Hedging your bets

Hey there, time traveller!
This article was published 30/10/2010 (5476 days ago), so information in it may no longer be current.

It’s the same time of year, same darn subject: hedge funds.

Last Halloween, this column examined the mysterious investment world of these private funds that can use just about any legal form of money-making in the markets.

Unlike a typical mutual fund, which may be limited to stocks and/or bonds, hedge funds can short-sell stocks, use derivatives and leverage, go to all cash if need be and, of course, still invest in more traditional assets like stocks and bonds.

Last year’s column discussed how these funds aren’t the bogeyman they appeared to be after the credit crisis and the Bernard Madoff scandal, the so-called fund-of-hedge-funds manager who wasn’t really investing people’s money at all.

This time around, the focus is on how these alternative investments may offer investors with larger portfolios, at least $50,000 in size, a possible means to manage risk and volatility in this precarious economic climate.

“I would genuinely say investors who are looking to create a balanced portfolio for savings and retirement would be well-served by looking at alternatives to simply being long on commodities, equities and bonds,” says Anthony Lawler, co-head of portfolio management of Man Investment’s Multi-Manager business.

Lawler, who is based in London, manages a sort of super-fund of hedge funds for Man, one of the world’s largest alternative investment firms with more than $63 billion in assets.

Lawler recently spoke to the Free Press while he was on business in Switzerland to discuss the value of hedge funds as part of investors’ portfolios.

He says besides the fact hedge funds have more arrows in their quiver when it comes to asset classes and strategies, they also often differ in overall investment philosophy. They generally seek absolute returns rather than relative returns. They attempt to make money no matter the weather in the markets, as opposed to most mutual funds, which seek performance better than or matching similar funds or an underlying benchmark index like the S&P TSX composite index or the S&P 500. Mutual funds will make money in good times and typically make less of it — or often lose money — in bad times.

In contrast, many hedge funds’ goal is to make money in adverse conditions by using techniques such as short-selling and make more money in good times by using leverage.

Although they can be a more risky asset class than mutual funds, particularly when they’re using leverage, many hedge funds can do exactly what their name implies — hedge risk.

 

“Our mantra is to ‘first, do no harm,’ so we are looking to invest capital prudently, but the big difference is we invest with managers that can both go long and short with currencies, interest rates, a stock or a commodity,” says Lawler, who helps manage tailored portfolios of hedge funds for institutional (that is, pension funds) and high-net-worth clients.

Miklos Nagy is a Toronto-based money manager and adviser who specializes in Canada’s approximately $35-billion hedge fund industry. (On a global basis, hedge funds manage almost $2 trillion in assets.)

He says when looking at hedge-fund industry performance as a whole, hedge funds expose their investors to less risk than their investments in the broader equity markets. In the last 20 years, the HFRI Fund Weighted Composite Index — a sort of S&P 500 for hedge funds — has had only two down years: 2002 and 2008. In 2002, Nagy says the HFRI composite lost about 1.4 per cent, whereas the S&P 500 lost 22 per cent. In 2008, it lost a record 19 per cent, but the S&P lost 37 per cent of its value.

Nagy, who also manages a fund of Canadian hedge funds called the Canadian Hedge Watch Index Plus, says “meaningful data” on Canadian hedge funds have only been available after 1995. Since then, they went negative in one year only — 2008. Canadian hedges lost about 28 per cent that year compared to the TSX composite losing about 33 per cent.

Yet hedge funds aren’t for every investor. Nor are they available to everyone.

They are considered exempt market securities, only available to eligible or accredited investors. Basically, you need a fair amount of dough to get in the game.

“If you don’t make $75,000 a year, most likely you wouldn’t be looking at hedge funds anyway because you don’t likely have enough money to invest,” says Nagy, president of Quadrexx Asset Management.

Investors who do meet the wealth test should consider investing about five to 20 per cent of their portfolio in alternative investments such as hedge funds to help protect against downturns in the market, he says.

But they also need to understand the risks, meaning they should have a firm grasp on the methods used by the fund to earn money, or have an adviser who is able to explain the fund’s strategy.

And there’s no guarantee the fund won’t “blow up,” Nagy says. “If you invest in one single hedge fund, you may be exposing yourself to higher risk because of the higher minimum investment,” he says “Therefore, to properly diversify, the way to do this is to invest in eight to 12 hedge funds.”

This is costly and time-consuming. Alternatively, investors might choose a fund of hedge funds that invests in several hedge funds for the investor.

Man’s Multi-Manager business offers an assortment of hedge fund portfolios, for instance.

“We have a bias to be with very liquid, nimble hedge funds,” says Lawler, adding Man doesn’t invest in Canadian hedge funds. “Once you look at liquid and really nimble funds, then you can get guys who run funds that really do roll with the punches and not lose your money in tough times.”

More than ever, both Nagy and Lawler argue investors with substantial portfolios need some exposure to hedge funds because these investments are often uncorrelated with the stock and bond markets.

“You could see stocks sell off significantly because growth rates are disappointing, and people could become worried about sovereign risk and corporate debt,” Lawler says.

“So the supposed diversification that you have across bonds and stocks may not hold true if we go into a difficult period, because they certainly have both rallied quite a bit (from their 2008 lows).”

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