While savvy market participants say long-short equity strategies are essential for managing risk, retail investors in most provinces are shut out of these investment pools if they are not “accredited investors” – people with portfolios of $1-million or more, or income of at least $200,000 a year ($300,000 for a couple).Belova Larissa/Getty Images
Imagine the dream fund: A long-short equity strategy for retail investors who don't have fat salaries or million-dollar portfolios; one that offers long-term capital appreciation without the hair-raising ups and downs of the stock market – and with less downside risk.
Ideally, this dream fund would churn out net real returns of, say, 4 per cent a year after subtracting fees and inflation. That would mean a nominal return after fees of 7.1 per cent (based on the August inflation rate of 3.1 per cent.) The minimum initial investment could be $25,000 or less, with additional investments of $1,000. It would be eligible for RRSPs and RRIFs. The fees? Who cares, as long as the manager delivers steady returns.
But it's not available for all.
While savvy market participants say long-short equity strategies are essential for managing risk, retail investors in most provinces are shut out of these investment pools if they are not "accredited investors" – people with portfolios of $1-million or more, or income of at least $200,000 a year ($300,000 for a couple). Active traders with solid knowledge of financial markets can create their own hedging strategies, but smaller investors are pretty much left with long-only mutual funds.
Fortunately, some money managers are expanding the mutual fund structure to encompass alternative strategies, including the classic long-short equity hedge. BluMont Capital's Exemplar Canadian Focus fund, for example, seeks capital appreciation through long-short positions in Canadian stocks and equity derivatives. The fund can sell short up to 40 per cent of its portfolio, but cannot use leverage.
Although investors were slow to respond at first, "it's picking up," says James Wanstall, chief executive of BluMont Capital in Toronto. "Our trouble is we're unfamiliar to most people and different is often seen as dangerous."
Historically low interest rates are forcing people at or near retirement age into the stock markets where once they would have settled for bonds or guaranteed investment certificates. A typical investor today might be age 65 with a company pension of $30,000 a year and $300,000 in savings, Mr. Wanstall says. When interest rates were 9 per cent or more, their investment decisions were easy. Not so today.
"Those are the people who need to get their heads around alternative strategies because they can't afford to recover from a drop in their portfolio's value."
Charles Schwab pioneered the long-short mutual fund in 2002 with the Schwab Hedged Equity Fund. Aware that hedge funds draw sideways glances from conservative investors, the firm emphasizes that its offering is "not a hedge fund," but rather a traditional mutual fund that employs a long-short strategy.
So just what is a long-short equity strategy?
Alfred Winslow Jones coined the term "hedged fund" in 1949 to describe his strategy of defending investors' portfolios against big drops in the stock market. To protect against market drops, Mr. Jones balanced his portfolio by buying stocks whose price he expected to increase, and at the same time selling short stocks whose price he expected to decrease. Hedging was a tool for managing risk.
Since then, though, the term hedge fund has been broadened to include all manner of strategies, from the conservative to the purely speculative. This veritable zoo of diverse hedge fund creatures poses a problem for regulators, who are charged with protecting retail investors from their own periodic exuberance.
Indeed, every time stock markets take a dive, regulators move to tighten the rules for hedge funds – and with good reason. In addition to the occasional fraud, these strategies have an unfortunate habit of blowing up in treacherous markets – the very type of situation they were designed to navigate.
Even if they don't blow up, they sometimes don't live up to investors' expectations. In the third quarter ended Sept. 30, for example, hedge funds suffered the worst three months since the depths of the 2008 financial panic, according to U.S.-based Hedge Fund Research. Almost every type of alternative strategy lost money, with average fund losses of 5.5 per cent. For the full nine months, long-short equity funds that hedged their positions turned in the same performance as the Standard & Poor's 500 stock index, including dividends, falling 8.7 per cent, the research organization says.
The BluMont Exemplar Canadian Focus fund, overseen by veteran money manager Veronica Hirsch, is up 11.2 per cent since its inception in May 2008 but down 11.8 per cent for the year to date. The fund requires a minimum initial investment of $1,000. That's a lot less than the $150,000 retail investors – those without fat portfolios or big salaries – would have to plunk down to buy into a hedge fund.
B.C. investors have an advantage in that portfolio managers in the province can buy hedge funds for their clients, who benefit by being able to participate in several different strategies for their $150,000 minimum investment. Bob Thompson, portfolio manager and alternative investment strategist at Canaccord Wealth Management in Vancouver, runs a fund of hedge funds for clients through Thompson Investment Partners.
"The number one reason to own a hedge fund is that it fits with the rest of your portfolio," Mr. Thompson says. "Buy it either to increase returns with the same risk, or for a given return to reduce the risk."
One of the strongest arguments for hedging strategies is that they tend to have a low correlation to the broader stock and bond markets, proponents say. Ideally, they offer steady returns year in and year out that offset ups and downs in other asset classes. The best approach is to combine strategies, says Craig Machel, associate portfolio manager at Macquarie Private Wealth Inc. in Toronto. He thinks investor interest in alternative strategies will rise.
"Investors have become smarter and are asking more questions about how to protect and grow their assets – and how to reduce volatility," Mr. Machel says. Seeking ways to survive turbulent stock markets "leads to the alternative investment space," he adds. "I don't think people are too concerned about how to get down the road. They just want to get there intact."