Is hedging for you?

Many equity fund investors are fed up. They’ve watched their savings dwindle away for the past three years and there seems to be no end in sight. Of course, not all stock funds have lost money. But with the average Canadian equity fund losing 4.3 per cent annually for each of the past three years (to Feb. 28) and the average US stock fund dropping a painful 15.5 per cent, it certainly seems that way.

As a result, some people are looking at alternatives and there is a growing interest in the concept of hedge funds. These used to be seen as the preserves of the super-rich but lately more are being targeted at average investors.

Not all hedge funds operate the same
The concept of hedge funds is difficult for many to grasp and not all hedge funds operate in the same way. They may employ a variety of techniques, including short-selling, spread trades, currency speculation, and leverage. In theory, hedge funds are supposed to be lower risk than traditional equity funds because of the flexibility available to the managers. In practice, however, some hedge funds have been financial disasters. So don’t assume that putting your money into a hedge fundill keep it safe. It could be quite the opposite.

That said, the best of these funds can indeed provide that ideal combination of below-average risk and above-average returns. As my co-author Prof. Eric Kirzner, a hedge funds expert, writes: “Overall, hedge funds have the potential for solid returns over the long run since the return from these funds is not usually dependent on the performance of bond and equity markets. The record thus far supports this. A properly designed hedge fund should have the effect of reducing your overall portfolio risk, since it will have a low or zero correlation with the rest of your positions.”

Top performers
The top Canadian hedge fund in the past year that publicly reports results (not all do) is the Sprott Hedge L.P., which gained 39.5 per cent. It is now closed to new investors, but the company is offering Sprott Hedge L.P. II, which was launched last August and which was ahead 17.9 per cent for the three months to the end of February. As with most hedge funds, you need a minimum of $150,000 to get in, except for residents of Alberta, B.C., Manitoba, P.E.I., and New Brunswick, where the minimum is $97,000 and Newfoundland, where it is $100,000.

If you think you would like to add a hedge fund to your portfolio, here are some options that may be more within your budget range. As always, talk things over with a financial advisor before acting.

For example, let’s look at the company’s US Market Neutral Portfolio. The fund’s mandate is “to produce positive returns on an annual basis by combining a long portfolio with a short portfolio in such a way as to largely neutralize the impact of overall market movements on the portfolio’s return.” How well has it succeeded in that goal? Not very. This fund lost 26.3 per cent in the past year. That was worse than the average US equity fund and worse than the performance of the S&P 500 Index. The fund was also a big loser in 2001.

The Canadian L/S Portfolio has fared better in relative terms, so if you’re looking for a hedge fund from this company you may want to wait until it is open again. Note that @rgentum also offers several regular equity funds.

Next page: More funds, and a warning

The Mackenzie Long/Short Equity Fund uses a multi-manager approach, employing the talents of several hedge fund experts around the world. The company says that this approach has an advantage over single manager strategies “by smoothing out the impact of market conditions or investment styles on any one manager’s performance.” The goal is to provide superior returns while providing downside protection in falling equity markets. Results so far are inclusive; the fund was down 7.3 per cent in the year to Feb. 28, but that was certainly a better result that the S&P/TSX Composite Index or the S&P 500 in the States.

The company describes itself as “market neutral specialists”. Says their website: “We don’t rely on instinct or sentiment – we rely on a sophisticated investment process to create superior investment portfolios that can weather any market condition. Our funds are market-neutral, sector-neutral, and style-neutral, with returns that are anything but neutral.”

We’ll need more time to assess whether they can indeed provide superior returns over the long haul. However, the early results are encouraging. The Market Neutral Equity Fund shows a one-year gain of 7.9 per cent. Few people would feel unhappy with that result, given what’s happened to equity markets in the past 12 months. Most of the other funds date from the fall of 2002. All are performing well thus far.

The SciVest funds are sold on a front-end load basis only and the annual fees are high so check out all the details before making a decision.

Understand what you buy
Obviously, this is a new field for Canadian fund managers and they’ve only dipping their toes in the water so far. But if investor demand is there, more products will follow. But remember the classic rule: if you don’t understand what you’ve buying, pass. For many people, hedge funds will fall under that warning.