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Hedge funds face struggle for survival

Black clouds have been building over the hedge fund industry for much of the year, and a storm could break in coming weeks as investors receive their second set of lousy monthly results from funds that are meant to do well in good markets and bad.

A series of challenges, some unrelated to the hedge funds' investment strategies, have combined to create lower returns and investor redemptions.

Industry experts expect some funds will be forced to close down as clients walk away.

The single biggest problem is performance. The most recent update of Scotia Capital Inc.'s hedge fund index shows the average fund was down 8.6 per cent in July, compared to a 1.74-per-cent decline in the S&P/TSX equity benchmark. Since its inception in 2005, the Scotia Capital hedge fund index averaged a 13.9-per-cent annual gain.

Results from August are also expected to be grim, reflecting a volatile market that's been cruel to resource plays, favourite holdings of domestic funds.

Renowned manager Eric Sprott's flagship Sprott Canadian Equity Fund averaged a 30.1-per-cent annual return for the past decade, but data from Friday's close of trading showed the fund was down 13.5 per cent month to date for August.

Assets in Epic Capital Management Inc.'s Canadian Long/Short Fund are up threefold since inception, but down 27.1 per cent year to date.

Net asset value fell by 11.6 per cent in July, the fund's largest monthly decline to date.

The Goodwood Capital Fund, which has posted an annual 6.9-per-cent return since inception in 1999, is down 24.8 per cent, year to date.

"It's really hard at a time like this, but you have to keep the faith in your strategy," said Peter Puccetti, chairman and chief executive officer at Goodwood Inc. and a veteran of numerous market downturns.

"It's always shocking to me how bad it can get, but it's always shocking as well how quickly it can reverse," Mr. Puccetti said. Value-focused Goodwood has about 3,000 clients, and Mr. Puccetti said their reaction ranges from sharp criticism to strong support for the fund's approach.

Poor results are being compounded by industry-wide problems that can all be traced back to the credit crunch.

Globally, the hedge fund community has been in a tailspin since Bear Stearns Cos. Inc. went down earlier this year. The investment bank was one of the industry's major players as a so-called "prime broker," providing back office services and loans to funds.

Hedge funds saw their ability to borrow curtailed as fears about the health of financial institutions rocked Wall Street. Spooked investors began to take flight, and some funds were forced to sell investment positions to cover redemptions, sinking the value of holdings across the industry.

"The credit crunch starts, and as it progresses it becomes not so much an issue of business and relationships, but an issue of survival," said James McGovern, managing director and CEO at Arrow Hedge Partners Inc., which runs a fund of different hedge funds.

"Some hedge funds were participating in a piece of paper that was incorrectly priced or changed substantially in price, due to what happened with the credit crunch. Others were forced to sell good paper at a discount because the vultures were circling," Mr. McGovern explained. "This, in turn, drives down performance even more, which generates further redemptions, and what you have is a vicious circle."

Large, established Canadian funds - with $1-billion or more in assets - may have a lousy year, but will survive and thrive again, Mr. McGovern predicted. However, smaller domestic hedge funds plagued by weak results will have a harder time keeping and attracting investors.

An attrition rate of up to 10 per cent of domestic hedge funds would not be surprising, Mr. McGovern said. As a rough guide to the size of the sector, Canada's Alternative Investment Management Association has 79 members. Losing 10 per cent of funds would be in step with the yearly global death rate for this "Darwinian" industry, Mr. McGovern added.

The other problem facing many hedge funds in Canada is that they aren't really hedged, or market neutral, Mr. McGovern said. Instead, many funds are chock full of stocks, known in the industry as being long on the market, often looking for operational efficiencies in small- to mid-cap commodities plays.

These resource companies have been ravaged in recent months, and lack of interest and liquidity in the sector often means the hedge funds are left trying to sell these equities to one another.

"Flip it on its head, ex-this year, and they've made so much more money than the market. One shouldn't be super surprised they could get hurt," Mr. McGovern said.

© 2007 The Globe and Mail. All rights reserved.

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