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The Pros and Cons of ‘Wild West’ Hedge Funds

by Wayne Cheveldayoff, 2003-05-12

Hedge funds are managed by free-wheeling cowboy or gunslinger-type investment pros who face none of the restrictions put on equity fund managers. This ‘Wild West’ of investing has outperformed equity funds on average over the past three years. But there are many reasons for investors to be cautious and to take a long, hard look at the details of any hedge fund before getting involved.

One important investing advantage for hedge funds is that they are able to do virtually anything. The name “hedge fund” was originally used to describe funds that had long positions in some securities hedged with short positions in others, but the name is now more broadly used to specify funds where anything goes.

Unlike equity funds, hedge funds can borrow and sell short. They can also speculate in commodities or currencies. In addition to borrowing, they can leverage the portfolio in various ways using such things as futures and swaps to get a bigger bang in performance.

With this freedom comes the sizeable benefit that a hedge fund manager can make money for investors in up and down markets. But there is also higher risk and greater volatility, as there can be huge losses as well as huge gains.

The main risk, in essence, is manager risk. Whereas the performance of an equity fund is linked to a large degree to how the stock market does, the performance of a hedge fund depends entirely on how well the manager does.

In addition to some spectacular returns, there have been many examples in recent years where hedge fund managers have blown it, either due to bad strategies, bad luck or bad speculative calls, leaving investors with nothing or next to nothing.

But the lure of the potential big returns has nevertheless caused the industry to grow dramatically to the point where assets managed by more than 2,000 hedge funds worldwide exceed US$600 billion.

Hedge funds in Canada were traditionally treated like private placements, available only to sophisticated investors willing to put up $150,000 or more per fund. But changes in recent years have made them as available to investors as mainstream equity mutual funds, with minimum investment amounts as low as $5,000.

Hedge funds are classified as “alternative strategies” funds in mutual fund listings in newspapers and financial websites. A recent check showed the average performance of those listed by the Globe and Mail was –3.6% for the past year and +2.4% annually for the past three years. This average performance wasn’t spectacular, but it was better than that of Canadian equity funds (–19% on average in the past year and –6.2% annually over the last three years), although not as good as mutual funds focused on income trusts (+3.6% in one year and +13.7% annually over three years).

Investors interested in picking a hedge fund can start by reviewing the range of funds (98 at last count) listed under the “alternative strategies” category at www.globefund.com. It is not enough to simply look at past performance, since there have been cases where fund performance has done well for a while and then collapsed as the manager hit a rough spot.

This is why it is important for investors to understand what the manager is doing in order to assess for themselves what the risk is and if they want to go along for the ride. However, the descriptions listed on websites may not be specific enough to know exactly how the money is invested and at what risk. Investors may need to consult the prospectus and speak with the hedge fund company representatives. An investment advisor or broker may also be of help, since they are often briefed, sometimes on a regular basis, by the fund companies and additionally may have had an opportunity to make a detailed comparison of the various hedge funds or to get to know the managers.

Another factor to keep in mind is that hedge funds usually charge performance fees that can diminish final returns to the investors putting up the money. The typical hedge fund has a management expense ratio (MER) of around 2.5% a year, which is about the same as for equity funds, but the hedge fund has an additional performance fee that gives the manager 15% or 20% of the returns above a specified target (around 10% a year). While performance fees provide incentives, they may also in this case foster a “go for broke” mentality that causes the fund manager to take excessive risks to try to get the big payoff.

A recent development in Canada is the introduction of mutual funds that invest in a basket of hedge funds. Such a ‘fund of funds’ has the advantage of spreading the risk among several hedge fund managers, although it is not clear what this means for potential investment returns since these funds have not been around long enough to make a proper historical assessment.


Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at wcheveldayoff@yahoo.ca.


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©2003 Wayne Cheveldayoff