Dispelling hedge fund myths

Hedge funds can play an important role when it comes to asset allocation and risk tolerance due to their non-correlation with traditional investments and the ability to provide true portfolio diversification. Yet myths about hedge funds continue to keep advisors and investors on the sidelines.

Myth 1: Hedge funds are risky and highly leveraged

Hedging is a strategy used to guard against the risk of loss. The perception of hedge funds as riskier than traditional investment vehicles is incorrect. In fact, the long-only approach to investing is unable to handle the fundamental risk of market downturns, while hedge funds utilize a wide range of tools to execute advanced investing and trading strategies (such as the ability to go long or short). What’s more, the use of leverage, which is typically controlled and monitored by a hedge fund’s prime broker, is widely minimized to protect the broader portfolio.

Hedge funds can be categorized into five investment styles:

1. Trend-following: These programs (also known as managed futures) profit from seeking and exploiting pricing trends in a wide range of instruments such as currencies, interest rates, equities, metals, energy and agricultural commodities.

Managers obtain exposure to these investments through global futures markets, with over 200 standardized futures contracts that can be traded both long and short. Discretionary managers rely on judgment and expertise to make investment decisions, while systematic managers use proprietary mathematical models and high-frequency data analysis to identify and capture price trends.

2. Global-macro: Managers capitalize on upward or downward trends across markets, asset classes and financial instruments by analyzing macroeconomic data and developing a thesis.

3. Equity-hedged: Managers take offsetting long and short positions in undervalued and overvalued stock. This is the founding strategy of the hedge fund industry.

4. Event-driven: Managers identify specific events to trigger an investment decision, including corporate actions such as bankruptcies, asset sales, mergers or takeovers. Activist hedge funds invest significant amounts in order to influence management and board decisions.

5. Relative-value: Arbitrage refers to opportunities presented by the mispricing of related assets. Managers are able to exploit the expected convergence of these prices by taking a short position in the overvalued asset and a long position in the undervalued asset, and can produce profits regardless of the overall market direction.

Myth 2: Hedge funds are new

Alfred Winslow Jones, a Doctor of Sociology, is generally regarded as the pioneer of the hedge fund industry. He launched the world’s first hedge fund in 1949, based on his belief in the complementary nature of short selling and the use of leverage — using borrowed money to enhance the investment. This conservative model has become known as equity-long/short or equity-hedged. In his 34 years of fund management, Jones lost money in only three years, while the S&P 500 index recorded nine years of negative returns during the same period.

The industry experienced significant growth through the nineties, and entered its real boom period following the collapse of the technology bubble at the turn of the century. The number of hedge funds and fund of funds (a hedge fund that invests in other hedge funds) has doubled over the decade from less than 4,000 in 2000 to more than 9,000 by mid-2010. The equity-hedged investment style is still the largest segment of the industry, according to the HFR Global Hedge Fund Industry Report for 2010, as it accounts for approximately 30% of total assets.

Myth 3: Hedge funds have high fees

The underlying philosophy of the hedge fund industry is that the skill of the manager (generating alpha) should drive the performance of the fund, rather than the performance of the market or asset class (tracking beta).

Aligned with the principle of driving performance from investing skill is the remuneration model of performance-based compensation. Traditional investment funds typically charge a flat fee for active management regardless of performance.

Hedge fund managers, however, often derive a substantial portion of their fees when the investor sees a positive return. In this case, they are a consequence of strong returns. As best industry practice, hedge fund managers generally show their products’ historical performance net of fees and expenses.

Myth 4: Hedge funds are unregulated and lack transparency

Like all investment funds, hedge funds operate in a heavily regulated environment. Hedge funds designed for retail investors are often offered by way of prospectus and require detailed information on the fund, its investment objectives, risks and the qualification of the investment manager. Other structured products provide access through a stock exchange and are subject to exchange regulation. Additionally, many of the hedge fund providers themselves are publicly traded and subject to the same oversight.

While those hedge funds that rely on the exempt market (servicing the accredited investor community) do not require a prospectus, they are restricted by rules on marketing and promoting investment products. Money managers, including hedge fund managers, are registered with, and regulated by, provincial securities commissions.

Myth 5: Hedge funds are only for high-net-worth investors

Hedge funds were not traditionally offered by prospectus, and so sales were restricted to accredited or eligible investors under National Instrument 45-106 (NI 45-106). Generally, in order to purchase products offered under NI 45-106, investors would have to meet hefty levels for minimum income, financial assets and/or minimum purchase levels for the particular security in question.

If the hedge fund is offered by prospectus, the above restrictions do not apply. Fund providers may place minimum investment requirements, and these will vary from fund to fund.

The retail hedge fund marketplace in Canada continues to grow as fund providers develop both products structured to be exempt from prospectus requirements (some of which are even exchange-listed) and products offered by prospectus. This, in turn, is providing larger access to new strategies and investment styles previously only available to high-net-worth individuals — strategies and investment styles that can offer excellent diversification and enhanced returns with mitigated risk against broader financial market moves.

Debunking these myths is important in fostering better conversations between advisors and investors about hedge funds and their role of helping to provide a wider range of tools to accomplish their wealth management objectives. More broadly, advisors and their clients should discuss what allocation is generally appropriate to alternatives as a portion of a diversified portfolio.

Toreigh Stuart is CEO of Man Investments Canada Corp.