Need for disciplined due diligence process underscored by recent scandals

par Al Emid | September 18 2006 08:07PM

The fallout continues from fiascos involving Toronto-based Portus Alternative Investment Management and Montreal-based Norshield Asset Management, including a harsher-than-ever look at new investment products, explains Dave Paterson, chartered financial analyst and president of Toronto-based Dave Paterson & Associates.

Mr. Paterson, who was a speaker at the 5th Annual Compliance Forum organized by the Investment Funds Institute of Canada (IFIC) and Association of Canadian Compliance Professionals (ACCP), explained that the recent scandals underscore the need for a disciplined due diligence process. During a follow up interview with The Insurance Journal this summer, he explained the theory and practice of due diligence.

In a typical scenario, Mr. Paterson may be called in by a mutual fund dealership’s executives or its investment committee and asked for a report on a new investment offering, a practice that has indirectly become more important recently as dealerships looking to court advisors with large books of business often tout the quality of their investment research as a marketing tool. Moreover, the financial and credibility losses suffered by advisors following the Portus fiasco underscore their own need for reliable research into new products by their dealerships.

In a mutual fund context, the dealership’s concern would not be holdings or investment objectives since the simplified prospectus requires standardized regulatory and reporting information built into the text. However, the dealership may want an unbiased opinion on the manager’s track record especially if he or she has recently made a dramatic professional change such as leaving an investment management company and setting up a new organization. Mr. Paterson may also look at the new company’s financial structure and ability to grow its business. “In their new firm, are they going to do what they have done historically?” he wants to know.

By comparison, hedge funds are offered through an offering memorandum for which there is no standard format, so he checks factors such as the pricing structure, which individuals have access to deposits, audit procedures, the fee structure and its potential impact on investors. Fees may be payable to the manager of the underlying fund, the investment manager and perhaps other managers, a structure sometimes called double-dipping and reducing investor return.

Even less formal, a principal protected note is offered through an information statement which also has no standard format and information requirements.

With a principal protected note, he checks for factors such as the method for calculating the return. In the zero coupon bond structure a specific percentage of the investment goes into a zero coupon bond that matures at 100% of the principal value. With the balance the company pays fees and sets up a call option structure that will provide the investment exposure to the underlying investment.

In the constant proportion portfolio insurance approach, the company sets up a theoretical bond and tracks the difference between the theoretical bond which will mature at (for example) $100 and the note value. The gap between the current value and the theoretical bond floor determines how much of the exposure is in the underlying investment.

He also checks for the method used to calculate projected future returns on start up products. Some promoters use the pro forma approach which is basically a hypothetical calculation. Other start-ups use what is known as the back test approach which suggests that if a given product had been started (say) ten years ago, it would have produced a certain return. This could mean a false sense of assurance to an investor, since there is obviously no guarantee that the next ten years will produce equivalent returns.

Products he has recently recommended against in his reports include a principal-protected note that provided for locking-in returns every time the product hit a new high value, which then became the guaranteed amount. However, one downside of this structure is that the fees were high relative to the benefit of the locked in guarantee.

Another disadvantage of that good news is that this approach raises the bond floor meaning that the gap between the guaranteed amount and the investment amount (as determined by market value) might trigger monetization of the note in the event of a sharp market downturn. That would leave investors with only the principal value. Moreover, the management fees were high relative to comparable direct investments, Mr. Paterson says.

In another example, an established company issuing a new series of notes dramatically increased the fees payable to managers when compared with earlier series, meaning that investors would receive lower gains. “I suggested to the company (dealership) that because of this increase they may want to pass,” he recalls.

In a third example, a series of principal-protected notes was linked to a group of income trusts. Mr. Paterson again recommended to a dealership that they forego offering the product since there are similar mutual funds that offer a better reward. “The fees were higher than a comparable investment in an underlying mutual fund, while the distributions were all treated as interest income (with the principal protected notes) while a direct investment in a comparable underlying fund would have the distributions treated as a mix of dividends, capital gain, interest income and return of capital, thereby qualifying for more advantageous tax treatment since interest income is fully taxable while capital gains income is only partially taxable.

This kind of analysis does not come easy, he explains. “Some of the valuation formulae can be very complicated.”

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