Hedge funds to own when stock markets are down

By Larry MacDonald
Globe Investor Magazine Online, April 23, 2008

Hedge funds are seen as risky instruments by many investors. But chosen wisely, they can reduce portfolio risk. That's because they have the capacity to generate positive, or absolute, returns regardless of market direction. So when stock markets are down, gains in hedge-fund holdings can serve as an offset.

One way hedge funds can provide absolute returns is by "investing in the stocks of a group of promising companies and short selling the stocks of a group of terrible companies," explains Cam Richards, chief investment officer with Halifax-based institutional adviser Keel Capital Management Inc. "A key task is adjusting the ratio of long and short positions to take into account market conditions," he adds.

When it comes to selecting hedge funds, however, the burden of due diligence is greater compared to mutual funds. Hedge-fund managers have a wider range of tools at their disposal. Beside short selling, they include derivatives and leverage. Performance consequently depends more on the skills of individual managers than on the direction of financial markets.

Furthermore, transparency is poor at some hedge funds. And investing in a hedge fund is also a big decision, as minimum investment requirements can be high. According to Globefund.com, the most common threshold is $25,000, with some as high as $5-million and others as low as $5,000.

Hedge funds are therefore one area where it may make sense to consult with a financial adviser - one with the certified hedge fund specialist (CHFS) or chartered alternative investment analyst (CAIA) designation. It's even better if the adviser "knows the fund mangers," says Darren Coleman, a TD Waterhouse investment adviser who has passed the CHFS course (where he met fund managers) and is enrolled in the CAIA course.

What Canadian hedge funds do knowledgeable financial advisers recommend when stock markets are down? Here are five considerations.

1. Sprott family of hedge funds.

Sprott Asset Management Inc. received the most recommendations from the specialists consulted. The nine hedge funds in the family are among the largest in the Canadian universe and tend to emphasize long/short positions in small- to medium-cap stocks, where "they have informational advantages due to their size," Mr. Coleman said.

Chief executive officer Eric Sprott has also made some strong broad market calls that has helped find stocks to buy and to short. He has had a "a long bias on commodities, especially gold bullion, gold stocks and energy-related stocks," Mr. Richards says. The flagship Sprott Hedge L.P. Fund, managed by Mr. Sprott and Anne Spork, has earned an annual return of 29.9 per cent since inception in 2000, 27.3 per cent over the past year, and 11.1 per cent year-to-date. The flagship fund is now closed, but a cousin, Sprott Hedge L.P II, is open.

Jean-Francois Tardif has managed the Sprott Opportunity Hedge L.P. Fund to an annual return of 28 per cent since inception in April of 2004, 18.3 per cent over the past year, and 2.8 per cent year-to-date. The fund is closed but the F and RSP versions are open. Mr. Tardif won The Globe and Mail's My One and Only stock-picking contest last year, and is way ahead in the contest this year. The other funds in the family are: Sprott Bull/Bear, Sprott Small Cap Hedge, the Sprott Global Market Neutral (A and F versions). For more information see www.sprott.com.

2. BluMont Core Hedge Fund.

BluMont Core Hedge Fund is picked by Mr. Coleman and Tim Niblett, a CHFS graduate and founder of Milton, Ont.-based financial-planning firm Donaldson Niblett Financial Group. The fund uses the "pairs trading" approach, which involves matching a long position on a promising stock with a short position on a weak stock in the same sector.

The fund is up 8 per cent annually since starting on March 31, 2006, up 5.4 per cent over the past year and down 1.6 per cent in 2008. Messrs. Coleman and Niblett have confidence in managers Geoffrey Barth and Allan Brown, who were "highly regarded" when they previously ran the biggest technology mutual fund in Canada, Investors Group's Global Science and Technology Fund. More information can be found at www.blumontcapital.com.

3. Salida Multi-Strategy Hedge Fund.

Salida Multi-Strategy Hedge Fund can diversify, as the name suggests, across a variety of strategies, such as directional bets on global macroeconomic trends and merger arbitrage, i.e. bets on certain mergers going through. At the 2007 Canadian Investment Awards Gala, the fund was named Multi-Strategy Hedge Fund of the year by the Hedge Funds Award committee chaired by Pierre Saint-Laurent, president of alternative-investment advisory Asset Counsel Inc.

The fund has recorded annual returns of 52.3 per cent since its birth in September of 2004, 16.3 per cent during the past year, and 1.1 per cent this year. The managers, Daniel Guy and Brad White, are heavily invested in the fund, adds Mr. Coleman. More details can be found at www.salidacapital.com.

4. Arrow Distressed Securities.

Some hedge-fund strategies go in and out of favour depending on the state of the market, so one approach is to invest in funds whose strategy is likely to dovetail with the unfolding environment. For example, given the variety of securities that have sold off sharply due to the financial and housing crises in the United States, a fund like the Arrow Distressed Securities has plenty of material to work with, and "could shape up well," Mr. Coleman believes.

New York-based Schultze Asset Management LLC has guided the fund to an annual gain of 24.4 per cent since the start date in July 2003, a 6.1-per-cent loss over the last year, and a loss of 3.6 per cent in 2008. More information can be obtained at www.arrowhedge.com.

5. MAN AHL Diversified Fund (Canada).

"One of the funds I like is MAN AHL Diversified," declares Bob Thompson, alternative investment strategist at Canaccord Capital Inc. The fund, advised by Man Group PLC investment manager, AHL Diversified invests in a diversified basket of futures contracts trading on dozens of world markets. As such, it falls in to the managed-futures category, which historically has had one of the weakest associations to the stock market compared to other hedge-fund strategies.

During the current downturn, it has been one of the better performers, with a 34.6-per-cent gain over the year and 12.6-per-cent gain in 2008 - thanks in large part to energy, agriculture and precious metal prices shooting to new highs. Since launching in October, 2006, annual returns have averaged 20.4 per cent. More details are at www.maninvestments.com.

Special to The Globe and Mail