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Hedging smoothes the peaks and valleys

The quest for yield and deep fear of another market collapse are fuelling interest in long-short strategies

Special to The Globe and Mail

Aside from peace of mind, a million-dollar portfolio offers investors an array of innovative strategies for preserving capital and making an above-average return.

One of the most interesting but often hardest to grasp is the long-short strategy, commonly referred to as hedge funds.

Poke around the retirement savings accounts of the world's savviest investors and you will likely find these alternative strategies. Indeed, David Rosenberg, chief economist and strategist at money manager Gluskin Sheff + Associates Inc. in Toronto, described long-short strategies as "vital" for controlling risk in a portfolio in a recent Globe and Mail column.

Here's how they work.

First, the long part of the strategy is vanilla: Buy investments expected to make slow, steady growth.

The short side, though, is far more interesting. Long-short investors can profit on stock expected to fall in value by borrowing it, usually from a broker, and selling it immediately. If the stock falls as expected, they can buy their loan back at a cheaper price.

In other words, profiting when others don't.

They can also hedge, meaning these predictions are employed on several stocks. If one goes down and the other up, the hedging still sees the fund come out ahead.

Funds using hedge strategies are generally not available to investors without a lot of money. While securities regulations vary from province to province, alternative strategies are the preserve of people able to drop $150,000 on a single investment, people with $1-million portfolios, or people who earn $200,000 a year (or $300,000 for both spouses).

For example, at Gluskin Sheff, the minimum investment is $3-million. The firm offers an array of stock and bond portfolios to high-net-worth investors, among them alternative strategies run mainly in-house.

"The advantage of hedge funds over mutual funds is you have more tools in your tool bag," says Courtenay Wolfe, president and chief executive officer of Salida Capital in Toronto. "Shorting can be very advantageous in a difficult environment."

Long-short strategies can also temper risk in other ways, industry participants say. Ideally, they offer steady returns year in and year out that offset ups and downs in other asset classes, although riskier strategies can swing from steep losses to heady gains in the space of a year. Most funds charge a 2-per-cent management fee and a 20-per-cent performance fee.

"A strong selling point for long-short funds is that they have a low correlation to stock and bond markets," says Gary Ostoich, chairman of the Canadian branch of the Alternative Investment Management Association, known as AIMA Canada , and also president of Spartan Fund Management in Toronto. This tends to reduce a portfolio's volatility, Mr. Ostoich said in an interview.

In 2008, for example, when panic hit financial markets, the main hedge fund indexes fell only half as much as major stock indexes, Mr. Ostoich said. Some hedge fund managers actually made money that year, including renowned Canadian super-traders Eric Sprott and Al Friedberg.

One, the CI Trident Global Opportunities Fund managed by Nandu Narayanan, was up 43.6 per cent.

"He called the economic collapse," said Bob Thompson, portfolio manager and alternative investment strategist at Canaccord Wealth Management in Vancouver, who as head of Thompson Investment Partners runs a fund of long-short funds for clients. (Under B.C. securities legislation, portfolio managers can buy hedge funds for their clients, who benefit by being able to participate in many strategies for their $150,000 investment.)

For individual investors, finding a broker who specializes in hedge funds is helpful because so many different strategies are lumped together in the same category, Mr. Ostoich said. There are about a hundred or so investment advisers nationwide who are "quite well versed" in the strategies, he added.

"The number one reason to own a hedge fund is that it fits with the rest of your portfolio," Mr. Thompson said. Don't buy just because a strategy did spectacularly well last year, he cautioned. "Buy it either to increase returns with the same risk, or for a given return to reduce the risk."

The best approach is to combine strategies, says Craig Machel, associate portfolio manager at Macquarie Private Wealth Inc. in Toronto. When choosing hedge funds he looks for consistency, track record, capacity constraints and whether the people who run the fund "eat their own cooking" by investing in the funds they manage.

A quest for yield and deep fear of another market collapse like 2008 are behind the growing interest among individual investors in alternative strategies, industry participants said. As well, people who manage money and sell investment products are looking for better ways to meet their clients' needs.

"These markets have shaken people's confidence in a big way," Mr. Machel said. "People are disappointed by the conventional approach. Conventional diversification is out the window."

Besides, the strategies have been doing well. The Scotia Capital Canadian Hedge Fund Performance Index ended 2010 up 20.2 per cent, easily beating the S&P/TSX Composite Index, which was up 14.5 per cent. Among the most impressive gains were Vision Opportunity Fund's 47.4-per-cent net return, Salida Multi Strategy's 44.9 per cent, Sprott Hedge Fund's 41.2 per cent and Rosseau LP's 40.8 per cent.

Often, though, too much success leads to the strategies being closed to new investors, partly to keep out the fickle who tend to flee at the first bad quarter and partly to keep the fund small and nimble. Fortunately, there are always more diligent, dynamic traders seeking to test their mettle, "so there'll be good capacity for years to come," Mr. Machel said. The way he sees it, hedge funds are about securing your financial future.

"I know of no other way to get the job done consistently but to embrace the hedge fund world."

***

THE LONG AND SHORT

Hedge fund managers have a reputation for spectacular gambles, like George Soros's billion-dollar bet against the British pound during the early '90s. A closer look reveals that most hedge fund management firms offer a range of strategies, from conservative to high stakes.

"If a client is looking for outsized returns and doesn't mind short-term volatility, we have a fund that has delivered incredible performance, short to medium term," says Courtenay Wolfe, president and CEO of Salida Capital Corp.

The Salida Strategic Growth Fund fell 66.5 per cent in one dizzying lurch in the 2008 stock market panic, only to zoom back, rising 181.55 per cent in 2009 and an additional 44.9 per cent in 2010. The fund specializes in resource stocks.

If a client is looking for low volatility and doesn't mind giving up some performance, Ms. Wolfe points to the Salida Wealth Preservation Fund. It's designed to give clients a 12- to 15-per-cent average annual return with half the volatility of the S&P/TSX Composite Index, Ms. Wolfe said in an interview. In its first year, 2010, it was up 19.5 per cent.

Nervous investors dipping their toes in the alternative strategy pond for the first time should look for stable returns, industry watchers caution. The idea is to pick a few suitable managers and stick with them.

Dianne Maley

© 2007 The Globe and Mail. All rights reserved.

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