Hedge funds aren't just for billionaires any more, and they're supposed to make your portfolio safer. Well, that's the theory
The mystique of hedge funds is an odd thing. Hundreds of quiet, unassuming hedge funds have done well for investors over the years, but that's not what sticks in the mind. Rather, it's an image of these funds as a plaything of people like George Soros and others so wealthy they can afford to gamble millions on risky black-box speculative schemes that either hit the jackpot or implode. Just the thing for investors who love the smell of napalm in the morning.
Hedge funds do have a history of disaster. Long-Term Capital Management was a hedge fund that threatened to create a global financial catastrophe when it imploded in 1998. But you know who some of the biggest hedge fund investors are? Pension funds and insurance companies who abhor risk. Many hedge funds are run to achieve higher returns than government bonds, with less volatility than stocks.
Intrigued? The volatility in the stock markets over the past year has been exhausting for investors, and hedge funds are becoming a hot new product in Canada. Several mutual fund companies have introduced them recently, and more are sure to follow. That said, hedge funds will never be a product for the masses. There are a few funds available to small investors, but most require a minimum investment of $150,000. Some begin at $1 million or more. Also, it's probably best not to put more than 5% or 10% of your holdings in a hedge fund. That means you'd need a portfolio valued at at least $1.5 million. Just as importantly, hedge funds use intricate strategies that many investors may find baffling. There's an old maxim that you shouldn't invest in anything you don't understand. With hedge funds, this is particularly good advice.
Hedge funds get their name from their investment goal, which is to provide returns that are not correlated to the stock and bond markets. Just as you might hedge your bets to minimize the impact of making a wrong decision, these funds allow you to hedge your portfolio by giving you returns that are not tied to the markets. They do this by using strategies that ordinary mutual funds aren't allowed to employ. Short selling is one of them. A hedge fund might take a long position in some stocks – buy the stocks and hold them – while shorting others. This is called a "market neutral" strategy. When you short, you bet on a stock price falling by borrowing shares and selling them in the hope of replacing them later at a lower price. Leveraging is another strategy that hedge funds, but not mutual funds, can use. Leveraging can mean using derivatives such as options, futures and commodities or, as Long-Term Capital did, using borrowed money to invest, like an individual who buys stocks on margin.
In the hands of a skilled manager like Jeffrey Vinik, the greater freedom of running a hedge fund can make a huge difference. You may remember Vinik from his unhappy tenure managing Fidelity Investments' flagship Magellan Fund from 1992 to 1996. But he then put together one of the great runs in investing history, with a hedge fund called Vinik Partners. From 1996 until last year, Vinik produced a gross return of 645%, and an after-fees return of 440%, for a small group of clients. His secret strategy? Nothing complex, just buying beaten-down stocks on the verge of reporting higher earnings. Last fall, Vinik returned most of the $4.2 billion (U.S.) held by his 160 investors so he could spend more time with his family.
Typical hedge funds haven't delivered anywhere near these numbers, but they still compare well with traditional mutual funds. According to Nashville-based Van Hedge Fund Advisors International Inc., the top 25% of U.S. hedge funds delivered a compound average annual return of 36.3% from 1995 to 1999, compared to 20.3% for the top 25% of U.S. equity mutual funds. Even the bottom quartile of hedge funds outperformed their mutual fund counterparts 6.4% to 5.6%.
All things being equal, a hedge fund should be less risky than a comparable mutual fund. The problem with hedge funds is that when they go wrong, they can vaporize wealth like nothing else. A fine example is Long-Term Capital, a fund that included Nobel economics laureates Myron Scholes and Robert Merton among its strategists. Long-Term Capital borrowed heavily from major banks to fund a complex bond-investing strategy that blew up so resoundingly there were fears it would trigger a global financial meltdown. In the end, the U.S. Federal Reserve Board had to step in to organize a $3.7-billion (U.S.) bailout by major banks and brokerage houses. How did investors make out? Not great – the fund lost about 90% of its value in its final months. Canada has also seen hedge funds implode. Last year, unauthorized trading at Phoenix Hedge Fund LP caused losses of about $125 million (U.S.) and, eventually, the demise of the fund.
Robert Parnell, who heads the Canadian operations of Rye, N.Y.-based Tremont, says there are about 20 hedge funds in Canada with assets of $10 million (U.S.) or more. That's the threshold Parnell uses to distinguish funds with a substantial asset base. One such fund is Hamilton-based Greyhawk Equity Partners (Millennium), which has total assets of about $17 million (U.S.) and fewer than 20 clients. "A majority of our clients have net worth in excess of $20 million, and they're between 50 and 70 years old," says Terry Bedford, the fund's managing director. "We just have a small portion of their portfolios."
Greyhawk aims to prosper if stock markets are up or down. It does this by holding long and short positions in U.S. companies. In its first six months, ended last Dec. 31, the fund returned 15.3%. The cost is typical for a hedge fund. To start, there are management fees equal to about 1.5% of assets each year. If the fund's return exceeds 8%, the managers keep 20% of the additional gains.
In the United States, Parnell says there are maybe 4,000 hedge funds, about half of which are big enough to be classified as serious funds. Canada has lagged the United States for a couple of reasons, he says. One is the comparatively small size of the Canadian stock market – it simply offers fewer investing opportunities. Another is that hedge funds are often run by hotshots who learned the business on the trading desks of major investment dealers. In Canada, there are far fewer operations like this than in the United States.
Another reason is the lack of typical hedge fund customers in Canada, the type of person Mr. Parnell describes as "the newly liquid entrepreneur." But Canadian mutual fund companies now seem to see more potential in hedge funds. For example, Mackenzie Financial Corp. launched its Alternative Strategies Fund in early 2001. It is a "fund of hedge funds" in that its assets are portioned out to a group of 20 or so hedge fund managers who all pursue different specialties. Another traditional hedge product is C.I. Mutual Funds Inc.'s BPI American Opportunities Fund.
Both of these funds are typical in that they require large minimum initial investments – $150,000 in Mackenzie's case, and between $97,000 and $150,000 (depending on the province) in C.I.'s case. But other fund companies have introduced hedge fund products for small investors. Argentum Management & Research Corp.'s U.S. Market Neutral Portfolio has a minimum investment of $500, while Transamerica Life Insurance Co. of Canada's Global Market Fund has a $1,000 minimum. The manager of the fund is Newcastle Capital Management Inc., a company that runs a closed-end hedge fund, the Newcastle Market-Neutral Trust, that trades on the Toronto Stock Exchange under the symbol NMN.UN. Through a broker, investors can buy individual trust units.
Hedge funds are sometimes considered a fourth asset class, in addition to stocks, bonds and cash, and that's a good way for prospective investors to think of them. You should be well diversified in the other three asset classes before buying a hedge fund. You also have to understand how hedge funds work. You're asking for trouble if you don't understand the nuances. Securities regulators in Canada assume hedge funds are for sophisticated investors who can afford a minimum $150,000 investment, which is why these funds are sold using informal offering memorandums, not prospectuses that must be officially vetted by regulators.
One of the biggest hedge fund skeptics around is Kelly Rodgers, a Toronto consultant who helps clients select investment managers. To her, hedge funds are too opaque, too unpredictable and too expensive. Rodgers acknowledges that conservative-minded pension funds are buying into hedge funds, but she says they invest just 2% to 3% of their total holdings. "There's no magic with hedge funds," Rodgers said. "They're high-risk funds that are only for very sophisticated investors with very large amounts of capital."
Tremont's Parnell finds it ironic that hedge funds have a reputation for being dangerous. "Most investors in the hedge fund industry are high-net-worth individuals who want less risk than they'd find in regular equities, and that's what they're getting."
Photograph Derek Lea |
