Tread carefully in the world of hedge funds

Date: Saturday, May 27, 2006
Author: ROB CARRICK Globe & Mail

From Saturday's Globe and Mail

You won't find a better stress test for a hedge fund than the miserable month of May on the stock markets this year.

"May will be a very good indicator," said Tony Sanfelice, president and CEO of Canadian Hedge Watch, a leading provider of hedge fund research and education. "If a fund has made a little bit of money in May, they've done extremely well, in my opinion."

Mr. Sanfelice said interest in hedge funds tends to pick up dramatically when stock markets are choppy or falling, and the reason is simple. Hedge funds have the ability to use short selling, a strategy that permits profits to be made off the share price declines that hammer most investors who own stocks, exchange-traded funds and mutual funds.

Today's Portfolio Strategy column is all about how to pick a hedge fund or, as they're sometimes called, an alternative strategies fund. A good start is to not be overly influenced by the market-beating mystique of hedge funds, or the cynicism that has come out of hedge fund disasters like Portus Alternative Asset Management and Norshield Financial Group, both of which are now in receivership with investors owed hundreds of millions.

Canadians have about $25-billion invested in hedge funds today, according to Canadian Hedge Watch, and the quality level ranges from superb to pathetic, just as it does in the mutual fund world. The difference between hedge funds and mutual funds is that you have to work much harder to find a good hedge fund.

Hedge funds have been around for decades, but it took the stock market meltdown that began in 2000 for them to build a profile with individual investors. Back then, hedge funds demonstrated their potential by making money when most retail investors were being massacred. Short selling was a big part of this success, but it's only one of the many strategies that hedge fund managers can employ. Others include the use of leverage, or borrowed money, to increase market exposure, and investing in things like the futures market, emerging markets and private equity.

Do not assume that all hedge funds use all these fancy techniques to, as the name suggests, provide a hedge against a falling stock market.

"There are really two types of hedge funds: a risk-reducing fund and a performance-enhancing fund," said Ken Stern, an investment adviser with Creative Planning Financial Group who has researched hedge funds extensively. "Very few funds do both."

We'll assume, given the carnage on the stock markets lately, that you want a risk-reducing hedge fund. Be sure this is what you actually buy because the performance enhancers can fall hard in the current market environment.

An example cited by Mr. Stern is Dynamic Power Hedge, which made a stunning 157.6 per cent in the 12 months to April 30. Last week, however, this fund lost 17 per cent (figures for this week haven't been issued yet).

Mr. Stern said an example of a risk-reducing hedge fund is Abria Diversified Arbitrage Trust, which made 5.3 per cent for the year to April 30 and averaged 5.1 per cent annually over the past five years. May figures haven't been issued yet, but in 2001 this fund made 9.2 per cent while the S&P/TSX composite index fell 12.6 per cent. When the index fell 18.6 per cent in 2002, the Abria fund made 7 per cent.

Finding the right hedge fund involves asking a lot of complex questions, which is why Mr. Stern recommends getting the help of a knowledgeable investment adviser. This sounds self-serving, given that Mr. Stern is just such an expert, but it's sound advice that may help protect you from hedge fund fiascos like Portus and Norshield.

"When you're getting rid of the market risk by going into a hedge fund, you're assuming other risks like manager risk," Mr. Stern said. "That's what Portus was all about, and that's what Norshield was all about."

Quagmires like these can be avoided by delving into a hedge fund manager's track record and pedigree, he said. This means asking not only for information about a manager's current record, but also about past employment and the investment returns that were delivered.

Specific risk-related questions suggested by Mr. Stern include:

How bad were the fund's worst months?

How long did it take to recover from its lowest point?

Why and how did the recovery occur?

Phelim Boyle, a finance professor and hedge fund expert at the University of Waterloo, said it's important to understand that risk cannot be eliminated altogether. "If you're not taking on risk, you won't make any excess returns," he said. "But risk has to be measured and controlled."

One way an investor can assess risk is to ask if a hedge fund has an independent third-party auditor who verifies the net asset value of the fund and provides valuations for illiquid assets such as private equity. As for the risk of losing money, there are a variety of fairly complex indicators to consider.

"Some of it is math stuff," Prof. Boyle said of the process of assessing hedge fund risk. "But some of it is also about looking the manager in the eye and seeing if he can explain things to you simply."

There are several different kinds of hedge funds, and differing opinions about which are best for the investor who wants a true hedge against a falling stock market.

Mr. Sanfelice suggests a fund of funds, which invests in a carefully chosen mix of hedge funds. "You're dealing with different strategies that would provide the investor with portfolio diversification."

The knock on the fund-of-funds approach is that there are two layers of fees -- one from the company offering the fund and another from the individual funds that are part of the portfolio. But if a fund of funds can generate solid returns after fees are applied, Mr. Sanfelice argues that it's a good value. Another hedge product with appeal to the investor who wants to cut risk is a market-neutral fund. Here, short positions (bets that stock prices will fall) are matched up directly with long positions (bets that prices will rise) so that the fund ideally has zero tendency to move up and down in sync with the stock market. Don't confuse market-neutral funds with long/short funds, which use long and short positions but tend to have a bias on the long side.

Other issues that Mr. Stern recommends you and your investment adviser look into include the extent to which a fund uses leverage and ownership costs and fees, including management and performance fees. He also places a lot of emphasis on governance, particularly the question of whether a fund has an independent third-party auditor.

Globefund.com says there are 264 different alternative strategy funds and fund permutations (such as U.S.-dollar versions) available to Canadian investors. Mr. Stern uses only 11 for his clients, and he has about 20 per cent of their assets in these funds.

He said he first got interested in hedge funds five or six years ago because he realized he could provide more value to his clients in this area than by selling them mutual funds.

"Anyone can go onto mutual fund websites and do a fair bit of analysis on their own," he said. "Hedge funds are a whole other kettle of fish. I make presentations to advisers because they don't understand hedge funds. For the lay person, it's even more difficult. It's a potential minefield, as we've all seen."

Hedge fund primer

Q: What are they?

A: Hedge funds are pools of money that are managed using techniques and strategies that are off - limits to the vast majority of mutual funds, including short-selling and leveraging.

Q: Why own a hedge fund?

A: With their greater flexibility, hedge funds can offer steady year by year returns that hold up when the stock markets are falling; They also have the potential to delver bigger returns than manual funds along with more risk.

Q: Who can buy hedge funds?

A: High net worth individuals who have sufficient income or assets to qualify as an "accredited investor" and who can afford minim investments ranging from $25,000 to $150,000.

Q: Aren't hedge funds risky?

A: It all depends on the strategies in use and the manager's aggressiveness. Hedge funds have in rare cases had to close their doors because of catastrophic losses.

Q: What are the pitfalls?

A: Because they're sold to investors who presumably have some money savvy, hedge funds aren't required to offer the same level of disclosure as the mutual funds industry. This means investors and their advisers have to do alot of work to find out what a hedge fund manager is up to, what past returns have bee like and the level of fees which can be high in some cases.

Q: What about small investors ?

A: There are some hedge funds that are listed on the Toronto Stock Exchange as closed end funds and can be purchased by anyone. Also, hedge funds are sold in a principal-protected note format, where you're guaranteed to at least get your money back at the end of a set term.

Hedge fund report

Here is how some of the largest hedge funds have performed this year.

SOURCES: BANK OF NOVA SCOTIA AND GLOBEFUND.COM