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Smiles disappearing in hedge fund land

You think you've got bad timing with your investments? Spare a thought, and maybe a prayer, for hedge fund manager Jim Allan.

Back in the rosy hope of summer, which feels like a hundred years ago, Mr. Allan invited friends and business acquaintances to a party. The scene was the Rosedale Golf Club in Toronto and the occasion was a birthday: His firm, Roundtable Capital, was one year old. Paul Beeston, who once ran the Toronto Blue Jays, was there. So was former RJR Nabisco boss Ross Johnson, a man who will live on forever as the antagonist in Barbarians at the Gate, one of the best business books ever written.

The guests noshed on tuna sashimi and coconut shrimp. Mr. Allan dished out some thoughts on the stock market. A society photographer captured the event and the National Post published a short item on it. Three days after it appeared - July 31 - he launched a new, multimillion-dollar fund. Life was good.

Then all hell broke lose.

The credit markets, already rattled, lapsed into full-scale convulsions. Asset-backed commercial paper, a form of short-term debt once thought to be ludicrously safe, proved risky. Summer turned into fall and the news from Wall Street grew worse: a mortgage crisis, a banking crisis, recession. Mr. Allan's Arrow Roundtable Fund plunged 16 per cent in November, 5 per cent in December and 11 per cent in the first 2½ weeks of January. By the end of last week, a $1-million investment made when the fund opened in July had shrunk to less than $750,000.

This week's numbers are not available because, like most hedge funds, this one doesn't publish daily values. What we do know is that Mr. Allan favours energy stocks, especially small ones, especially oil sands and uranium plays. We also know the names of 10 of his favourite stocks - UEX, Paladin Energy and others - because he talked them up in a recent commentary to shareholders; on average, they've lost 8.8 per cent since Friday. (Mr. Allan did not return calls.)

Is it any wonder these are nervous days for hedge funds? For many, the old tactics are not working. Until recently, it paid to be aggressive with commodity stocks - the more speculative, the better. Anything with oil was great, uranium was fabulous. Borrowed money was a good thing, the better to turn small gains into bigger returns and fees. (Mr. Allan's new fund, for example, contemplates using leverage of up to 200 per cent.) But the real promise of the hedge funds - and the reason they went from obscurity to a nearly $2-trillion (U.S.) industry - was supposed to be that they'd protect your money in times like this. Sure, the fees are high, even outrageous in some cases. But in rough times, if you've got a lot of money, what are you going to do? Buy a mutual fund? What really fuelled the growth in hedge fund assets, remember, was the sting of 2000-02 bear market, during which the Standard & Poor's 500 fell by nearly half.

So, how are they doing so far in the credit crunch? The evidence suggests, not so great. The Credit Suisse/Tremont Blue Chip index, which takes the performance of several dozen of the best hedge funds, was basically flat in the second half of 2007, a little better than the S&P 500, a bit worse than the Dow Jones world index. For the year, the hedgies were up 7.4 per cent. Even at that, there's plenty of debate about whether the numbers are inflated by survivorship bias - hundreds of hedge funds that blow up or close down get the quick boot from the index.

So this market brings a real test. The game is probably up for commodities. Hedge funds won't be able to use as much leverage to juice returns, as banks and brokerage firms try to cut risk. And because the bond market has fallen apart, the tactic of forcing companies to sell to private equity or do massive share buybacks with borrowed money isn't going to work. And if the returns don't materialize, the customers will ask: Why, exactly, am I paying 20 per cent of the profits in fees? That's when there will be real trouble in hedgeland. On the bright side for Mr. Allan, in his moment of misery, he'll have plenty of company soon enough.

© 2007 The Globe and Mail. All rights reserved.

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