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Maverick money

Date: Saturday, June 2, 2007
Author: Karen Mazurkewich, Financial Post

Canadian hedge funds must still climb uphill to gain true respect

Allan Jacobs is the latest hedge-fund convert. Named Canada's top mutual fund

manager last year, his boss at Sceptre Investment Counsel Ltd. has given him the

green light to start hedging.

Companies must be "prepared to allow their portfolio managers room to flex or they

will leave," says Sceptre's president and CEO Richard Knowles. He's seen it happen

countless times. Now, Sceptre -- a traditional firm that has long managed a

conventional platform of funds -- is taking its first baby steps, of $27-million, in the

hedge fund world.

For Mr. Jacobs, launching a hedge fund was a no-brainer. At Sceptre, he vetted a lot

of great companies that were too small to be included in his existing equity funds.

By setting up a small hedge fund with concentrated assets, "we would be able to

take advantage of these small companies," he says. The timing was also right.

"Canadian pension funds are moving to alternative investments," he says. "We

needed to set up a track record."

Canada has lagged behind the world in hedge-fund assets. The U.S. money grab is

nothing short of remarkable. The sector jumped from 610 funds with US$39-billion

in assets in 1990, to 9,000 funds with US$1.3-trillion in assets.

For much of that time, Canadian investors sat on the sidelines. Today, there are still

only 200 hedge funds, with $30-billion in assets, in Canada. But while local

institutions traditionally have given them wide berth, Canadian hedge funds are

finding traction outside the country. International institutions are drawn to their

heavy interest in commodities. While that has made Canadian institutions take a

second look at the industry, it has also raised alarm bells with the Standing Senate

Committee on Banking, Trade and Commerce. Last year, it began hearings to

determine whether hedge funds needed to be more regulated. The growth of the

industry, and a couple of scandals, has put hedge funds under the spotlight.

Since it was founded in 1996 by Frank Mersch and Norman Lamarche, former

mutual fund stars at Altamira Investment Services, Front Street Capital has raised

$1.5-billion in assets by parlaying their expertise in resource stocks. Overseas

investors have rocketed Front Street to the top of the hedge fund heap. Same with

Salida Capital. The Toronto-based company sells only one fund in Canada with

assets of $183-million. The rest of its US$1.1-billion of assets under management is

from institutions outside the country.

Greg Boland, who manages a fund for Greenwich-based Paloma Partners, raised

$500-million in capital earlier this year for his own offshore multi-strategy hedge

fund with capital from -- you guessed it -- overseas institutions and U.S. fund of


Despite some spectacular returns, Eric Sprott, who invested heavily in uranium and

molybdenum, says no Canadian institutions own his hedge funds.

"Financial advisors [here] are misinformed about risk and concentration," says Mr.

Sprott. "They always take a conservative view on things."

The lumbering response by Canadian institutions to the Canadian hedge-fund

market is a source of irritation. Having attracted outside interest, fund managers

want to attract more Canadians. While many blame "docile" consultants for the lack

of interest, tight constrictions have also constricted the investment pool.

Gary Selke, president of Front Street, blames regulators "who do not trust Canadian

investors and advisors to make sound judgments." Hedge fund managers in this

country can only sell to "sophisticated investors" willing to make a minimum

investment of $150,000. He admits that the "opaque" nature of the U.S. hedge fund

industry has had an impact here.

Canadian hedge funds have been tarred with the same brush as their American

counterparts. For years, hedge funds were all lumped together as investments that

employ "exotic" and risky" strategies. Tales of pirate tactics employed by activist

managers such as Daniel Loeb of Pirate Capital, and the colourful reports of fat

profits and greedy consumption, made colourful headlines.

Not surprisingly, the Senate Banking Committee is trying to get up to speed with the

brave new wave of funds. They have two concerns: that hedge funds can create

volatility in the marketplace, and investors unfamiliar with the risks might loose

their shirts. A parade of hedge-fund managers like Eric Selke, president of Front

Street Capital, have trekked to Ottawa to defend their interests. Their message:

Don't impose further "father-knowsbest" regulations.

Truth be told, Canadian hedge funds are kinder, gentler versions of their U.S.

cousins. Better described as "alternative funds," they short less than their U.S.

counterparts, use less leverage, and avoid event-driven strategies. Whereas an

aggressive overseas hedge fund might leverage 100% of its assets, the average

Canadian fund's leverages range from about 15% (Vancouver's Vertex One's

position) to 50% (the maximum that Goodman & Co. will take), making them less


Hedge funds are less regulated, which means managers can tap into a host of

strategies to generate higher "alpha" returns for their clients. They also work

through "incentive fees." Hedge-fund managers can cream 20% in profits if they

perform over a certain benchmark, whereas mutual-fund managers must be content

with 2% to 3% management fees. It can be their pot of gold. In fact, the term

"hedge fund is a misnomer that can mean anything that's a non-mutual fund," says

Rohit Sehgal, chief investment strategist at Goodman & Co.

Still, two controversial scandals in 2005 did not help dispel fears. Portus Alternative

Asset Management, which boasted $800-million in assets under management, had

its licence withdrawn by the Ontario Securities Commission after numerous

allegations; and Norshield Financial Group allegedly transferred $500,000 to

Caribbean banks instead of investing in Canada.

"Sadly we are going to have setbacks in the alternative space like any other sector,

but it's behind us," says Lionel deMercado, managing director and global head of

equity finance for TD Securities. "I believe there are more controls in place now," he

adds. "Unfortunately, it happened, we learned, and we drive on."

Mr. deMercado is so bullish about the Canadian hedge-fund industry that last month

he organized a forum where four pension managers spoke to a crowd of 90 hedge

funds about their strategies. Although Mr. deMercado won't say how many hedge

funds his brokerage firm represents, he says the industry is evolving. The biggest

change he has seen is the willingness of wealth management companies and even

mutual fund companies to run hedges. Everyone from Goodman Inc. to Gluskin

Sheff & Associates have folded them into their portfolios.

"People are beginning to understand the benefits of hedge funds within a diverse

portfolio," says Andrew McCreath, president and CEO of Waterfall Investments Inc.

"That message is gradually leaking out and is responsible for the growth," he says.

One of the advantages, hedge funds here have is that they can profit from the

greater inefficiencies in the domestic market due to the fact that Canadian

companies have fewer resources to research and analyze data.

In Canada, good deals get overlooked, he says. A subset of hedge funds, such as

Goodwood Inc., are even taking an activist role. "They are helping to eliminate

inefficiency by forcing a sleepy company to do something," says Mr. McCreath.

Still, not everyone in the financial community is a fan. The most outspoken on the

subject is Stephen Jarislowsky. He calls hedge funds "scum" for forcing companies

into making quick decisions that don't always benefit the shareholders. And while

many in the industry think the Canadian hedge funds will grow, William Holland,

CEO of CI Financial Income Fund Ltd., takes a more contrarian position: "I'm of the

view, I think they've peaked."