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The Hedgeweek Interview: Colin Stewart, portfolio manager, JCClark Focused Opportunities Fund and Focused Opportunities Offshore: "We utilise a fundamental approach in an inefficient market segment"

Colin Stewart, portfolio manager with Canadian long/short manager JCClark, says the firm focuses on sectors and ideas that are not widely followed in which it can gain an informational advantage.

HW: What is the background to your company?

CS: Established in January 2001, JCClark is a Toronto based 14-person hedge fund management firm co-founded by John Clark and myself. John is the former chairman of the Toronto Stock Exchange, co-founder of Connor Clark & Co., a leading wealth management firm, and co-founder of Connor, Clark & Lunn, a large pension fund manager. He has 37 years of investment management experience and more than 20 years of long/short experience. He has successfully managed money through six bear markets during his career.

I have worked directly with John as a key member of the investment team since 1999. I have eight years of experience managing long/short strategies and am directly responsible for the day-to-day management of the Focused Opportunities Fund.

I am supported by an investment team, trader, in-house compliance officer, operations staff and business development personnel. The firm focuses on opportunistic, high-return investment opportunities and emphasises open and transparent client relationships. JCClark currently manages more than USD300m, predominantly in long/short equity strategies.

HW: Who are your key service providers?

CS: Key service providers include Deloitte & Touche as auditor, Ogilvy Renault as legal advisors, National Bank as prime broker, Swiss Fund Services as offshore administrator, Caledon Trust as domestic administrator and National Bank Correspondent Network as custodian.

HW: What is your investment process?

CS: The JCClark Focused Opportunities Fund is a long/short hedge fund that seeks to generate positive absolute returns on capital across varied market conditions. The manager allocates capital to a small number of core investment ideas and takes significant positions in each of these ideas, a focused investment approach that aims to generate exceptional long-term returns for investors. The fund invests primarily in North American equities but the manager also considers investments in other jurisdictions and across other asset classes.

The manager bases investment decisions on rigorous fundamental analysis and attempts to purchase high-quality businesses that are trading at a significant discount to their intrinsic values and sell short those companies that possess significant fundamental weaknesses or are trading at a significant premium to their intrinsic values.

The fund allocates capital to between 10 and 30 long and short positions at any one time, and can also invest in fixed-income securities, options, futures and forward contracts. The fund can also enter into other derivative transactions and lend portfolio securities. The fund aims to maintain a low correlation with major market indices, generating returns in both up and down markets.

The manager generally employs a value-based strategy, focusing on the fundamental characteristics of individual companies. Through a rigorous bottom-up research process, members of the investment team focus on fundamental business and industry analysis. Long and short positions will typically be outright and distinct in nature rather than as a hedge to one another.

Hedging is done at the overall portfolio level, and periodically at the sector level, sometimes using index futures or exchange-traded. While the manager may moderately adjust the fund's overall net market exposure from time to time, the general focus is on security selection rather than market timing or attempts to predict market direction.

HW: How has your fund performed?

CS: While the offshore fund, Focused Opportunities Offshore, was launched on May 1 this year, the strategy was launched in Canada in June 2005. After restating onshore fund returns Focused Opportunities Offshore has annualised returns of 17.6 per cent, and a standard deviation of 6.5 per cent since launch. It has demonstrated an ability to generate positive returns in down months as well as up months in the market.

HW: How many positions are in your portfolio?

CS: The average number of positions in the portfolio is 20-30, longs and shorts inclusive. The hold period is typically between six months and three years for long positions, and three months to two years for short positions. The average market capitalisation is USD100m to USD3bn for long positions and USD500m to USD5bn for shorts. Gross exposure typically runs in a range of 100 to 120 per cent, with a net dollar-weighted position exposure of approximately 30 per cent. It is a variable bias strategy that maintains a modest net exposure and is generally relatively non-directional in nature.

HW: What differentiates you from other managers in your sector?

CS: Relative to most of our Canadian peers, we generally have a lower exposure to commodities and resources. We also tend to be contrarian investors and focus on sectors and ideas that are not widely followed, where we think we can gain an informational advantage. Our returns have historically been relatively uncorrelated to the broader markets and to our Canadian long/short peers.

Again, because we manage a variable bias strategy, we tend to have a much lower dollar-weighted net long exposure than our peers. Since launch this strategy has averaged 40 per cent net long versus many of our peers that are closer to 100 per cent net long. On a beta-adjusted basis, our net long exposure has been even more modest at about 20 per cent since launch. The end result is that we are much less directional than most of our peers and offer uncorrelated returns as opposed to competing strategies that are typically highly correlated to the Canadian equity indices and therefore produce high levels of beta.

While this strategy is relatively new it is being launched from the platform of a much larger and established firm. We have a robust operational infrastructure with 14 staff including a very senior chief operating officer and a dedicated compliance officer.

We believe we have a distinct edge because we utilise a fundamental approach in an inefficient market segment. With a focus on the Canadian mid-cap segment where low levels of institutional ownership and limited analyst coverage lead to inefficient pricing, thorough fundamental analysis can provide a significant advantage.

We also believe that Canada is a unique place to invest. This strategy has a large exposure to Canada, a market with very few hedge funds and unique sector opportunities. Moreover, the history and investment experience of John Clark provides us with an informational advantage over many of our peers. John has an extensive contact base in the tight knit Canadian business community, providing us with significant access to board and management level personnel across a variety of industries and companies within Canada.

Another factor making us unique is that our track record shows an ability to outperform in difficult markets. We have less focus on the hot sectors in the market and employ a relatively non-directional long/short strategy in a market with predominantly long-biased hedge fund managers.

Finally, there is a significant alignment of interests between the management and investors. More than 20 per cent of the assets the firm manages are those of insiders, invested directly alongside clients.

HW: What events do you expect to see in your sector in the year ahead?

CS: Already 2007 has been a year of distinct contrasts. We spent the first five months of the year in a very bullish environment, but the past three months have been much more volatile and bearish. We had anticipated a change in the market environment for the last few quarters and have worked to position the fund defensively to insulate it against increased market volatility.

We believe that by continuing to employ a bottom-up value based investment process, the fund should appreciate due to the specific security selection rather than general market movements. This type of approach should also continue to generate returns that are relatively uncorrelated with the broader equity markets.

We also believe that the next few years will be more of a stock-picker's market than the broad-based bull market that we have experienced over the past three to four years. It would not be a stretch for us to envision a scenario where equity markets are at today's levels two or three years from now. Clearly this would represent a significant change in the equity market environment.

HW: How will these developments impact on your own portfolios?

CS: As our fund returns tend to be relatively uncorrelated to the broader market, we think this change of environment would have minimal impact on our strategy. For example, from the end of May this year to the end of August, Focused Opportunities Offshore has appreciated significantly even though Canada's primary equity index, the S&P/TSX Composite, suffered three straight negative months, gaining 6.24 per cent while the S&P/TSX lost 2.81 per cent.

In August, a month that was marred by significant hedge fund losses in Canada and abroad, the fund delivered a positive 0.26 per cent return. In the first eight months of this year Focused Opportunities Offshore posted 14.99 per cent gains, while the S&P/TSX has gained only 5.83 per cent.

Over the past quarter we have reduced gross exposure in the fund from the average of 115 per cent down to around 100 per cent, and net exposure has also been reduced from 40 per cent to about 30 per cent. As a variable bias strategy we would expect the dollar-weighted net exposure to range from -20 per cent to +40 per cent for this fund. In a lower return market environment we would expect to maintain a relatively non-directional stance and focus on special situation opportunities and event-driven ideas.

HW: What are your views on risk in the current environment and in general?

CS: Our risk tolerance is driven by two factors: the individual investment opportunities that we are able to identify through our bottom-up process, and the overall economic and financial market conditions.

When we are less certain regarding the direction and outlook for the broad financial markets, we typically reduce gross exposure and maintain a relatively neutral net exposure. When we are more confident regarding the direction and outlook for financial markets and are finding many new individual opportunities, we increase our gross exposure and increase the weightings of individual positions.

More generally, we view risk from an overall portfolio level and manage our gross, net and sector exposures accordingly. Risk on individual names is more a function of our analysis on the individual merits and risks of each portfolio company. This is obviously managed by maintaining a sound due diligence and research process.

HW: Are investors' expectations moving upward, and how do you deal with this?

CS: We believe investors are becoming increasingly diligent in their search for uncorrelated returns, or alpha generation. Returns that are primarily driven by beta are no longer acceptable and relatively easy to replicate through various low-cost alternatives. We believe that a lower return environment is coming (if not already upon us) and the ability to generate absolute alpha-driven returns and offer downside protection in more difficult equity markets will be an increasing focus for hedge fund investors.
We also believe that risk controls and operational infrastructure are becoming an increasing focus, particularly as larger institutional investors allocate to the hedge fund space.

At JCClark, we believe that our relatively non-directional strategy and historically uncorrelated returns position us well as hedge fund investors increasingly focus on alpha generation. We have also spent considerable efforts over the last several years developing a robust operational team and process.

HW: How do you distribute your products?

CS: We sell our funds directly both domestically in Canada and offshore, where we have partnered with Dexion Capital to raise funds for our newest offering, Focused Opportunities Offshore. Dexion has established a strong reputation internationally by listing a large percentage of the closed-ended hedge funds on the London Stock Exchange as well as building an internationally recognised consulting business. Their single-manager marketing arm was a natural extension and we are pleased that they have chosen our firm and this fund to introduce to their international institutional contacts.

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