10 things you didn't know about hedge funds

Hedge funds can be alluring. They aim to make money regardless of market direction, can borrow money to boost returns and can use techniques such as shorting stocks to protect themselves. But they can also suffer big losses - such as what occurred during the 2008 market meltdown.

Before you invest, consider these 10 things you may not know about hedge funds.

Hedge funds don't always hedge

Early hedge funds got their name because they used to "hedge" against the possibility of the market falling by holding some short positions in which they bet against stocks they felt were overvalued. Now, the term has become a catch-all for managers using all kinds of strategies. Some managers don't truly hedge and are really "alpha dogs looking for outperformance," said Michael Nairne, chief investment officer of Tacita Capital Inc., which advises wealthy investors on buying hedge funds.

Hedge funds are loosely regulated

Investors receive an "offering memorandum," which is not vetted by regulators the way a prospectus is. That means you have to do more homework. The Canadian chapter of the Alternative Investment Management Association provides a due-diligence questionnaire for its members to fill out. "There is nothing stopping retail investors from asking for a copy," said Gary Ostoich, chairman of AIMA Canada. "It contains more in-depth details, like a fund's five biggest losing periods, and how long it took to recover."

They're not open to everyone

Hedge funds are sold only to accredited investors - people with $1-million in assets or annual income of $200,000 (or $300,000 along with their spouse) in each of the past two years. One exception is if investors are willing to invest $150,000 into one fund. The risk is that an investor could end up putting a large portion of their net worth in one fund that may not do well, said Craig Machel, an investment adviser with Macquarie Private Wealth Inc.

Unlike the larger Canadian mutual fund industry, which has $720-billion in assets, the hedge fund industry has only $25-billion in assets.

Middle-class earners can get access to some hedge fund strategies through exchange-traded funds (ETFs) run by companies such as U.S.-based Index IQ, which invest in other ETFs and charge a fee of about 1 per cent.

You can get a group discount

"Fees are sometimes negotiable," said Audrey Robinson, chief investment officer of WaterStreet Group Inc., which counsels high net worth investors. She has been able to negotiate smaller management fees by bringing a group of clients to the table as potential investors. Investors might also get a break if they have a sizable amount to invest or are dealing with a start-up firm.

Your hedge fund manager may not be the right fit

Hedge fund managers may have less experience than you think. Sextant Strategic Opportunities Hedge Fund, which was put into receivership last year, was run by Otto Spork, who spent most of his career as a dentist. "I am looking for someone who is not on training wheels," and has a big part of their net worth in the fund so that person feels "substantial pain" if the fund fails, Mr. Nairne said.

Don't go by early numbers

Some hedges post off-the-chart returns in their early years because their funds are small and nimble. But eye-popping gains can disappear as funds get bigger. For instance, Lawrence Partners Fund, which posted a 75-per-cent return in its first full year in 2006, lost 81 per cent in 2008. Ignore set-up years because "guys can really knock the ball out of the park when they have very little money," Mr. Nairne said.

Leverage can boost returns - and destroy them

There are no restrictions on how much money a hedge fund can borrow. If lenders call in their loans, as some did during the 2008 market downturn, investors can suffer big losses as managers are forced to sell securities in a falling market to raise cash. Be cautious about any fund that has borrowed more than twice its assets. The funds that got hurt the most or went out of business that year were highly leveraged, said Thane Stenner, director of wealth management at Richardson GMP Ltd.

Performance fees can lead to risk-taking

Hedge funds typically charge a 2 per cent management fee, as well as a 20 per cent performance fee for outpacing a specific hurdle rate, index or high-water mark (peak value of a fund). The performance fees can light a fire under a manager to excel, but can also backfire by encouraging risk taking. "One of the inherent flaws with performance fees is that a manager could take excessive risk," warned Pavan Arora, director of PARK Private Wealth Inc.

Fees can be confusing

Most funds need to recoup losses before charging a performance fee, but some can reset the high-water mark every year or few years. For instance, Salida Multi-Strategy Hedge Fund needs to only beat its highest value over the previous 12-month rolling period. Funds with a reset button are in a "heads I win, tails I win" situation, said Ms. Robinson.

You can't always sell

Some hedge funds come with "gates" that restrict withdrawals during heavy redemption periods. Some have a lock-up period when investors can't sell. Investors typically must give advance notice - ranging from about five to 60 days, depending on the fund - to get their money back. A fund may have 30-day redemption policy, but if it is valued monthly, it may take longer to get money back because "you can only get to sell at the end of the month," Ms. Robinson said.