Although the hedge fund industry has grown to about $30 billion in assets in Canada, it has had a limited effect on the mutual fund business, largely because of the different nature of its business, products and client base.

“The hedge fund industry is having a modest impact on the mutual fund business — at this stage,” says Pierre Saint-Laurent, president of Montreal-based financial services consultancy AssetCounsel Inc. and chairman of the education committee of the Canadian chapter of the Alternative Investment Management Association.

Performance fees, for example, are a characteristic of hedge funds that are difficult to adopt on the mutual fund side. Saint-Laurent notes that hedge fund managers differ from mutual fund managers in that they are paid to generate absolute returns rather than to beat a relative benchmark such as the S&P/TSX composite index.

“It’s a key priority not to lose money, so you will benchmark to a money market rate, such as London inter-bank offered rate,” says Saint-Laurent.

If the fund loses money, no performance fee is paid — until the fund returns to its “par” level.

“The concept of absolute returns is somewhat complex,” Saint-Laurent adds. “It’s not only saying, ‘You’re paid when you make me money,’ it’s also saying, ‘If I do lose money, whether it’s your fault or not, I’m not going to pay you twice to get me back to par’.”

That complexity, he adds, has not trickled down to the mutual fund world: “The complexity is not in tune with the otherwise simplicity of a mutual fund. It may happen one day, but I’m not fully convinced it will.”

One key issue, Saint-Laurent says, is whether the mutual fund investor would feel comfortable with this type of fee structure and an absolute-return benchmark. “The benchmark would have to be a bit more complex, contrary to a long-only strategy in which you are trying to outperform the S&P/TSX index, for example,” he says. “It’s a whole different world.”

Indeed, when it comes to employing strategies such as short-selling, very few mutual fund com-panies have shown an interest. Dynamic Mutual Funds Ltd. and CI Investments Inc. , both of Toronto, are among those that have. In the case of Dynamic, the Ontario Securities Commission granted the firm an exemption from the conventional rules of fund management in October 2003 and allowed Dynamic to sell short to a maximum of 10% of the net asset value of several funds in its Power fund family. As of June 2007, however, a Dynamic spokesperson says none of the Power funds has an outstanding short position.

Short-selling and performance fees go hand in hand, according to Dan Hallett, president of Windsor, Ont.-based fund analysis firm Dan Hallett & Associates Inc. “Often, those same funds that are allowed a limited amount of short-selling charge a performance fee as well as a base management fee,” he says, citing as examples the $1.9-billion Sprott Canadian Equity Fund, whose MER is 4.33% including its performance fee (as of Sept. 30), and the $1.5-billion Dynamic Power Canadian Growth Fund, whose MER is 3.56% including its performance fee.

But this combination of performance fees and short-selling is “still more the exception than the rule,” says Hallett. Few managers are interested in short-selling; it is a very different skill from long investing. “It’s one thing to buy a stock you think will rise in price over two or three years and sell when it no longer offers the same return,” Hallett says. “It’s quite another thing entirely to short a stock and bet that it will fall in price. A long-only manager has the luxury of waiting for the market to see the same value that he/she sees. In shorting — and this is why there is a limit on it — you can go broke waiting, because of margin calls.”

For Saint-Laurent’s part, he maintains that the ability to take short positions is something that will expand over time. “It does add value when it’s well done,” he says. “That is a development to come.”

To make short-selling more widespread, regulators will have to be more accommodating. “It needs to be part of the mainstream,” Saint-Laurent adds. “As regulators get more comfortable with the ability to take short positions, they will allow managers to take larger percentages of short positions. They will basically allow more firms to go in that direction.”

@page_break@There are also differences in business cultures, which minimizes the direct impact of hedge funds on the mutual fund industry, says Jim McGovern, a mutual fund industry veteran who is now CEO and managing director of Toronto-based Arrow Hedge Partners Inc. This is especially the case when it comes to attracting assets away from the fund industry. “There is potential for people to leave mutual fund firms and start hedge funds,” he says. “The infrastructure and distribution capabilities are coming. But it hasn’t been very material so far.”

For now, the mutual fund’s response to the hedge fund industry is demonstrated in two ways, says McGovern. First, it is happening directly, as in the case of Dynamic and CI Funds, the latter of which gives free rein to Nandu Narayanan, chief investment officer at New York-based Trident Investment Management LLC, to short stocks in two funds, including the $79.5-million CI Trident Global Opportunities.

It is also occurring indirectly, as is the case with Toronto-based Mackenzie Financial Corp. , which has entered the fray with a fund-of-funds approach. The $95.7-million Mackenzie Alternative Strategies Fund, which was launched in January 2001, offers access to more than 20 hedge funds, which are hand-picked by Tremont Capital Management Corp. of Rye, N.Y.

The minimal impact may be explained, in part, by the fact that Canadian investors tend to be more conservative and more reliant on financial advisors when buying funds, says Jim Fraser, senior vice president of marketing at Mackenzie: “Most hedge fund investors in the U.S. more often than not buy funds directly. They are more likely to be seduced by high posted returns, which are historical and not an indication of what the fund will do going forward.”

In Canada, financial advisors may or may not include hedge funds in their books. “But they are not likely to consider them a major allocation,” says Fraser. “It may be 5% or 10%.”

While it’s common for hedge funds to demand $1 million minimum investment per account, Mackenzie wants to serve a less-affluent market and so has launched its fund with a $150,000 minimum.

“We can access those funds only by pooling resources and going to Tremont,” Fraser says. Tremont scanned more than 5,000 hedge funds and selected those with differing strategies, such as long/short and convertible arbitrage.

Fraser admits that there is some “blurring” of the line between hedge funds and mutual funds: “We’ve already had a few funds take on some shorting — but with heavy restrictions.”

And Mackenzie is not about to take the plunge itself. “We want to make sure managers who are given that tool have experience in shorting,” says Fraser. “It’s a different skill set from going long.”

There are also concerns, he adds, about liquidity and the ease of borrowing securities to short.

What about the stir the hedge fund industry caused when a high-profile mutual fund manager jumped ship? Last summer, Allan departed Toronto-based Sceptre Investment Counsel Ltd. , at which he had managed Sceptre Equity Growth Fund for many years, for Toronto-based Sprott Asset Management Inc. Jacobs now runs the $110-million Sprott Small-Cap Equity Fund and the $30-million Sprott Small Cap Hedge Fund. The latter fund, ironically, originated at Sceptre last spring but had been sold to Sprott.

Mackenzie’s Fraser puts Jacob’s move into perspective: “It has not been happening in droves. It may well be because the Canadian hedge fund business has not attracted the same level of assets as in the U.S. relative to that market. The demand for hedge funds is not as great and the opportunity is not as lucrative for mutual fund managers to cross the road.”

Still, Saint-Laurent says, the potential for higher compensation is key in attracting talent. “Because it is a very specialty-oriented environment,” he says, “someone who is skilled at short-selling or convertible arbitrage strategies, for example, and who does it well will be very well compensated.”

Moreover, he says, there is a less-known source of talent other than former mutual fund managers. “It’s not the classic long-only manager who moves into the hedge fund space,” says Saint-Laurent. “It’s more the trader on the trading desk or proprietary bank desk who moves to the hedge fund environment. That is more typically the case — and that is why you don’t see as many mutual fund managers moving to hedge funds. In large numbers, [hedge fund managers] come from the trading desks.” IE