Six things you should know before investing in hedge funds

They can provide much higher returns -- but beware the risks that come with leverage

Bruce Freedman
Globe Investor Magazine Online, Thursday Oct. 23, 2008

Hedge funds are often considered the most glamorous part of the fund business. Their returns can be much higher than plain-vanilla mutual funds because hedge funds can use derivatives and debt, and they can sell short.

But in recent months, investors have been giving hedge funds the cold shoulder. Stories abound of heavy losses amid the global commodities rout, with some, like Ospraie Management, going belly up in September. A Eurekahedge poll of 4,000 hedge funds around the world found that just 3 per cent of the funds surveyed were making money. Still, the HFRX Global Hedge Fund Index has fallen 18 per cent year-to-date, compared with a 35-per-cent decline for the S&P 500 index during the same period. Are hedge funds worth a second look? Here are six factors that investors should consider before counting out their dollars.

Strategy

Rudy Luukko, investment funds editor at Morningstar, said Canadian hedge funds are incorrectly considered market-neutral - using tools to ensure that returns are not correlated to the market's direction.

In fact, there are more than 25 different strategies that hedge funds can follow. Many funds make large directional bets, while others focus exclusively on arbitrage or volatility.

"Most hedge funds based in Canada run long/short strategies, are opportunistic and tend to be often heavily into commodities or popular areas of the market," said James McGovern, managing director at Arrow Hedge Partners. "This, unfortunately, means a number of them are also currently having very bad years to date."

"Finding the right hedge can be a real challenge," Mr. McGovern said. "Sometimes managers resort to shorting proxies like index futures or exchange-traded funds because they cannot find a trade to properly offset or hedge the exposures they have." To minimize unpleasant surprises, investors need to understand how a fund works. For example, a fund that goes long and short in one sector will have a completely different risk profile to one that trades across sectors. That's because stocks within a sector generally move in the same direction.

So, a fund that began the year by buying Bank of Montreal (believing it is undervalued), but shorting Royal Bank of Canada (believing it is overvalued) will, no doubt, be feeling a lot of pain - Bank of Montreal has fallen 25 per cent while Royal Bank of Canada has fallen 8 per cent. Still, that fund would have fared better than one that bought Bank of Montreal but shorted software maker Open Text. Open Text is flat for the year.

Track Record

"When you are evaluating a track record, it's very important to look at how the fund performs against different end dates," says Mr. Luukko. "So a fund manager's strong performance in one year could more than offset his weak performance during another." In the Canadian hedge fund universe, this significantly narrows investors' universe of choices. There are only 33 hedge funds in the Morningstar database that have a track record of at least five years, and only five with a track record of at least 10 years. Experience weathering different market conditions is critical, Mr. Luukko says.

"The reality is, five years isn't enough time to make an informed judgment about a fund manager's performance. Ideally, you should see performance over at least one bull market and one bear market."

According to Mr. Luukko, the median loss for Canada-based hedge funds was 14.8 per cent in the 12 months ended September and the compound annual return was 4 per cent over the last 10 years. While this easily beat the S&P 500 index's 0.6-per-cent compound annual loss in Canadian dollar terms, it was well below the 9.7-per-cent return of the S&P/TSX composite index. Still, he says that investors shouldn't judge hedge funds too harshly.

"The disparity of performance can be wide, given the many different styles among managers. For instance, Sextant Strategic Opportunities saw a 122.9-per-cent return in the last 12 months, while at the other extreme, Pathway Explorer Series A Rollover, which specializes in mining stocks, lost 53.5 per cent."

Risk is another consideration. Mr. McGovern cautions against relying too much on the most commonly used barometer of risk, the Sharpe Ratio, which measures volatility of performance.

"Sometimes the riskiest funds are the ones with the highest performance and the lowest volatility," he said. "Volatility measures are not perfect guides to measuring risk in a portfolio. It's only after certain stories or strategies crack that euphoria fades and volatility shows up."

Leverage

Unlike mutual funds, hedge funds may leverage their bets. They can gain exposure to assets by borrowing or using derivatives. This can work for or against them.

For example, a hedge fund could buy a call option on the S&P 500 index. If the S&P goes up 10 per cent, the hedge fund doubles its money. But if the index stays flat or falls, the hedge fund loses every penny spent on the option. Leverage is key to understanding the potential for losses or profits. For example, for a mutual fund that has $1-billion in stocks, a 10-per-cent drop in share prices would lead to a 10-per-cent loss for its unit holders.

But a hedge fund could have $1-billion in assets, with half invested by unit holders as equity and the other $500-million borrowed. So, if share prices fall 10 per cent, the unit holders lose 20 per cent of their money. Of course, if stock prices rise 10 per cent, the hedge fund unit holders earn 20 per cent, as opposed to the mutual fund's 10 per cent. Eric Sprott, chief executive officer at Sprott Asset Management, cites leverage as the No. 1 factor he focuses on when assessing fund managers.

"Leverage played a factor in the case of Ospraie's demise. It's very easy to pump up performance in a rising market from leverage, and I always worry about it. When times turn, it's the overleveraged fund that can be hurt the most."

Fees

Management fees tend to be higher at hedge funds than at mutual funds, with funds of funds adding another layer of fees. A typical hedge fund charges a 2-per-cent flat rate plus a share in profits once a certain hurdle rate of return is surpassed. If a fund has a stellar year, a hedge fund manager might earn millions of dollars in bonuses. But if the fund goes sour, it is the investors' money that gets lost.

One overseas currency trader described what he did after he lost $20-million for his fund and was fired. "I had a pint and a laugh about it with my mates. Three months later, I had another job doing the same thing." Mr. Sprott agrees that compensation is asymmetrical. But he noted, "This is also the case for many businesses - look at banks, for instance. You need to do your due diligence and make sure the fund manager is not just a 25-year-old hot shot but somebody with credentials and experience."

Regulations

Investors should also consider whether they can easily get their money out of the fund, according to Mr. Luukko. Most hedge funds are not listed, and investments may be locked up for a longer period of time than mutual funds. Hedge funds also face less regulation than traditional funds. There are no restrictions on strategies. They are also often sold without a prospectus and are available only to "accredited investors" who have net assets or income above a certain threshold. "While the theory for including hedge funds in a portfolio is strong, in practice, it's difficult to implement. That's because there's a limited supply of good products available at the retail level," said Dan Hallett, whose eponymous research firm provides counsel to financial advisers.

Hedge funds have higher fees, poor transparency and the wide range of performance, he says, adding: "I've yet to give a recommendation on any hedge fund."

Timing

Timing is another consideration. Mutual funds generally perform in-line with the stock market, because they always hold long positions. Hedge funds have different return profiles. An equity-neutral fund, for instance, would see lower returns than a mutual fund in a bull market, but higher returns when markets are plunging. Christopher Guthrie, founding partner of Hillsdale Investment Management, asks prospective investors whether they can stomach the different timing.

"Potential hedge fund investors should ask themselves if they will be comfortable underperforming in a bull market in return for performing well when their friends are losing," he says.

For more information, see the Alternative Investment Management Association's Canada Hedge Fund Primer at http://www.aima-canada.org/doc_bin/AIMA_Primer.pdf

- Special to the Globe and Mail