Forget what you've heard -- they're not just for high rollers

Date: Thursday, February 22, 2007
Author: Tony Martin, Globe and Mail

Despite their reputation, hedge funds were actually designed to help reduce portfolio risk, TONY MARTIN writes

Special to The Globe and Mail

Hedge funds are the Angelina Jolie of the buttoned-down world of Canadian investing: headstrong, somewhat mysterious and often in the company of the rich. They're also similarly prone to covetous glances.

If you're relatively well off, acting on that envy by adding exposure to hedge funds can make sense, but not for the reasons you might think.

Forget about using hedge funds as a way to earn handsome profits. If hedge funds serve a purpose for the typical Canadian investor, many experts say, it's to reduce your portfolio's volatility.

"The right reason to invest in a hedge fund is to lower the overall risk of your portfolio without giving up returns," says Bob Thompson, alternative investment strategist for Canaccord Capital Inc. in Vancouver.
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Though they are often associated with high risk and high returns, hedge funds were initially designed to help investors, well, hedge their bets. Hedge funds do this by investing so that their ups and downs run counter to those of the markets in general.

Even so, the question of whether hedge funds might be a useful addition to your portfolio earns a fast and no-nonsense reply from some advisers.

"They're simply too high-risk," says Larry Jacobson, a principal with fee-only financial planner Macdonald Shymko & Co. Ltd. in Vancouver. Mr. Jacobson says he has never needed to employ them in his 35 years as a financial planner. If you want to reduce volatility, he says, "you can do it with asset allocation."

It's not just the risk of poor performance he's talking about. Hedge funds can and do go under. Investors in Portus Alternative Asset Management Inc. still cannot get at their funds, which remain frozen as the Ontario Securities Commission looks into the firm's collapse, which occurred in March, 2005. That same year, Montreal-based Norshield Financial Corp. suspended redemptions after a liquidity crisis that the company ascribed to bad press.

The term "hedge fund" applies to a broad category of investments, however, and only some are considered high risk. Mr. Thomson points out that, in general, the hedge funds that fail have used excessive leverage. He says investors can find numerous low-risk, long-short equity funds that use minimal leverage and largely resemble traditional stock mutual funds -- except they can bet on stocks falling in value as well as appreciating.

Some conservative hedge funds are worth a look, says long-time mutual fund analyst Dan Hallett.

"There is certainly some significant potential value of including a hedge fund in the context of a larger portfolio," says Mr. Hallett, the president of independent investment research firm Dan Hallett & Associates Inc. in Windsor, Ont.

But although they can reduce the overall volatility of a portfolio, it will come at a price. The management fee on many hedge funds is around 2 per cent. On top of that, the management company will keep a good-sized chunk of the gains once the fund achieves a certain level of returns. And if you're looking at a fund of hedge funds, which experts often recommend to investors, you will face an additional 1 or 2 per cent management expense ratio, or MER, as well as a secondary performance-related fee.

With all the fees, "it gets tougher and tougher for the investor to pull performance out," Mr. Hallett says.

In addition, to buy hedge funds directly you must meet some fairly stiff financial requirements. While the rules vary from province to province, you generally need about $25,000 to invest. Alternatively, you likely qualify to purchase them directly if you have at least $200,000 of net income (or $300,000 including your spouse's), or net liquid assets totalling $1-million or more.

Retail investors can get around these requirements by buying principal-protected notes linked to a hedge fund. But in addition to their complexity come more costs. With these notes, a portion of your original investment is set aside to earn interest so that at maturity you get your principal back. Leverage is then used on the balance to boost your exposure, which means extra fees. And no matter how numerically inclined you are, estimating the fees is often difficult due to fluctuating interest rates.

Even setting aside the costs, complexity and requirements of hedge funds, they aren't an appropriate option simply because you're unhappy with the returns you're getting from regular mutual funds. It's usually not a matter of all mutual funds being bad, Mr. Hallett argues, but simply a case of a poorly put together portfolio.

Consider that even Peter Beck, the co-author of Hedge Funds for Canadians, suggests taking a critical look before leaping. And it's not that Mr. Beck isn't comfortable with risk. He's also the president of Swift Trade Inc., which makes money through its hundreds of day-traders.

Says Mr. Beck, "You have to approach hedge funds like any other instrument and look at whether they fit with your overall objectives."