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Craig Machel, an adviser and portfolio manager at Richardson GMP in Toronto.

Andrew Kolb

Pity the poor stock investors with nothing to protect them from the next bear market.

Six years of nearly unbroken gains may have restored confidence in financial markets, but the good times can't roll forever. The reversal, when it comes, could be big.

In the 2008 panic, the drop from the market peak in 2007 to the bottom in 2009 was roughly 50 per cent in both Canada and the United States. Investors who hung in made their money back and more, eventually, thanks to an unprecedented bailout of the financial system by central banks. Those who panicked and sold didn't fare so well.

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But it's not the job of central bankers to bail out the stock market, so after such a strong rebound, it may be time to do a little hedging.

"Our view is that the easiest money has been made," says Craig Machel, an adviser and portfolio manager at Richardson GMP in Toronto who specializes in alternative investments.

Valuations are being stretched, growth in corporate profits and the economy is slowing and a U.S. interest rate increase looms on the horizon. The challenge now is to achieve decent returns without taking too much risk, Mr. Machel says.

Hedging has become a little easier for Ontarians. As of May 5, residents of the province wanting to invest in alternative strategies no longer needed to have high incomes or plunk down a minimum $150,000 in a single investment. Investors with discretionary accounts – where the adviser is a licensed portfolio manager who can buy and sell at his or her discretion – are now able to buy hedge funds in smaller amounts, allowing for greater diversification.

Before this, Ontarians had to have income of at least $200,000, or $300,000 with a spouse – and cash and securities of more than $1-million. The changes bring Ontario into line with the rest of the provinces.

The good thing here is that these investors will be dealing with a discretionary portfolio manager, says Neil Gross, executive director of investor advocate FAIR Canada (Canadian Foundation for Advancement of Investor Rights). "Those types of investment people have a fiduciary duty to act in the best interests of their clients," he says. As well, discretionary portfolio managers must have the highest level of proficiency in order to be licensed in that category, he adds. "One can be comforted by that."

Investors still need a fair amount of capital to engage the services of such an adviser, and not all portfolio managers deal in hedge funds. While some have no minimum, in practice discretionary accounts tend to have investable asset of $500,000 and up, with $1-million being the norm for investment counsellors.

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Removing the income barrier means that a teacher, for example, who is planning to commute her pension – take the cash value – will be able to invest in a broader array of alternatives than before. Some people with defined-benefit pensions are taking the cash value because the amount is higher when interest rates are low, like they are now.

True, hedge funds have been tarnished over the past decade by some spectacular blowups, but they are not all equally risky.

Take the classic market-neutral, long-short fund. Typically, this fund will buy – or go long – the strongest stock in each category and sell short the corresponding weakest one (short selling is the selling of a stock that the seller doesn't own). For example, the fund goes long on the strongest insurance company and sells the weakest one short.

In theory, when the market is rising, the strongest stocks will rise more than the weaker ones, so the fund makes money. When the market is falling, the weakest stocks can be expected to fall the most, so again the fund stands to make money, or at least not lose as much.

This is the type of fund the legendary John Templeton invested his own wealth in during the years leading up to the 2008 panic. He died in July of 2008, just three months before he would have seen his strategy play out. He was 95.

Waratah One, the market-neutral strategy managed by Waratah Capital Advisers Ltd. of Toronto, is the type of classic market-neutral fund Sir John might have invested in if he were alive today. It caters to institutional investors and wealthy individuals, selling directly and through advisers. Waratah was founded in 2010 by Blair Levinsky and Brad Dunkley, who formerly ran the long-short equity strategy at Gluskin Sheff + Associates Inc.

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"Where Waratah One really shines is not giving anybody a heart attack," Mr. Dunkley said in an interview. "Big down years really eat away at all the hard work accomplished in the years prior."

The goal is to "minimize the worst possible experience," which should appeal to investors who care about capital preservation.

Waratah One's target return is 8 to 10 per cent a year. Its average annual return since inception is 7.7 per cent. Over the same period, the relevant benchmark returned 13.7 per cent, so you are giving up potential return for peace of mind.

Indeed, the Waratah fund's return came with much less volatility. Its largest drawdown since inception – the peak-to-trough drop – was 2.5 per cent. The biggest drawdown for the benchmark, in contrast, was 15.9 per cent.

"If I'm looking at my statement and my million dollars just turned to $600,000, the pain is too much," Mr. Dunkley says. "I'm the guy who doesn't even want to see a big loss on paper."

A fund that has caught Mr. Machel's eye is EdgeHill Partners' EHP Advantage A fund, a long-short hedge fund designed to produce returns of 10 per cent to 12 per cent a year with "substantially less risk and volatility than the market," he says. It is a little different than the Waratah fund in that it is based on a quantitative model, although it actively gears down risk in declining markets, rotating to more defensive stocks and strategies to preserve capital.

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The EHP Advantage A buys undervalued, rising, stable stocks and shorts overvalued, declining, volatile ones. As of March 31, the EHP Advantage A fund was up 28.7 per cent since inception in April 2013 – a short but promising track record.

Neither the Waratah One nor the EHP Advantage A has weathered a bear market, although their managers have. Just because you hedge doesn't mean you can't lose money.

The point, Mr. Dunkley says, is that a properly hedged fund can be expected to lose less than the market and could even make a little money. As with all stock investments, there are no guarantees.

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