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Hedge funds growing fast: Canada's hedge fund industry is winning over mutual fund clients

Date: Wednesday, January 7, 2004

By Keith Kalawsky: Financial Post- Frank Mersch tongue-lashing the mutual fund industry is like a former priest condemning the church or a retired U.S. general skewering the Bush administration on CNN for attacking Iraq. The mutual fund business, after all, is what made Mr. Mersch a big name on Bay Street. During his 12 years at Altamira Management Ltd., his equity fund posted an average annual return of more than 19%. It was the No. 1 equity fund in Canada for more than a decade. But six years ago, Mr. Mersch defected from mutual funds to the "dark side" as he calls it, joining Front Street Investment Management Inc., which runs about $400-million in its hedge funds. As he markets Front Street's products to brokers and advisors, Mr. Mersch dumps on his former brethren. "I don't think [the mutual fund industry] serves the interest of the investor any longer. It really serves the interest of large institutional fund managers, who are more interested in size rather than returns," he told a hedge fund conference in December. Mr. Mersch is not being altruistic here. It's part of his sales pitch to retail investors, "the final frontier" for hedge funds, as he said. "After selling mutual funds for a number of years, we're in a process now of trying to introduce hedge funds, not only to our high-net worth clients and the institutional client base here in Canada, but also the retail side." These are fighting words to the mutual fund industry, since retail clients are their bread and butter. But whether they like it or not, hedge funds are steadily moving from the margins of Canada's investment industry to mainstream. Yes, the Canadian hedge fund industry is still small, with about $14.1-billion under management in June, 2004, according to Toronto-based Investor Economics Inc., compared to $480-billion for mutual funds. But hedge fund assets grew at a compound annual rate of 46.2% between 1999 and June, 2004, compared to 4.6% for mutual funds, noted Investor Economics, which is releasing a major new report on the hedge fund industry next week. While hedge funds are expanding here, they have exploded in the U.S. About US$1-trillion is invested in hedge funds there now, compared to US$76-billion in 1995. Meanwhile, the number of funds has ballooned to 7,000 from 2,080. To the most ardent supporters of hedge funds, Canada is headed for a battle royale that will eventually eliminate mutual fund companies that stick to a plain vanilla, buy-and-hold investment strategy. Investors want performance. If mutual funds can't provide it, they're done. "They're going to wipe it out," said Tristram Lett, senior vice-president at Norshield Financial Group, which handles about $1-billion in so-called alternative investments. "Anybody sitting in a mutual fund company at the moment has to know that. They have to ask themselves, 'How are we going to going to involve ourselves in this so that we just don't get wiped out?'" This kind of trash talking obviously irks mutual fund executives. Ed Legzdins, head of Bank of Montreal's $20-billion mutual fund division, is cognizant of hedge funds moving on to his turf, and he doesn't like it. They are too complicated, secretive and expensive, he contends, and most investors are just better off buying mutual funds. "Hedge funds are popular because they're lucrative to the managers, they're lucrative to the distributors, but it remains to be seen how lucrative they're going to be for the investors," Mr. Legzdins said. "Hedge funds to date, and I hope it remains this way, are for sophisticated, more affluent investors." Hedge funds are currently restricted to wealthier investors. In Ontario, for instance, investors must invest at least $150,000 into a hedge fund. Or, they can invest a smaller amount if they own at least $1-million in financial assets or earned more than $200,000 in each of the last two years. To get around these and other hurdles, some funds have created closed-end investment trusts or funds of hedge funds. These however, often carry high fees for investors. Like Mr. Legzdins, most mutual fund executives are quick to portray hedge funds as a niche business that could never hope to challenge the dominance of mutual funds. They also want to see the regulation of hedge funds increased, not relaxed. A few fund companies like CI Fund Management Inc. and Mackenzie Financial Corp. sell hedge funds. But the rest of the industry is hoping they're just a fad. "The most common approach by mutual fund firms has been to stick to their knitting," says Rudy Luukko, Investment Funds Editor at Morningstar Canada. Nonetheless, evidence of hedge funds entering the mainstream is everywhere. Witness the acquisition of Highbridge Capital Management last year by J.P. Morgan Chase & Co. Highbridge boasts $7-billion in assets and an average annual return of 20%, excluding fees, over the past 10 years. "It is the recognition by large banks that hedge funds are here to stay," said Donald Putnam, managing director at Putnam Lovell NBF Securities Inc. in San Francisco. He sees another $1-trillion or $2-trillion flowing into hedge funds over the next few years. However, there are still lingering concerns about the lack of disclosure. Mr. Legzdins at BMO is hoping Canadian regulators, like their U.S. counterparts, will increase their oversight of hedge funds. "I would like to see that rules get tougher on hedge funds to start providing the kind of transparency that mutual funds have always had and put hedge funds on equal footing to mutual funds so people can start to understand them," he said. Even Bill Holland, chief executive of CI, thinks hedge funds are better suited to the wealthy. "For most retail investors it's not a good product because they don't have a good enough understanding of what they're investing in. Some of the fund of funds are just ridiculously expensive, so they don't even make sense." Mr. Mersch has heard all these complaints. Mutual funds are more transparent, but Mr. Mersch still questions their business model. A fund might charge an annual fee of 2% of assets, so to make money and satisfy company shareholders, they want to grow as large as possible. With size, however, it gets more difficult to outperform other funds because all the big funds are investing in the same securities, just in slightly different proportions and combinations. "That is not what investing is about," Mr. Mersch said. "Investing is getting a return for your client and trying to find all the options available out there for you to get that rate of return." There is no question the economics of hedge funds are also lucrative. They charge a fee of typically 1% or 2% of assets and managers usually take 20% of any profits generated beyond a benchmark. Mr. Mersch doesn't deny this. But most hedge funds managers are also putting up their own money, he argued. Of the $400-million in Front Street's hedge funds, $100-million is management's money. "I'm not going to stand up here and make apologies for making money for my clients because I've never done that in the 24 years that I've managed money," Mr. Mersch said, pointing to the 26% return of Front Street's flagship Performance Fund over the past five years. "At the end of the day, the client looks at me and says, 'What have you done for me lately?'" National Post 2005