Hedge funds taking it on chin; losses expected to fuel mergers

Date: Tuesday, October 28, 2008
Author: Shirley Won, The Globe And Mail

Hedge fund manager Ravi Sood is having a rough time navigating through the tsunami that has hit stock markets around the world.

The stellar record of his Lawrence Partners Fund suffered a 48-per-cent hair cut in September, sending its year-to-date loss to 53 per cent for the first nine months of 2008.

Mr. Sood would not comment about his fund, but told investors in a letter that he was forced to "reduce the size of core positions at inopportune levels in midmonth. ...

"We cannot restore all of this year's loss to date in the next few months or quarters, but we are confident we will get there," said the president of Toronto's Lawrence Asset Management Inc.

The global credit crisis and market carnage, which has dealt a blow to Canada's fledgling hedge fund industry, is expected to spur mergers or force funds to wind down, market observers predict.

The industry could shrink by 30 per cent to about $20-billion in assets within a year from about $30-billion, suggested James McGovern, chief executive officer of Toronto's Arrow Hedge Partners Inc.

"A fair number of managers won't make it through this period," said Mr. McGovern, whose firm runs $750-million in hedge fund assets using various investment styles. "The ones that are net long and focused on commodities - and particularly small-cap, resource names - are the ones getting killed in general."

Managers like Peter Puccetti, whose Goodwood and Arrow Goodwood funds are off 48 per cent this year as of last Friday, have also been caught in the downdraft because of the credit crisis that prevents potential buyers from getting financing for takeovers of names in his fund, Mr. McGovern added.

Investment fund analyst Peter Loach agreed that some hedge funds will have to sell or merge as lucrative sources of additional revenue dry up. "Most of these firms make their money on performance fees," he said.

Hedge funds often earn a 2-per-cent management fee, plus a 20-per-cent performance fee if they reach a hurdle, which could be a percentage return or beating a benchmark index.

If they rack up a loss, they usually have to reach their high water mark - the highest peak in value that the fund has reached - before getting a performance fee again.

"A market like this is always going to cause a shakeout," independent fund analyst Dan Hallett said. "Because of the way hedge funds invest, and generally they use leverage, the highs and lows will be magnified."

Mr. Puccetti's Goodwood funds, sold directly to investors currently, can reset their high water mark after two years. That feature is under review and could be cut because "it's the right thing to do" given the funds' steep losses, said Goodwood Funds chief executive Cameron MacDonald.

Some Canadian hedgies have already found new homes. Last month, Sentry Select Capital Corp. and affiliated C.A. Bancorp Inc. bought Waterfall Investments Inc., founded by Andrew McCreath.

And Industrial Alliance Insurance and Financial Services Inc. bought Sarbit Asset Management Inc. Founder Larry Sarbit's hedge fund - Sarbit Total Performance Trust - may be merged with his U.S. equity mutual fund.

Others have quietly left the industry. Since December, Brendan Kyne, founder of Leeward Hedge Funds, has only been running his own nest egg built from eight years of managing hedge funds.

"I did well, and decided I didn't want to deal with whiny clients," the 45-year-old Toronto-based manager said. "I am sure that in this kind of market environment a lot of my bigger peers in the city would be having client conference calls every 10 minutes. You can imagine the stress."

Poor performance has also caused some firms to give their hedge funds a new lease on life by changing the managers, and their investment style.

JovFunds Management Inc. bought Horizons Mondiale Fund two years ago when it was run by Vancouver-based hedge fund manager Mondiale Asset Management Ltd.

Earlier this year, the fund's name was changed to Horizons Contrarian Fund, and it is now managed in-house by JovFunds using research provided by U.S.-based HSC Management Inc. on changes in commodity futures trading. The performance has turned around with the fund only losing 1 per cent this year as of last Friday - a stellar performer in the current market.

"Hedge funds are great, but if you are going to use hedge funds, you should use an array of mandates," JovFund chief executive officer Adam Felesky said. "In 2009, we'll be coming out with alternative hedge fund styles."

The problem with the Canadian industry is that it is dominated by a strategy focused on being mostly long Canadian stocks with some short selling, Mr. Felesky said. "To be honest, they [hedge funds] were leveraged long and did very little shorting. ... It worked well for them.

"I think everyone was surprised at how quickly things turned. They weren't able to effect their shorting strategies to protect themselves and limit downside risk."

Canadian hedge funds are facing their toughest time since the domestic industry began taking off eight years ago. The once hot commodity sector also put domestic funds on the radar screens of foreigners.

"The question is whether they will stay," said Christopher Holt, founder and editor of AllAboutAlpha.com.

Institutional investors will remain attracted to hedge funds for diversification reasons, but the downturn "may take the winds out of the sails of the industry" for retail investors focused on returns, he said.

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Some Canadian hedge funds take a beating

DOUGLAS COULL/THE GLOBE AND MAIL

SOURCE: GLOBEFUND.COM