With the current market volatility, many investors have found it difficult to navigate the market to find ‘safe places’ that generate returns beyond government bonds and GICs. Most long-term investors understand the concept of staying disciplined by focusing on the long term. However, we understand this long-term view can get lost when volatility is staring you in the face.

My most recent post "Diversify with Alternative Investments: Pt 1" discussed Structured Notes as an investment vehicle that can help manage volatility and also provide diversification from the conventional asset classes of Fixed Income and Equities. However, alternative investments are not only limited to structured notes. Hedge funds are also alternative investments that can provide investors with diversification and risk management.

Hedge funds are complex investment vehicles that can employ different strategies to meet investors’ objectives. Hedge fund managers attempt to create a better risk-adjusted return compared to traditional fixed income or equities. Some, but not all, hedge funds will use leverage to enhance returns and/or to help manage risk. If used inappropriately or excessively, leverage can potentially magnify losses. Therefore, it is critical to seek an advisor to help review the specific hedge fund strategy to determine whether the investment is suitable for you.

Like mutual funds, hedge funds have a wide variety of strategies. Some focus on growth enhancements and aim to capture the most upside. Others are more conservative and aim to be a counterbalance to traditional equities.

The two strategies in focus today will be those that manage volatility and provide less of a correlation to the overall markets. In other words, these strategies try to “zig” when the markets “zag”.

Equity Market Neutral: This strategy attempts to provide returns that are not derived from the overall direction of the markets. This is accomplished by taking offsetting long and short positions which in effect neutralize market exposure. Many market-neutral funds use arbitrage strategies based on statistical correlations or other qualitative approaches. The returns of these funds are largely driven by stock selection which can differ greatly from the overall index.  Due to the complexity of the strategies involved, the fees can also be higher.  These products should not be treated as core holdings and are not appropriate for all investors.

Long/Short Equity: These managers typically incorporate a net long bias. This means they are generally long more stocks than they are short stocks. They attempt to reduce general market risk through short positions on indexes or what they perceive to be overvalued stocks. They also aim to earn a return through long positions in what they perceive to be undervalued stocks. This strategy can complement existing equity portfolios that want to participate in the market with less risk exposure.

The goals of these hedge funds are to minimize volatility and to generate better risk-adjusted returns. However, they are not immune to market downturns. When the markets decline, hedge funds will also experience losses, especially for funds with a bias towards long positions. With that said, investors in hedge funds expect these losses to be more muted with their short positions helping to offset losses.

Before making investments into hedge funds, one must consider the risk and structure of these funds which can include, but are not limited to:

• Liquidity
• Fees
• Transparency of fund (ie. strategies, pricing, and valuation)
• Manager's track record
• Regulatory Framework

Hedge funds can be seen as a diversification vehicle for traditional equities and fixed income portfolios. However, the complexity of these strategies may not be suitable for everyone. Investors considering to incorporate hedge funds  into their portfolios need to understand the risk and structure of these strategies. To determine if these types of strategies are suitable, speak with us so we can review your situation to provide a recommendation of the products that would appropriately fit your investment goals.

 

 

The content in this article is for information purposes only and does not constitute advice. It is imperative that you obtain professional advice from a qualified advisor before acting on any of the information in this article. This will ensure that your own circumstances are properly considered, as this investment may not be suitable for all investors. Hedge funds are offered without a prospectus are generally considered high-risk investments.