Hedge funds flourish despite risks

Canada's so-called alternative investment strategy industry says the sector is growing and the instruments themselves have received a bum rap regarding their risk.
Canada's hedge fund sector is growing, with two new funds launched last year. ((Canadian Press))
You might think, in the wake of the 2008-09 recession and this year's European debt crisis turbulence, that any investment that has the term "risk" attached to it would be as popular as a personal trainer at a junk food convention. After all, many experts blamed various financial instruments involving mortgages, including some hedged vehicles, for the U.S. subprime mortgage meltdown.

But Canada's so-called alternative investment strategy industry says the sector is in fact growing and the instruments themselves have received a bum rap regarding their risk.

"Hedge funds can do everything mutual funds can't do," says Gary Ostoich, who is president of Spartan Funds Management Inc., a Toronto-based wealth management firm that uses hedge funds, and also president of the Alternative Investment Management Association, essentially the hedge industry association.

On the other hand, there is that pesky "R" word — risk.

"While hedge funds may make sense for certain accredited investors, the combination of data issues, downside risk and structural characteristics suggests that hedge funds, on average, may not offer the desired return and diversification goals," says senior analyst Christopher Philips of U.S. investment managers the Vanguard Group.

High growth

Regardless of the real or perceived risk involved in holding hedge funds, Ostoich is dead right about the sector's growth.

Canada's hedge fund industry is worth about $30 billion, according to the Alternative Investment Management Association (AIMA). That's a small fraction of the estimated $1.7 trillion US held by American hedge funds, but it's still a doubling of the Canadian sector's dollar value since about 2003, Ostoich said.

That growth shows few signs of slowing. Last year saw the startup of Lawrence Park Capital Partners, a hedge fund led by former Deutsche Bank managing director David Fry, and East Coast Fund Management, headed by a pair of ex-execs from Scotiabank and RBC. 

AIMA says Canada's funds have seen an uptick in investment in the last four to five months, with institutional investors in particular drawn to them. 

Fees are also dropping. Instead of the industry's erstwhile "2/20" standard of a two-per-cent annual management fee plus 20 per cent of profits, East Coast is assessing a 1.25 per cent management fee and only collects its share of profits in years where the annual return is above four per cent.

As well, Canada's hedge sector — paralleling the development of the industry worldwide — has become much more sophisticated.

From a single style…

At its beginning in 1949, the first hedge fund was a financial pool in which the manager would hold some shares, or stay "long" in the stock, but also bet against others, by going "short."

The result can actually be pretty conservative in terms of risk, the idea went, because if markets tanked (or skyrocketed), not all of the hedge fund's positions would fall or rise concurrently. The fund would lose money on some equities but make a profit on others.

Nowadays, there's myriad strategies and funds that employ them.

Hedge funds can be more conservative or far more volatile than the underlying market, depending on their strategy and leverage. (Richard Drew/Associated Press)

Some funds still use the traditional long-short position strategy. Others use arbitrage strategies, trying to lock in profits from inefficient pricing between related bonds, equities and futures.

A third class of investment methods tries to extract short-term profits from the market volatility sparked by corporate events such as mergers or bankruptcies. Funds will buy distressed stocks where the underlying companies are insolvent, or will try to make money on stocks that are takeover targets by other companies or individuals.

All those investment tactics tend to be market-neutral, meaning the overall profitability isn't affected by whether stock and bond markets are trending up or down. Other hedge fund strategies, generally seen as riskier, do expose investors to the broader market's direction. They can involve moves like trading in commodities, placing bets on currency fluctuations in advance of interest-rate changes, or plowing money into emerging economies.

The rising number and different types of funds in Canada's alternative sector basically ensures that knowledgeable investors, the only buyers currently allowed to purchase these instruments, can find a fund to fit their risk tolerance and return goals, Ostoich says.

Purchasers are basically limited to individuals spending more than $150,000 on hedged investment vehicles and so-called "accredited investors," such as pension plans and mutual funds.

Opening up the sector

As hedge funds become more varied and sophisticated in Canada, the rationale for preventing retail customers from buying these instruments is becoming increasingly moot, Ostoich says. Provincial regulators, especially the Ontario Securities Commission, should really look at dumping the restrictions, he says.

"That's the next big challenge," Ostoich said.

That debate, however, is part of the bigger question of whether hedge funds should become more mainstream or stay as a specialized investment.

In one corner, Ostoich and others argue the funds can be structured to be more conservative than mutual funds or other more conventional investments. For example, North American markets shed approximately 40 per cent of their value during the 2008-09 financial meltdown, Ostoich said. Meanwhile, hedge fund losses were in the range of 25 per cent, he said — a huge amount but less than the overall equity market.

Ostoich's own fund actually posted a positive return of three per cent in 2008, though it lagged behind the market in 2009. Since its inception five years ago, it's outpaced the market more than fourfold.

But independent analysts have often argued that these financial instruments, as they are generally used, often boost volatility in the securities marketplace. In addition, investors who might perceive hedge funds as riskier investments could be more likely to redeem their holdings more quickly in the face of a weakening equity market.

For now, though, that concern is academic, since hedge funds remain out of reach of most Canadian retail investors.