AIMA has issued a “Guide to Sound Practices for Disclosure and Promotion of Alternative Investments in Canada.” That wordy title alone feels as expansive as Hudson Bay. But one does catch, near the end, the term “alternative investments,” not the narrower term “hedge funds.” Thus, the remit as you might expect involved not just hedge funds, but the promotion of funds of funds, and of structured products linked to hedge funds.
Two Particular Provinces
Quebec presents a special case. Pooled funds in that province, including hedge funds sold via private placement, are subject to regulation by Title VII of the Securities Act (Quebec), which can constrain the payment of incentive fees and the use of leverage. It is possible for a hedge fund to stay clear of the reach of these restrictions, via exemptions, but the guide counsels that “fund managers should discuss these options with their counsel” and notes that many hedge funds “obtain exemptive relief from Quebec regulators prior to any sales of these securities in the province.”
Ontario also presents province-specific concerns. Any individual offering investment advice to a fund or an individual residing in Ontario must (subject to limited exceptions) register as an adviser with the Ontario Securities Commission. The Guide cautions that the OSC “takes a broad view of its mandate and also requires fund advisers that are not resident in Ontario, but whose securities are held by Ontario residents” to register as well.
The meat of the guide addresses what AIMA Canada considers sound practice in marketing and promotion, such as in the calculation and presentation of returns, in selecting a benchmark relevant to a specific strategy, and in explaining the various ratios used for the same purpose.
It notes that the Association for Investment Management and Research’s Performance Presentation Standards (AIMR-PPS) recommend using a time-weighted method for the calculation of returns, a model otherwise known as the Modified Dietz method.
The guide recommends against the use of side letters that allow some investors preferential terms or an extra level of disclosure. The hedge fund or fund of fund manager “should attempt to treat all investors as equally as possible.” Further, preferential agreements may have “significant legal consequences.”
Performance reporting should occur in a consistent way that lets the investor compare results among different managers. Though back-tested or pro forma reporting “can be used to provide investors with a sense of how the manager and the particular model may have worked in the past … or could work in the future” the nature of the exercise must be quite clear to the investors.
As to benchmarks, the guide observes that the hedge fund industry uses a lot of different ones (S&P, MSCI, CSFB/Tremont and so forth). What is crucial is that when managers use a benchmark, it be identified, easily understood, and relevant to the particular portfolio strategy that manager employs. If a benchmark is itself investable, that is a point in its favor. If it isn’t investible, then managers have to be able to explain how it is relevant for benchmarking.
There also exist a variety of ratios that are used to measure performance: Sharpe, Sortino, Treynor, and Omega. If a manager wants to allude to any or all of these ratios in communications with investors, they should be clearly explained in footnotes, “including all material information including … the data source, whether or not the calculations are gross or net of all fees and expenses, a description of the calculations, the relevance of the ratios to the product being evaluated and any assumptions.”
Much of the guide outlines the content that ought to be included in the offering documents of alternative investments. Redemption policy, for example, ought to be spelled out in detail, including:
- How the redemption price is calculated
- Whether the redemption price is based upon actual (or estimated) values
- Whether the net asset value is determined by a third party
- Lock-up periods
- The potential tax consequences of redemption
- Redemption fees
- Redemption notice requirements
- Definition of a ‘market disruption’ or ‘extraordinary event’
- Suspensions or other contingencies in the event of a market disruption or extraordinary event.
For fund of funds, offering documents should disclose the exposure to the various underlying strategies.
For principal protected notes tied to hedge funds, the documentation should clearly explain the nature of that tie, inclusive of the participation rate.
What to Avoid
Critical regulatory background in Canada includes National Instrument 81-102 and NI 81-105. These regulations govern sales practices for retail mutual funds. The issuers of alternatives want to rely on applicable exemptions that keep them out of the range of 81-102 or 8-105 [and they also generally hope to avoid 81-104, which concerns commodity pools, as well].