Hedge funds have exploded onto the Canadian marketplace since the beginning of the year.
They have now gone mainstream and are more affordable. Estimated to be a $400 billion industry in the United States, the Canadian market represents a small but growing fraction of that at about $5 billion.
Most Canadian mutual fund line-ups now include a hedge offering.
In their simplest form, hedge funds, or absolute return strategies, are a pool of assets that are managed using exotic investment strategies to provide positive returns whether the stock market goes up or down.
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For example, a hedge fund may simultaneously combine long and short positions in the stock market to hedge market risk. (Long positions include buying stock and short positions include borrowing stock and selling it in the hope it can be bought back at a lower price.)
This lack of correlation with stock markets is unique to hedge funds.
Mutual fund investment managers cannot employ these strategies and their only defensive tactic is to increase the cash component of their portfolios in times of falling markets.
Hedge funds’ risk-reducing features have been overshadowed by some recent public failures.
For example, the near collapse of Long-Term Capital Management in the U.S. in 1998 turned the spotlight on the risks of hedge funds rather than their conservative merits.
Because these types of investments were traditionally available only to an exclusive club of high- net-worth investors and institutions such as pension funds, little information was made available to average retail investors about their unique advantages relative to mutual funds. These include trading advantages and incentive-based compensation.
Hedge fund managers have greater flexibility in investing strategies and investment products than mutual fund managers.
For example, hedge fund managers have the ability to go long and short the market, use leverage (borrow) and take advantage of derivatives (options) to maximize returns when markets fall. On the other hand, mutual fund managers are restricted to owning securities and raising cash in falling markets.
Hedge funds often compensate their managers on the basis of performance. They traditionally attract the most talented managers who are willing to forgo salary for a percentage of the profits.
Hedge funds don’t have a long track record in Canada, but in the U.S. an index of hedge funds was created in 1993 by money managers Credit Suisse First Boston and Tremont Advisors Inc.
Known as the CSFB/Tremont hedge fund index, in 2000 the index returned 4.8 percent while stock market barometers such as Morgan Stanley World Index, Standard and Poor’s 500 and Nasdaq declined 14.1 percent, 10.1 percent and 39.3 percent respectively.
About 25 hedge funds are available in Canada.
An example is the iPerform Gabelli Global Fund managed by iPerformance Fund Corp. with Gabelli & Partners LLC acting as the funds adviser. Gabelli & Partners LLC is a subsidiary of Gabelli Asset Management Inc., which manages more than $23 billion US in client assets.
The fund’s objective is to outperform the Morgan Stanley World Index, and seek annual returns of more than 20 percent over a three- to five-year period, through investment in a diversified portfolio of global long-short equities.
Since inception in July 1999, the fund has returned 20.85 percent compounded annually relative to the Morgan Stanley World Index, which has fallen 5.27 percent compounded annually for the same period.
Hedge-type funds continue to be launched.
Most of them are available by informal offering memorandum, rather than prospectus that must meet the scrutiny of regulators.
As such, provincial securities commissions limit the minimum investment to “sophisticated” investors, which means higher minimums.
For example, in Alberta the minimum investment into a hedge fund marketed by informal offering memorandum is $97,000 Cdn. In the U.S., investment minimums start at $1million US.
In a year where the performance of conventionally managed long-equity funds are being challenged, hedge funds are worth a look for sophisticated investors.
Consider a small weighting in your portfolio if you wish to remain fully invested when markets are falling.
Consult a financial adviser who has expertise in these relatively new products and can distinguish between funds providing strategies that mitigate risk and those that masquerade under the title of hedge funds.
Ian Morrison is a financial consultant with Wood Gundy Private Client Investments in Calgary and is licensed to sell insurance products. His views do not necessarily reflect those of CIBC World Markets Inc. This article is for information only. Morrison can be reached at 800-332-1407 or by e-mail at ian.morrison@cibc.ca.
