer, and depending on
how the OSC moves with some of their suggestions we may be getting re-registered
as a manager/ administrator of our own portfolios.
The Chairman: If you put out any prospectuses could you send us a
variety of the most recent ones?
Mr. Kangas: Definitely. I have a couple of things I want to share with
you and leave behind.
We have been proponents as a firm of education and building an industry, much
like my colleagues here. BluMont is a founding member of AIMA, the Alternative
Investment Management Association. I was one of the initial executives of the
committee when that started in 2004 and I served for two years on the executive
committee. We are highly interested in promoting, encouraging and supporting
financially our employees to take a new professional designation called the
Chartered Alternative Investment Analyst program. From your knowledge of
financial markets, think of it as much like a CFA but focused on alternative
assets. That is the fastest-growing professional designation in the world. I was
one of the first Canadians to achieve that designation. Two of our employees
passed last week. There are about 50 Canadians now, and we are very much
interested in that.
Mr. Guthrie and his firm, as well as BluMont, helped sponsor and kick off an
unfortunately short-lived designation called the Certified Hedge Fund
Specialist. We helped in terms of education content, speaking, encouraging and
promoting. About 130 or 140 financial planners went through that program, but
the viability of the organization did not stick around. We were very much in
tune with that.
I personally, with the sponsorship of the Canadian Securities Institute,
spoke across the country, taking their seminar program, so I was more or less
certified to teach their content to financial planners and financial advisers
across the country, and I ended up doing 13 different cities which received nine
or 10 hours of continuing education. We stand behind the fact that advisers need
to learn more about this area, whether through a full certification course or an
in-house program from their company, much like CIBC Wood Gundy makes their
advisers take an on-line, internet-based course. Others are asking their
advisers to take the Canadian Securities Institute course. We highly support the
educational movement happening.
We have about $800 million in assets under management across a variety of
portfolios and structured portfolios. We have a long-short Canadian equity
portfolio managed by Veronika Hirsch, which is offered to investors as an
offering memorandum, very similar to what the Hillsdale folks do. We have also
put managers, including Hillsdale, as a sub- adviser we have contracted with, in
multi-manager portfolios, so some clients that do not like the potential risk of
a single manager will package that — Veronika Hirsch in combination with
Hillsdale Investment Management Inc. We have also used Gary Selke's firm of
Front Street Capital on a different portfolio, all with the idea of finding
different risk return continuums for our clients.
We offer that through a variety of vehicles, one of which can be an offering
memorandum. We have also publicly traded hedge funds that are listed on the TSX.
We are a reporting issuer currently on two funds. One is symbol BSP.UN, which
stands for BluMont strategic partners, and has four Canadian hedge fund managers
in it right now: Hillsdale, Front Street Capital, Sprott Asset Management and
Veronika Hirsch. We have another publicly traded vehicle, a Man Investments
portfolio, which combines their flagship fund of hedge funds with Man's futures
and trades under the symbol BMY.UN. I mention these for a specific reason.
We are currently offering another fund as an initial offering called BluMont
Equity Advantage. It is Hillsdale participating with Veronika Hirsch, Salida
Capital Corp and Vertex. Not only are they reporting issuers on the TSX, so
there is a certain reporting requirement and transparency requirement to our
investors, but they were offered as a prospectus product. I am not using the
term the same way it is used with a conventional mutual fund because, as the
senators would know, mutual fund rules prohibit the kind of investing styles
that Veronika Hirsch and others do in terms of long-short and the use of modest
amounts of leverage. They are prospectused; they have been vetted by the Ontario
Securities Commission. That does not mean they are guaranteeing any results, but
it is important in terms of disclosure, et cetera.
In our instance, with those types of products, two different law firms have
reviewed them — our counsel and the underwriter's counsel. We have had our
issues led by CIBC World Markets, probably the leading investment banking firm
in terms of underwriting, as well as syndicated through a number of investment
dealers. Sometimes those are the most vetted products available and they provide
potentially more liquidity than might be gotten from a conventional hedge fund
that might have 90 days' notice and lock-ups.
We are in that market. That market makes hedge funds available without a
restriction on wealth. The restriction would be on the suitability for the
client based on their discussions with their financial adviser. Those three
products, or two currently listed and one potentially listed, are available only
through a registered stockbroker or a member of the IDA because they are treated
as listed securities. Subject to the know-your-client risk tolerance, they can
buy it; it is not restricted to $1 million of investable assets, $200,000 annual
income. It has come through in some of the work from the IDA task force, and you
will hear from Ms. Moorehead, as well as the OSC, making these diversifying
vehicles with potentially better returns or certainly less correlated returns
available to a broader audience. We have supported that.
There is a final area that is probably open for more discussion. We have
about $500 million of principal protected notes that we closed on Friday
afternoon. We also have had a distribution and partnership arrangement with a
company called Man Investments, which is a division of Man Group plc, a publicly
traded company on the London Stock Exchange somewhere in the $12-billion or
$15-billion market cap area. They are heavily regulated in all of the
jurisdictions they are in, including being a registered offerer of a category of
hedge funds that is registerable in the United States under the Securities and
Exchange Commission. Man has $54 billion assets under management.
We have offered their products. They have been constructed around the world
and offered to Europeans, less so to Americans, but all across Europe and Asia.
They have just brought the same vehicle to Canada. Ours is offered through
Citibank Canada, so it is a Canadian bank-issued paper. Yes, it does avoid the
accredited investor status because the current structure of principal protected
notes does not fall under that regime.
You might say I am biased, but the issue with principal protected notes is
not so much the potential exposure to hedge funds as perhaps the lack of
knowledge on how principal protected notes actually work. That is the rapidly
growing area in the Canadian market right now. Mr. Guthrie, Mr. Kaul and myself
lust longingly after these 30 per cent growth rates because we have not seen
them in our firm. We have been challenged, marketing to private client investors
who do not see the need or are skeptical about hedge funds. Principal protected
notes are probably doing $4 billion or $5 billion a year and are a rapidly
growing area. Very few of them are actually linked to hedge funds.
The Investor Economics report, which I have scratched my head over,
constantly claims there is something in the order of $8 billion to $10 billion
in notes linked to hedge funds. I would say, modestly, except for a couple of
competitors who have not been doing as well, we may be the largest in hedge fund
principal protected notes across our market. There may be some product available
in the province of Quebec, which might skew the numbers a bit, but I have not
had any evidence of that.
We have done $500 million. Portus, whose name has some notoriety in Canada,
was $800 million at its peak. Tricycle Asset Management, which some people say
is a hedge fund — we do view it as an alternative firm and hedge fund firm using
a different strategy — was, at its peak, $1 billion.
The Chairman: Mr. Kangas, are you drawing to the conclusion of your
comments? We have another witness and all the senators are lined up to ask you
questions. Could you please summarize or conclude?
Mr. Kangas: We have some structured products. I have brought content
with us, materials in both English and French, and our latest new issue which
has been syndicated. We have to get our products approved by all of the dealer
firms from the large-name firms we are all familiar with and they now all have
departments or individuals who have to vet all these documents and put us
through a rigorous due diligence. Not only corporately, but the structure of the
product and the disclosure available have put the pressure on us to put more and
more into the documents. We are very fair in what we are presenting to the
public. I will conclude with that, because I am sure there may be some
Senator Angus: We have been trying to get a handle on the hedge fund
industry in Canada, and to what extent, if any, there needs to be some
oversight. I am getting the impression that every witness — and we have been
blessed with fine expertise — is bending over backwards to say not more
regulation, but less. Am I correct that you fellows are all of the view that
there is ample regulatory oversight of the hedge fund industry in Canada right
Senator Angus: Mr. Kaul says yes.
Mr. Kangas: A qualified yes. Where we may have some issues, and it is
not necessarily regulated, is at level of the education and knowledge of the
financial advisers. Many of these are complex strategies. Financial advisors
can, however, take the time to learn and people like Mr. Guthrie will tell them
what they are doing in their portfolios. Firms recognize that and are putting
more pressure on their people to take in-house courses. The managers are
regulated enough. The incidents we have had in Canada were more fraudulent
activities than actually things they were doing wrong as hedge funds. Portus was
not actually doing the hedge fund part; they were more of a marketing firm.
Senator Angus: Exactly. Did you want it say something on that, Mr.
Guthrie, just under regulation? Putting it simply, is there a need for further
Mr. Guthrie: I am trying to think of some of the larger firms that are
not here, the billion-dollar capital moguls on bank trading desks. The large
money moves in these other markets, the over-the-counter market, and the swap
markets. That is where the big money is. It is regulated by the IDA or not —
that is part of their problem. If there is any systematic risk, it may happen
there. We have thought about that a great deal in house and how avoid that risk
with our clients.
Regarding the distribution and the qualifications required to manage money in
Canada, we are probably the highest in terms of levels of expertise required
Mr. Kaul: Some of the perspective on this comes from the U.S., where
it definitely is not regulated at the SEC. Although half the funds are
registered and most of the large ones are, there is an area that is not
registered — it is very different — and that is where the main lens comes from
when you talk about hedge funds.
Senator Angus: If I were to start off our report, I would be writing
something along the lines that this is a very confusing area. It is a whole new
investment landscape for a Canadian investor. Twenty-five years ago it was a
totally different landscape. You had stocks and bonds. Some of have a mindset
related to that landscape.
Clearly, having heard all the testimony here and in New York, I recognize
that today things are totally different. I do not know whether my colleagues are
quicker studies than I am, but I am totally confused. I have read the material.
It is the best piece I have seen yet. Your picture is in it, Mr. Guthrie. This
is recent; you have not seen it, I am sure. I have 100 copies. I see your boys
have them. This is a very helpful thing.
Hedge funds are brand new in Canada for the most part — say, starting around
1999 — especially for the smaller operators. They have grown and are growing
like Topsy. We have used these huge numbers to indicate the extent of money
under management, but it depends on what you are talking about.
I will now ask what may appear to be rather elementary questions. Let us
start with Hillsdale Investment Management Inc. We had a group in here called
Front Street Capital. Their picture is in here, too. Are you in the same
business as them?
Mr. Guthrie: We are.
Senator Angus: If I understand well, both firms hold yourselves out as
investment managers. People give you their money and your firms manage it. In
Hillsdale's case, it is usually the more conventional instruments: U.S., Canada,
Japan, bonds, stocks, and equities. You folks seem to do different things. We
talk about hedge funds. If I understand it, both Front Street Capital and
Hillsdale have a bunch of funds that you have started yourselves. You present
those vehicles to your clients and you say, "We get 10 per cent on this one
because this one is in energy. We get 22.7 per cent on that one because it is
senators,'' or whatever it is you are dealing with. Am I correct that you will
have X number of single-managed funds — and that is a buzz word, I am finding
out — as opposed to funds of funds? Do you have funds of funds in your
Mr. Guthrie: No. It is helpful to think of a manufacturer versus a
distributor. Front Street Capital, Hillsdale and Sprott Asset Management are
primarily manufacturers; BluMont is primarily a distributor. It does some
manufacturing, a small amount in-house, with one manager, 15 people and two
people manufacturing distribution through BluMont.
Senator Angus: Right. Some of your products are sold through BluMont.
Mr. Guthrie: Yes, they are.
Senator Angus: You will get the money in and you will decide, for
example if we have $1 million, to put X per cent in one fund. We are talking
about an average leverage of 1 to 3, I gather. I think of it in terms of golf,
as does Senator Massicotte. Press number 1 means that it is 2, and P3 is 3 to 1.
That is what you are doing.
How many funds do you have at Hillsdale?
Mr. Guthrie: We have five. Front Street Capital has 20, depending on
your size. We have created those.
Senator Angus: You have manufactured those. In terms of the structure
of each of those five funds, that is your intellectual property. You have a
model. You may be using the chaos model or other models, but you do not want
anybody else to know what that is because that is your mouse trap.
Mr. Guthrie: There is some element of discretion required. It is where
hedge funds run up against disclosure. We have a window with the securities
commission that says that we can sell to smart rich people, or sophisticated, as
you find it.
Mr. Kangas: "Smart'' and "rich'' are not always together.
Mr. Guthrie: We can say "and/or'' without necessarily having to post
our holdings on the website for everyone else to see. It is a little window that
Senator Angus: That is where we get to the area where this committee
said that we better have a look at this thing. You put your money in. One of
your clients says, "I want to get into hedge funds. I will go to Hillsdale
because they are specialists and they have great hedge funds. All their clients
are getting a bigger number than the ones that are at Jarislowsky Fraser in
conventional equities.'' The individual goes there and puts the money in, but he
does not know what you will be investing it in. Am I not right?
Mr. Guthrie: How much do any of us know about our suppliers? I fly on
an airplane; do I have to know how it works? I do not want to be obtuse. When
Jarislowsky Fraser first began its ascension, not too many people knew what they
were doing, either.
Senator Angus: No, but they send you a holding sheet every month
stating that you have 300 shares of Canadian Pacific.
Mr. Guthrie: That is important to know. Any of our clients get the
same reporting, if not more.
Senator Angus: What does it say? It is the name of your fund?
Mr. Guthrie: No, once every six months they get each stock in the
fund. It is the same disclosure.
Senator Angus: So the funds hold equities?
Mr. Guthrie: Yes.
Senator Angus: I thought they were trading every day, trading
derivatives and structures products.
Mr. Guthrie: Some are; not these.
Senator Angus: Yours do not.
Mr. Guthrie: Trading funds are one class of hedge funds. High
turnover, low turnover — they are different ways of managing the same strategy.
Even in mutual fund space or in investment management space, even from
Jarislowsky Fraser to Phillips, Hager & North to GBC Asset Management, you still
have ranges of skill sets. It is just that the degrees of freedom that we have
are more. Most of them are long-only, for now, because, we would argue, it is
harder to do long-short. I will put that on the record. It is more than twice
the work to get it right. You need more staff and resources.
Senator Angus: And it is riskier?
Mr. Guthrie: No. You almost got me.
Mr. Kangas: When I first became a mutual fund analyst and analyzed the
long-only managers like Jarislowsky — and I did that for 10 years — I told my
mother that I was going into mutual funds. She said, "Aren't those really
risky.'' They go from money market all the way to emerging market where an
emerging market fund can lose 50 per cent of the client's money yet it is fully
prospectused and Ms. Smith can own it for $5,000.00.
You can have something as straightforward — I do not want to call it simple —
as Veronika Hirsch, a five-star recognized mutual fund manager who became a
hedge fund manager. We advertise her as a Canadian equity manager, but now she
can go long with her stock-picking ideas, the companies she knows very well, and
short the ones that she does not think will do very well. That is probably the
simplest one you can do. She can say, "Here is one in that area that I think
will do well. Here is the worst company in that area that might be more of a
pair trade. Here are some dog companies that have horrible managements and bad
balance sheets. I just know they will go down and I can make money off of that
going down, like Nortel.'' It can involve very complicated strategies and black
boxes and things that are esoteric, but there are a whole range of instruments
available. Depending on how they have restricted themselves, all the managers
are focused on making money. If you give them a broader palette to use, using
the artist analogy, they are trying to find something inefficient in the market
where they have an edge and they can make money. Jarislowsky, however, has
confined himself to Canadian equity say for one portfolio that will be long
only. It is a huge portfolio; he cannot make many interesting moves around
because that portfolio is so large.
Mr. Guthrie: It is $72 billion.
Mr. Kangas: Yes, $72 billion, which is fine. He is then forced to own
the top 100 stocks, which is fine. Over time stock markets have gone up, but it
is a different vehicle. Not everyone will understand because the world has
gotten a lot more complex.
Senator Angus: But he is not called a hedge fund or none of his
portfolios are, whereas yours is. Is it because of the short dimension? That is
a hedge. You are shorting because you are betting. You are gambling.
Mr. Guthrie: No! There he goes again.
Senator Angus: Yes; that is what it is.
Mr. Kangas: The long-only manager is gambling that the stock will go
up. Veronika Hirsch will gamble that it will go down. They are both gamblers.
Senator Angus: They are not gambling. They are making a judgment. They
are buying a security, and the investor knows it. In the shorting, you are
selling it short because you figure the price will go down and you will buy it
back and make a killing.
Mr. Kangas: But why are you going long on the stock? You figure it is
a great company and it will go up and you will make a killing.
Senator Angus: That is logical.
Senator Goldstein: It just bothers us.
Mr. Kangas: It bothers CEOs of the companies that are being shorted.
The Chairman: We are agreed that going forward is a bet and going
backwards or hedging is also a bet.
Senator Harb: You are mostly lawyers. I am probably the only engineer
here, so I will ask you two questions. When we were in the United States, we
heard over and over from different witnesses that everybody seemed to be betting
on the same thing, almost, and I am not sure if I am using the proper word. Like
a herd, they all bet on the same thing. Everything gets crowded. If there is a
problem, not just one goes down but everybody goes down. Is it the same here in
Canada, or is it different?
Mr. Kangas: I will make one global comment. With the statistics from
hedge fund research, overwhelmingly the largest area of hedge funds is
long-short equity managers. Yes, there are some interesting traders like
Amaranth doing things that get large headlines. I guess it can happen that they
all pile into the same stocks and buy Microsoft and short Cisco, but they all
believe they have their own intellectual capital in the niche they are in or
their own information edge. There are other trading strategies, managed futures
being one, where many of them have a similar kind of model, which is what we
would refer to as a trend following. They all see the same trend accumulating in
the market, and they can all pile in.
That whole industry as a subset is around $120 billion to $150 billion, which
is small. That is a fifth of the Canadian mutual fund industry. Yes, you can
have correlation where they are all going the same way, but I do not think that
at $1.5 trillion overall or even $3 trillion — the largest number heard — they
are all on the same trade.
Mr. Kaul: I would answer that question more dramatically. No, they are
not in the same trade. It is an easy comment to make, but it is not true. Take
the long-only space, for example; today, 30 per cent of the index is weighted
towards energy stocks. Anyone who owns the index owns the same stocks. They are
effectively also all in the same trade, to follow the analogy. That comment can
be made about any asset class. Anybody who owns Toronto real estate or Ottawa
real estate is in the same trade. It is easy to say, but it does not really have
A hedge fund can actually control its risk exposure. You asked before what
our returns were. You also need to asked, what is the level of risk you
undertook, and what was the correlation to the other asset classes? Those two
other questions, which do get as much press regarding risk management and
diversification through correlation, are the two tremendous benefits that you
get by building a different type of portfolio.
Senator Harb: A hedge fund manager also has the ability to be a mutual
fund manager; is that true?
Mr. Guthrie: Yes.
Senator Harb: He can manage two portfolios. In hedge funds, you are
tied to performance. If the hedge fund does well, you do well. On mutual funds,
you are based on fees. It does not matter. You can go to developing countries,
you can go to developed countries, you can do whatever it is, and you are
guaranteed to get the fees.
Is it possible that at some point you would have to look in the mirror and
feel a bit embarrassed as a manager? Perhaps you are a bit biased because you
say to yourself, why not do this? Why not short the stock and turn around and
buy the long end of it? Do you think it is a potential for a conflict of
interest? In the U.S., according to The Wall Street Journal, November 1,
there are 124 individual portfolio managers who run both mutual funds and hedge
funds. The year before, there were 112, but the year before that there were only
60, so there is a huge shift from running one portfolio to running two. The
chief executive officer of Clover Capital Management said that this area is rife
with potential conflict of interest. Do you share that view and, if that is the
case, is it the same here in Canada? If that is the case, what can we do as
Canadians to deal with that?
Mr. Kangas: It is a potential conflict at the level of an individual
portfolio manager level as opposed to of a firm, which is a distributor or
packager where they are selling different products. You could have a totally
different department down the hall on another floor that is your hedge fund
department, and then you have your long only. There can be some separation of
duties. It is the perception of the public. Where you have a direct conflict is
the portfolio manager running a long-only mutual fund and a hedge fund. The most
obvious conflict is the performance fee. If I am getting 20 per cent of the
performance fee for the hedge fund, that is where my best idea goes; second best
goes to my mutual fund.
Senator Harb: Exactly.
Mr. Kangas: There should be policies and procedures around that and
compliance and fairness to clients. It gets greyer for the firm if they allow
their manager to have both. It is becoming a conflict of interest particularly
in the U.S. because very successful money managers want to go to the hedge fund
industry. If they are good, they can make a lot more money.
The Chairman: To continue with Senator Harb's point, there are no
Chinese walls within firms, other than being nice.
Mr. Kangas: I do not know that we have that potential exposure in
Canada. It should be monitored with mutual fund companies and what they are
Senator Massicotte: What would you do?
Mr. Kangas: The quick answer would be to prohibit the practice and
physically separate it or do something. It is hard to Chinese wall it or
Mr. Kaul: At our firm we do run long-only as well as long-short funds.
If we are trading the same stock in both funds, we trade them together. We have
a fair dealing policy where we trade all of our clients.
Mr. Guthrie: It is Ontario Securities Commission policy. It is a big
one. If you are caught, it is a big crime, not a little crime.
Mr. Kaul: Under our CFA charter also, it is also a fairly significant
Senator Angus: Do they do reviews?
Mr. Kaul: They have audits, yes.
Senator Angus: Market timing and late trading came up regarding mutual
funds, and that is the area that you are getting into, Senator Harb, is it not?
Senator Harb: In physics, there is a principle that is straightforward
and applied everywhere. Anything that goes up continues to go up until the point
where it must come down. As for hedge funds, from what I have heard, here in
Canada we have a solid regime, and we may or may not have to do anything.
However, in Europe as well as in the United States, we were told that this
industry is growing at an incredible rate of 30 per cent. It started small and
now it is in the trillions, and it is getting into retail and into all kinds of
sophisticated types of investment and so on. How long will the party go on? In
your estimation, what do you think the government or you as an organization or
the securities in Toronto should do in order to prepare a potential safety
mechanism in the event that the party comes to an end, if it comes to an end?
Mr. Guthrie: Many things are going on. If you asked us where the
industry is going in five years, we would say eventually hedge funds would merge
into main stream investment management.
Our best competitors come from the long-only space, not Jarislowsky perhaps,
because he is not yet interested, but Barclays Investment Counsel has a large
hedge fund, huge distribution and a high-quality product, as well as Goldman
Sachs, all previously long-only, now doing hedge funds.
Going forward, we see that there will no longer be a designation of hedge
funds; there will just be investment management, and this will be an asset class
or a way of doing it, like long-only, which is going the way of the dodo, not
because it is a bad thing. There is nothing wrong with investing long-only; it
is just that you can now buy it for free in exchange-traded funds, ETFs, or
index funds, which cost 2 basis points. It has forced the entire industry to
differentiate itself from those index funds. That is the first step, which is
why everyone had to go somewhere else, not at 2 basis points.
Your other question related to the party. It is not a party; it is just an
Mr. Kangas: We have not had a party. I was at the global hedge fund
conference just outside of Toronto and there was an exhibit, a fascinating
chart, which I can have emailed to the senators. The chart showed the hedge fund
index for the United States over a longer period of time than we currently have
an index for in Canada. He showed Scotia Capital's hedge fund index, and it was
almost right on the TSX for the last couple of years. Except for what happened
on Halloween night, the TSX has been pretty much straight up. A lot of Canadians
say, "What do I need a hedge fund for? I hear they have higher fees and I am
doing very well.''
If we had the index going back to 2000, which is what the exhibitor showed on
his longer-term U.S. chart, you would have seen that hedge funds prior to the
bear market were almost on top of the S&P 500 index. Then the S&P fell and hedge
funds were able to carry their way through. That is why the other countries say
they want something that diversifies. I have seen it happen. The bear market
might come around again.
Hedge funds have been growing like Topsy. They have been having a party. I do
not know that it will end. It will just be a different way of investing, a
better way. Mutual funds have asked for up to 15 per cent short-selling and to
still be called a prospectus mutual fund. When will they ask for 20 per cent?
When will they ask for 1.5 leverage?
Senator Goldstein: I am very happy that you are here, Mr. Guthrie.
You should know, Mr. Chairman — the deputy chair knows this — that Mr.
Guthrie's father is a justice of the Superior Court of Montreal and an expert
on, amongst other fields, bankruptcy.
The Chairman: So we have three generations of great people: Mr.
Guthrie, his sons and the grandfather. Aren't we blessed.
Senator Goldstein: I have had the pleasure of knowing three.
I want to go back, Mr. Guthrie, to systemic risk. You indicated by way of
analogy that all investments are risky, which they certainly are. You used, by
way of example, Calgary real estate, 20 times more expensive than it was way
back when; and Nortel, which operated like a yo-yo.
This is true of all classes of assets over time, that one can look at Calgary
real estate, to use your example, on a day- to-day or week-to-week or
month-to-month basis and see what is happening with it; one can look at Nortel
on a day- to-day basis and see what is happening to it. However, one cannot
really look at the investment of hedge funds. I am talking perhaps less about
the short-long funds that are relatively easy to deal with. I am talking more
about the derivatives and certain other more sophisticated tools in one's
arsenal that are not well known, coupled with the fact that whatever one is
doing in Canada may be duplicated, in a way which one does not know, by offshore
hedge funds, the result of which is you can find an Amaranth-like phenomenon
caused not by an Amaranth that itself went short so significantly, but by a
group of hedge funds. There is no way for people to know that that is happening
if it is spread throughout the world, which at the moment it is, I think.
Mr. Guthrie: We do have measurements of total options outstanding,
Bank for International Settlements. That is why we brought you the data. We can
tell how fast the asset classes are growing. In that chart, the fastest-growing
asset classes were not hedge funds; they were derivatives. We know this and
banks know this. As least it is being measured. It is not necessarily true that
we do not know where the clustering of risk is happening.
Senator Goldstein: It is being measured, but not on a day-to-day
basis. Short interest versus on the New York Stock Exchange is published once a
Mr. Guthrie: Yes. That would be probably one of the most primitive
measures. It is one of those lagging indicators where no one has told the TSX to
get with it and do it faster. The option data and the over-the-counter market is
pretty real-time, the futures market. These are very sophisticated, real-time,
global markets that settle instantaneously, before the trade is even finished.
That data is known.
I am sure that the Federal Reserve Bank monitors that data very closely. The
only thing I can offer in terms of clustering of risk is that when we all begin
to have the same opinion about anything, then we have clustering. When
everyone's interests align as to both the time of my retirement and the risk
budget I can have, and my opinion as is the same as everyone else's, such as it
was with the Internet, then we have risk.
With hedge funds, we have been trying to say that there are enough different
players. To get a coincident bubble of risk bets in that industry is less likely
than in the industries about which we have spoken before, which are traditional
asset classes where everybody, without knowing, is participating in a bubble.
They are the ones to worry most about.
Our being here and talking about the option market is a good thing, but it
probably is not where the risk is right now. It is probably something we have
not seen yet, unfortunately. I do not know that it would be just because of
hedge funds that that would continue to happen.
Senator Goldstein: What role does the custodian play? I understand it
to be a passive role. There is no oversight or supervisory role, is there?
Mr. Guthrie: No, that is not the case with ours. It is not the case
with IDA at all.
Senator Goldstein: Tell us what the role would be.
Mr. Guthrie: It is their capital. Their role would be to monitor the
risk allocated to each of their clients, which would be us, in an aggregate
sense. It would apply to their balance sheet, as any other bank. In this case,
prime brokers have an allocation of risk to corporate finance and merchant
banking, and somewhere at the top of the bank is someone measuring that risk
budget. They are monitoring very closely how much their exposure is.
Senator Goldstein: Do they set off their own risks?
Mr. Guthrie: Yes, absolutely.
Senator Goldstein: Do they deal with counterparty transactions?
Mr. Guthrie: They set it off by time, long versus short duration; they
set it off by different clients, by virtue of the different approaches we are
all using. That is not just an oversight; that is an actual profit-centred
occupation. They are on it.
Mr. Kaul: They are probably the most regulated; the Market Regulation
Services, RS, looks at the custodian, as well as the Montreal Exchange, the OSC,
the IDA. Everybody regulates the custodian. That is where the primary control is
in terms of the capital adequacy margin lending. They are very much regulated
and they are the centre of where all the cash is flowing through.
Mr. Guthrie: Margin calls happen to us, as anyone else, just like in
the long-only space, every day.
Senator Massicotte: Obviously, the sector is hot. I agree; it is
another asset class, and I agree with allowing a lot of freedom. Let me make a
hypothesis. Every 10 or 20 years we have a new theory or monetary policy and we
find out 10 or 15 years later that it did not work. The way you look at it now
is you cannot lose. You are obviously hedging. Suppose that five years from now
this is a disaster. What is it that went wrong? I am not talking about fraud,
which is hard. What is it that will have gone wrong if, five years from now,
people are upset and governments are really clamping down harshly on your
sector, which allows immense freedom, contrary to many other funds?
Mr. Guthrie: We already have opinions, so thank you for asking. The
fact that capital will outrun the rest of us is the biggest part of this — that
capital unfettered makes the world go too fast, as when a hedge fund
restructures Stelco at its pace, as opposed to our pace. These are the important
things we have to talk about here; and that is usually when the restrictions
start to happen. Whether we are talking about private equity funds or hedge
funds, when they participate in corporate restructurings that affect real people
at a faster timetable than most people can even imagine, that is when the
push-back starts to happen.
Senator Massicotte: In other words, given that capital has no
citizenship or feelings and given the lack of structure to it, it might not
necessarily be in society's best interests. Is that what you are saying?
Mr. Guthrie: That is a very difficult thing to agree with, because
there are huge benefits to having capital lead us certain places. We would not
have built the Internet as quickly as we did without unfettered access to
capital. Nortel went up and down, but along the way we built the Internet. It
was not government spending that built it, so it got done.
It is difficult to balance those two, but you need both. You need capital to
lead and you need people to say maybe it is too fast or maybe it is the wrong
Senator Massicotte: Mr. Kangas, how would you answer that question?
Mr. Kangas: I guess there are two things. Is there some implosion of
this growing hedge fund? One thing can be returns just eroding — not anyone's
capital deteriorating, but the hedge fund managers cannot justify their higher
Senator Massicotte: Because of competition?
Mr. Kangas: Everybody is in it; and they are all long-short or doing
whatever, and there are no more returns for which investors are willing to pay a
premium fee. There is no question the fees are higher in this than in a
conventional index fund.
Senator Massicotte: I was looking for something very negative. I
consider that to be good news, not bad news.
Mr. Kangas: That would change the industry. Capital would leave to
find better returns. The other thing is that maybe for some of the investments —
I think both you and Mr. Guthrie may be hinting at this — managers seeking a
return are often called activist shareholders now, getting on to company boards
because they perceive the company to be undervalued. It is much like the
leveraged buyout, LBO, craze that we went through. Fire that management team,
put a new team in, lever it up, fire a bunch of employees — are those good
socially for us? Free markets tend to balance those out over time. Do you
regulate that away? I do not know that you can.
Mr. Guthrie: There is a natural equilibrium. It is not possible for
all managers to successfully run hedge funds. If you are running a skill-based
program, there is a maximum limit that the market can bear. If you need a
certain skill set to create a gap between your good and your shorts, you maybe
have a 10 per cent to 15 per cent maximum on the participants in the hedge
The Chairman: I do apologize; we only have less than a half hour for
our next witness. I only have one question, if you can answer it in one word; it
is a key question. We heard from the derivatives market in Montreal that they
have a clearing house, and a formula to hedge risks there. Would you fellows be
in favour of a clearing house dealing with your business? If you want to
consider the question, take a look at the transcript from the session with the
Montreal Exchange. We went into this question extensively and we do not expect
you to answer right away. You can come back and say yes, no or maybe.
I want to thank your sons, Mr. Guthrie, for being so patient, intelligent and
thoughtful. William is gone but Caleb is still here. We are delighted that they
could come and spend the time with us without falling asleep. Thank you very
Our next witness, Colleen Moorehead, is the president and CEO of Nexient
Learning Inc. and the representative of a task force that is looking to
modernize securities legislation in Canada. Welcome, Ms. Moorehead, and thank
you for your patience.
Colleen Moorehead, President and CEO, Nexient Learning Inc. and
Representative of the Task Force to Modernize Securities Legislation in Canada:
Thank you. I appreciate having a chance to speak to you on behalf of the
Task Force to Modernize Securities Legislation in Canada.
By way of background and context to my comments, 16 months ago the Investment
Dealers Association, IDA, charged us with studying how we in Canada could
modernize our securities regulation and how we could enhance or maintain the
competitiveness of our capital markets. I was lucky enough to have the privilege
to serve as a committee member on this task force, under Tom Allen's
chairmanship, to work with some of the most respected experts in the capital
markets — not just in Canada, but anywhere.
A lot of work went into the project, and we had the benefit of unprecedented
amounts of expert data to support and form the basis of our work. The
culmination of this process was our report, which was called Canada Steps Up.
We called it that because we wanted it to be more than just a report on the
state of our capital markets, or more than just a compendium of all those expert
recommendations; we wanted it to be a call to action for the stakeholders.
The context of my comments is that we believe that in Canada there is a "made
in Canada'' discount that is holding us back. Currently, our capital markets are
operating under a burden of cumbersome compliance regulations, uncoordinated,
uneven enforcement and, frankly, too many investors who are not adequately
informed. We called it the made-in-Canada discount because it undermines the
value of our capital markets by increasing the cost of capital to Canadian
The crux of this report was to transform the made-in-Canada discount to a
made-in-Canada premium. Specifically, we made 65 recommendations, and today I
have been asked to address our recommendation on hedge funds. That is the
context of the way the work was done.
As you know, hedge funds are a new and emerging product that can help make
our markets more competitive. That was the context of the task force mandate.
Simply put, the more products that are available for investors to choose, the
greater investor participation and the more competitive our markets.
The other thing to note is that the hedge fund industry represents a highly
valuable pool of talent in Canada's capital markets, which needs to be fostered
and not discouraged from conducting legitimate operations in Canada. Therefore,
we take the view that the pool of investors permitted should be as large as
possible. We also take the view that investors should make investment choices
within a regulatory framework that promotes transparency, investor protection
and sound management and governance.
We believe that it is time to establish a regulatory framework to allow hedge
funds to be sold to the public, just as the regulatory framework was created for
mutual funds. Our recommendations were focused on retail investors and not the
We made the point that hedge funds were formerly for the super wealthy. The
average retail investor now sees them as potential investment products.
Unfortunately, hedge funds are loosely regulated and poorly understood by many
Up until now, there have been few offerings of hedge funds by way of
prospectus. For all intents and purposes, members of the investing public who
can invest in hedge funds are wealthy Canadians who meet the accredited investor
definition under National Instrument 45-106 or who have the means of investing
more than $150,000.
One important variance to the above is with respect to principal protected
notes, or PPNs. Currently, Canadian investors, regardless of wealth, are allowed
to purchase complex structured investment products, such as principal protected
notes, linked to hedge funds via the back door without the protections afforded
by securities laws because they are structured as evidence of deposits and
therefore are considered exempt securities. Direct investments in hedge funds,
on the other hand, are limited to investors who qualify to purchase an exempt
security — in other words, the wealthy. This state of affairs struck us as
ill-advised and contradictory.
How, then, does the task force see the features of the new regulatory
framework for hedge funds? In our view, it would focus on, first, transparent
disclosure to help retail investors make informed decisions. That would include
a number of elements: first, full disclosure of all performance, management,
administrative, referral and other fees, including the compensation of the
investment adviser and manager; second, a description of the relationship
between the hedge fund manager, adviser, administrator, prime broker and
appropriate cautionary language regarding conflicts of interest between them;
third, mandatory disclosure of any side letter or other collateral agreements
between the funds and investors who receive special fees or liquidity
arrangements; fourth, a description of the mechanism by which funds assets are
valued; fifth, a description of the fund structure and its investment
strategies; and sixth, in the case of principal protected note products linked
to hedge funds, a full description of the underlying investment incorporating
all of the features listed above.
The second area of focus would be to provide better investor protection by
first regulating the sale of principal protected notes where the economic value
is based on the underlying hedge fund according to the nature of the underlying
investment rather than according to the exempt character of the related
principal protected note in which the investment is actually wrapped. It would
allow sales to the exempt market but not treat the securities as an exempt
security. Second, it would require all advisers selling hedge funds and other
structured products to demonstrate that they understand these products by
satisfying certain proficiency requirements. In other words, it is know your
The third area of focus would be to increase regulatory oversight as to
reduce the very real risk of inadequate capitalization, inappropriate internal
controls and governance procedures.
Hedge funds are particularly vulnerable to operational risks associated with
poor management, but there currently is no safeguard in place to ensure a hedge
fund manager has adequate capitalization, appropriate internal controls or, at
the most basic level, whether the manager's principals are fit to manage an
investor's money. Accordingly, we recommend that consideration be given to the
registration of hedge fund managers to ensure appropriate regulatory oversight
of the manager as well as the fund's capitalization and governance procedures.
We are well aware that a similar U.S. proposal related to the registration of
hedge fund advisers, not managers, met with resistance and judicial
intervention. In Canada, as we know, advisers have been registered for a very
The task force is recommending that all securities regulators in Canada
undertake empirical and rigorous cost- benefit analysis on the introduction of
any new rules. We have not undertaken — and the task force did not undertake —
such an analysis and that should happen before any new rules are brought
Those are my formal comments. I would be delighted to take your questions.
Senator Massicotte: I would like to ask you the same question I asked
of another witness. Let us say that five years from now hedge funds hit the wall
and people are upset and they lose money but not because of fraud. What is the
weak point in the structure of hedge funds as it exists today?
Ms. Moorhead: The hedge fund asset class is an important asset class,
an emerging asset class in Canada. Our recommendation revolved around access to
that asset class in a framework that included disclosure. If disclosure,
transparency, good governance procedures and controls are there, then based on
the recommendation we made we think there would potentially be a lower
likelihood of that type of outcome because there is a regulatory regime in which
a retail investor is making an informed choice.
Senator Massicotte: Since you are concentrating on retail investors, I
gather you are reasonably comfortable that the exempt provisions for the wealthy
individual as currently defined are adequate and that they have no further need
for fuller disclosure. Is that accurate?
Ms. Moorhead: That is accurate.
Senator Massicotte: In your mind, they are sophisticated enough. In
spite of the fact that these funds have immense freedom and significant fees
with immense leverage, they are okay, they are smart enough to know what they
are getting into.
Ms. Moorhead: When the task force reviewed it, we used external
research. We used André Fok Kam and Wes Voorheis, who also did some work on the
two particular incidents in Canada.
Based on the research, we concluded that the informed investor, the
sophisticated, institutional investor, is making decisions and has the ability
to do a deep due diligence. Our view is that hedge funds continue to be an
important asset class globally. Having access to that with the suggested
regulatory regime is what we should do to modernize our markets. Our markets are
global. We compete globally for assets.
Senator Massicotte: You talk about the public offering of hedge funds.
My understanding is that any public offering of securities needs to go by way of
prospectus. You basically list six items which should be disclosed on that
prospectus. I am not an expert on that, but I gather that the current
requirements by the securities commission on prospectus would not have provided
those five issues; is that right? I would have thought the prospectus as
currently structured would have provided that information. I gather that is not
the case, or you would not have recommended it.
Ms. Moorhead: I want to be careful to answer that question correctly.
The retail customer accesses the asset class today predominantly through
principal protected notes. That asset class, for retail participants, does not
have the safeguards that you have just listed.
Senator Massicotte: My understanding is that that is only because the
banks are the principal distributor. Given that they are regulated under the
Bank Act and not under the securities commission, that is why there is no
prospectus; is that right?
Ms. Moorhead: That is the form versus substance argument, yes. That is
where retail is investing today.
Senator Goldstein: Are you aware of whether there would be any
resistance on the part of banks for the principal protected notes to be subject
to registration and a prospectus? Did your task force canvass that issue?
Ms. Moorhead: I am not aware of a specific response from the banking
community on that.
As part of the task force consultation, we had an open forum facilitated by
André Fok Kam. We had representatives from prime brokers, custodians and bank
representation, and there was an open dialogue around principal protected notes.
Senator Goldstein: Was there no specific concern about resistance on
the part of the chartered banks?
Not that chartered banks really market those things, but on the part of
others who are marketing them? I am thinking for instance of the situation of
Portus where they were essentially a marketing operation that purported to
market principal protected notes but they were not principal protected notes at
all, as I understand it.
Ms. Moorehead: Right.
Senator Goldstein: They were regulated by the OSC, yet they were
giving a 4 per cent commission, as I understand it, to people selling these
products. The products were sold to people who perhaps did not understand what
they were buying. They thought they were buying principal protected notes but
they were not.
That was a regulated, registered operation which somehow escaped appropriate
scrutiny. How does one avoid that?
Ms. Moorehead: Mr. Voorheis wrote a good report on the Portus
situation. Clearly there were a number of issues in the Portus file. Some of
them related to whether investments were actually made, whether there were
control procedures in place, whether or not the adviser was making investment
decisions under a blind or an investment council right.
I think Portus is a good example for us to review regarding whether, if
retail investors are to participate in this asset class, there needs to be
disclosure protection and all of the things I outlined in my opening comments.
It does not say that fraud cannot occur in the capital markets, just that there
is a regulatory regime and a scrutiny process that allows issues to bubble to
Senator Goldstein: In the previous presentation, one of the presenters
spoke about moving to a principles-based regulation and to use the example of
the financial services authority in the U.K. for that purpose. According to this
news release furnished to us, there is a rule book, which they intend to replace
on November 1, 2007; the previous presenter suggested to us that that would be
an adequate type of regulation, as I understood him.
Ms. Moorehead: As part of our deliberations, we met with people in the
U.K. I do understand what they have done. As well we met with people in the U.S.
I would say our recommendations around retail also include the obligations of
the people distributing and providing advice to know the product. Some of the
rules in that principles-based discussion are around segregation of duties,
pricing by a third party, that type of thing. We said that it would be an asset
class that retail investors should be able to participate in, subject to having
those principles in place.
In Canada the precedents are generally rules-based. We are not commenting on
the regulatory framework. We are talking about whether there should be one, not
whether it should be rules-based or principles-based.
Senator Goldstein: Let me tell you why I am asking the question. On
the same day that the financial services authority published proposals for moves
to principles-based regulations, an article by Marietta Cauchi appeared in the
Wall Street Journal. The article said that the U.K. financial regulator has
warned of risks to financial markets posed by the multi-billion dollar private
equity industry, particularly through excessive leverage levels and subsequent
trading in debt and credit markets.
The Financial Services Authority said it planned to step up surveillance of
both issues, and yet the same Financial Services Authority said we will be okay
with principles-based regulations, although they seemed to say that they are not
quite ready to deal with the hedge market generally through the suggestions made
earlier the same day. I find that very confusing, given that the previous
witnesses said essentially that a move to principles-based regulation would be
okay. That would satisfy all the needs for surveillance. Do you agree with that?
Ms. Moorehead: I do think it is dealing with two very different
issues. I start with that comment. The U.K. is already a principles-based
regulatory regime to start, so it is not inconsistent that they would follow on
along that line. The second thing you are talking about is whether or not there
is systemic risk in the asset class. The task force did not speak to systemic
risk specifically, although André Fok Kam does discuss it briefly in his report.
Systemic risk and the monitoring of that risk and having the controls in the
system do not necessarily need to be done in the regulatory framework. When we
look at how it is done in North America or in Canada, the view to systemic risk
in the capital markets generally is held by a different jurisdiction, if you
will. It is really two separate things.
As to what the past speaker said as to whether or not that is sufficient,
good controls for systemic risk reduce the risk of systemic risk. Good
compliance to a principles-based regulation has been effective in the U.K., as
rules-based regulation has in the U.S.
Senator Goldstein: As hedge funds become more available to Mr. John
Brown on the corner of the street and less institutional, we and regulators have
to become more concerned about appropriate supervision, control, surveillance
and knowledge. I got the feeling from the previous presentation and others that
within the industry there is no great consciousness of that need. They are
saying, "We know what we are doing, we are careful, we understand the situation.
Do not worry about it; trust us.''
Ms. Moorehead: Again, the task force recommended that if a retail
investor is to be given access to that asset class, it should be in a regulatory
framework that preaches as stated. If that were the case, then we would support
Senator Hervieux-Payette: I will speak in French. For our Quebec
audience, it is nice to hear the other language spoken on occasion.
I have a question for you. When a regulated product is available to all
investors in the market, is the same product already available under the same
conditions in other markets, whether in England, the United States or Hong Kong?
In other words, have these countries made hedge funds available to the general
Ms. Moorehead: In our research, which André Fok Kam talks about in the
report or subsequent to it, our view was that Singapore was a regulatory regime
allowing access to hedge funds through a retail regime. It was interesting for
the task force to look at how they approached mutual funds first and then hedge
funds as an extension of the asset class.
Senator Hervieux-Payette: Does the lack of a regulatory framework — an
initiative that you are recommending — present a risk to the market, even though
the current clientele is supposedly sophisticated and well-heeled? Do you take
into account the sad stories that have emerged as a result of the major setbacks
suffered by the Amaranth energy hedge funds?
Do we need a regulatory framework if small investors do not have access to
Ms. Moorehead: The task force did not comment on that. We commented
specifically on retail access, because we believed that that would increase the
competitiveness of our capital market, which was the mandate. We were also
attempting to harmonize relative to other marketplaces. If retail participated
in a fund that invested — I will not speak about Amaranth — if the processes
were followed, and if there was clarity around capitalization, the reporting
requirements and the method of investing, I cannot say what the outcome would
be; but there would be clarity.
Senator Hervieux-Payette: My sense is that these funds cover virtually
every type of investment, which can be quite varied.
According to your investigation, are fund distributed only to very large
corporations, or do you think that one of the structural problems in Canada is
that SMEs do not have ready access to these funds, both equity and liability
types. It is difficult for them to access such funds to ensure growth. In terms
of fund accessibility and distribution, have you considered the possibility of
having to share the risks associated with smaller groups of companies that could
prove very attractive as potential hedge fund clients? They could potentially
experience significant growth, while these funds could minimize risk. Many SMEs
would gain access to capital that is currently unavailable to them.
There do not appear to be many financial vehicles that allow major investors
like banks as well as private investors to invest in SMEs here in Canada.
Ms. Moorehead: At the very basic level, or at the bottom of the
capital markets pyramid, is access to capital. The more access there is to
capital, the more funds there are available to invest in Canadian companies. No
matter what size those companies are, they can prosper. That is one of the very
important elements of the work of the task force. If investors were able to
access, through hedge funds, one of things we talked about in the retail regime
that allows retail investors indirectly, then they would disclose their
investment strategy. They would do that as part of the know-your-
client-know-your-investment category. We believe that access to capital in
Canada is great and positive.
The task force has 65 recommendations and only five of them are on hedge
funds. Many of the other 60 deal with how to reduce that discount in Canada, and
that is important. Anything we can do to drive capital to companies that are
under-funded or want to grow is a good thing.
The Chairman: I will end on that note. As you might recall, the
committee did a report on productivity. Currently, in listening carefully to
this emerging business, we are trying to balance consumer protection and risk
assessment with productivity while allowing capital to move swiftly and be agile
in order to attract more capital into the market and to make it more liquid.
I have one question. In your study, did you examine the productivity
consequences if the regime were to bear the additional regulatory elements that
Ms. Moorehead: No, not specifically. The task force deals with many
things around productivity but nothing about the hedge fund specifically.
The Chairman: I will raise one last question. Senator Angus and I have
been both thinking about the question of a clearing house. Did the task force
look at the question of a clearing house similar to the one that the derivative
markets have to accumulate and calculate risk on a systemic basis throughout the
Ms. Moorehead: I am familiar with the concept.
The Chairman: Would you look at that question?
Ms. Moorehead: We would have looked at it as part of our
deliberations. We would have had submissions from the Montreal exchange as well
as from the Department of Finance.
The Chairman: Did you opine on the question?
Ms. Moorehead: We did not opine on the question.
The Chairman: Thank you. If there are no further questions, I thank
the witnesses for their patience and their testimony. The information has been