Message from Ed

Would you be interested in an investment that earns 10% or more virtually every year and never loses money? Some hedge funds have been doing this for years, even through our recent bear market. Ed is now a Certified Hedge Fund Specialist (C.H.F.S.) - one of the first 15 or 20 investment advisors in Canada to get this degree. Should we consider adding hedge funds to your portfolio?

Hedge funds have generated a lot of interest lately, since they have been showing up near the top of the performance charts. The good news about the recent 3-year bear market is that we now have a hedge fund industry in Canada. Hedge funds have been popular in the U.S. and Europe for nearly 20 years, many operating from tax-free jurisdictions, but there were only a handful in Canada 3 years ago.

First of all, what is a hedge fund? Hedge funds are like mutual funds, except that they:

1. Can generate positive absolute returns in both rising and falling markets.
2. Are designed for high net worth or sophisticated investors.
3. Usually have a key priority of minimizing (hedging) risk.
4. Have much more flexible investment options and operate with much less regulation.
5. The manager charges fees mostly based on the performance of the fund.
6. The manager tends to invest much of his own money in the fund.

How has their performance been? They have had both higher returns and lower risk than stock markets. The Tremont world hedge fund index has average returns since 1990 of 11.8%, while the MSCI world stock index had returns of only 6.8%. At the same time, the worst ever drawdown (decline from top to bottom) has been only 13.8%, compared to 35.3% for the stock market.

In fact, the Canadian hedge fund with the longest track record has averaged 19.5%/year for the last 12 years, has volatility less than government bonds, the largest drawdown is only 2.25%, and has made more than 8% every year.

Are there different kinds of hedge funds? Many articles talk about hedge funds as if they can all be put into one category. The difference between aggressive and conservative hedge funds is at least as wide as with different mutual funds. They include conservative strategies, such as market neutral equity, convertible arbitrage or merger arbitrage, and aggressive strategies, such as long/short equity, futures trading and global macro.

Why should we consider them for our portfolio? Studies have shown that adding even 10-20% hedge funds into a portfolio significantly reduces the risk of the portfolio, while usually increasing the returns. On the other hand, an aggressive hedge fund can earn us a higher profit, without increasing risk.

Most pension funds and university endowment funds now include some hedge funds in their portfolios. In fact, the Yale endowment fund, which is probably the best managed university fund, now has nearly 30% in hedge funds.

That sounds great. So why shouldn't we all buy only hedge funds?

1. There are many potential risks other than temporary market declines. Hedge funds are mostly unregulated, often use very complex strategies, and are based on a manager and a model that may or may not work. These risks can be minimized with in-depth due diligence.
2. They will probably not keep up with markets in a strong bull market or strong market recovery (except for aggressive hedge funds).
3. Not everyone can afford them since the minimum investment per fund is $150,000 in Ontario (although there are some ways around this limit). There are also exceptions for people with incomes over $200,000 or investment assets over $1 million.

So what do we conclude?

1. They are a great investment. Everyone that can afford hedge funds should include them for at least a portion of their portfolio.
2. Don't buy hedge funds without doing in-depth due diligence or without getting advice from a knowledgeable, trusted advisor.