Canadian Hedge Funds

Hedge fund managers come out of the cold

Philippa Aylmer

While much of Canada remains uncharted territory, there is a burgeoning hedge fund industry that is now very much on the map. Canadian hedge funds may represent a micro portion of global hedge fund assets, but they are becoming a popular option.

As of December 2005, hedge fund assets under management in the country stood at $16.4 billion, but estimates for 2006 are showing signs of reaching the $35 billion mark. There are over 150 hedge fund managers in Canada; 10% of those manage assets of over $100 million, with the majority of assets in single manager funds.

“We are seeing an increasing demand from high net worths and some local institutions, but the majority of interest is coming from Europe,” states James McGovern, CEO of Arrow Hedge Partners and chairman of AIMA, “The size of the market in comparison to the US and UK shows that there is a real under-capitalisation of hedge funds in Canada.”

Arrow Hedge currently manages in excess of $700 million in funds of hedge funds and single-manager funds. McGovern suggests that, market forces depending, the Canadian hedge fund industry could triple in size in the next five years with both Toronto and Montreal playing host to major hedge funds.

The Canadian High Commissioner to the United Kingdom, James R Wright, at a recent hedge fund conference in London, claimed it was a good news story. “The economic fundamentals are positive. Canada is in its fifteenth year of expansion with low inflation and excellent corporate profits. And there are a multitude of opportunities available in the resources sector.”

According to figures released by the Canadian Government, the first quarter of 2006 saw real GDP grow 3.8%, over one percent more than that of the US economy. The current account surplus is now in its 27th consecutive quarterly surplus at 3% of nominal GDP, although it dropped $9.5 billion to $52.1 billion in the fourth quarter of 2005. Corporate profits remain at a healthy 13.7% as a share of GDP, although they too have suffered a drop of 15.3% in the last quarter.

Rich pickings

There is certainly a market for increased hedge fund activity in Canada. The Toronto Stock Exchange is the 3rd largest in North America, predominantly trading small to mid-caps. It is small and illiquid, but the attraction is that it is inefficient, creating potential for huge gains. A survey conducted last year on institutional equity managers in Canada found that hedge funds’ trading velocity actually accounts for nearly one-third of market activity. Mutual funds average 15-20% turnover every year, while hedge funds reach 600-800%. Hedge fund managers are now one of the most important providers of liquidity in Canada’s capital markets.

There is no doubt that Canada offers a wealth of opportunities, but local market knowledge is essential, say those on the ground. Margo Naudie, managing director and portfolio manager from TD Asset Management, advises bottom up fundamental research in order to take advantage of this fact. “It is Canada that one invests in, the culture and the in-depth knowledge that the hedge funds offer.”

One of the country’s key attributes is its strong focus on energy. A third of the market in the TSX is in energy and the junior exchange, the TSX Venture, founded in 1999, trades 75% oil and gas and mining stocks. However, as the recent Amaranth story testifies, it is not without its risks.

Teething troubles

For a hedge fund industry in its infancy,Canada’s financial regulation is considered one of the most stringent. However, last year two major hedge fund scandals upset the equilibrium. The Ontario Securities Commission withdrew Toronto-based Portus Alternative Asset Management’s trading licence, with allegations that sales were made to unauthorised investors. At that time, Portus had $800 million in assets from 26,000 investors for its principal protected notes. It turned out that there was no protection and the funds are said to be still missing.

In June 2005 came news that one of Canada’s largest funds of funds, Norshield, went in to receivership, although as yet, much of the details have not been uncovered. But in a speech earlier this year, David Wilson, Chairman of the Ontario Securities Commission stated that “corporate governance structures in Canada are basically sound.” And, in many cases the regulatory environment is stricter than that of the US with the OSC chairman regularly voicing his commitment to greater transparency in the Canadian hedge fund industry.

Canadian investors can access hedge funds through managed accounts, pooled funds and derivatives, but there is a mandatory registration requirement along with additional provincial regulation. A portfolio manager must be registered as an adviser or be able to rely on a registration exemption and those portfolio managers not resident may have limited registration exemptions available to them. Even if there is no direct contact with potential investors, if the fund is trading in securities, then the fund manager is still required to obtain registration. Securities law also requires hedge funds to file interim and annual financial statements and in some cases funds have an adviser registered in the local jurisdiction.

With the foundations laid, Canada looks set to prosper. Despite last year’s setbacks, figures prove that Canadian hedge funds are on the up. True, it is a late developer, but as Arrow Hedge’s McGovern says, “Canada may be short on capital, but it is long on ideas.”