It seems hedge funds are replacing terrorism as a threat to global security. Finance ministers from the world's leading industrialized nations emerged from this month's G8 meeting in Germany expressing "concern" over the rising power of hedge funds. And for good reason. Months after the Amaranth Advisors hedge fund lost billions on a risky natural gas bet, the Red Kite Metals hedge fund is struggling to keep it together in the wake of a short-lived sell-off in copper.
Hedge funds have been around for decades, but it's their popularity in an age of cheap borrowing costs that has raised investor interest and regulatory alarm bells. The same week the finance ministers were expressing concern over the degree to which hedge funds are leveraged, the first publicly traded hedge fund managed by San Francisco-based Fortress Investment Group rose 68 per cent on its debut day of trading.
We Canadians, being a cautious lot, have not embraced hedge funds with as much fervour as our U.S cousins. For starters we classify hedge funds as "alternative strategy" funds. Of the roughly 200 open-ended alternative strategy funds on the Canadian market, the overwhelming majority are hedge funds, and the overwhelming majority of Canadian hedge funds employ one predominant hedge strategy -- long/short.
When a fund holds a long position, a security is purchased with the intention of it rising in value and being sold at a profit. When a short position is taken the investor borrows securities and sells them with the intention of purchasing the same securities at a lower price and returning them. Long/short managers try to boost returns regardless of the broader market direction by holding simultaneous long and short positions.
The degree of borrowing is one aspect that makes long/short funds risky -- especially when you consider there is no limit to how much a short position can lose, since there is no limit to how high a stock can go. The lowest a long position can fall, on the other hand, is zero.
"Whenever you use leverage you're putting yourself at risk," says Bob Thompson, alternative investment strategist with Canaccord Capital Inc. in Vancouver. "Hedge funds require a higher degree of sophistication than mutual funds," he says.
Here, sophisticated means wealthy. The average minimum initial investment to get into an alternative strategies fund is $25,000 and could go as high as $500,000. A few have more modest entry levels.
One other aspect of hedge funds that turns the risk meter up is their lack of regulatory oversight compared with standard mutual funds. Hedge fund managers are not required to disclose much of the information that mutual fund holders may take for granted. Mr. Thompson's advice to hedge fund investors wanting to gauge risk is to check the degree of leverage in the fund's offering memorandum, and make sure it is updated regularly.
He says Canadian alternative-strategy funds have been diversifying from the long/short model over the past few years to the point where roughly a quarter employ other strategies involving derivatives and arbitrage trades -- simultaneous positions that produce a profit from the spread. Since spreads are often narrow in relation to the overall investment, a great amount of capital is needed, which again requires a high degree of leverage. "They're having to add new strategies all the time," he says.
For investors who want to hedge their hedge-fund risk, Mr. Thompson suggests a fund of funds. Funds of funds diversify alternative strategies, which often involve merger or fixed-income arbitrage, commodities and managed futures, real estate or private equity.
While alternative-strategies funds seem slow to evolve in Canada, increased demand for hedge products has mutual fund companies pressuring regulators to allow hedge strategies in standard funds. CI Investments Inc., Dynamic Mutual Funds Ltd., Front Street Capital Inc. and Sprott Asset Management Inc. can now short as much as 20 per cent of the assets in some funds, provided they aren't leveraged.
"Ten years down the road I don't think there will be much difference between a hedge fund and a regular mutual fund," says Mr. Thompson.
A comparison of alternative-strategies fund returns over the past year gives a good indication of the volatility associated with hedge funds. If you held one there's a good chance you're either really happy or really disappointed.
From Jan. 31, 2006, to Jan. 31 of this year, the top performing open-ended alternative strategies fund more than doubled, while the worst performer lost nearly 80 per cent. The average alternative-strategies fund returned more than 70 per cent over the same period. To put that in perspective, the TSX returned just under 12 per cent.
At the top of the heap is the Sextant Strategic Opportunities fund, launched by Sextant Capital Management Inc. about one year ago. It posted a year-over-year return of 110 per cent with a long/short strategy, although the fund prospectus allows positions in gold, silver and industrial metals.
Down at the bottom of the alternative strategies pile is the DeltaOne Energy Fund LP, which had its value cut by 79 per cent. DeltaOne Capital Partners Corp. takes long and short positions in the energy sector with the option of employing "a variety of hedging strategies," which it doesn't disclose.
One alternative strategies fund with a decent return is Northern Rivers Innovation Fund LP, which grew 89.4 per cent over the past year. It's a long/short fund that utilizes puts and calls to manage risk.
While the fund has the latitude to employ just about any hedge strategy, portfolio manager Hugh Cleland tries to keep things simple and limits his leverage to 115 per cent gross long -- small compared with other hedge funds that may go as high as 150 per cent gross long. That means for every $100 in invested assets, $15 is leveraged. "I dislike leverage both personally and professionally," he says.
Mr. Cleland says 10 to 50 per cent of the $110-million portfolio is invested in short positions, but that number has been coming down. Short positions include the Nasdaq 100 and the S&P TSX Energy Index.
On the long side, the Northern Rivers Innovation Fund generated most of its gains through a 60-per-cent stake in natural resource stocks and 40-per-cent in technology and health care stocks.
The long mix has since been inverted to a 70-per-cent weighting in tech and health care, and a 30-per-cent weighting in resources. "I feel there's better opportunities in health care . . . in resources you need to be more selective," he says.
Mr. Cleland advises unitholders not to expect a repeat performance over the next year. In order to control risk he targets an annual return of 20 per cent in a good market and a 5- to 10-per-cent loss in a bad market. Like many hedge fund managers he sets a return goal and adjusts risk to meet that goal.
Dale Jackson is a producer at Report on Business Television.
© 2007 The Globe and Mail. All rights reserved.
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