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PH&N hedging bets on a new fund

Date: Thursday, February 14, 2008
Author: Sean Silcoff, Financial Post

In the staid Canadian fund-management business, Phillips, Hager & North Investment Management is as blue chip as they come. If you know anything about the low-profile Vancouver firm, it is probably that PH&N charges low fees, has two-thirds of its clients' $69-billion in assets invested in bonds, and runs one of Canada's top dividend funds.Now, PH&N is trying something different: a hedge fund. For the past year, it has quietly offered its wealthiest clients a chance to buy into its "Absolute Return Fund," which employs several strategies normal mutual funds avoid, such as convertible arbitrage, short selling, stub trades, pairs trading and interest-rate hedges. To show it's serious, more than a dozen PH&N partners have invested more than $40-million in total of their own money in the fund. Since it was offered to "qualifying" investors (with $1-million portfolios) in January, 2007, the fund has grown to $175-million, and returned 18.5% after fees.

Even last month, as markets tumbled, the fund gained 0.2%.

"We were concerned initially there may be some backlash" from clients, said chief investment officer Hanif Mamdani, who is lead manager on the fund and has invested the bulk of his own liquid assets in it. "But virtually every client that has learned about this has said, 'It's great you guys are trying new things and being innovative.'"

That's not the only new trick in the bag at PH&N. In May, it will launch two alternative funds that pair traditional long-only investing with short-selling. In one fund, managers will short $30 worth of stock for every $130 they buy. That allows them to increase their exposure to stocks they like while betting against stocks they don't, using information stock-pickers would otherwise discard.

A second fund will employ a similar strategy, but sell short $100 of stocks for every $100 held long. Experience shows managers can spice up returns by 200 to 300 basis points through this so-called "market neutral" investing. Five inhouse quantitative research experts have spent 18 months developing the funds -- which will be incubated for a period using firm money before being offered to clients--and the algorithms to support them.

What may seem like an out-of-character departure for the 44-year-old firm is actually part of a deliberate effort. In a complex and challenging investing climate, PH&N is adding a bit of sophistication to enhance returns and attract business from new and existing clients.

"We've got some interesting plans here [to develop] an entire suite of alternative investment products," said Mr. Mamdani. A handful of fund managers in Canada, such as Sprott Asset Management and several U.S. firms, have done the same.

"This is something that our clients have been demanding for some time," said PH&N president John Montalbano.

The idea for the hedge fund was hatched in 2001. Mr. Mamdani, chairman Tony Gage and a few others were having lunch when "someone said, 'wouldn't it be great to have a fund where people like Tony and you could manage money the way you manage your own…in this unconstrained but very controlled manner,'" said Mr. Mamdani, a Vancouver native who joined PH&N in 1998 after 10 years on Wall Street, including a stint running Salomon Brothers' convertible bond trading desk. The idea caught on with the firm's partners.

By September, 2002, the fund was ready to launch, with all the hallmarks of a PH&N product. For starters, it began with $5-million of the partners' own money, to allow Mr. Gage (now retired) and Mr. Mamdani and their team to get the hang of their strategies. The fund operated in-house for four years before it was sold to clients.

"We have a very high hurdle rate here" for new products "to make sure that we don't embarrass ourselves, or, more importantly, lose money for our clients," said Mr. Mamdani. Since inception, the fund has earned annualized net returns of 12.9%.

Unlike other hedge funds, which charge a 2% fee and let managers keep 20% of the gains, PH+N charges just 1.5% in fees and expenses, and keeps none of the upside.

"We said, 'Let's eliminate perceptions of conflict of interest and design a product that's good value for the end user, the kind of fund we'd like to invest in ourselves," Mr. Mamdani said. "I told friends in New York and they laughed. But we said 'We can't with good conscience sell a product where fees could chew up half the gross return. That's just not the PH&N way.'"

The fund doesn't use as much leverage as other hedge funds and steers clear of aggressive strategies that can destroy hedge funds that are caught out by bad bets.

"We wanted a very low risk of a large loss for our clients," said Mr. Mamdani. "We went asset class by asset class, category by category, and said, 'which sectors fit with what we're really trying to achieve.'"

So far, the fund has surpassed its goal of beating short-term treasury bills by two to four percentage points. But the firm doesn't want to grow the fund much beyond $200-million--for now.

"At that point we may just pause and maybe slow the growth and feel comfortable that we can manage at $200-million and still provide very good risk adjusted returns," said Mr. Mamdani.

"That's what we did with PH&N's high-yield bond fund, launched a decade ago. Now, that fund has $700-million in assets."

It's not difficult to imagine PH&N's hedge fund growing that large, either. "It is a very important fund for our clients and thus our firm," said Mr. Montalbano. "A good experience in this fund for our clients will provide the trust and comfort required to step into other non-conventional portfolios that will lower the risk profile but not compromise their returns."