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Stable returns?
Investors have been jumping at alternative investments largely on the promise that they will deliver stable returns regardless of how stock markets perform. Many hedge funds promise annual returns of 8 per cent or more. That looks pretty good if you believe, as many do, that the stock market is expected to return just 3 per cent annually over the next decade.
But can hedge funds really deliver the goods? Not necessarily, says Atanu Saha, a Canadian-trained academic who has studied hedge funds at Princeton University. In a recent review of the U.S. hedge fund market from 1996 to 2003, Mr. Saha and his colleague, Burton Malkiel, found that hedge funds did not do any better than the Standard & Poor's 500-stock index and they often provide misleading performance figures.
"We conclude that hedge funds are far riskier and provide much lower returns than is commonly supposed," said their study, which was done for Analysis Group, a Washington-based research organization.
In an interview, Mr. Saha said a product known as a "fund of funds," in which one fund invests in several others, typically do even worse. These funds are popular with average investors because they are supposed to spread out risk. According to Mr. Saha's research, they underperformed the S&P 500 by almost 5 per cent.
He and other researchers have also raised concerns about how hedge fund companies report their performance. Because there are few regulations governing hedge fund companies, they don't have to report results regularly. In some cases, companies wait until they have a batch of favourable results and then cherry pick the best numbers to "backfill" earlier performance.
Mr. Saha said the only solution to all this is mandatory reporting. "Investors should be allowed to make an informed decision, and [in] the state of the world as it is today, that's not possible," he said in an interview.
The industry has shot back by arguing that Mr. Saha's research is outdated and that most funds regularly report audited results to investors. Many industry players also say the same sorts of reporting issues raised by Mr. Saha are not exclusive to hedge funds but can be found in stock market and mutual fund indexes.
Another issue confronting hedge funds is fees. Typically, hedge funds charge a management fee based on 2 per cent of the fund's assets. The manager also gets 20 per cent or more of any profit. A fund of funds often has layers of additional fees. By contrast, most mutual funds charge a management fee of about 1.5 per cent of assets and they don't award performance bonuses.
The industry defends the bonuses by noting that managers play a far bigger role in hedge funds than in mutual funds. But others say the high fees make it more difficult for hedge funds to generate returns for investors. Some of the Portus funds, for example, had to earn more than 13 per cent annually just to cover all the fees.
A recent report by the Investment Dealers Association of Canada (IDA) also said many funds do not fully disclose their fees. For example, the report said 30 per cent of Canadian fund of funds companies did not disclose performance fees.
The IDA, the self-regulating agency for Canada's brokerages, also noted that while managers pocket a share of the profits, they don't share in the losses. "The asymmetry gives the manager an incentive to take undue risks, including extensive use of leverage, particularly where the manager is still guaranteed some compensation through other fees whatever the performance," the IDA said.
"The management fees [in hedge funds] are exorbitant by any standards," said one industry player who did not want to be identified. "I agree that there's a very good argument about mutual funds charging 2.4 per cent to underperform the U.S. market is expensive. But hedge funds are just twice as expensive."
Some hedge funds include a so-called high-water mark, a performance level that must be reached before a manager receives a bonus. For example, if a $100-million fund earns 10 per cent in a year and grows to $110-million, that becomes the new high water mark and future bonuses are calculated only on returns over that amount.
High turnover
The trouble with these hurdles is that if a fund consistently fails to reach them, a manager can simply close the fund. Many observers say that's one reason the turnover rate in the hedge world is so high (around 10 per cent of funds close annually). Other researchers have found that hedge fund managers who perform poorly in the first half of the year tend to "roll the dice" in the latter part of the year in order to hit the mark. If they fail, they disband the fund and start another one.
One of the fastest-growing features in the Canadian hedge fund market has been the "principal-protected note." These notes, typically backed by a bank, offer investors a guarantee that their initial investment in the hedge fund will be paid back when the note matures, usually within 11 years. But the structure of these products can make it difficult for a manager to produce returns beyond the guarantee. Let's say an investor puts $100 in a principal-protected hedge fund. The fund manager has to put at least $70 into some kind of security that will cover the principle protection. The remaining $30 is invested in hedge funds, but it is subject to a myriad of fees.
"There is no guarantee that the investor will earn any positive return on the original investment," the IDA said in its report. It added that tying up money for a decade and then only receiving the principal back "is no small risk" for average investors.
Regardless of all the issues surrounding hedge funds, the bottom line for most investors will be whether they make money. So far this year, hedge funds have struggled and the average returns are less than 1 per cent.
"Is there an appetite for hedge funds? The answer is, if the hedge fund industry can demonstrate results and performance, then there is, and if it can't, then there isn't," says Dan Richards, a Toronto-based fund industry consultant. "The only sustainable business is one that delivers results."
Investor's guide to hedge funds
Who is the sponsor? Understand the company's organization, and find out about its auditors, legal counsel, and so on. For example, is it clear who is backing a principal-protected note? French banks Société Générale and BNP Paribas dominate this market.
What is the investment objective? Do you need it in your portfolio? If so, how much should you invest? Many protected-note products are not tied to hedge funds and others use a variety of strategies to generate returns.
What are the fees? Hedge fund managers typically charge a 2-per-cent management fee and also collect 20 per cent, or more, of any profit. Often a fund, particularly if it is a fund of funds, will charge additional fees.
How are the fund's investments priced and how often are prices calculated? Depending on the fund manager's strategy -- particularly if it uses some exotic derivative -- pricing can be tricky and irregular.
How easy is it to get your money out? What are the lockup provisions? Redemptions can be difficult with hedge funds because many use complicated investment strategies that are difficult to unwind. Fund mangers also usually have the right to suspend redemptions under various circumstances.
Where can you get information? Hedge funds are not as regulated as mutual funds, which means information can be difficult to find. The Canadian chapter of the Alternative Investment Management Association has some general information on hedge funds and it is establishing reporting guidelines.
The alternative appeal
Unhappy with the conservative returns available in the stock markets, Canadian investors have been flocking to alternative products such as those offered by troubled Portus Alternative Management Inc. But the prospect of higher returns also comes with higher risk.
33%: Canadians who plan to invest is some kind of alternative investment in the next 12 months.
6%: Canadians with holdings in hedge funds. Thirty-eights per cent plan to add to their holdings this year.
17%: People who don't own hedge funds now, but might this year.
66%: Canadians who are not confident in the level of regulatory oversight of hedge funds.
47%: Investors who are not confident in the regulatory oversight of income trusts.
Decima poll (based on a sample of 1,018 adult Canadians Feb. 10-13, 2005. Survey is accurate within 3.1%, 19 times out of 20).
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