Investors could have avoided the Portus hedge-fund mess if they had asked one important question to their advisors: “How much are you getting paid if I invest in these hedge-fund notes?”
The answer, if truthfully given, would have raised a warning flag up as high as a Rocky Mountain.
The hedge-fund notes being offered by Portus Alternative Asset Management weren’t anything special. The potential returns were not demonstrably higher, nor the managers more experienced, than hedge-fund notes offered by competitors.
So, why were investment advisors so eager to recommend the Portus hedge-fund notes? Why was Portus able to appeal to advisors and thereby grow its assets to around $700 million so quickly – easily outpacing the growth of its hedge-fund competitors?
The answer to both questions: It was all about the money.
Portus offered such rich commissions and other financial inducements that advisors succumbed to the temptation.
As a result, many investors have been burned. At the very least, their investments are tied up while regulators sort through Portus’ books. At this point, nobody knows what the final result will be, although Portus management claims the invested funds are safe.
Hedge-fund notes with bank guarantees typically carry the same commission for advisors as equity mutual funds.
There usually are two options. If the investor pays an up-front commission of 0 to 5 per cent, the advisor gets that commission plus a trailer (service) fee of 1 per cent a year.
Most investors balk at paying a 5-per-cent up-front commission, so advisors usually steer them to the deferred sales charge (DSC) option, where the investor does not pay any commission up front but the advisor gets a 5-per-cent commission from the fund company plus a trailer fee of 0.5 per cent a year.
The drawback for the investor with the DSC option is that if the fund is sold within the first six years, the investor must pay the fund company a redemption charge, starting at 6 per cent in the first year and falling to zero after the sixth year.
Portus offered advisors much more than the usual commission, according to one advisor who researched things well, saw through the ploy and kept his clients away from the Portus notes.
The Portus DSC offer was 5-per-cent commission, plus a 1-per-cent annual trailer fee (double the usual amount), plus 20 per cent of any performance bonus fee that Portus collected (not offered elsewhere).
(The Portus performance bonus fee was itself quite aggressive, since it was 20 per cent of any return achieved by the underlying hedge funds – not the usual, more-limited 20 per cent of the return above a certain threshold return of 8 or 10 per cent).
Not only was the commission juicy, but perhaps more importantly to some advisors, Portus was offering them very large amounts of so-called “soft money” to pay for the advisors’ marketing expenses for such things as seminars or newspaper advertising.
This type of “soft-money” inducement – essentially a way of buying business from advisors – is relatively scarce since it is strictly controlled by rules set out by regulators. But Portus’ largely unregulated status allowed it to ignore the rules.
Another flag would have been raised if investors asked their advisors another question: Does the offering memorandum for these notes confirm Portus’ claim of a bank guarantee?
Many advisors obviously didn’t read Portus’ offering memorandum, which, in fact, did not name the bank that is supposed to be providing the guarantee.
Do you want to confirm all of this? You can’t, unless you were one of the investors who actually received the offering memorandum.
It’s a hole in our country’s regulatory framework since it prevents wide scrutiny of some financial products. Unlike mutual fund and stock prospectuses, an offering memorandum for bank-guaranteed notes doesn’t have to be filed at www.sedar.com and if Portus ever had these documents on its website, they’re not there now.
Many people are uncomfortable asking their advisors how much commission they stand to earn.
But think of it as part of your due-diligence research – something many advisors showed they cannot be trusted to do properly.
Or would you rather hold your tongue and risk being stuck in some Portus-like mud hole in the future?
Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.
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©2005 Wayne Cheveldayoff