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Dan's Reports
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THE IMPORTANCE OF THE SIMPLIFIED PROSPECTUS
Investors must do their homework

Driving instructors teach young drivers to do a true "look over the shoulder" check before switching lanes. Nine times out of ten, there won't be any vehicle in the blind spot but it's a safety measure that all of us are taught, and few follow well. Mutual fund investors are constantly reminded, thanks to provincial securities regulators, that they should thoroughly read a mutual fund's simplified prospectus before investing. Again, most of the time, investors won't need to look much further than the first two to four pages in the summary. However, there are instances where you'll be glad you did even a routine but thorough investigation (or making sure your advisor has done so) before investing your hard-earned money.

A CASE IN POINT

I was recently asked by a journalist to provide an opinion on a hot Canadian small cap fund known as the Norrep Fund ( http://www.hesperiancapital.com/norrep.htm ), managed by Hesperian Capital. Since I wasn't familiar with the fund, I turned to the prospectus, the annual information form, the annual and quarterly reports, and other regulatory filings - something investors are always urged to do but rarely do in thorough fashion. Frankly, I didn't expect to make any startling discoveries, but I always go through this process to make sure I do my due diligence. However, what I found was a bit out of the ordinary and stands out as a good example of why investors should do their homework before investing.

First stop, the simplified prospectus. The summary at the beginning of the prospectus shows a list of very typical information. However, go about ten or twelve pages deep and investors will find additional information regarding conflicts of interest.

A gentleman by the name of Gary Perron controls all of the shares of Norrep Inc., an Alberta-based private corporation. Mr. Perron, is also an officer and director of brokerage firm BMO Nesbitt Burns Inc. It is clearly stated that, "Mr. Perron will receive the benefit of some or a portion of commissions payable to Nesbitt Burns Inc. in respect of trades on behalf of the Fund and sales charges payable to Nesbitt Burns Inc. in respect of sales of Units". In case you missed that, the guy that owns Norrep is also a broker who personally benefits directly from some of the trades put through by this fund. It's also worth noting that this fund's management agreement specifically prohibits Mr. Perron or Norrep Inc. from making any investment decisions on behalf of the fund but can still make recommendations to the fund's portfolio manager, Hesperian Capital. The potential conflict comes through loud and clear.

As for brokerage fees incurred by the fund, on behalf of its unitholders, approximately 17 per cent of the total of such costs were directed to Nesbitt Burns. As the prospectus suggests, Mr. Perron likely derived some direct benefit from these fees. You won't find this information in the prospectus, but the more detailed annual information form (AIF) contains brokerage information.

LIQUIDITY RISKS

In most prospectuses, you'll see some statement allowing the fund to buy unlisted stocks or other illiquid securities (i.e. difficult to sell quickly). However, looking at the fund's most recent statement of portfolio holdings (September 30, 2000), investors will find that this small cap sizzler held about 10 per cent of its assets in private companies (i.e. unlisted stocks). While that, in itself, isn't necessarily cause for concern, it may be if lots of money is pulled out of the fund by investors and/or if the fund trades heavily.

At the beginning of 1999, this fund has total net assets of more than $20 million. Despite reporting returns of 44.7 per cent and 31.7 per cent in 2000 and 1999, respectively, the fund still had just $24 million in assets at the end of 2000. Those numbers just don't add up since the growth alone would almost double the asset size over the two years if nobody bought or sold units of this fund. However, what the annual report reveals is that more than $11 million has been yanked out (net of any purchases) of the fund by unitholders over the 1999 and 2000 calendar years. That's a large amount considering the size of this fund.

Trading frequency is measured by a fund's "turnover rate". A turnover rate of 100 per cent means the portfolio has flipped all of its stocks once during the year. However, it's based on the value of transactions, not number of stocks. For the Norrep fund, turnover has averaged 133 per cent over the past two years. While that's pretty normal for a small cap fund, it's still high on an absolute basis.

So, does this fund have any liquidity risk? I'd say there are some potential risks given the fund's significant holding in private companies, the high trading frequency, and the substantial amounts of money pulled out by investors over the past two years. They mitigate the liquidity risk to some extent by imposing a 2 per cent redemption charge on units held less than two years.

SUMMARY

It can't be stressed enough that the potential conflicts are just that - potential. I know of absolutely no wrongdoing or questionable activities by this fund, its management, or any party to which it is affiliated. In fact, the fund has more than 90 per cent (total return) over the past two calendar years, and is up more than 15 per cent so far in 2001. That performance has been achieved despite the challenges it has faced. Hence, it appears the heavy weighting in energy companies and astute trading has worked quite well, but the risks mentioned do remain. And don't forget, it's a fund that invests in very small companies and it is concentrated in the energy stocks - a very volatile sector.

I used this fund as an example to remind investors of a fundamental lesson: do your homework. Just like the driver who should do a full shoulder check, investors should read their prospectus and annual report, even though most are very standard. Blindly buying any investment based on performance or other superficial qualities could lead your portfolio straight into a head-on collision. Most regulatory filings (like those used to examine the Norrep Fund) can be found at SEDAR (http://www.sedar.com).

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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