Violent markets and plummeting small-cap stocks have wreaked havoc for hedge funds, with some forced to hold fire sales to free up cash and repay investment loans.
Toronto-based Salida Capital this week reported a 37-per-cent loss in September, prompting rumours that the company was on the verge of imploding. Courtenay Wolfe, the fund’s chief executive officer, was quick to dispel them, calling them “unfounded.”
But she acknowledged the use of leverage has backed Salida into a corner, as noted in its October investor letter. The decisions to buy gold and energy stocks in mid-August “have been costly, as the market has moved against us,” the letter said. “We still believe that the reasoning was logical, but arguably ill-timed. In hindsight, we underestimated the short-term impact of forced selling.”
This isn’t the first time Salida has been in hot water. After years of big returns that prompted an ambitious marketing campaign in 2008, Salida became tangled in Lehman Brothers Inc.’s bankruptcy when three of its eight funds were frozen by the failing investment bank. Salida was also highly levered to resource stocks at the height of the last crash.
It wasn’t the only firm losing money at the time, and the same is true now. Globally, hedge funds posted their worst quarter since 2008, dropping an average of 5.02 per cent, according to Hedge Fund Monitor. In Canada, some respected fund managers lost 15 per cent to 20 per cent last month.
Hedge funds that invest in small-cap resource stocks, a popular strategy in Canada, are particularly hard-hit. These companies are often junior mining and energy names traded on the TSX Venture Exchange, which is down about 25 per cent since global markets started tumbling in early August.
Hedge funds also employ leverage to boost returns, but it’s a strategy that also magnifies losses in a falling market.
Even funds that don’t employ leverage can get burned. The main fund of Toronto’s Goodwood Inc. was down about 8 per cent in September. Chief investment officer Peter Puccetti attributed the losses to the underlying index as well as mutual funds that are selling smaller cap stocks as retail investors liquidate their fund holdings.
Retail investors are more prone to sell in volatile markets, which reduces the amount fund managers have available to invest. When that happens, managers are more likely to unload their smaller cap, illiquid holdings while there is still a market for them – even if they have to sell at a big discount. In turn, that reduces the ability of hedge funds to sell the same stocks.
Mr. Puccetti pointed out that his firm’s aversion to leverage ensures that it isn’t as badly off as those who borrowed and now have to sell stocks to repay the loans.
