Look before you hedge

Kelly Rodgers, MoneySense September/October 2003

Chances are that your financial adviser is trying to sell you on the merits of hedge funds. These funds, which use alternative investing strategies, are all the rage because they performed relatively well during the last three years, when most mutual funds sucked wind. But before you make your adviser's day and say yes to whatever fund he's touting, consider a few facts he may not mention.

The most important of these facts is risk. While most mutual funds restrict themselves to buying some combination of stocks or bonds, hedge funds use more exotic tactics to boost results. For example they can go "short" by selling stocks the don't own in an attempt to benefit from falling stock prices. they can also "lever" your investment by borrowing additional money in order to magnify the size of the bets that they place.

These strategies can be very successful and result in double-digit returns. Problem is, they can also backfire and if they do, your hedge fund will plummet faster than a falling brick. Until a few years ago, hedge funds were restricted to rich investors - people who could afford to take a big loss. Today thresholds have been lowered so that you can buy some hedge funds for as little as $500. But the fact that hedge funds are more accessible doesn't make them appropriate for all portfolios. You must ask yourself if you can stomach losing money

This is a real danger. Your adviser might tell you that a good hedge fund will make your portfolio less volatile because a hedge fund can go up even when stocks go down. But while this is true in theory, it's difficult to know if it's true of any single hedge fund. Yes, hedge funds as a group tend to have low volatility when you look at measures like standard deviation. But other critical measures of volatility - such as "skewness," which measures the probability of winning big or losing all your money - show that hedge funds are still dangerous. A big loss in a single year can cripple them.

Proponents of hedge funds like to quote figures that show that such funds, as a group, have done very well. Keep in mind that those returns are partly due to what's known as survivorship bias. That is, only funds that have survived the dismal markets of the past few years are included in the statistics. Those that blew up are no longer included in the averages because they no longer exist. As a result, many hedge fund indexes overstate the group's returns and understate its volatility.

To make matters even more complicated, we don't have enough of a track record to assess the host of new players that have popped up since 2000. Of the 82 hedge funds listed in Morningstar Canada's database, only 22 have three year track records and only four - four! - have five-year track records. In most cases, you are buying an unknown quantity. Three years is simply not long enough to determine whether good returns are due to skill or luck.

A hedge fund can be a good addition to your portfolio only if you're aware of the risks and you understand exactly what you're investing in. The following tips can help steer your choice:

• Avoid funds that charge a management expense ratio (MER) of more than 3.25%, including performance tees. Big fees eat up profits and leave little for you.
• Don't fall in love with any single manager. Hedge funds that follow similar strategies tend to have similar returns. So no matter how good a manager's track record, you shouldn't be paying more in fees than similar funds are charging.
• Start with a "fund-of-funds." These funds invest in a number of different funds, giving you diversification across different managers and investment styles. The result? Less risk. TD Private Wealth operates a good fund-of-funds that is well worth looking at.
• Ensure the fund isn't overly leveraged, since too much leverage means risk. Leverage of three times (which means the fund borrows up to $3 for each dollar you invest) should be the max. This should be spelled out in the prospectus.
• Invest no more than 5% of your portfolio in hedge funds. Your adviser might recommend taking this allocation from the bond side of your portfolio. Don't do it. Treat hedge funds like equities because their ride could be bumpy.