Large-scale institutional allocations to Canadian hedge funds have been hard to come by. Many managers spent most of last year pitching, only to come up short. No one is quite sure why the bulk of schemes managing Canadians' retirement money, barring Omers and Ontario Teachers Pension Plan, the country's largest pension funds, have kept hedge funds at bay.

After all, the industry has grown rapidly over the last two years to more than 250 funds managing CAD30bn of assets. Some of the country's biggest managers, such as CAD2.2bn Front Street Capital, have amassed long and respectable track records. But industry participants are quick to point out a suspect: scandals.
 
The reputation of the country's fledgling hedge fund industry nose-dived in 2004 due to alleged fraud at Montreal-based Norshield Asset Management and Portus Alternative Asset Management of Toronto. Norshield is accused of inflating assets over four years while Portus, currently in bankruptcy proceedings, is alleged to have diverted assets to defray fees and costs. Investors are  bracing themselves to write off much of the capital they allocated to the two managers.

Aftershocks are still being felt. For example, the Portus saga took a new twist last month when insurer and investment adviser Manulife Securities International, a marketer of Portus, brought a CAD1.6bn class action lawsuit against French-based bank Société Générale, which issued so-called principal protected notes used by Portus to fund hedge fund investments.

Then last year, funds of funds were stung by mistimed natural gas trades made by Brian Hunter, who wiped out USD6.6bn of New York-based Amaranth Advisors' assets via his Calgary operation, leading to the collapse of the once high-flying investment manager. 'Clouds hung over the industry after recent scandals,' says Patricia Koval, a partner at Toronto law firm Tory's. 'But they're blowing away.'

Regulators are attempting to introduce changes in the industry aimed at reducing the risk of similar upsets in the future. Currently only firms managing portfolio assets need to be registered with their provincial regulator, but the federal supervisory authority, the Canadian Securities Administrators, is proposing that all hedge funds be registered via its Registration Reform Project. The Montrealbased CSA wants to ensure that managers meet capital adequacy and insurance requirements and that there are no conflicts of interest in the way capital is managed. Phil Schmitt, who runs Toronto-based Summerwood Capital and heads the 80- member Canadian chapter of the Alternative Investment Management Association, says that although the country's hedge fund regulations predate recent blow-ups, they have served the country well. However, Schmitt argues that the new registration rule would be welcome because it would allow regulators to  'cast a wider net'. The Aima chapter is working on numerous fronts to keep participants in step with changing rules, and is making efforts to boost investor awareness. The CSA also plans to release a policy statement soon on risks and disclosures associated with principal protected notes, which essentially are bond-like instruments popular among investors that are risk-averse and seek capital protection. Investors have so far put billions of dollars into such investments, awarding a fee windfall to the banks and insurers that sponsor them and providing capital protection.

The regulator believes that investors aren't getting adequate disclosure regarding fees, risks, underlying investments and structuring of such products, and hence could be vulnerable to unexpected losses. In addition,  some distributors may be offering these products to investors for whom they are unsuitable.
 
The CSA also sees pitfalls in the way  investor referrals work within the network of broker/dealers and other distributors, which may refer such investments without disclosing the fees they stand to make from selling them. Dealers, in addition, have to be knowledgeable about hedge funds so that they can match clients' investment goals and risk profiles to the products.
 
Additionally, the federal regulator wants managers to improve the disclosure they offer in offering memorandums and prospectuses. It seeks clarity on  historic returns, other performance data, fees and costs for investors, and it wants hedge funds to become more transparent about the way they conduct net asset value calculations and other aspects of their business.

However, in January this year the CSA concluded that the rules governing hedge funds are largely adequate and only need to be tweaked. 'We're not expecting to see any drastic changes from the regulatory perspective,' Koval says. 'The new regime will slightly increase the administrative burden, but the industry is well prepared. The changes are viewed as a minor impediment. They'll only be an annoyance, not a killer.' The CSA's investigation included a survey of 13 managers running assets of CAD1.25bn in 37 funds, and of nine principal-protected notes with assets of CAD1.4bn. It was spurred by 65 recommendations made in October 2006 by the Task Force to Modernise Securities Legislation.

The body's key recommendation was that hedge funds needed their own regulatory framework, just like the mutual fund industry, because they currently sell via the 'exempt' market without issuance of a prospectus. This allows them to circumvent certain registration disclosures that issuers of other public securities are required to make. Meanwhile, Canada's Senate Banking Committee, headed by Senator Jerry Grafstein, has been reviewing Canadian hedge funds since the autumn of 2006, concerned about the potential risk of hedge funds and lack of investor education. Hearings last November included meetings with Jean St-Gelais, chief executive of the Ottawa-based Autorité des Marchés Financiers, Ontario Securities Commission chairman David Wilson and representatives of the federal Department of Finance. Another facet of regulation that needs to be addressed is the disparity of rules from province to province, according to Miklos Nagy, who founded Toronto-based Quadrexx Asset Management in 2005 and now manages a single-manager fund and a multimanager vehicle. He is also chairman of Canadian Hedge Watch, a Toronto-based provider of information about the Canadian Hedge Fund industry with 2,000 subscribers split evenly between Canada and the US. Nagy notes that each of the country's 13 provinces has its own set of regulations, creating a complicated maze for managers and investors to navigate. A country the size of Canada should have harmonised rules, he argues.

If all goes according to plan, industry participants expect the updated regulatory regime to be finalised by year-end; it could  be in force as early as spring 2008. 'Regulations are evolving in a positive way,' says Richard Morin, co-founder of CAD100m Montreal asset manager Landry Morin. 'Our ability to broadcast more information to investors and talk more freely is good. When information is more readily accessible, there's lesser chance of a blow-up such as Portus, which was very opaque in its disclosures. Industry participants are convinced that as regulatory initiatives gain traction, both retail and institutional investors will return to the marketplace. Jeffrey Shaul, founder and chief executive of Robson Capital Management in Toronto, 

regrets the exclusion of hedge funds from investor portfolios because of their obvious diversification advantages. Shaul, who markets funds tied to the performance of Van Eck Absolute to Canadian investors, says: 'They provide noncorrelated, lower volatility access to strategies that aren't available through longonly investing. Investors need to look at hedge funds as a diversification tool to reduce the overall volatility of their portfolio.' Peter Kline, who works as investment chief at Vancouver-based fund-of-funds operator KCS, agrees that the benefits of hedge fund investment will eventually outweigh the image of scandal in investors' minds. 'With the passage of time, as investors see things done the right way, they'll recognise that they just can't put all their eggs in one basket. They'll realise the need for diversification in their portfolios. They'll see that hedge funds aren't just chasing mad money on the margins. They do provide consistent returns.'

Kline says his KCS team has so far successfully produced bond-like returns by adhering to a consistent risk/return and low volatility formula. He adds: 'There's a perceived risk among institutions about hedge fund investing. Our research shows otherwise.'

The industry's ability to attract institutional investors' money has also been hampered by the turbo-charged performance of Canadian equities over the past two to three years. With the traditional markets delivering between 20 and 25 per cent returns, Shaul asks, why would investors pay a conservative hedge fund manager the typical fees of 1 per cent of assets and 20 per cent of gains to obtain bond-like returns? But this obstacle is also set to recede if some of the steam goes out of Canadian equities.

However, others believe the next year or two will prove to be challenging for many hedge fund managers. Morin argues that a large portion of Canadian players have so far masqueraded as hedge funds and are in fact long-biased managers, employing hedging strategies on the margins. Given the equity market's strong gains over the past four years, it has been very easy to generate returns of between 10 and 15 per cent, but if equities lose ground or start drifting sideways, such managers' skills will be tested to the utmost.

'It has only been a one-way bull market that has made the beta-jockeys look good,' Morin says. 'But if it moves sideways for an extended time or moves down, we'll see the difference between alpha-generators and betaseekers. It'll make for an interesting time.' So what type of funds can investors expect to see this year? Funds of funds will continue to be the preferred route for most first-time investors. 'They are an easier sell because of the diversification story,' Koval says. 'They still hold intuitive appeal.' However, she believes that eventually the smaller to mid-size pension funds will try to mimic their bigger counterparts that are investing directly in single-manager funds. Industry players also expect to see more banks distribute notes via

shelf prospectuses. In addition, mutual fund managers are setting up close-ended listed funds, which typically allow yearly redemptions but have more trading flexibility than their long-only counterparts, and which Koval jokingly refers to as 'hedge lite'. Still, most managers are widely expected to stick with equity long/short strategies. Hedge fund managers are predominantly offshoots of traditional long-only establishments, Nagy says. 'For them it was a natural and easy transition to long/short,' he says. 'Equities are what they know best. They haven't done anything else before.' Patrick Blessing, a director at Scotia Capital's prime brokerage business in Toronto, also expects more mutual fund houses to launch hedge funds this year. Following the example of UK asset managers earlier this decade, traditional managers in Canada are rapidly diversifying their product bases by offering hedge funds.

Blessing also expects to see bigger launches: 'A few years ago, you'd see hedge funds launch with CAD5m, but now you're seeing launches that are  significantly larger.' At the same time, he says, domestic hedge fund managers are beginning to allocate to international equities. 'Canada isn't home to international fund management talent, but that's slowly changing as managers start dipping their toes into global markets with a 10 or 20 per cent allocation.' However, he believes it will still be a while before a pure international fund is run out of Canada. As Canadian managers' attempts to play globally gather momentum, local prime brokerages will have to scale up their operations overseas. With the brokerage arms of US and UK investment banks reaching into Canada, homespun players could get left behind if they only compete locally, Blessing says.

Under the leadership of Jim Buckley, Scotia's prime brokerage already has a presence in Toronto, London, New York and Singapore. It also launched last year Canada's sole hedge fund index, which was backtested for two years prior to its inception and currently comprises 50 constituents.

Meanwhile, Schmitt is in early stages of pioneering exotic strategies, such as carbon trading, asset-backed lending and intellectual property, in Canada. 'I'm working on forwardlooking, alpha-generating products,' he says. But such trailblazers are few and far between. Equity long/short remains the simplest  tory to tell high net worth clients, who must invest a minimum of CAD150,000 in a single fund. It may still be relatively unrewarding pitching to institutional investors, but managers are convinced that better times are not far away.'Scandals won't shut this market out forever,' Shaul says. 'Regulations are tightening up. Gradually, investor confidence is returning, although it still might take a few years to rebound fully.'

 


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