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Keeping Up With JONES

Starting a hedge fund, according to the great Alfred Winslow Jones, was once just a matter of long and short. Today, two Bay Streeters discover, it's more about many (competitors) and few (investors). May the best spiel win

With only a couple days to go in East Coast Fund Management Inc.'s push to raise cash for its first hedge fund, Mike MacBain was set to run out the door of his Toronto office to meet potential investors. It was big game he was after: MacBain and East Coast co-founder John Schumacher want to play in the top levels of the Canadian hedge-fund industry, with an end goal of $500 million for their first offering. The minimum investment is $250,000.

But MacBain realized he had a small problem on that day last June. Or, rather, a series of problems, and they weren't that small.

No pitch books had been printed out so that investors could see how the fund works. Likewise with the documents that would need signing if anyone wanted to write a cheque. The firm didn't even have letterhead.

"I took a deep breath, printed out the copy, everything is fine, I still have time, went to staple it - and there were no staples in the stapler," says MacBain. "Not only that, nobody else was in the office, and I couldn't find any staples. I had a bit of a moment there, where I had to come down and think about, holy Christ, how the mighty fall. I can't even find a freaking staple to staple a pitch book together."

Critical Lesson No. 1 of starting your own fund: You are your own support staff.

The question of staple supply lines never crossed MacBain's mind when he was president of TD Securities. Nor did a printer jam threaten to ruin a deal for his partner, John Schumacher, the former co-head of Scotia Capital.

When they launched their first fund last April, the two boasted a combined 50 years in Canada's banking industry, where both had reached the uppermost echelons of the Bay Street elite. They left behind all the infrastructure support of a big bank - and a milieu where guys of their stature could take in millions a year in bonuses.

But the allure was obvious: Everyone knows that the hedge fund life is a level of luxe straight out of Hollywood, complete with Cristal and fine art and Lamborghinis. It's the scene that made billionaires out of fund managers like George Soros and John Paulson.

Critical Lesson No. 2 of starting your own fund: This is Toronto, not Wall Street. There's not much investor money, there are not many big funds, and there are not many big stars.

MacBain and Schumacher are out to change that. At least, as soon as MacBain can find a staple.

There are an estimated 100,000 people around the world already doing what MacBain and Schumacher have embarked on. The industry, whose centre is New York and environs, boasts total assets of about $1.9 trillion.

The ideal hedge fund finds steady, solid returns that aren't correlated to the markets: The fund makes money no matter whether stocks and bonds are going up or down. The idea is to make better returns than the rest of the Street when financial markets are rising, and, at the very least, to lose less when they are plummeting.

The man behind the first hedge fund, Alfred Winslow Jones, called his 1949 creation a hedged fund, reflecting his belief in buying some stocks and selling others short. "Hedging, that is, the taking of both long and short positions, makes our fund more stable and conservative than the ordinary forms of common stock investment," he wrote in 1961. Jones also believed in using borrowed money, or leverage, but held to the idea that hedging ensured that using a little leverage wasn't risky.

The industry was slow to take off. By the late 1960s, only about 200 funds were in business; there was plenty of money to be made just buying and holding financial assets, so there wasn't much need to hedge. By the 1980s, the number of hedge funds had dwindled to fewer than 70.

Then came the 1990s. Plunges in the market, including the tech wreck, made buying and holding a lot less attractive. Investors wanted alternative strategies, and maybe a little sexiness. Star managers like Soros and Julian Robertson made headlines for big performance.

By the end of 2009, there were more than 9,000 funds, even after a cull of about 1,000 during the financial crisis. As the sector boomed, a thousand strategies bloomed, diluting Jones's definition of hedge fund.

Today, one of the few characteristics that hedge funds still share is that they are relatively lightly regulated, and are generally only sold to investors under exemptions from securities rules that govern stock and bond offerings. The thinking is that high-net-worth investors and institutions such as pension funds are sophisticated enough to do their own due diligence - or, at least, they're rich enough to handle the losses if things go south.

Another remaining common trait of hedge funds is a fee structure that would make investors in most mutual funds blanch. There's an annual management fee, traditionally 2% of assets, just like in a mutual fund. But the manager also takes a big cut of any gains, usually 20%.

Beyond that, "hedge fund" can mean almost anything. Some funds invest in stocks, buying some and betting against others in a Jones-style strategy known as long-short equity. Others focus on bonds, as East Coast is doing in its first fund, capitalizing on the partners' backgrounds in the fixed-income business.

Some funds try to profit from the spread between the acquisition price of a takeover target and its market price, a business known as arbitrage. Others sniff around the distressed asset jungle, looking for underpriced stocks and bonds that will rebound if the company that issued them can be turned around.

Still other funds play in the commodity world, betting on movements in natural gas or gold or cocoa or exotic minerals, or try to make the right calls on global economic and financial trends, a strategy dubbed "global macro."

When a hedge fund fails spectacularly enough to make the news, it usually stems from the toxic combination of lots of leverage and little or no hedging.

That's what happened to Amaranth Advisors, a huge U.S. fund with a Canadian connection. The fund, with an energy trading side run by Calgary-based Brian Hunter, made a giant bet that gas prices would rise in winter months and fall in non-winter months. It used more than five times leverage. When the bet on winter prices suddenly went wrong in 2006, Amaranth was forced to liquidate.

In part because of their propensity for such large positions (Amaranth at times was said to control more than half of the American natural gas market), hedge funds are also viewed by some as a destabilizing force in markets. Regulators around the globe are tightening rules on the sector in the wake of the financial meltdown.

But the vast majority never crash because they play it safe. Only about 5% of all funds are of the high-risk, big-bet, big-leverage variety.

MacBain and Schumacher plan to be among that happy majority. They are hedging their bets, and they are not shooting for the stars. East Coast aims for a return of 8% to 12%, with a goal of building the portfolio to keep potential losses to only about half that even in the most severe market event. They plan to invest in investment-grade bonds, the highest-quality corporate debt, and to trade other assets like equity options and gold to hedge out the risks that bonds face, such as inflation and interest-rate movements.

Even for a fund marketed as low risk, early 2010 - when debt shock waves rolled across Europe - was not an ideal moment to debut. "Our timing really sucked," Schumacher says. "We launched in April with just Mike's and my money, and then May happened, with sovereign debt and the world going to hell in a hand basket."

As countries like Greece, Spain and Portugal took on an insolvent hue, investors began to bail out of government bonds. Bonds on the whole had been a hot asset class. Now they suddenly went ice cold.

That wasn't the only problem. MacBain and Schumacher hadn't foreseen that even after the financial crisis abated, the bankers and traders who should have been key customers of East Coast wouldn't have much cash. Sure, they still got big bonuses. But around the time that East Coast was launching, banks were starting to pay employees mostly in stock. By the time bankers paid for cars, school fees, club memberships and the like, there wasn't always much left from the new, smaller cash payouts for investing.

This quandary illustrated Critical Lesson No. 3 of starting your own fund: You are now in Sales. But MacBain and Schumacher are soft-spoken and cerebral, even shy; there's no Glengarry Glen Ross in them. "John doesn't want to talk to a single client," says Barry Allan, a hedge fund manager who is advising East Coast. "He wants to sit in his kitchen and trade."

"It's very important to trade well and perform, but as we get to understand the business more, it is very clear that the business is raising money, and it never stops," says Schumacher.

Raising money means changing out of the jeans or cargo pants that pass for office wear at East Coast, and getting out and glad-handing. It means telling a good story about how you're going to bring in steady returns, with less volatility than the rest of the market.

To prove you can do it and that your system works, you need a track record. That means running your own money for months to get some numbers you can stick in your pitch book. There has to be a compelling spiel about how the fund has a strategy and a system that works in all markets. You need references. You need a story.

"You can't actually just say, 'I'm a good instinctive trader, and I'm going to hire some really trustworthy people, and you can count on the fact that we won't lose your money,'" Schumacher laments. "That isn't sufficient. But you know what? That's all you need to know."

MacBain knows he's not a born salesman. "I don't want to be a pain in the ass," he says. "If they don't want to invest, they don't want to invest. That's fine. It's their money. We need to hire some people who don't have that reflex mechanism to actually care whether they're bugging people."

Notwithstanding their awful timing and reluctant salesmanship, MacBain and Schumacher got off to a pretty good start last spring.

It didn't hurt that the reference page of their pitch book lists three current and former bank CEOs, along with Onex Corp. founder Gerry Schwartz.

The partners set a short-term goal of $100 million for their initial fund. They hit it by midsummer. That made them, just three months into the life of East Coast, one of the bigger hedge funds in the country. And this while they were still waiting for the contractors to finish work on their new offices.

Yet by global standards, it's still tiny. How tiny? Put it this way: Steven A. Cohen, founder of SAC Capital Advisers, has an art collection whose value has been placed as high as $1 billion (U.S.). (If you ever wondered who bought Damien Hirst's shark-in-a-tank-of-formaldehyde, now you know.)

Globally, the industry is thriving again after the crash of 2008. The amount of money in hedge funds is approaching its pre-meltdown zenith of $1.9 trillion.

Much of that money is concentrated in the U.S., where the top five fund companies (including those of Soros and Paulson) together managed more than $165 billion (U.S.) as of the beginning of 2010.

Huge funds of that sort are money machines for their operators. A $10-billion fund with a 2% management fee generates $200 million in management fees alone, before any performance bonuses.

In Canada, there are about 150 managers running a total of about $30 billion to $35 billion. Most of those funds have between $25 million and $100 million in assets under management. Not a single Canadian fund manager made the Top 100 list put together by Institutional Investor in 2010. Funds as large as Barry Allan's Marret Asset Management, with $1.2 billion of hedge-fund assets, are exceedingly rare.

The problem in Canada isn't just that there aren't as many rich people with oodles to invest. As well, some of the biggest potential investors - the huge pension funds like Ontario Teachers' Pension Plan - try to save money by creating their own hedge fund strategies internally. There's also a chicken-and-egg conundrum. Many big pension funds or university endowments need to invest a lot of money at one time, given their own sheer size. It's hard to do that in a small hedge fund. So the funds need to get bigger before they can get bigger. "There is a Catch-22, as many investors will not invest in Canadian hedge funds because it's such a small market, and it will stay a small market until more investors buy in," says Leon Chin, a partner at Ernst & Young who specializes in the industry.

The economics of a $50-million fund aren't of the get-rich-quick kind. Take the so-called two-and-20 fee structure. A 2% annual management fee brings in $1 million to cover office rent, staff salaries, computer systems and other costs of doing business. The 20% performance fee part of that "two-and-20" only gets paid if the fund managers make money for their investors. A small fund leads to small takings. Say the $50-million fund's manager is a superstar, and the fund gains 25% in a year, meaning $12.5 million in investment income. The manager would take 20% of that, or $2.5 million. That's nothing to sneeze at, but it's not the kind of money that will buy a castle somewhere and Impressionist paintings to decorate it. A top trader at a securities firm can do better.

And that's in a great year. Finish a year flat, or down, as many hedge funds were doing in the crisis, and there are no performance fees at all.

There's also the issue of the so-called high-water mark. Most funds offer investors a scheme where they only pay performance fees to the manager if the fund is setting new highs: The idea is to ensure investors don't pay for the same performance twice. The crash of 2008 was so deep - taking the Scotia Capital Hedge Fund Index of Canadian funds down 23% - that some fund managers took months to claw back near their high-water marks.

But MacBain and Schumacher are making the numbers even more daunting for themselves, by trying to undercut the two-and-20 model.

When they were bank executives, and managers were pitching them, they thought that two-and-20 was overpriced. So they are charging less. They are keeping the 20. But East Coast's first fund charged no management fee for initial investors, and now charges 1.25%. They also have a hurdle rate of 4% - meaning their fund needs to return at least that rate before they start collecting the performance fee. Given that many corporate bonds lately trade with yields below 6%, and the pair are advertising a target return for investors of 8% to 12%, that's a tough bar to surpass.

So perhaps it's no surprise that MacBain and Schumacher aren't making Lamborghini money. In fact, they aren't making any money. What's worse, they're owed by the company. Apart from all the overheads any fund would have, they've had to cough up for a very nicely renovated office space - complete with concrete floors and wraparound windows overlooking sylvan midtown Toronto, not to mention a gym and plenty of room for expansion (the current staff complement is just a half-dozen).

Barry Allan remembers that phase well. "I had to write cheques to the company for the first two years to pay the staff," he says, describing his entire set of funds, hedged and not. "We started out with $10 million and now we have $5 billion. That's 10 years of working 24 hours a day, seven days a week, and doing everything you can to build the company."

Of course, one could always stay at the banks. There, as former traders like Schumacher and MacBain can attest, there's really only one investor. It's the bank's money, and beyond that the faceless mass of shareholders. Sure, you might get fired if you really screw up, but the bank will probably live.

Jérôme Kerviel is a case in point. He managed to lose almost €5 billion at French bank Société Générale. He's long gone, and facing jail time, but the bank is still standing. Contrast that to the fate of Amaranth.

When it's not bank money but investor money in your fund - and that money is often a chunk of the life savings of friends or family or former colleagues - the pressure is much different. And, to Schumacher and MacBain, it's invigorating.

"Working for banks, there's not a lot of volatility in how you feel from day to day," says Schumacher. "It's an up day, it's a down day, it's 5 o'clock - let's go have a beer. With a small business, you really feel everything. The first time we got a $5-million cheque, it was a really big day. Then something happens and you have an equivalent low.

"That amplitude is a result of the fact that it is risky. It's like the Flying Wallendas. You're out there on the wire, and there's no net."

Failure certainly is a possible outcome. According to an industry report, 21 Canadian funds shut their doors in 2008 as markets got hammered.

On the other hand, if you can get to billions in assets, as Allan has at Marret, the fees do start to add up. But if it was just about the money, Schumacher, for one, would still be at a bank. For the longest time, he always wanted to be the highest-paid trader wherever he worked. By his reckoning, in the later years of his career, he always got paid more than not just all the other traders, but more even than the bank's CEO.

The cash stashed from those years means Schumacher doesn't have to worry about money. What motivates him now is the desire to build something - something big. "That's what replaces the money," he says. "I like this better. I got tired of fighting for the money."

Having his own shop also gets him back to the focus that characterizes the early phase of a trader's career, before promotion into management spells less time in the market. "I used to just sit there and shake my head," Schumacher remembers. "Someone's paying me to do this? You're fucking kidding me. I have never had more fun in my life. There are lots of difficult things about this whole process [of creating East Coast] but a lot of the real upside is getting back to actually being a trader."

The next goal for East Coast is to open another fund. Schumacher has already been trading stocks to get a track record. He's had a great year, clocking in gangbuster returns. Unfortunately, dramatic numbers suggest volatility, and that's going to be tough to sell.

Schumacher's had to rethink his trading style to try to minimize the swings. It comes as a bit of a shocker to a pure trader that the sales side of the industry doesn't want huge numbers. Slow and steady wins the race. That's a rich irony in the post-Madoff era, where it's received wisdom that Bernie Madoff's clockwork returns of 1% or 2% a month should have tipped investors off to his fraud.

There was another big shift to face in the fall. One way to get a big pile of assets in Canada is to try to appeal to retail investors. While Canada has a limited number of high-net-worth people who invest in hedge funds, once the door is open to more people, the assets - and, with it, the pay - can really start rolling in.

But dealing with retail investors and their brokers is more work - more work of the human-interaction kind. It means more glad-handing. More golf trips with brokers. More time on the phone holding the hands of nervous investors.

Schumacher wasn't sure if the retail idea was a good one, but MacBain wanted to give it a shot. The plan is going ahead. "It's really Mike's pet project," says Schumacher. "Like any marriage, you have to compromise, and I don't have a veto on anything.

"I don't feel I know enough to be saying yes and no, unilaterally. I think that partly this is a journey of discovery. I would like to know where we'll end up, but I don't know today where that's going to be. I'm very curious."

*****

The House That Paulson Built

From U.S. homeowners to hedge fund managers, the financial crisis spelled ruin for many. But, for a select few who saw the maelstrom coming, the crash meant cash - a fortune's worth.

And no fortune was bigger than that made by John Paulson, who went from a bit player in the hedge fund world to a legend. The New York-based fund manager's dead-on call that the U.S. housing sector would crash led to otherworldly returns for his investors - one of his funds was reportedly up 590% in 2007 - and for Paulson personally. Alpha magazine estimated his pay at about $3.7 billion (U.S.) that year. Even by the standards of Manhattan, that's unheard of.

Paulson wasn't alone in the billion-dollar club, as George Soros, Renaissance Technologies head James Simons, Harbinger Capital manager Philip Falcone and Citadel's Ken Griffin all took home more than $1 billion in what Alpha said "may well prove to be the greatest display of individual wealth creation in any year in the modern history of finance."

That performance earned the men the distinction of a trip to Washington in 2008, where they defended how they did business before a congressional committee. Still, 2008 wasn't all bad for Paulson: He pulled in another estimated $2 billion (U.S.).

Nowadays, after making a killing betting against housing, Paulson is a bull on U.S. homes. In a recent speech, he urged people to get into the market. "If you don't own a home, buy one," he said. "If you own one home, buy another one, and if you own two homes, buy a third and lend your relatives the money to buy a home."

Hmmm...isn't that exactly the kind of behaviour that brought the market down?

© 2007 The Globe and Mail. All rights reserved.

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