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If you're thinking about investing in a hedge fund, read this first

The first article I wrote for the Report on Business in 2006 was one of my most controversial. It questioned the value of hedge funds. Not how they invest, but rather their high fees, lack of transparency and, in general, client-unfriendliness.

These funds, which represent a broad array of investment strategies, have had their ups and downs since that time. They've grown significantly – the latest tally is $3.2-trillion (U.S.) – but have come under increasing scrutiny. Investors are saying, "I bought the sizzle, but where's the steak?" In general, actual returns have not justified the fees and complexity. As it turns out, the managers have done much better than the clients.

Nonetheless, hedge fund-like products are creeping into portfolios of individual investors. I'm referring to investment products where the manager shares in the profits, or what I fondly refer to as "fee impaired" funds.

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To justify higher fees, these fund managers have to do things that are different and difficult. That might mean using leverage, shorting, private securities, and various forms of arbitrage and hedging. In addition, managers point out that performance fees better align their interests with clients. "When you do well, I do well."

If you're considering such a product for your portfolio, you and your adviser have some work to do. You need to know how it works, what the risks are, how much you're paying and, importantly, who you're dealing with.

Sources of return and risk

First off, you should understand where the profits are expected to come from. I mean the basics, not the details. The strategy should make sense and fit well with the manager's experience. Using leverage, shorting stocks and taking advantage of illiquidity require special skills and temperament.

Bob Hager, my former partner at PH&N, regularly reminded me that with any investment product, it always comes down to bonds and stocks. That's what drives returns. Well, he's right about that, but with additional strategies layered on top, the character and timing of the returns and risks can be different. Not to mention that increased complexity broadens the range of outcomes.

Hedge funds have risk profiles ranging from conservative to aggressive. A good rule of thumb is, if the product promises equity-like returns, then it has equity-like risk. Warning bells should go off if the marketing materials promise high returns with little or no risk.

How impaired?

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The fees may be as hard to understand as the investment strategies, but it's important to know if the manager will be rewarded for exceptional performance, or simply because markets go up. If he loses money, is he required to make it up before collecting additional performance fees?

In a well-designed fund, the performance fee doesn't kick in until after a minimum return has been achieved. If the manager gets above the hurdle rate, as it's called, then he shares in the additional return, usually to the tune of 20 per cent . Unfortunately, many funds don't have a hurdle rate. In other words, they get 20 per cent of the first dollar earned.

Another element to look for is what's called a "high-water mark." The HWM requires that the fund recoup any prior losses before further performance fees are collected. The HWM should be perpetual, although some funds have an annual reset (they get to start fresh after one year). For me, if the HWM isn't perpetual, it's a deal breaker. I'm not willing to give the manager all the upside while limiting their downside.

The bar is higher

I've had experience with fee-impaired funds for two decades, both personally and on behalf of institutions. If the manager and fund structure is right, they can be a nice complement to the bulk of your assets, which hopefully is at the other end of the spectrum – understandable, low cost and transparent.

To justify client unfriendliness, hedge funds must be held to a higher standard. Before you write a cheque, make sure you know how the fund works, what the risks are and how much you're paying. After all, you want some assurance that you'll do well if your manager does well.

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Tom Bradley is president of Steadyhand Investment Funds Inc.

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