Hedge funds appeal to sophisticated investors

Hedge funds have traditionally been available only to sophisticated, high net worth individuals.  But some companies are creating hedge-related products marketed to a wider range of investors.

What is a Hedge Fund?

The original hedge fund strategy involved two parts – long and short.  The first part involved investing in individual equity positions that the manager thought would increase in value (also known as holding the stock “long”).  The second part of the strategy involved the manager selling other positions “short.”  When a manager sells a position short they believe the position will decrease in value.  The term “short selling” is key to understanding the origin of hedge funds.

Today hedge funds employ various investment strategies, all quite different from one another. What they share in common is that they are actively managed investment funds with absolute return objectives. Performance-based compensation and the ability to use leverage are also typical characteristics of hedge funds.

Hedge funds are often broadly classified as “alternative strategies,” the following are some of their strategies:

  • Long/Short Equities
  • Equity Market Neutral
  • Dedicated Short Bias
  • Emerging Markets
  • Event Driven (also known as special situations)
  • Fixed Income Arbitrage
  • Global Macro
  • Convertible Arbitrage
  • Managed Futures

Mutual fund companies and small boutiques are among the participants making hedge funds available.  Most of the generally available funds are sold as private placements with high minimum investments and most are of the long/short or equity market neutral variety.  Minimum investments, for those offered by private placement, vary by both issuer and province.  Some hedge funds have included certain limitations to make themselves acceptable for prospectus offerings, allowing minimums as low as $5,000.  Other hedge funds are priced exclusively for the ultra-affluent market with minimums running in the millions of dollars.

Despite the low minimums indicated above, they are not for everyone.  They may not be suitable for investors with total equity investments less than $250,000.  Hedge funds are primarily designed for sophisticated investors and carry with them significant risks that are different from other funds.  Similar to traditional long-only mutual funds, there are only a handful of managers and funds that are worthy of an investment.

The starting point for investors wanting to look at hedge funds is ensuring that they are considered within the context of a well-diversified portfolio and personal risk tolerance.  Certain hedge funds can be useful for providing additional portfolio diversification.   Hedge funds tend to move with a lower correlation to traditional equity markets.

Sophisticated investors with an equity component greater than $250,000 may want to know how much of a portfolio is appropriate to allocate to alternative strategies.  Provided the sophisticated investor also has a high tolerance for risk, five to ten per cent of their equity component is a reasonable allocation.

Hedge funds have been somewhat less than fully transparent from a reporting perspective.  As a result, people should obtain a detailed understanding of a fund’s manager, their strategy, and fee structure.  Most hedge funds have two components to their fee structure, the management fee and performance fee.  Management fees may typically run between one and four per cent a year.  Typical annual performance fees are between 10 and 20 per cent of the total return of the fund.  Management fees and performance fees vary from fund to fund.

For investors wanting to invest in hedge funds, we recommend doing your research.  The first thing you may come to realize is that certain strategies carry higher levels of potential risk than others.  Experienced investors ensure they obtain an understanding of the potential risk and return characteristics of the strategy itself.

Risk is not necessarily what has happened in the past but what could happen in the future.   Beyond the strategy itself, it is important to review the credibility and experience of the manager.

Here are some important questions to ask prior to investing in a hedge fund o ask prior to:

  • What is the investment training and background of the manager and their team?
  • Are the managers investing some of their own assets in the fund?
  • Have the managers ever run a hedge fund before?
  • What is the hedge fund’s strategy?
  • How does the strategy work, and what are the parameters or guidelines outlining what the manager can or cannot do to implement the strategy?  What is the extent of leverage, position sizes, etc.?
  • What is the level and consistency of reporting results? Are explanations of those results supplied?
  • What are the fund’s risk management and compliance procedures? Are they effective?
  • How liquid is the hedge fund? (this should be consistent with your time horizon)
  • What are the fees to sell?
  • What are the management and performance fees of the hedge fund?

The number of structured products and alternative strategies, like hedge funds, are continuously growing.  Hedge funds are also becoming more accessible.  There are major variations in the quality, structure, strategy and risk of hedge funds.  We strongly recommend that people be very careful prior to investing in hedge funds.