Due diligence key to maxing hedge fund potential

Date: Friday, October 19, 2007
Author: Mark Noble, Advisor.ca

Despite the Portus and Norshield debacles, hedge funds can still play an important role in an investor portfolio, provided advisors understand how they work and conduct proper due diligence, hedge fund specialists say.

Hedge funds and alternatives produce an absolute return regardless of what happens in the market. This should allow its moderate steady gains to outperform over the long-term the ups and downs of particular market benchmarks.

These moderate gains can make them a difficult sell, notes Gordon Kim, an advisor with Aon Consulting. In a bull market where most standard Canadian equity mutual funds are huge returns, hedge funds just aren't that appealing.

"Too many people go into hedge funds expecting double-digit returns," Kim says.

Kim also notes that hedge funds are more an art form than a science. Hedge funds focus heavily on the manager and absolute returns, so the standard bank research and market predictors used by mutual fund dealers do not always apply to determining the potential of a hedge fund. This makes it difficult for clients to understand what they're investing in.

"I tell clients with a hedge fund you replace market risk with manager risk," said panelist Mike Hayhoe, a Waterloo-based advisor with IPC securities. "I look for the best managers and the majority of those are in hedge funds."

Hayhoe says hedge funds attract the best managers and the compensation structure of hedge funds allows them to make earn more money. He notes hedge funds are also very illiquid and require a long-term investment horizon to work, which should allow their moderate steady gains to outperform over the long-term the ups and downs of particular market benchmarks.

Many hedge funds use leverage by shorting assets, and this leverage can vary. Therefore, the volatility of hedge fund strategies can very drastically. Hayhoe says it's important that clients understand the concept of risk-adjusted returns, so they can see the risk associated with the strategies.

Panelist Christopher Kruczynski from The Marchand - Kruczynski Group at Scotia McLeod, says some clients will be comfortable to concepts of leverage considering the fact that most take out a mortgage on their homes. He relates their home leverage to how leverage can be used in investing, and if advised properly has relatively low risk.

Nevetheless, widely-reported failures of hedge funds highlights the extreme risk associated with managers not subject proper scrutiny. Most of this scrutiny has to be conducted by the advisor themselves.

Alex Chapman, vice-president of Mintz Fund Services, which provides third-party consulting to hedge funds, says regulators are taking a closer look at hedge funds, which he feels will ultimately make the risk management assessment for advisors easier.

Currently, the majority of investors cannot invest in hedge funds because they are not accredited investors with either the $1 million in pre-tax capital or an annual salary of $200,000 or more.

"In Canada just to manage to assets, you need an ICPM, which is an investment council and portfolio manager. If you want to sell hedge fund to accredited, investors in Ontario you need a limited market dealer registration," Chapman says. "The proposed National Instrument 31-103, will effectively create a new category called investment fund manager, which is something from the ICPM and market dealer registrations of today."

Under 31-103, hedge funds will have to have a minimum working capital of $100,000 and will be required to take out a secured bond equivalent in value to of 1% of assets under management.

Rules can be bent if not broken. Portus used principal-protected notes to circumvent these rules and sell to non-accredited investors. There's no surefire way to ensure investors won't be taking on unnecessary risk without doing your homework, Kim says.

Kim says he always asks a prospective hedge fund manager how he defines risk. Risk is a relative term, and this gives him a sense of what types of risk that manager is going to be taking.

"You really don't want to handcuff these managers with too many rules," Kim says. "Regardless of regulation, I want to see risk management."

Kruczynski would like to see the hedge fund market opened up more because Canadian hedge funds are dominated by resource long-short strategies. Investors are not getting the chance to diversify, which is core risk management strategy.

"These products we have in Canada are specific to Canadian market managers," he says. "There is not a lot to choose from. I would like to see Canadian investors have more access to global hedge funds."

Chapman emphasizes advisors can drastically minimize risk by choosing hedge funds that have their auditing conducted by independent parties.

"I think a lot of the times, it's perceived the hedge fund managers themselves do their own accounting, to get their own Net Asset Value, and calculate their own performance fees which are based on NAV," he says. "Having a third party do this is much better, because you get an extra level of independence. The advisory network should really look at who the service providers are as part of their due diligence. Make sure that they don't have the managers themselves calculating their fees and their own NAV."

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com