Get hedge funds right

Date: Monday, July 30, 2007
Author: Bob Thompson, Financial Post

Here's What Could Get You In Trouble, What Might Pay Off.

It's fun to jump on the bandwagon and slam hedge funds. Blow-ups, writedowns, meltdowns and financial catastrophe are the words of the day with regard to hedge funds.

I thought we would separate the wheat from the chaff this month and discover the real reasons why hedge funds can be good for a portfolio, and what to look for that could get you into trouble.

Fiction: All hedge funds are risky.

Hedge funds were originally introduced to reduce risk in a portfolio, hence the name. It may be an oversimplification, but the original idea was that if you could isolate a good manager's ability from the gyrations of the market, you could have a portfolio that zigs when other's zag.

This was the opposite to academic gurus who came up with the Capital Asset Pricing Model (CAPM), which suggested that non-market risk should be eliminated through diversification, and hence market risk should be the only risk that an investor should be exposed to.

If you define risk by the volatility of returns, which is generally accepted, then some hedge funds are risky and some are not.

Fact: The two things that generally make a hedge fund volatile are excessive leverage, followed by a liquidity crisis.

Whether it was Long Term Capital Management back in 1998 or other high-profile hedge fund problems, the common denominator in disaster is generally debt or leverage. This should be no surprise, as it is the same with everything in life. Fortunes have been made in real estate because of leverage, but real estate can be the fastest way to the poorhouse if your investment is overleveraged -- just ask all the real estate gurus who went bankrupt in the early 1990s.

Margin debt on stocks was at a record high in 1929, just before the market crash; it was also at another peak in early 2000, just before the crash.

Leverage in hedge funds works well until the market turns the wrong way fast. During times of market upheaval, an over-leveraged position should be reduced, but that is when the bids for the securities dry up. In other words, an overleveraged position can rapidly become a liquidity problem. In some cases, knowledge of a hedge fund in trouble can cause the liquidity crunch, as nasty traders "pull" the bids.

With assets that are volatile enough on their own -- such as stocks -- there is not usually much leverage required to generate a substantial return. On the other hand, assets that are regarded as safer -- such as bonds or various arbitrage strategies -- require a greater amount of leverage to generate the return. If no leverage is used, low-volatility strategies can't help but generate low returns.

This is the ironic part of it: Sometimes low-risk strategies become high-risk because of market shocks, causing a liquidity crunch. There are all kinds of mathematical models to predict such events (to diversify into non-correlated trades and the like) but when it comes down to it, if you have borrowed a lot, the bids dry up and you have to sell, you are basically hooped.

Lastly, it can be argued that excessive concentration is a cause of hedge fund problems. I guess it can be, but market guru Peter Lynch calls diversification "di-worse-ification," highlighting the fact that concentrated portfolios are better.

Warren Buffett says the only reason people diversify their stock positions is because they don't know what they are doing. This makes them use the "spray and pray" approach -- buying a lot of stocks and praying that some of them go up.

Hedge funds should lower the overall risk of a portfolio, as they can produce non-correlated returns with the rest of the portfolio.

Long/short equity strategies tend to be more correlated with the market, except equity market neutral, and for this reason they tend to give equity-like returns, without the use of excessive leverage.

With about three-quarters of the hedge funds in Canada being long/short equity, these provide a way for investors to add investments to their portfolio, and in turn may be the next step past equity mutual funds.

--- - Bob Thompson is a senior investment advisor and alternative investment strategist at Canaccord Capital. Mr. Thompson and his team manage hedge fund portfolios for high net worth individuals.

bobthompson@canaccord.com