Are hedge funds suitable for the average investor?

Toreigh Stuart, Chief Executive Officer, Man investments Canada

Stance: suitable

Investors with limited savings need to protect capital as much—or even more—than the wealthy. Hedge funds make sense for investors looking to invest in equities with a medium-to long-term horizon, because they offer better risk-adjusted returns across the board.

They provide upside participation, with a lot more downside protection, while allowing exposure to different markets, trading techniques and strategies investors wouldn’t normally be exposed to.

Historically, hedge funds have offered tremendous diversification to traditional stock and bond portfolios. And their risk-adjusted returns have been far better than typical long-only investments in stock markets.

You need only to look at the last two decades where investors witnessed drawdowns of more than 50% in long-only equity investments. Everyone deserves the opportunity to invest in strategies that help avoid such drastic decreases.

The good news is, over the last several years, hedge funds have become increasingly accessible to the everyday investor, with minimum asset requirements in Canada and Europe dropping to as low as $5,000.

Read: Hedge funds surpass traditional investments

Manager vs. market

Hedge-fund managers have a wider array of tools to achieve profits—such as derivatives like options and futures, short sales and leverage—than mutual-fund managers.

In addition, mutual funds track market returns, whereas hedge funds aim to generate growth based on the skill of the hedge-fund manager, irrespective of market direction.

Hedge-fund managers invest a sizable portion of their own capital in the fund, so both the investor and the managers have aligned interests, and share equally in the risk and rewards.

There are still a lot of myths surrounding hedge funds. But there’s a growing sense of awareness among informed retail investors that hedge funds should be an essential part of any well-diversified portfolio.We’re seeing a lot of interest from mainstream fund companies and banks.

Share the bounty

The market offers a huge selection of hedge-fund strategies, ranging from very low-risk to very high-risk. For instance, market-neutral equity seeks to exploit differences in stock prices by being long and short in stocks within the same sector, industry, market capitalization, country, etc.

This strategy creates a hedge against market factors because the gains and losses offset each other. If the sector moves in one direction or the other, a gain on the long stock is offset by a loss on the short. Managed-futures strategies are also great portfolio diversifiers.

Debunking myths

Risky: Historically, hedge funds have been less risky, and have provided better risk-adjusted returns. They can use derivatives and bet on currencies, but only to reduce risk by buying put options on a portfolio, or selling futures to protect downside. Investors buying 100% long-only stocks are more subject to the risks of the market.

Unregulated: Hedge funds and hedge-fund strategies are becoming increasingly regulated. Participants in the market—particularly the larger ones—understand providing regulated products gives them greater access to distribution channels.

A good example is the UCITS directive—a public limited company that coordinates the distribution and management of unit trusts in the European Union—which is regulated and has grown by leaps and bounds as far as alternative strategies are concerned.

Highly leveraged: Typically, leverage ranges from one to two times net asset value. Many hedge funds use no leverage at all. Leverage, when used prudently, and by the right manager, can be far less risky than a portfolio of long-only stocks. A manager who goes 100% long on portfolio stocks and uses stock futures as a hedge would make that portfolio far less risky.

Illiquid: There are hedge funds that offer weekly, even daily liquidity. Besides, in order to take advantage of true market inefficiencies, a longer time horizon is necessary for the portfolio manager to provide better returns on a risk-adjusted basis. I don’t think anybody should invest in a hedge fund, or a longonly strategy in the equity market, unless they’re taking a three-to-five year view.

David Bruce, Director and Portfolio manager, the David Bruce Group

Stance: Unsuitable

People are lured into buying hedge funds because they believe someone smarter than they might be able to make them money in good times and bad. The truth is hedge-fund managers have no more ability to predict the market than anybody else.

Of the thousands of hedge funds flooding the market, there are bound to be some winners. But no one knows in advance who’s going to succeed, and who’s not. According to Hedge Fund Research, the average hedge fund lost 5.2% last year, whereas the S&P was up 2.1%. If the average hedge fund lost 7.3% more than the index, imagine how the below-average funds fared.

Due diligence checklist

To find key risks associated with the investment, ask about:

• volatility of returns
• leverage risk
• concentration risk
• market risk
• liquidity risk
• how often the fund is assessed
• the fund’s maximum drawdown (loss) and in what circumstances it occurred
• how distributions are taxed (as capital gains, income or both)
• how the hedge fund will be taxed upon redemption (i.e. income or capital gains)
• how returns are stated(gross or net of all fees)
• how often you can redeem the hedge fund, and inquire about redemption restrictions (lock-up periods, notice period, redemption fees)

Source: For detailed checklists visit The Alternative Investment Management Association, Canada.

If hedge funds were so riskproof, there wouldn’t be a market for regular mutual funds. A true fund that hedges all risk and claims to neutralize market exposure would have a risk-free rate—the same as a U.S. Treasury Bill. Why wouldn’t I just go buy T-bills directly?

Hedge funds have lowered minimums not because they wish to spread the wealth, but because they need more money.

Opaque, risky, expensive

I’m leery of hedge funds for three main reasons:

• Opaque, difficult to understand: Average investors aren’t capable of reaching an informed decision about hedge funds due to lack of transparency. It’s hard to gauge the market performance of hedge funds, and come up with a good reliable source of data because their recorded returns are voluntary.Some are so private, it’s impossible for an outsider to even get perspective on how they operate, or what their positions are.Being a money manager myself, I wouldn’t delegate to anyone who won’t disclose what they’re intending with my clients’ money. How will I explain it to my clients if things go wrong? I have a fiduciary responsibility.
• Leveraged, risky:The market disparities hedge funds hope to capitalize on are becoming so small that managers need to use increasing amounts of leverage to exploit them. Leverage might work in bull markets, but it’s a killer in bear markets.If people want their money back because they’re fearful, hedge funds can put up their gates and refuse. Even if a month’s notice is mandated, the fine print can negate it when there’s a run on the fund. In case of redemptions, managers sell the best stuff first. The junk that’s left causes net asset values to spiral downward.The whole thing unwinds in a hurry.
• Expensive: Most hedgefund structures are unregulated black boxes. Managers can do anything they want. As a result, there are a lot of unethical practices. For example, take the “2 & 20” compensation rule where managers receive 2% fee on assets under management, and earn 20% of the returns on investments.Sometimes they need to make up for what they’ve lost to be entitled to the 20% fee. If they don’t make that threshold, they collapse the fund, give investors their money back, and start over. Retail investors have to be very careful because they can get burned.Read: Institutional hedge fund investors demand transparency

Buyer beware

Hedge funds may be good for institutional investors that have the wherewithal to understand a manager’s philosophy and style, and recover if they got clobbered.

But most Canadian investors aren’t savvy enough to dabble in these alternative investments.They don’t even understand how a regular mutual fund works, let alone a hedge fund.

I’ve met a lot of people who think they don’t pay any management fee on their mutual funds. How could they possibly be well equipped to understand the multiple layers of fees involved in hedgefund management?

To be successful in hedge funds, people need statistical analysis. Most retail investors don’t have access to that. Over a short term, some managers may have a very strong track record. They might be in the gas sector when the sector’s hot. I call that luck, not skill—unless they can repeat the performance over and over.

If, despite the risks, clients wish to make hedge funds part of their portfolios, steer them toward funds that have a long-enough history. If they have a history, ensure the manager hasn’t changed.