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Hedge funds - some finer points
Structure and liquidity make for a tough fit

This week, in part two of this four part series, we'll venture into an intermediate class of how hedge funds are structured; we'll touch on how hedge funds differ than mutual funds; and other issues which affect how investors use them in portfolios.

Structure

While their mainstream popularity is a newer phenomenon, hedge funds have been around for more than fifty years. In the U.S., most hedge funds are not traditional funds at all. In fact, they are structured as limited partnerships. Typically, this involves one general partner who invests a lot of personal capital - usually the investment manager - and many limited partners. Think of limited partners as "silent partners" who want a piece of the action but only want to put up some cash - with no interest in taking an active role in the partnership itself.

In Europe and in Canada, it's more common to find a "trust" type structure. Mutual funds are technically structured as trusts, but that's where the similarities end. In Canada, hedge funds are distributed by "offering memorandum", which is similar to a mutual fund's simplified prospectus. While hedge funds are regulated in Canada, they're simply not subject to many of the same restrictions and scrutiny that regular mutual funds face.

As a result, that means individuals investing in hedge funds fall under certain rules. For instance, in Ontario such funds require a minimum investment of $150,000. That threshold can be reduced to $25,000 if investors meet certain income and net worth tests. The reasoning goes something like this: If you're wealthy, you're sophisticated enough to know what you're doing with your money.

Fees

At one time, the investment manager simply took 20 percent of all profits made by the fund. Today, there is usually a flat base fee of about 1 per cent annually, in addition to a 20 per cent take of all profits net of the base fee.

Management fees on mutual funds typically range from 1 per cent on bond funds; to 1.5 per cent on balanced funds; to 2 - 2.5 per cent annually for stock funds.

Some argue that since most of a hedge fund manager's compensation will come from the performance bonus, there is greater incentive for the manager to perform well for fund investors. For this reason, hedge fund managers don't need to manage huge sums of money in order to have a profitable business. By contrast, mutual fund managers aim to gather billions and billions of dollars under their guidance since their fees (as a percentage of fund assets) tend to be lower over time.

Taxes and other costs

Hedge funds often use instruments known as "derivatives". A derivative instrument is simply something that derives its value from something else. Derivatives include things like options and futures. Most derivatives carry with them negative tax implications.

While buying stocks directly can result in favourable tax treatment - by receiving dividends and selling them for a profit (capital gain) - many derivative strategies result in fully taxable income. Also, since hedge fund managers tend to trade very frequently, even capital gains are triggered quite frequently - assuming the strategies are profitable.

High trading frequencies also introduce the issue of brokerage fees. If I buy or sell a stock in my brokerage account, I am charged a fee. Similarly, investment managers incur this fee on behalf of fund investors when positions are sold and others are purchased. Hence, heavy trading is not only associated with higher taxes but also with higher brokerage fees.

This makes hedge funds more suitable for tax-deferred savings plans like RRSPs and other similar plans.

Liquidity

Many of the positions held by hedge fund managers are relatively difficult to liquidate. For example, a manager buying bonds of a distressed company may have little ability to liquidate the holding prematurely. (Just try finding a buyer for WorldCom bonds these days.) Also, recall that long/short fund managers go long (i.e. buy an interest in) stocks they like, while shorting (via short selling or buying put options on) stocks they think will fall in value. Relatively small companies whose shares trade relatively infrequently are often the subjects of a long/short manager's interest. If they don't trade often, it can be tricky to sell them unexpectedly.

In essence, a hedge fund manager takes positions and intends to hold them until his/her expectations are realized. Hence, most reputable hedge fund managers will offer investors the opportunity to sell no more often than once monthly. However, reputable managers should require 60-90 days advance notice of redemption requests. While this may seem like an inconvenience to investors, it's really a measure to protect fund investors.

If this feature turns you off, that should tell you something about how well suited you are to investing in hedge funds.

Be suspicious of any hedge fund that makes it easy for investors to sell their interests more frequently.

Leverage

Hedge funds are aggressive. This opinion isn't based at all on past performance, but rather on the types of strategies employed by many funds. More importantly, my opinion is based on the fact that almost all hedge funds use some type of leverage.

The potential for things to go wrong is substantial if enough wrong bets converge - and the consequences are potentially catastrophic. Strict and prudent risk controls, however, can keep risk exposure to a reasonable level.

An August 2001 report by Assante Product Management illustrated the range of leverage used by various hedge fund categories. (A leverage ratio of 2:1 means that for every $3 of fund assets, $2 is borrowed and $1 is owned.) Assante concluded that high leverage (a ratio of 10:1 or higher) was only employed in the more conservative strategies, while the more aggressive strategies involved lower leverage (ratios ranging from 1:1 to 4:1).

Further, The Hennessee Hedge Fund Advisory Group found in its 2000 survey of managers that hedge fund leverage has been significantly reduced since the 1998 Long-Term Capital Management (LTCM) crisis. (LTCM was a hedge fund run by Nobel Prize winners that collapsed upon the demise of Russia's currency.) Roughly 90% of the managers they surveyed in 2000 reported leverage ratios of 2:1 or less. That is in sharp contrast to the less than 80% prior to LTCM.

(As an aside, LTCM - the infamous hedge fund that was in so deep it obtained a bail out from the U.S. government - failed because of extremely high leverage, more than 50:1, and a huge reliance on historical statistical relationships.)

Next week: A peak into hedge funds' past performance and why the performance can't be taken at face value.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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