An imbalanced regulatory environment created the Portus affair. All hedge fund products should be regulated alike, regardless of packaging

Miklos Nagy

Special to the Financial Post

Friday, May 13, 2005

As a hedge fund manager, I may be accused of bias but I feel I must speak out against the daily doses of half-truths and mixed messages in the media in the wake of the Portus fiasco. It is high time we took a good look at how hedge funds have been sold in this country and how they will be sold in the future.

Portus first got into trouble not because of its hedge fund management but rather because of its sales and marketing practices — practices prompted by regulation. Without the current regulations that limit hedge fund sales, the rise of Portus would never have occurred and the size of Portus-like operations would never have achieved their business volumes.

The hedge fund industry in Canada is still relatively small, but it has grown tremendously (about 40% a year since 2000) and now stands at about $16-billion retail and $10-billion institutional. Retail sales are still very small compared with the mutual fund industry as a whole and currently represent just about 3% of this market.

Until a few years ago, the few hedge funds available in this country required a high minimum investment. The Ontario minimum was $150,000, in New Brunswick it was $97,000 and in other provinces, with the exception of British Columbia, provincial minimums ranged in between. Basically, the only qualification for buying into a hedge fund was the amount of money a client was able and willing to invest.

In November, 2001, a new rule allowed so-called accredited investors to buy into hedge funds for a minimum determined by the company (usually between $10,000 and $25,000). An investor was considered to be accredited if he or she met either of two threshold requirements: income or net worth. The former required a minimum $200,000 individual annual income or $300,000 household annual income in each of the current and the previous two years; the latter required a minimum net worth of $1,000,000 excluding real estate. Investors who did not meet either of these requirements could still invest in hedge funds under the previously established minimums.

The new rule greatly lowered the minimum investment required for accredited investors and made it clear that, while regulators still wanted to bar most investors from hedge funds, they were prepared to make them more accessible to upper-middle-class and high-net-worth individuals.

Beginning in 2002, more and more a hybrid structure was developed so that hedge fund investments could be marketed to even more investors. These were the principal protected notes or PPNs. The basic idea of a PPN is that a large proportion of the portfolio is invested in a zero-coupon bond with a value at maturation (usually seven to 10 years) exactly matching the value of the original investment. The remaining, smaller portion may or may not be leveraged and is then invested in one or more single-manager hedge funds or in a fund-of-hedge-funds.

So, assuming that for each $100 of investment the required zero-coupon bond exposure is around $75 and the portion invested in hedge funds is leveraged at 200%, then $75 is invested in hedge funds in such a fashion that it is dynamically managed and cannot lose more than the original $25 principal. If the hedge fund portion works as well as in the past, its performance will increase the performance of the PPN.

There is no problem with this approach provided the investor is aware that fees for this type of investment are normally higher than those for hedge funds that do not allocate any portion to bonds and are not PPNs.

This awareness becomes even more necessary as more companies (including but not limited to leverage providers, guarantee providers and insurance companies) are offering this kind of hedge fund investment. Even though there are wide variations on excess fees among products (and data is not readily available), I estimate that the annual management fees for these investments are at least 2.5% higher than those of the average, unleveraged fund-of-hedge-funds.

To understand the impact of the structure on the performance and risk of a PPN versus a fund-of-hedge-funds, consider the performance comparison’s in the table above.

The last line shows that creating a product similar in terms of risk (with a 300% leverage on the hedge fund portion for an exposure equal to 100% of the principal) using the PPN route results in a 3.38%-per-year reduction in returns.

Why would the prospect of lower returns attract so much investor interest in Canada? Firstly, because these hybrid hedge fund products are packaged as so-called notes; they are subject to neither the minimum investment provisions nor the accredited investor rules applicable to other hedge funds. This means the minimum investment in a PPN can be, and usually is, as little as $5,000 regardless of the type of investor or his/her province of residence. Secondly, the principal guarantee is a feature with great appeal for Canadian investors, especially after the devastating years of 2001 and 2002.

That being so, it is not surprising that advisors have been selling large amounts of PPN product with the aim of diversifying their clients’ portfolios by including hedge funds. PPNs have become the vehicle of choice in Canada in large part because of the regulations governing investment in hedge funds proper — and that’s unfortunate because these note products considerably reduce the benefits of including hedge funds in a portfolio. In addition, PPNs are undoubtedly easy to sell.

Modern Portfolio Theory establishes that diversification can significantly reduce overall portfolio risk. This may be accomplished by including only low-risk products, but it can also be achieved by incorporating higher- or even high-risk products as long as they are uncorrelated with, or negatively correlated to, each other. These theories are in the public domain and have been a part of any investment course for the past 30 or 40 years.

Whether or not hedge funds constitute high-risk investments, and whether and to what extent investors should be protected by regulation, is a subject open to debate. However, I would suggest that if investors are to be protected, the same regulations should apply to all hedge fund products, regardless of their packaging. A loophole in the current policy has given rise to PPNs, a hedge fund product whose advantages are a low minimum investment and a principal guarantee but which, by its very nature, is likely to perform differently and with lower returns than a straight hedge fund or fund-of-funds.

The Portus affair is the result of this uneven regulatory environment. Small investors who were banned from hedge fund investments by regulation were naturally attracted to the PPNs, which promised hedge fund exposure but at lower returns. It is my view that without this uneven regulatory set up, Portus and other similar funds would never have grown to be such a major business over such a short period of time.

I am in favour of regulations as long as they level the playing field and apply to all hedge fund products, regardless of their structure. Investors who want the principal guarantee provided by a PPN should certainly be able to buy one and pay for the security with a likely lower rate of return. But investors wishing to include hedge funds in their portfolios for the purpose of diversification should not be presented with PPNs as the only option because of their low minimum investment requirements.

Miklos Nagy, CFA, is CEO of Quadrexx Asset Management Inc. a Toronto hedge fund company, and co-founder of Canadian Hedge Watch Inc. nagy@quadrexx.com. This article appeared in Canadian Hedge Watch Inc.