Thursday, November 18, 2010

Ultra Wealthy Investors Increase Their Use of Hedge Funds

A recent study of ultra wealthy investors, shows that in spite of the uncertain investment environment, their appetite for hedge funds has increased. The Chicago-based Spectrem Group study on ultra wealthy investors, i.e. those with assets of greater than $25,000,000 found almost 50% of them  owned hedge funds. That was a significant  increase from the 35% that owned hedge funds just 3 years earlier. The average net holdings was $4.6%.

Besides hedge funds,  other alternatives investments gained in popularity as well. More than half, 56%, of households worth $25 million or more owned private equity, 44% had precious metals and 38% invested in commodities. In terms of the distribution of investable assets, alternatives comprise about 20% of overall holdings in an ultra wealthy client’s portfolio with traditional stock and bond investments making up  made the remaining 80%.

In the management of their investment portfolios, the ultra wealthy often follow the investing trends of the sophisticated institutional investors. The trend for institutional investors is to increase the use of alternative investments including hedge funds in their investment portfolios and the ultra wealthy are just following suit.

The Bottom Line

Hedge funds and alternative investment are different from traditional investments and that explains much of their appeal and why they deserve a place in investment portfolios. Those who do not have them in their portfolios, should look seriously at including them.

Thursday, November 4, 2010

Looking For Mr. GoodFund: Chapter 2 - Creating A Workable List of Hedge Funds

Finding a good hedge fund is by far more difficult than finding any other traditional fund or manager. The industry in Canada is both diverse and fragmented, with many small funds. There is no concise and universal definition of a “hedge fund”. Furthermore, hedge funds are marketed through two different markets - the exempt market (for high net worth and institutional investors) and the retail market. Consequently there isn’t a central data base or directory with all of the information readily available.

Our first goal is to identify the hedge funds available in Canada and find some basic information on them. Information on hedge funds can sometimes be found in the mutual fund data bases of Morningstar and Globe Fund under ‘Alternative Strategies’. Also, the Alternative Investment Management Association of Canada’s (AIMA) website contains a directory of members. Subscription services like Global Manager Research Database (GMRD) has additional information on alternative strategies. Pulling names from these places, and including multiple asset class mutual funds, we arrived at a list of about 250 alternative strategy funds.

Creating A Workable List
A list of 250 different funds is both unwieldy and unworkable. The next step is to quickly create a working list of about 40 hedge funds by applying various ‘screens’ or ‘filters’. First we want to eliminate all those alternative strategies that are not hedge funds. This includes precious metals, private equity, distressed securities, high-yield bonds, real estate, and any other fund that is predominately long. Next, we eliminated all those strategies that were structured as principle protected notes or offered to institutional investors only. We wanted hedge funds that have an established track record, so we eliminated all those funds that have been in existence for less than 3 years. Finally, we wanted to eliminate the poor performing funds; therefore we filtered out funds with negative performance for the past three years.

In the end we had a list of 45 different funds. Some basic characteristics of the list follows:
  • Only 6 had been in existence for over 10 years
  • About 65% had a minimum purchase requirement of $150,000 and above
  • Most were based in Toronto
  • About 50% followed long/short equity or market neutral strategies
  • Some were relatively low risk strategies and others have exceptionally high levels of volatility
  • In 2009 the best performing fund was up 160.6% and the poorest was down -29.0%
  • In 2008 the best performing fund was up 61.2% and the worse was down -72.1%
  • There were 11 funds that were positive in both 2008 and 2009
  • Over 3 years ending September 2010, the best performing hedge fund returned over 35% annually. 

Another observation was that many funds were closed down over the last couple of years and went out of existence. Also, most of the hedge fund managers are relatively unknown and quite small compared to those who manage the traditional asset classes.
The Bottom Line
Before an investor rushes to buy the latest hot hedge fund it is important that they do their due diligence to ensure that it is appropriate for them and they understand the risks. A good start is to create a workable list of funds.

Tuesday, November 2, 2010

Is an Exchange Traded Fund Considered Equity? Is A Coffee Mug Considered Coffee?

Is an exchange traded fund equity? It seems like a basic question with an obvious answer. But it is question that confuses some of our largest financial institutions?  As an example on my investment statement the asset mix summary classifies all ETFs as equity even though some are commodity based and some are bond ETFs. If I had a 100% of my portfolio in commodity ETFs, or 100% in a T-bill ETF, or 100% in a bond ETF or 100% in a leverage ETF or 100% in an inverse ETF, it all shows up as 100% equity.

I was pondering the question is an Exchange Traded Fund equity? - as I was walking my dog Kobe on one cold, dark, damp,  early morning on the deserted streets of Toronto. As I was approaching the corner of Yonge and St. Clair, lease in one hand, and a mug of Tim Horton’s coffee in the other, it came to me in a flash.  An Exchange Traded Fund is just like a coffee mug – they are both merely a vessel – i.e. an object used as a container.

A coffee mug, originally designed to hold hot coffee can be used as a vessel for other things, like tea, hot chocolate, orange juice, water, beer, wine etc. I also use a coffee mug as a measuring cup for flour, sugar, rice, milk, and Kobe’s kibble. A coffee mug is very versatile and can be used for many things besides holding hot coffee. Although, originally designed to hold coffee, a mug is not coffee!!!

ETFs were originally designed to hold the stocks of indexes, like the S&P500, Dow Jones Industrials, or the S&P/TSX Composite. ETFs are like mutual funds except they trade on stock exchanges. Now, ETFs are used as vessels for all kinds of investments like equity, bonds, commodities, currencies, futures and even other ETFs. Like a Swiss army knife they have many uses and applications. They can give an exposure to different assets classes, used for hedging or can be combined with other investments. There are even ETFS that will go up in value when the underlying investments go down. Although, originally designed to hold equity, an ETF is not equity!!!

Equity is defined as the ownership in a corporation in the form of common stock or preferred shares. Therefore if an ETF does not contain equity or positively track an equity index then from an asset mix perspective it is not equity.  If an ETF contains bonds , it should be considered fixed income. If the ETF contains gold then it should be considered commodities or precious metals from an asset mix perspective. If an ETF is designed to increase in value if the market goes down it should be considered a short position not a long position.

The Bottom Line

An ETF is only considered equity if the underlying investments are equities. If you own ETFS, do not assume that your asset mix summary properly classifies your ETFs. Therefore you might have to calculate it yourself. Although a child knows the difference between a coffee mug and coffee you cannot assume that our large financial institutions know the difference between an ETF and equity.

Looking For Mr. GoodFund: Chapter 1 - The Different Types of Hedge Funds

There is a large number of investment managers and managed products in Canada. Our task is to be able to sift through the invesment products to indentify the hedge funds and then choose which ones we believe will have superior performance in the future. The first step is to understand what we are looking for.

The term hedge fund covers a very diverse field of organizations, and investment strategies that defy a simple definition. Hedge funds are part of larger class of investment called alternative investments or strategies. In simplest terms an alternative investment or strategy is an investment that is not a simple stock or bond or an investment product that is long stocks or bonds. Alternatives can include real estate, infrastructure, private equity, commodities, currencies and hedge funds.

Hedge funds are considered absolute return investments. A fund manager will “hedge their bets” by shorting securities against their long positions. In theory,  a hedge fund can make money in both up and down markets. The returns they generate are not tied to the overall market like most stocks portfolios, but to the skill of the manager. Consequently, hedge funds can have a low or even negative correlation to the market. That is a very desirable characteristics for investors who are looking to diversify the risk of their investment portfolios.

Hedge Fund Strategies
Hedge fund managers can use a wide assortment of investment strategies and securities to take advantage of specific investment opportunities. The use of derivaties and leverage are common as each mager will craft a uniqe strategy. Below are some of different types of hedge fund strategies.

Equity Market-Neutral
An equity market-neutral strategy is designed to create an absolute return, independent of the direction of the underlying market.  The strategy involves creating a long and short portfolio of approximately the same size. A well-designed equity market-neutral portfolios will have very limited market risk. Leverage is sometimes used to enhance the returns.

Equity Long/Short
An equity long/short strategy involves holding both long and short equity positions with either a net long or net short exposure. The objective is not to be market neutral but opportunistic, looking for money making investment ideas. This strategy is not only heavily reliant on a manager’s skill in picking stocks but their skill in market timing – i.e. knowing when to be net long or net short. This strategy will generally have greater risk than a market-neutral strategy.

Merger Arbitrage or Risk Arbitrage  
This strategy tries to generate investment returns by capturing the spread between the current market values of securities and their values in the event of a merger, restructuring, or other corporate transaction. Most merger arbitrage strategies will exploit both cash-only deals and stock deals. Whenever a merger or acqusition is announced, the risk arbitrage hedge funds become very active.

Convertible Arbitrage
A convertible arbitrage strategy aims to profit from mispricing opportunities within convertible bonds and other hybrid debt/equity securities. Convertible securities are a combination of various instruments typically an option and a bond. The convertible security may have a different price than the sum of the component parts. A typical strategy is to buy the convertible bond and sell short the common stock of the same company, to take advantage of the stock’s price volatility.

Fixed Income Arbitrage
Fixed-income arbitrage managers aim to profit from price anomalies between related interest-rate securities. As an example, if the yield spread between corporate bonds and governement bonds are historically high, a hedge fund manager will be long corporate bonds and then short government bonds. The strategy would then be profitable if the yield spread narrows.

Global Macro
A global macro strategy can  involve a wide variety of strategies and asset classes. Global macro is the considered the most flexible hedge fund strategy. Unlike most hedge fund strategies which are typically bottom up, global macro managers typically take a top-down  approach to investing. With a top-down approach, managers can move between countries, markets and different financial securities based on expected changes in interest rates, exchange rates and liquidity. A variety of trading strategies are used depending on the opportunities identified.

Managed Futures
A managed futures strategy is based on speculating on the direction in market prices of currencies, commodities, equities and fixed-income securities. These managers trade futures markets globally and are referred to as Commodity Trading Advisors (CTAs).  Since many commodities such as agricultural commodites have no real correlation to the underlying equity markets, the returns generated from a managed futures program will look considerably different from most hedge funds.

An excellent introduction and description of hedge funds can be found in Alternative Investment Management Association (AIMA ) Canada Hedge Fund Primer.

Bottom Line
The strategies of hedge funds are not only comlex but not very transparent as well. It requires considerably more due diligence on the part of the investor to understand a hedge fund versus a plain vanilla equity fund. However, the benfits of well designed hedge funds makes it worthwhile to spend the extra time it might take to understand them.