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Andrew Allentuck

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The fashionable alternative

Andrew Allentuck

 As alternative investments, hedge funds are the fashion of the times. Hedge funds may be managed to play short positions in which assets are sold before they are bought - a plan that works if prices plummet. They may invest entirely in futures, play at merger arbitrage or invest in defaulted bonds and stocks of bankrupt companies. Each concept has a strategy that is not available to conventional mutual funds. Call it style diversification and you're close to the idea that has made hedge funds seem glamorous.

Investment managers like hedge funds, not only because of the wide range of strategies that they can use, but because of the typical fee structure of 2 per cent of net asset value plus 20 per cent of the amount by which they beat various benchmarks.

The hedge business is flourishing. According to Chicago-based investment research company Morningstar Inc.., the hedge fund industry grew from $38.9-billion (U.S.) of assets under management in 1990 to $537-billion under management in 2001 to an estimated $1.1-trillion in 2007.

Hedge funds can produce impressive returns. For example, the $470-million Dynamic Power Hedge Fund produced a 42.9-per-cent return for the 12-months ended Feb. 28, 2007. That put the fund high up in the top decile of returns of more than 200 hedge funds sold in Canada. But finding a top performer like the Dynamic portfolio is not easy. The median return for alternative strategies funds for the period was a rather humble 5.0-per cent.

"We are able to short, but all of our performance is coming from long positions in commodities and indeed, most of the companies we own are in Canada," explains portfolio manager, Rohit Sehgal, vice president and chief investment strategist for Dynamic Funds in Toronto. "We stay ahead of the curve by monitoring our companies closely. That also helps to hold down our volatility."

Morningstar reports that for the 10 years ended Feb. 28, 2007, the average annual return of 6008 hedge funds was 9.8 per cent. That is not a bad outcome, but it was attainable in conventional Canadian mutual funds invested in such sectors as financial services that produced a 10.6 per cent average annual return for the 10 years ended Feb. 28, 2007. In the same time period, Canadian focus equity funds produced a 12.6 per cent average annual compound return. What's more, the more exotic hedge strategies involve a far higher level of risk that conventional mutual funds employ.

Hedge funds ought to lend themselves to sophisticated risk control strategies. Yet management erudition is no guarantee of success. Long-Term Capital Management, a U.S.-based hedge fund that specialized in bond trading, imploded in 1998 with a reported $1.2-trillion of exposure to bonds, swaps, options and other derivatives. Its managers and directors, including Nobel prize-winning economists, saw their stakes evaporate along in just two days when the fund lost 90 per cent of its capital. Exotic strategies do not guarantee winning outcomes.

Last year, Amaranth Advisors, a hedge operation based in Greenwich, Connecticut that specialized in energy trading, failed after its strategy went into a tailspin. Amaranth lost more than $6-billion (U.S.) of the $9-billion investors had put into the fund which had allowed star trader Brian Hunter to work what was expected to be magic. However, in this case, the money put into the top hat really did vanish. The fund shut down in Sept., 2006.

The risks of hedge fund investing cannot be ignored, but some funds do have the power to weather market storms. In the wake of the dot com implosion from 2000 to 2003, the Morgan Stanley Capital International (MSCI) World Index in U.S. dollar terms dropped 45 per cent. In the same period, returns from all hedge funds tracked by the Credit Suisse First Boston Tremont Hedge Fund Index were plus 11 per cent.

All that has now changed. Since March, 2003, emerging markets hedge funds tracked by Tremont have produced a total return of 104 per cent. But the MSCI Index, which blends all world equity markets, produced a 117 per cent gain in the same period. And had an investor chosen the MSCI Emerging Markets Free Index, which has no restrictions on allocations, he would have gained 267 per cent in the period.

Every hedge fund needs time to prove it worth - or lack of it. Hedge fund managers typically raise money, invest it, and then wait for a few years as their methods are tested. If their funds soar, they can be marketed on their records. If they fail, they are often just closed with remaining cash returned to investors. The phenomenon creates survivor bias, for only the records of the successful funds remain.

Why, then, do investors have a love affair with hedge funds? Karen Bleasby, Senior Vice-President of Investments at Mackenzie Financial Corporation in Toronto, explains that going short paid in a falling market. Yet things are different now.

"In a strong bull market, such as we have experienced since 2003, it is hard for a manager who employs both long and short strategies to outperform a pure, long-only strategy. But hedge funds remain fashionable because they hold out the promise of being able to outperform in difficult market environments."

Andrew Allentuck writes about investments for The Globe and Mail, and reviews books on finance for globefund.com and globeinvestor.com. He is also the author of several books.

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