The liquidity drought this past summer scorched a bit of earth in the Cana-dian hedge fund field but, with a few notable exceptions, most domestic hedge funds managed to beat the heat.

More than 80 of the 112 Cana-dian hedge funds produced negative returns in August, of which 13 had double-digit losses ranging from 10.1% to 22%. But about 75% of those in the red had bounced back into positive territory a month later, according to data from Morningstar Canada.

The reasons? Most Canadian hedge funds running money with a long/short strategy — and about three-quarters of Canadian funds fall into this category — are cautious about leverage and, therefore, were not forced to liquidate their investments, says Mark Purdy, managing director and chief investment officer at Arrow Hedge Partners Inc. of Toronto.

“The real effects of the credit issues in the U.S. have been liquidity in the system and ‘de-leveraging’,” Purdy says. “That’s really where the impact on hedge funds would be — anybody that was highly leveraged and had to sell to meet margin requirements.”

This creates a circular effect because reducing the degree of leverage causes more demand for liquidity, greater demand for liquidity prompts a need to reduce the degree of leverage, and so on.

But that wasn’t true to the same degree in Canada as it was in the U.S. Purdy has not heard of any Canadian fund getting a margin call related to U.S. subprime woes.

Colin Stewart, a portfolio manager and co-founder of Toronto-based J.C. Clark Ltd. , tends to agree: the hedge funds hardest hit, particularly after the asset-backed commercial paper crisis in Canada, were those that were highly leveraged — or had concentrated their investments on small-cap and speculative stocks.

“The ripple effect spooked the market and created this liquidity crunch,” Stewart says. “That caused a lot of more speculative investments in general to sell off, and that’s probably what hurt some of the hedge fund group. Stocks that were less liquid, that were smaller and didn’t trade as much, came under pressure because inves-tors wanted to sell and move more assets into cash.”

Stewart notes that while the Toronto Stock Exchange was down about 1.5% in August, the TSX Venture Exchange was down 17%: “There was a huge divergence between the performance of the higher-quality, larger-cap names and what we would consider to be lower-quality, more speculative names.”

J.C. Clark runs a variable-bias, long/short fund with a minimal amount of leverage. “We limit our market exposure significantly more than a lot of other Canadian long/short managers do,” Stewart says. “We have, for the past 12 months, been pretty defensively positioned.”

Another fund-management firm, Front Street Capital, actually went into the credit crunch with 25%-40% cash on hand. Says Gary Selke, the firm’s president: “We went into the thing heavy [with] cash.

“The only thing that would have a bid in the time of crisis would be a bid for quality,” Selke says. “You can’t sell the garbage in that type of event. So, what happens is if you’re a vendor in that type of scenario, you’re typically vending high-quality products. The guys who are the winners are the buyers. If you panic, you lose.”

The best thing for a hedge fund manager to do in that situation is “leave the desk and go for a long lunch — or sit there and buy situations that are significantly oversold,” Selke adds. “But to join the panic selling when there is no change in the big-picture fundamentals is an error.”

In terms of losses, the hardest hit on the Canadian hedge fund landscape turned out to be SciVest Alternative Strategies Inc., which had borrowed $3 for every $1 it put up in capital. This higher than average leverage mirrored on a smaller scale what had happened to some major U.S. funds, resulting, when combined with some other issues, in a high-profile implosion.

SciVest’s Aggressive Market Neutral Equity fund produced the worst one-month return of all Canadian hedge funds in August, with a monthend loss of 22.3%, although it had recovered to 3.6% by the end of September.

Most Canadian equity long/short funds did not go through the same cycle of margin calls followed by forced sell-offs in long positions and the surge of buying to cover short positions that plagued their peers south of the border, such as the infamous Bear Stearns funds that went belly up. But, fund managers say, Canadian funds using quantitative strategies were affected.

@page_break@Tristram Lett, managing director and portfolio manager at Oakville, Ont.-based Integra Capital Ltd. , says hedge funds with quantitative strategies were challenged to the limit when Goldman Sachs Group Inc. began to unwind its Global Alpha Opportunities fund, which had about US$20 billion in assets. The sale of long positions pushed down good stocks, while underperformers began to rise — and a short squeeze occurred.

“All of a sudden we have a spike in volatility and immediately all the quantitative filters are saying, ‘Time to de-leverage.’ So, the Goldman thing kicked off a massive de-leveraging of all these quant-driven strategies. They all started to buy and sell simultaneously. It was absolute turmoil,” says Lett, a specialist in quantitative management who also serves as deputy chairman of the Canadian chapter of the Alternative Investment Management Association.

“Nobody could figure out what was happening,” he adds. “Once they did, those who did nothing probably recovered back to where they were. Those who de-leveraged and stayed unleveraged then lost 30% because they never caught it on the upswing [when mean reversion kicked in]. Those who really figured it out re-leveraged and caught it all back.”

So, why aren’t there more Canadian funds engaged in quantitative strategies that involve arbitrage — profiting from very narrow spreads — that necessitate using high leverage to produce a significant return?

It’s partly due to the small scale of the Canadian stock market, which simply doesn’t provide room for the kind of high-volume trades needed for such a strategy, says Arun Kaul, chief operating officer and portfolio manager at Hillsdale Investment Management Inc. in Toronto, whose funds include two Canadian long/short funds — a market-neutral fund and a long/short U.S. equity fund.

“Really large quant funds simply do not exist in Canada,” says Kaul. “Because they’re not here, you didn’t see as dramatic an impact with hedge funds unwinding.”

In Hillsdale’s long/short Canadian fund, for every $1 of equity, it has $2.10 invested. Of that $2.10, about $1.30 would be invested in long positions and 80¢ in short. It’s almost the same in the U.S. fund: for every $1 of equity, $2.20 is invested, of which $1.35 is long and 85¢ is short.

That’s not an aggressive amount of leverage, considering some U.S. managers had leverage of up to eight times equity. Nevertheless, on the stressful day of Aug. 9, Hillsdale saw the return on its U.S. fund drop by 10% — the fund’s worst month-to-date return. Hillsdale’s U.S. fund bounced halfway back up the next day, and finished the month down only 80 basis points.

“We did not panic and we were inside our risk parameters,” Arun says. “We didn’t have any margin calls.”

One Canadian quantitative strategy fund actually de-leveraged in the spring of 2007 — months ahead of the crisis — due to concerns about how risk was being valued in the market. Fearing financial markets were not taking the subprime crisis seriously enough in terms of risk-management models, Toronto-based Picton Mahoney Asset Management took precautions, scaling down from two times leverage to about 1.3-1.4 times leverage — well below its target, says Michael Mahoney, portfolio manager and founding partner of the boutique firm.

“Some of the speculation is that this started out with multi-strategy funds — guys who do equities, bonds, credit products, derivatives, and so on — and them getting hit in their credit product,” Mahoney says. “That credit market freezing up and not being able to unwind caused them to have to reduce leverage in their liquid portfolios — that is, the stock world — something a lot of people didn’t see coming.”

Some of the impact on the TSX in August may have been the result of large positions held in Canada by U.S. hedge funds. “I’m sure that was part of the reason why there were spillover effects,” Mahoney says. “The Canadian market was behaving very similarly to the U.S., just, perhaps, in a less dramatic fashion.”

While the industry comes to terms with the causes of the market turmoil in August, what’s not known, Mahoney says, is the underlying value of any fixed-income securitized credit products held across the industry.

Hedge funds have come under fire for their lack of transparency to regulators, the public and even their own investors, Mahoney says. But publicly traded companies, banks and brokerages that must report publicly have yet to disclose the estimated value of their holdings in ABCP and securitized U.S.-based mortgage products.

Mahoney’s advice to individual investors with holdings in hedge funds is to research fully their funds’ strategy and know what the inherent risks are in all types of markets.

Some funds are not hedging as much as investors think, and may have a much higher correlation to market movement than is believed. Mahoney cites a Merrill Lynch & Co. Inc. study on U.S. hedge funds in relation to the S&P 500 composite index. The correlation, the report says, has increased to 90% earlier this year from 10% in 2000.

“A lot of hedge funds aren’t necessarily hedged. So, when the market cracks and they’re actually quite exposed, it’s a bit of a surprise,” Mahoney says. “If someone is managing a lot of money and has it levered up, obviously, if he or she have to get out, this shows it can be difficult.” IE