In 2007 Craig Machel looked at the state of the world and didn't like what he saw.
At the time, global equity markets were in the twilight of the longest bull market in modern history. The TSX composite had grown 14 times in value in 30 years. But it was the recent market swings that got him questioning some long-held assumptions about investing.
"You see world markets and the economy are completely volatile and uncertain, and you step back from it all and realize it doesn't have to be linked to all that volatility and uncertainty."
The Macquarie Private Wealth Management investment adviser noticed how most asset classes tended to move up and down almost in lock-step, making it pointless to use diversification as a way to reduce risk.
"Where investors really get it wrong is they include diversity in name and geography, but it's not really diverse," he says. "A lot of Canadians go with this notion of 70 per cent equities, 30 per cent fixed income and that's a balanced approach. It's been set in stone for decades and, for some reason, people stick with it."
That's when he decided market-neutral investing was the only way to make money without putting his clients' savings at risk.
The objective of market-neutral investing is to make gains regardless of the direction of the broader markets. Hedge strategies are implemented to target specific returns. The returns are generally modest and that's why it's only effective with high-net-worth investors, where returns as a percentage of assets invested can be significant.
Each strategy is tailored to the individual client: "Clients need to determine the outcome they want and the risk they're prepared to take," Mr. Machel says.
A few months later his decision proved right when the debt-burdened global financial system suffered a spectacular meltdown. From January of 2008 to the spring of 2009, the TSX composite lost nearly half its value. Over the same period, he says his more conservative market-neutral portfolios posted returns of between 6 per cent and 8 per cent annually.
"Through 2008 and 2011 the conservative hedge strategies made money without any capital fluctuation," says Mr. Machel, who now manages 80 high-net-worth clients with assets totalling $70-million.
The downside of market-neutral investing, however, is the broader market's upside. In 2010, the TSX rebounded with a 13-per-cent return. The market-neutral portfolio once again grew by about 7 per cent.
"Conservative portfolios and strategies that made money in tough markets won't keep up with fast-running equity markets," he says. On the flip side, returns remained in the 7-per-cent range in 2011, when the TSX lost 11.5 per cent.
One of Mr. Machel's market-neutral strategies invests in a pool of capital that draws income from private real estate. It collects yields from rent without the volatility of an exchange-traded security. "We're streaming out a yield of 8 per cent per year and it's deemed as REIT [real estate investment trust] income, so that's a tax-free return."
His market-neutral strategies, and returns, vary from 10 per cent from riskier ventures to 4 per cent or 5 per cent from simple dividend stocks, he says. Some strategies even lose money, but Mr. Machel says the key is to be diverse and flexible. "Each strategy needs to have its own ability to make money and provide value, and add individual strategies that have their own unique value and return stream."
A volatile global economy and the ongoing European debt crisis have boosted the popularity of market-neutral investing recently but it's nothing new for Bob Tebbutt. As vice-president of corporate risk management at Peregrine Financial Group Canada he implements hedge strategies to protect institutional investors from market volatility through commodity and currency derivatives.
He has a warning for everyone who holds assets in Canadian dollars: "The American dollar is going to continue to weaken against all currencies, along with the Canadian dollar. Those investments are going to lose some of their value based on the drop in the U.S. dollar."
He says even investors who already have hedges in their portfolios should hedge currencies through the options market. "The advantage of options is you get strategies developed that give you all of the upside and protect on the downside."
He also suggests hedging the Canadian dollar through commodities such as copper, aluminum and oil – which are priced in U.S. dollars. "Investments in companies that produce those kinds of items will benefit from higher prices," he says.
Mr. Tebbutt expects disasters like 2008 to become more prevalent and says hedges should stay in place until debt-laden governments around the world get their finances in order – something he doesn't expect to happen soon.
Special to The Globe and Mail