Until recently international investors paid little attention to Canadian hedge fund managers, despite their impressive returns. But increasingly humdrum performance across the border and the realisation that Canadian expertise in the ever more important area of resources investing is second to none have focused the spotlight on alternative managers in Toronto and Calgary.
Even Canadians admit that the country's fledgling hedge fund sector has been overshadowed for most of its existence by the alternative investments industry in its giant neighbour across the border. But now, just as Toronto is starting to attract attention as a centre for hedge fund servicing, investors abroad are starting to cotton on to the merits of the country's managers.
Not the least of these suddenly discovered virtues is Canada's role as a centre for mining and natural resources - a characteristic that attracted little notice during the commodity price slump of the 1990s, but one that has suddenly assumed huge proportions as soaring demand, particularly from China, has put a rocket under the prices of both raw materials and the companies that produce or extract them.
For that, reason, although Toronto is the principal location for hedge fund managers in Canada, the second ranking centre is Calgary, the focal point of the vast country's resources industry, with Vancouver a little further behind and Montreal trailing in a distant fourth, according to Ronald Landry, executive vice-president and chief operating officer of hedge fund administrator and transfer agent Felcom Data Services.
Says Landry: 'Toronto is Canada's financial centre, and because of its proximity to New York, the trends emerging there tend to be followed fairly closely. With the hedge fund market well established in the US, Toronto is leading the way in Canada. Other provinces are starting to pick up the pace now, but they're not moving forward as rapidly as Ontario.'
Landry says the resources boom has helped to focus interest on Canadian funds among investors from Asia and Europe. He says: 'We're seeing investors from Hong Kong and elsewhere in Asia and to a certain degree Europe recognising that a certain proportion of their portfolios should be here, and the greatest attention is on alternative products that invest in the resources sector.'
In the case of European investors, it is still a voyage of discovery, but one that is being signposted by a regular stream of conferences and seminars organised in Europe by members of the Canadian hedge fund industry, especially prime brokers, according to Sarah Caygill, managing director of Arrow Hedge Partners (Europe), the Geneva-based arm of a leading Torontobased fund of funds manager. 'These conferences are raising awareness of Canadian managers, Canadian talent, and a Canadian angle on producing high riskadjusted returns, which they have done,' she says.
'European-based investors are curious but do not know the specificities of the Canadian hedge fund market, because it has long been overlooked. When most people from Europe think about North America, it is more or less exclusively US centres like New York, Boston and Chicago. The number of people who will make it up to Toronto, let alone other centres such as Vancouver or Quebec, is relatively small.
'Canada has a very attractive combination of being relatively undiscovered and untapped, but everyone now knows it's the centre for resources, which is a theme we're all getting to grips with and that will be with us for years to come. As investors try to understand more about resources, they're realising it's something that Canadians know very well, since it's 30 per cent of their market and mining is also very well represented. Canadians are much more knowledgeable in this area than the average European manager or investor.'
This expertise is a useful attribute when investing not only in Canada but beyond - for instance in another resource-based economy, Russia, where Arrow Hedge is also active. Says Caygill: 'In investing in countries like Russia, it's much more challenging to do the work and feel comfortable with the investment, because you've got to take on board the political risk, as well as understanding local regulation, which may be not as easy to understand as in Canada.'
She argues that the limited scale of the Canadian economy and market compared with the US has given the country's managers an additional advantage. 'The industry is in its infancy in Canada, way behind the US, although it's catching up very fast. There won't be anything like the plethora of hedge funds in the US because the market is not so deep, but many Canadian managers have an edge because not only do they know their own market inside out, but they automatically have to follow the US market, as their main competitor, very closely.
'US managers have a large enough domestic market to be able to focus just on that. They don't have that inside edge of knowing the investment themes and special features of the Canadian market and sectors. For example, many of our managers can do very interesting paired trades, by going long on a Canadian group and shorting a US competitor, depending on what the characteristics and valuation are, or vice versa.'
Arrow Hedge is well placed to assess the relative qualities of Canadian managers and their counterparts abroad because the firm offers investors funds of funds and selected single manager funds drawn from both groups. Says director of research Keith Tomlinson: 'We visit managers globally, so we don't have to put any money in Canada, but we find excellent hedge funds here, so about a third of our number of allocations are to Canadian managers.'
Adds chief investment officer Mark Purdy: 'The increased demand globally for Canadian hedge fund managers probably has a lot to do with the returns being produced by oil and energy, but another important factor is that, very much like in the UK, almost all managers are registered with their respective provincial securities commission. That means there's a very good legal framework to operate within, on top of the advantages of a highly educated workforce and five big banks that provide good channels for distribution.'
The high degree of regulation and the importance of bank distribution reflect the specific characteristics of a market in which retail sales of hedge products in the form of principal-protected notes accounted for around 25 per cent of all investment with Canadian managers, including offshore funds, funds of funds and managed accounts for pension schemes, at the end of 2004.
According to Lionel deMercado, managing director and global head of equity finance with prime broker TD Securities, the range of strategies followed by Canadian managers is broadly comparable with those in other markets and include notably equity long/short, long-only, convertible arbitrage and risk arbitrage as well as fixed-income strategies.
Among individual funds, he says, there are a substantial number with assets of between C$20m and C$100m, rather fewer in the 'bulge bracket' of C$500m-C$1bn, and a handful with between C$1bn and C$2bn. DeMercado estimates that the industry now probably has more than 200 single manager funds and total assets of around C$18bn, including funds of funds but not managed accounts.
Arrow Hedge chief executive Jim McGovern, who also founded and heads the Canadian chapter of the Alternative Investment Management Association, argues that on the institutional investment side there is a sharp dichotomy between the attitudes of the biggest pension funds, some of which are experienced and enthusiastic investors in hedge funds and other alternative asset classes, and smaller schemes that he says are still reluctant to take the plunge.
He says: 'The big government pension plans and some corporate plans are very strong in terms of knowledge and acceptance of alternatives in general. Five or six very substantial plans are big buyers of alternatives across the board and have long incorporated them into their investment policy. However, the smaller endowment and pension schemes are not as keen on hedge funds.'
One of the big hitters in the market is the Ontario Teachers' Pension Plan, which has attracted headlines in recent weeks for its forays into the private equity market and is one of the biggest allocators to hedge fund managers. Says Purdy: 'One advantage of Toronto from an allocator's standpoint is that you've got the Ontario Teachers' Plan up the road which has 150 hedge fund managers. You often get a lot of managers coming up here from New York and London or even Asia looking for capital.'
Managers and service providers agree that two high-profile hedge fund collapses last year have resulted in a hiccup for the industry, although there is less consensus of how long the impact will be felt. Norshield, once one of Canada's largest fund of funds managers with C$1bn in assets in mid-2004, collapsed into receivership last June, leaving investors as much as C$500m out of pocket.
Portus Alternative Asset Management was placed in bankruptcy on March 24, just over a year after the firm had its licence withdrawn by the Ontario Securities Commission following allegations of sales to unauthorised investors and failure to follow the firm's stated investment policy. However, the firm's 26,000-odd investors are likely to get much of their money back after the court-appointed receiver KPMG said it had now recovered all but C$17.6m of the nearly C$800m placed in the Portus funds. DeMercado is relatively sanguine about the impact of the Norshield and Portus cases. He says: 'Canada is no different from any other jurisdiction. There's always going to be the odd bad apple that's going to cloud the marketplace. All it does is to make the regulators take a closer look at the industry, and makes the big banks tread more cautiously when offering the product at a retail level.'
Adds Mark Fieldhouse, director of technical sales and relationship for global products with RBC Dexia Investor Services: 'The impact has been minimal as far as growth in the segment is concerned. As with any other investment vehicle, it just underlines that investors must complete proper due diligence and look at the providers with which the hedge fund is dealing. Are they getting risk management and prime brokerage services from a reputable institution? This is an important point with any type of investment.' McGovern believes that the scandals may have affected the industry in the short term, especially at the retail level, but it should be able to shrug them off over time. 'The solid single manager funds and funds of funds have continued to take in capital from private clients, so for those that understand what's going on, it wasn't really a big issue. It affected more the pure retail market where they were using structured notes to distribute
hedge funds to retail investors.'
He argues that the inevitable calls for greater regulation of the industry are superfluous, since managers were already regulated more closely than by the new US rules introduced by the Securities and Exchange Commission in February. 'Anyone managing money in this country and offering their services to the public has to be regulated, which covers continuous reporting disclosure regimes, capital requirements, proficiency requirements and so on. We're ahead of the US on a lot of issues.' According to Landry, one importance consequence of the scandals is that hedge funds have embraced a significantly higher degree of transparency. He says: 'Setbacks such as Portus certainly impacted the marketing side for alternative products, although there still is an appetite for them. It's definitely impacted sales, and it will probably take a little while before sales of hedge funds in Canada continue their upward trend. There's a certain level of confidence that investors need to have restored.
'What you're seeing as a result of situations like Portus is that alternative products are elevating their level of disclosure to investors. Investors are moving toward the greater transparency offered by prospectus-based funds. This includes notably the history of the principals that are involved, to ensure that there isn't a risk that money will go offshore and never make it back. Managers who are not ready to face that kind of question will not get their product to market.'
Landry argues that it may take more time before the market emerges from its current hiatus. 'The market for domestic consumption of hedge fund products is in a lull, but that will ebb as things are clarified with Portus,' he says. 'Over the next year or so there will be growth, although it will be slower than in 2004 As people become aware of the increased transparency of these products, the market will start to rebound. It's just a matter of how easily confidence can be restored.'
McGovern believes the rebound will be felt as early as this year. 'We're going to see a surprising level of growth,' he says. 'There is a lot of international interest in the market, and at home the banks, who really are the drivers of financial services growth, will warm up to alternatives even more. In addition, we expect to get a bounce off Portus and Norshield as the problems fade from public attention, and some of the deferred investment from last year will start to come in. It should be a very good year.'
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