More information, please

There are times when our securities regulators are much too politically correct for my liking. A vital part of their mandate is to protect investors but often they are reluctant to impart specific information that would enable people to make more informed decisions about where to put their money. Why? Is it because they don’t want to embarrass anyone?

We had another example of this recently from the Ontario Securities Commission (OSC), the largest and most influential of Canada’s 13 (!) securities regulators. On Jan. 19, the OSC released a document with the long-winded title: Report on Focused Reviews of Investment Funds, September 2008 – September 2009.

The study, which was conducted by the OSC’s Compliance and Registrant Regulation Branch (Compliance Team) and the Investment Funds Branch was prompted by the turmoil in the financial markets in the fall of 2008. It focused on three types of funds: money market funds, hedge funds, and “non-conventional investment funds”.

The primary concern for most Canadians was money market funds. The collapse of the asset backed commercial paper (ABCP) market had resulted in a crisis for some short-term investment funds. National Bank had to pump $2 billion into some of its money market funds to maintain their $10 par value. In the U.S., Congress had to approve a multi-billion dollar emergency bailout for one of that country’s biggest money funds. No one knew what to expect next so the OSC launched an investigation to determine the soundness of Canadian money market funds. The two other categories were also added to the mandate.

The study was announced with a press release and then immediately vanished into bureaucratic limbo. The only report on the results was a tiny entry buried deep in last year’s OSC annual report. After several fund commentators asked for more details the Commission said they would be included in the report of the Compliance Team. That brings us up to date.

So what does the latest report tell us? More than we already knew, but still not enough in my opinion.

Referring to money market funds, the report says: “O ur focus was to determine if Canadian money market funds faced issues similar to those faced by U.S. money market funds relating to exposure to financial institutions having financial difficulties, illiquid securities or redemption risk. We observed that during the review period all funds were able to meet redemption requests, no investments held by the funds defaulted or were written down, and most funds were in compliance with the securities laws regulating money market funds.”

“Most” funds? That, of course, means that some were not in compliance with the laws. The report assures us that “the instances of noncompliance were not material and were addressed with each individual fund manager.” It does not tell us what the issues were or what funds were involved – information I certainly would like to know as an investor.

Going forward, the report recommends that money market funds be monitored “daily” for compliance with investment regulations and restrictions on concentration of assets – a daunting and probably impossible task considering there are hundreds of money market funds active in this country.

The report also found that in September 2008, about one-third of the assets of money market funds surveyed were held in bank-sponsored ABCP, a fact which, had it been known at the time, might have sparked a run on the funds. As of April 30, 2009 that figure had fallen only slightly, to 28%. The report tells us that fund managers practiced appropriate due diligence before investing in the ABCP they held and that the quality of the holdings was continuously monitored, which is reassuring.

Overall, the conclusion is that our money market funds are in good shape. But we are still left with the question of which ones were not in compliance and what their situation is today.

The review of hedge funds, even though it too fails to name names, should cause investors to think very carefully before investing in these controversial securities. Some of the findings:

Five hedge funds violated the prohibited investments restrictions by investing in companies in which the fund was a substantial stakeholder. This could have the effect of artificially inflating a company’s share price.

Five hedge fund managers were providing investment advice without appropriate OSC registration.

Six hedge fund managers were in violation of a section of the act which prohibits investing “in an issuer in which a responsible person is an officer or director.”

Two funds had exposure totalling $8 million to Bernie Madoff’s notorious Ponzi scheme.

Six fund managers did not adequately disclose risk factors associated with investing in their funds, including counterparty risk, credit risk, and interest rate risk.

Seven fund managers provided “inconsistent, incorrect or outdated information” in the offering documents of their funds.

An undisclosed number of hedge funds used questionable valuation methods for certain types of securities, for example valuing warrants at intrinsic value rather than fair market value and failing to discount the market value of illiquid securities.

Again, we are not told which funds are guilty of any of these practices. The report offers several recommendations for improving hedge fund oversight but until they are implemented (assuming that happens) investors are in the dark as to which funds are “clean”.

The section on “non-conventional investment funds” is relatively short but contains several warning signals for investors, including the fact that some of the funds surveyed “invested a substantial portion of their assets in illiquid investments, creating liquidity issues and valuation issues”. The report questions the method of valuing these securities noting that “in some cases, fund managers remained more optimistic about the future value of certain portfolio holdings”.

We also learn that “in at least one case, previous fund mergers resulted in the continuing fund facing challenges with respect to the combined level of illiquid assets”. It would certainly be useful to know which fund that is.

The report also comments on “linked notes”, those whose return is tied to the performance of an underlying index or basket of funds or stocks. In typical bureaucratese the report dryly warns: “Linked notes have many key terms and conditions, including mitigating control features based on market disruption events. During the period of market turmoil, the interpretation of certain key terms was subject to additional scrutiny, raising questions of how certain linked note features should operate (for example, determining if a ‘market disruption event’ had occurred which would trigger the need for an independent valuation agent).

In other words, even professional regulators aren’t exactly sure what all those terms and conditions mean. How are ordinary investors supposed to figure them out? The answer is they can’t until they get blindsided by something called a “protection event” or a “market disruption event”.

The report is certainly worth scanning for anyone interested in investing in any of these types of funds and the recommendations it contains are thoughtful although perhaps not always practical. It’s the obvious reluctance to identify the perpetrators of abuses that is so frustrating. The complete document can be found here.

Adapted from an article that originally appeared in the Internet Wealth Builder, a weekly newsletter that provides advice and commentary on a wide range of securities. For membership information, go here.

Gordon Pape’s latest book is The Ultimate TFSA Guide: Strategies for Building a Tax-Free Fortune, published by Penguin Group Canada. It can be ordered at 28% off the suggested retail price at