ROB KERRN - No doubt you are hearing a lot about hedge funds these days, how they are producing double-digit returns while the market indexes are dropping. (Wasn't it two years ago when index funds were the rage?)
Now hedge funds are the new, must-have investment. In between hedges and indexes we had ETFs, or exchange traded funds, which allowed investors broad diversification at low cost. A cynic might say that the investment industry is falling all over itself to find ways to earn large fees. And the confused investor is looking for any way to find safety or performance, and usually wants both.
The fun part is reading pundits, who one year proclaim growth funds are the place to be, then reverse their direction, lauding value funds the next.
Hedge funds strike me as a workable investment approach that is in danger of being overused and abused. The concept, as usual, is good. Empower really good investment managers to employ the best strategies they know with discipline and dedication, to provide above average returns with below average risk.
In small numbers for limited time periods, this is possible and profitable. The big investment trading professionals have been trading this way for years.
But as concepts become popularized, the market becomes more efficient, and what worked on a smaller basis will become increasingly less profitable. Inevitably there will be some spectacular disasters. Here's why:
- More demand for hedge funds will attract less-experienced managers who will make mistakes with your money.
- Too much money flowing to even good managers will require they make investments that are less rewarding than before.
- Some managers will use your money as a down-payment to borrow to make their hedge investments. This may work famously well or may end in disaster - over time, usually both. Invest this way only if you can comfortably afford to lose it all.
- The fee structure can be hazardous to your wealth. The funds usually charge a minimum fee of 2 per cent, plus a fee based on performance. This sounds fair - no performance, no extra pay. But it is a formula that encourages the manager to swing for the fences. And when they're going for home runs, there will be strike-outs.
The safer "manager of managers" funds, which invest your money in hedge funds with a variety of approaches for greater safety, may result in mediocre results and high cumulative fees.
There is no doubt that short-selling can work well in sinking markets, but when many managers make the same bets, the trades will be less profitable or may result in serious losses.
Pick up a copy of When Genius Failed, about the rise and fall of giant hedge fund Long Term Capital Management in the United States to see how some of the smartest people in the investment world lost billions. The fund's value would have fallen to zero if New York banks and the U.S. Federal Reserve Board had not jumped in to rescue it and the entire Western economy.
Be aware that many of the famous hedge managers of the world cashed in their chips in the 1990s as opportunities dwindled and strategies failed.
So if you want to place some of your money in hedge funds, then select one that emphasizes containment of risk, limit the amount you place with a manager, and watch carefully to see how he or she does it.
Better still, work with respected portfolio managers the old-fashioned way. Allow them to invest in superior businesses at good prices, and have the patience to allow the investments to grow in value over the years.
Slow and boring but it works. |
ERIC KIRZNER - The collapse of the biotech sector in March 2000 burst the technology bubble and served as the catalyst for the most vicious bear stock market since the 1930s. With stocks on the decline and only modest contributions from the fixed income side, it has been a major challenge to generate decent portfolio returns over the past couple of years.
To preserve wealth, some investors have recently stolen a page from institutional investors by looking to diversify their portfolios with so-called alternative investments. The most intriguing of these is the elusive hedge fund.
Although there have been some dramatic failures (Long Term Capital Management in 1998), these complex and generally misunderstood funds, if properly structured, can be less volatile than typical equity mutual funds. They have the potential for solid returns over the long run because the manager is permitted to concentrate on the securities or sectors he or she knows best. Hedge funds can actually reduce portfolio risk because they tend not to rise and fall in step with the rest of the portfolio.
This investment vehicle is not without drawbacks. Although the expected returns may be high, there is significant risk of loss.
If you are considering hedge funds, you should investigate carefully before taking the plunge. Make sure there is a clear statement of both the objectives and of the strategies to be employed. Look at the track record.
They key is the reputation of the manager-you do not want to be dealing with unknowns in this field. The key to understanding hedge funds is the long-short (buy-sell) concept. Suppose a hedge fund manager pairs up two gold mining companies - one that she considers undervalued and one that she considers overvalued. She then buys the undervalued company and sells short the overvalued one. She has now created a hedged position in the gold mining sector.
If she has done a good job analyzing the companies, then over time the spread between the undervalued and overvalued stocks will widen, creating a profit. She will make money on the strategy independent of market direction. Furthermore, the paired combination should be less volatile than the underlying market.
That's the simple notion. But these funds come in many guises. The potential returns - and risks - increase as you move from hedge funds that are market neutral to those that have greater exposure to the market.
An example of a market neutral hedge fund is the Hillsdale Canadian Market Neutral Equity Fund. Over the past year, the fund has realized a return of slightly more than 9 per cent and is ahead about 3 per cent year to date.
A more aggressive hedge fund category is the partly market neutral one. These funds maintain long-short positions but have a bias to either buy or sell.
An example is the iPerform Canadian Opportunities fund, which focuses on Canadian investments. The fund is managed by Hillsdale's Chris Guthrie and Veronika Hirsch (one of the country's best known Canadian equity fund managers). The fund is hot out of the gate with a 20 per cent return so far this year and a 27 per cent return over the past year.
Another fund worth considering is run by Eric Sprott, the founder of Sprott Securities, who has developed a formidable reputation in the alternative investment category. His Sprott Hedge Fund L.P., also a long-short fund, has been one of the top performing hedge funds in the country in recent years. Year to date it is ahead by well over 65 per cent and the 12-month return is a remarkable 112 per cent. This fund has a six-month lock-up, which means you must hold it for at least six months. |
