Since the financial markets fell into a tailspin last fall, there’s been severe fallout among Canadian hedge funds, some of which have been forced to wind up or halt redemptions. But most regular mutual funds have been able to sell enough securities in their portfolios to meet redemptions.

However, mutual funds with less liquid, small-cap portfolios could be vulnerable to redemption freezes should markets worsen and more unitholders head for the exit. “Anything small-cap is hard to liquidate these days,” says Jim McGovern, president of Toronto-based Arrow Hedge Partners Inc., which is in the process of winding up Arrow Epic Hedge Fund. “Even for publicly traded small-caps, the bids are ridiculously low.”

Although hedge funds deal in the illiquid world of debentures, private placements and distressed securities, mutual funds are bound by a tighter set of regulations that keep them invested primarily in securities that trade on recognized public exchanges. Fund managers can usually sell off securities if needed to meet redemptions, although not necessarily at attractive prices.

“Fund failures and freezes are definitely a big story in the hedge fund universe,” says Al Kellett, fund analyst with Toronto-based Morningstar Canada, “in which as many as a quarter of hedge funds around the world have put some sort of gate on redemptions.

“Declining assets values in regular mutual funds would not likely result in a freezing of assets,” he adds, “as long as there is a market for the securities in their portfolios. However, the prospectuses of mutual funds usually contain language that allows them to suspend redemptions in extreme cases.”

If you’re looking out for mutual funds vulnerable to redemption freezes, watch for portfolios concentrated in illiquid small-cap or micro-cap companies, suggests Dan Hallett, president of Windsor, Ont.-based fund analysis firm Dan Hallett & Associates Inc. A narrowly focused portfolio with large weightings in illiquid companies will be more problematic than a portfolio with a variety of holdings, each making up a smaller percentage of fund assets. Heavy redemptions will also be a warning sign.

“In a mutual fund, it may be hard to get rid of a portfolio of publicly traded stocks, but you usually can sell at a price,” Hallett says. “With hedge funds, it’s dicier, as the illiquidity of holdings runs a notch higher than the typical small-cap mutual fund.”

Ralph Lindenblatt, lead manager of Bissett Microcap and Bissett Small Cap funds with Calgary-based Bissett Investment Management Ltd., a subsidiary of Toronto-based Franklin Templeton Investments Inc., says that even in good markets, it can be difficult to buy and sell meaningful positions in small companies without moving the stock prices. And no manager wants to be forced to sell in a hurry.

Small-caps were hit even harder in 2008 than their large-cap counterparts. The BMO Nesbitt Burns Canadian small-cap index dropped by 46% during the year, compared with the S&P/TSX composite index’s drop of 33%. During the worst months this past fall, Lindenblatt was taking advantage of low prices to do some buying. He would often bid 20%-30% below a company’s market price and desperate sellers would capitulate.

“Maybe not right away; but usually within a few weeks, my bid would get hit,” he says. “I was shocked to see how strong the selling pressure was in a depressed market.”

Although the Bissett funds have not had significant redemptions, Lindenblatt is being more cautious and has increased his cash cushion beyond the usual 1%-3% of assets under management. Currently, 4.9% of Bissett Microcap Fund’s AUM is in cash. In addition, a holding called Lockerbie & Hole Inc. has been the subject of a cash takeover, providing “near cash” representing 5.2% of AUM. Both the Bissett funds had previously been closed to new investors but recently reopened their doors, allowing new cash to flow in and increase the funds’ liquidity.

In the mutual fund world, the only funds to suspend redemptions so far have been funds investing in real property, including Great-West Life Real Estate Fund, sponsored by Winnipeg based Great-West Life Assurance Co. ; and London Life Real Estate Fund, sponsored by London, Ont.-based London Life Insurance Co. Both funds, which imposed a moratorium on redemptions on Dec. 15, 2008, remain open to new money.

“The returns of the real property funds were good. In fact, they were excellent — on a relative basis,” says Alf Goodall, vice president of marketing at Great-West Life. “But people were redeeming as everything else was being liquidated. We are working on rebuilding the cash positions. It may take some time, but we don’t want to be forced into a situation in which we are disposing of high-quality income properties that our unitholders would prefer we retain for their long-term benefit.”

@page_break@Although the managers of the real property funds had previously set aside some cash to meet redemptions, Goodall stresses the goal is “to manage a real property fund, not a high-priced money market fund” and that most of the funds’ AUM is invested in high-quality real estate properties across the country. Large properties cannot be sold quickly, he says, and the redemption freeze gives the fund managers time to re-establish cash positions in an orderly manner without having to sell properties at distressed prices. Methods of raising cash include asset sales, refinancing properties and the sale of new fund units.

Hugh Cleland, portfolio manager of hedge fund Northern Rivers Innovation LP, sponsored by Toronto-based Northern Rivers Capital Management Inc., decided to suspend redemptions for two years in late January after the fund’s value shrivelled by 65% in 2008. He says many unitholders have responded positively to the freeze as it “stabilized the asset base” and that some new money has flowed into the fund in February.

“By suspending redemptions, we have avoided the fate of many of our competitors that have shut down,” Cleland says. “The halt will allow us to thrive and get through this difficult period without being forced to liquidate. Closing the fund was a wrenching decision and almost tore me apart. But it was the right thing to do. Markets will ultimately recover, and we need to be around to take advantage of it.” IE