What you don’t know can hurt a lot

As is so often the case in the complicated and opaque world of hedge funds, it is not yet entirely clear what happened at Sextant Capital Management. But if the allegations levelled by the Ontario Securities Commission are accurate, it went something like the plot of a Dan Ackroyd movie from the ’80s.

According to the OSC, a former dentist by the name of Otto Spork set up a private investment vehicle back in 2006 called the Sextant Strategic Opportunities Hedge Fund. About 240 Canadian investors, most of them in Ontario, handed about $22 million to Mr. Spork and his associates at Sextant. And for the most part, they have been very, very happy. At the end of November, Sextant was boasting of a 170 per cent return in the past 12 months, and a stunning 730 per cent return since the fund’s inception a few years ago.

In the midst of a historic market crash, Sextant has been the toast of the investing world. In September, when the industry handed out its annual awards in Toronto’s hip Distillery District, Sextant took home the award for best overall return for funds with more than $25 million under management. All this has made the insiders at Sextant very rich indeed. Performance fees for the month of November alone were said to be $1.5 million.

Alas, it seems Sextant wasn’t quite the success it appeared. The OSC recently conducted a routine compliance review to make sure all the rules were being followed, and what they found wasn’t pretty. According to the OSC, about five per cent of Sextant’s assets were invested in a pretty standard mix of stocks, cash, private equity and derivatives contracts. The rest of its portfolio consisted of investments in two private companies with ownership stakes in northern glaciers. Spork has lately moved to Iceland, and apparently envisioned these glaciers as the foundation of a business selling water around the world. These companies have no revenues, certainly no profits, and no prospect for operations in the foreseeable future. And yet, according to Sextant, their value has surged by 984 per cent in the couple of years since the Sextant fund was launched.

The OSC found no independent valuation to substantiate the claim that these icefields are now worth close to 10 times what Sextant paid for them. And since hedge funds like Sextant don’t have to regularly reveal their results and top holdings like conventional mutual funds do, nobody noticed that it hadn’t produced audited financial statements since 2007. For now, the OSC has barred Sextant from selling its fund to any more clients pending regulatory hearings in the weeks and months ahead.

It’s important to note that Spork denies any wrongdoing, and has vowed to fight the charges. But it’s fair to say this is doing nothing for the increasingly troubled image of the hedge fund industry. Sextant wasn’t even close to the biggest news to shake the investment world last week. That honour goes to Bernard Madoff, the legendary 70-year-old New York fund manager whose once-stellar reputation now lies in ruins. Madoff is accused of operating a US$50-billion Ponzi scheme, taking advantage of gaps in the regulatory framework to bilk a fortune from wealthy investors—from billionaire celebrities to international banks. Madoff didn’t have to report his activities to the SEC, so they went undetected for decades. The damage is enormous.

Hedge funds operate private investment pools that work much like mutual funds except that they can use debt and derivatives to leverage up their holdings and use risky strategies like short selling that are off-limits for conventional fund managers. The strategies are complex, arcane even, and often top secret, because hedge funds are exempt from the usual requirements for transparency that apply to public companies and mutual funds. Therein lies the problem.

The hedge fund industry exploded in size and profitability over the past decade, all the while claiming that its investors are rich and smart enough that they don’t need the protections afforded to ordinary investors. Cases like Sextant and Madoff eloquently demolish that rationale. After all, Sextant’s sophisticated investors appear to have given their money to a former dentist who used it to buy frozen water in Iceland. Even the SEC considered the notoriously secretive Madoff one of the wise men of Wall Street, and consulted him on regulatory issues.

Hedge fund managers insist that too much oversight will kill their industry, and deprive investors of the opportunity to make stellar returns. When the market was steadily climbing, no one was inclined to disagree and the hands-off approach prevailed. But the ground is shifting. Securities regulators from around the world are now deep in talks aimed at applying a tighter leash. The idea isn’t popular with the industry, but it’s long overdue.

If there is one critical lesson of this financial meltdown it’s that the markets are more interconnected than ever, and surprises in a handful of large funds can send huge shock waves around the world. It was one thing when hedge funds were tiny, fringe players. Now they represent hundreds of billions of dollars in under-regulated capital with the potential for devastating surprises.

These funds are private businesses, but they are operating in the public markets—just like private car owners operate on public highways. When a driver fails to maintain his car properly or drives too fast, the lives of everyone on the road are potentially at risk. That’s the basis for the whole Motor Vehicle Act, yet for years hedge funds have escaped scrutiny simply by arguing that they are such good drivers they need not follow the same laws as everyone else.

Most hedge fund managers are smart, honest, and worth every penny they make. But this crisis has included far too many surprises, and those painful lessons leave a lasting legacy. The markets work best when transparency is maximized, secrecy minimized, and everyone is playing by the same rules.