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.
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.
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.
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.
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.
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, B.Comm., CFP, CFA is the Senior
Investment Analyst with Sterling Mutuals Inc. He can be reached at dhallett@sterlingmutuals.com Sterling Mutuals Inc. is registered as a
mutual fund dealer in Ontario, British Columbia, Alberta, and Manitoba.