Analysis: Canadian hedge funds' growth dreams face tough reality

Date: Friday, February 1, 2013
Author: Alastair Sharp, Reuters

Canadian hedge funds will likely remain more boutique than big box in the future, as lack of scale, poor returns and difficulty accessing big investors weigh down growth.

Helped by start-ups in and around Toronto's financial district, the Canadian industry is estimated to manage more than C$30 billion ($29.73 billion), up from about $15 billion four years ago.

Some managers think that could more than triple in coming years, but it would still be miniscule compared with the roughly $2 trillion managed by U.S. and other foreign hedge funds.

The likely winners will be funds that offer the diverse strategies and risk-management that have attracted institutional and wealthy retail investors to the U.S. industry, leaving many smaller managers to merge or fade to irrelevance.

"The days of old, where you just had to show some good performance and maybe people will allocate assets to you, those days are probably gone," said Jonathan Aikman, a Toronto and New York-based lawyer who has written a book on alternative investments.

Even deep-pocked Canadian pension funds, some of which pioneered hedge fund investment, have been slow to put their money into the domestic industry, preferring to pick and choose from a much larger pool of managers a short flight away in New York, Boston and elsewhere.

For the C$170.1 billion Canadian Pension Plan Investment Board, almost all of the C$10.4 billion it gives to external public market managers goes to non-Canadian hedge funds such as Bridgewater Associates, Fortress Investment Group LLC, and Bill Ackman's Pershing Square Capital.

Quebec's C$159 billion Caisse de depot et placement pension fund and the C$117.1 billion Ontario Teachers' Pension Plan have also traditionally looked abroad for their hedge fund exposure.

WEAK 2012 PERFORMANCE

It hasn't helped that Canadian hedge funds offered dismal returns in 2012, with an almost 5 percent slip in the asset-weighted Scotiabank Canadian Hedge Fund Index. In contrast, the Toronto Stock Exchange's S&P/TSX composite index rose 4 percent.

Global hedge funds, mostly based in the United States, have done much better, returning more than 7.4 percent last year on average, according to Hedge Fund Research, an industry tracking group.

Canadian managers had an especially difficult year as slumping commodity prices hit many resource-focused managers and Toronto's stock market lagged Wall Street.

Hedge funds managers charge much higher fees than conventional money managers, based on the premise that their skill and sophisticated strategies allow them to deliver gains in both rising and falling markets.

Aikman, who is also an industry consultant, said the players growing at a healthy clip - major listed firms such as Sprott Inc and Fiera Capital Corp, as well as smaller outfits including arbitrageur Periscope Capital and Sherpa Asset Management - look at the big picture.

Other local success stories include Lawrence Park Capital Partners, which saw assets under management top C$200 million in December, helped partly by the backing of CI Financial Corp, one of the country's biggest mutual fund managers.

LIMITED RETAIL ACCESS

But for many smaller funds, building up assets is a struggle. In additional to the indifference of institutional investors, many hedge fund managers say accessing wealthy retail investors is a problem.

Smaller managers put part of the blame on the cost of accessing the FundSERV online fund distribution network, owned by the big Canadian banks, insurance companies and mutual funds that are its main customers. It dominates the market for connecting brokers and wealth managers to products they can sell to retail clients.

"It's a very stiff headwind for small hedge fund groups," said Chris Foster at Blackheath Fund Management, a commodity futures fund with about C$50 million in assets under management.

Much of the U.S. industry's growth has come from the wealth management arms of big banks, which give top clients access to hedge fund managers such as John Paulson and Steve Cohen.

Peter Hayes, who heads KPMG's alternative investment practice in Canada, said that, until Canadian hedge fund managers get better access to wealthy retail investors, growth will be slow and measured, making consolidation likely.

James Burron, chief operating officer of the AIMA Canada trade body estimated that the costs of registering a fund, paying salaries and maintaining suitable working capital range between C$500,000 and C$2 million.

Analysts said start-up costs have traditionally been higher in Canada because of a tighter regulatory regime, although they see that gap narrowing as the U.S. climate toughens.

"You'll need to get a few hundred million under management relatively quickly to be a viable concern," Burron said.

SMALLER SIZE, BIGGER UPSIDE

Still, some managers say the size of the Canadian industry is part of the appeal because smaller funds can be more nimble with their capital and potentially get higher returns.

They cite opportunities such as merger and regulatory arbitrage in the resource sector, where local managers can boast of expertise.

"This industry is going to blossom," said Jeff Olin, who reports that his C$160 million real estate-focused Vision Capital has produced annual returns of roughly 25 percent since 2008.

He forecast that Canadian hedge funds could triple assets under management within five years, but said success will depend on a better reception from Canadian banks, who have not traditionally steered clients into alternative investments.

On the other hand, retrenchment at big banks has helped small outfits find recruits, said AIMA Canada's Burron.

"It's nice to be in a hedge fund where you can see talent that's on the street and looking for work and hungry," he added.

($1 = $1.0092 Canadian)