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.

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.

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.

Looking For Mr. GoodFund - The Search for the Perfect Hedge Fund - Prologue

Finding a hedge fund with supersized returns and tiny correlations, is my mission. Is it mission impossible or merely mission difficult? Of course, with perfect hindsight finding a hedge fund that historically had superior performance with a low correlation to the markets is easy.  Finding a hedge fund that can outperform in the future is a different matter all together.

I plan to write a series of blogs about the process as I search for  those hedge funds. It is October 28, 2010 and I hope to have finished my assignment by the end of November. In the next blog I will discuss some of the criteria I will be screening on, and some observations about the hedge fund industry in Canada.

Commodity Fundamentals Look Positive

iShares S&P 500 (IVV) Vs SPDR Gold Trust ETF (GLD), Power Shares DB Agriculture Fund (DBA) 

Not only have stocks enjoyed a rally since the summer but so have commodities. Gold surged to an all-time high of $1,387.35 an ounce. Tin is at a record high and so is cotton. Soy beans have rallied 16 percent this year and corn has surged 37 percent.

There are a number of cyclical, and event driven factors that are at play. Stronger corn prices are a result of lower corn production forecasts, due to poor weather in the U.S corn belt. A drought in Russia, leaves wheat supplies at 25 year lows. A strong economic rebound in the developing countries, has caused a dramatic improvement for commodities. The causes of the current strong prices are many, and some may be temporary. However, the underlying fundamentals of a constrained supply, a weak U.S. dollar, and surging demand from  emerging markets particularly China are likely to result in stronger prices in the future. 

PowerShares DB US Dollar ETF (UUP) Vs 

PowerShares DB Commodity ETF(DBC) 

Commodities prices are mostly denominated in U.S. dollars and a falling dollar translates into rising commodity prices. The U.S. government has spent large amounts to keep the U.S. economy afloat during the financial crisis and is soon expected to see a $1.8 trillion gap between revenue and expenditure. These massive federal deficits undercut the dollar's value. A simulative  monetary policy does as well. Quantitative easing (i.e. printing money) in the U.S. is expected to further flood the financial system with cheap dollars raising a concern for higher inflation in the future. The possibility of currency wars as many countries try to get  competitive by devaluing their currency, will likely play an increasing role in rising commodity prices as well.

The demand for commodities in the emerging markets is the biggest reason for higher commodity prices. In 2006, the emerging markets' share of world output outpaced developing markets in nominal GDP terms. As those economies try to catch up to the developed, the the use of commodities intensifies as  the  standard of living improves and the countries become more urbanized.

As these nations become increasingly more industrialized, the sheer number of workers who will be buying their first house, their first car, and their first television are raising per capita consumption and demand of commodities. The world's urban population is growing by 70 million people per year and soon over half of the world's population is expected to live in urban areas. As populations migrate from rural areas into urban settings, additional schools, roads and other infrastructure will be required to accommodate them. This building boom of essential infrastructure is expected to propel demand for commodities like steel, concrete, oil and copper for years to come.

Bottom Line

Commodities have a place in a portfolio as as a means of improving diversification and reducing risk. The possibility of strong prices in the next few years, makes the use of commodities even more compelling.

Should You Join The Tiger-21 Club?

Image Source: Hollingsworth, John Karen  , U.S. Fish and Wildlife Service

The Tiger is on the prowl and I do not mean Tiger Woods. Tiger-21, (The Investment Group For Enhanced Returns for the 21st Century)  is opening up for business in Canada and is looking for new members. If you are a decamillionaire (have $10,000,000 in investments),  “Tiger Worthy”,  and willing to spend the  $30,000 per year membership dues, you can join this exclusive club.

According to their website Tiger-21 ”is a peer-to-peer learning group for high-net-worth investors. We help members build the skill set to successfully transition from focused entrepreneurs to disciplined managers of wealth. Participating in professionally-facilitated, 12-14 person groups, our members meet monthly to harness the varied expertise and collective intelligence of their peers in high-energy, day-long sessions.”

Since Thane Stenner, has been appointed Managing Director  for Tiger-21 in Canada, they have been actively recruiting new members. They plan to have 56 members in total in Canada with groups in Vancouver, Calgary, Toronto and Montreal. In a recent interview with Jon Chevreau of the Financial Post , Mr. Stenner, discussed the plans for Canada, some of the criteria for joining, and the benefits of being part of this exclusive networking group.

Would I ever join the Tiger -21?  That is a moot point  because I am definitely not Tiger Worthy,  with a net worth closer to 0 than it is to their minimum requirement of $10,0000,000.

Should an investor join the club? If the purpose of joining was to improve the performance  of their investment portfolio or looking for new investment ideas then there are cheaper and more direct ways of accomplishing that goal. For $30,000 a year, an investor can buy a lot of expertise to improve their investment performance. If an investor wanted to hear investment  ideas from  speakers like David Rosenberg or Bill Gross, much can be found for free on the internet.

The value in joining, in my opinion is the networking possibilities with like-minded, successful businessmen. Meeting with a dynamic group of investors could  be worth the  $30,000 a year in membership fees. I also believe the ideas coming from the group,  will be more valuable than the ideas that come from the investment experts brought in to speak.

Bottom Line  

Will Tiger-21 reach their 56 member limit? I believe it is quite likely. According to BMO there are about 27,000 households with over $10,000,000 in investments. If only 0.207% join or  1 in every 482 Decimillioniares then their goal will be reached.

Ten Commandments of ETF Investing

I have been following, investing in, and recommending ETFs since they first came on the scene. Much is written about them daily, but very few articles and blogs provide any new advice or insights into them. However, a recent article titled 10 Commandments of ETF Investing published by ETF Database - The Guide to ETF Investing provided 10 well written commandments, that all ETF investors should follow. They are:

• Honor Thy Expense Ratio
• Consider The Total Cost Of ETF Investing
• Thou Shall Not Use Market Orders Recklessly
• Thou Shall Not Covet Your Neighbors Weighting Methodology
• Thou Shall Not Bear False Witness Against ETFs
• Thou Shall Not Make Wrongful Use of The Name "ETF"
• Thou Shall Not Use Liquidity Screens
• Not All ETFs Are Created Equally
• Thou Shall Buy Commodity ETFs (But Only If You Truly Understand Them)
• Thou Shall Take Advantage of Free ETF Resources

Do Commodities Have a Place in Your Portfolio?

Most investors are well diversified within the equity asset class, both domestically and globally. Once diversified, trying to reduce risk further will have little impact as individual stocks, the different equity markets, and investment styles are highly correlated with each other. Moreover, correlations has been increasing in the last few years. Bonds traditionally have been used to diversify, but with record low rates, the prospects for decent returns are poor.

In order to reap the benefits of diversification, the investor needs to add non-correlated assets to  their portfolio.  The use of commodities can offer this improved diversification to an investor's portfolio. Commodities, like oil, gold, copper, wheat or cattle are impacted by factors considerably different from those that influence stock and bond returns and volatility. This makes commodities intrinsically different from stocks and bonds, resulting in a low correlation.

The prices of commodities respond more to current supply–demand conditions, whereas the prices of equities and bonds, respond more closely to the longer-term outlook. Commodities will react to events that in most cases are not related to the underlying economy. As an example a poor harvest of corn in the U.S can have signification price ramifications not only to corn but other agricultural products as well. We have all seen what happens to the gold price in time of any international crisis.

In addition, commodities can hedge against unanticipated global growth. As emerging countries  move up the development chain they consume commodities more intensely on a per capita basis, placing upwards pressure prices of those commodities.

                                                           
 Risk Return Profile of Adding Commodities

Not only do commodities have low correlations with traditional asset classes and the overall business cycle but correlations are also low between the different commodity sectors. Historical data indicate that their long term have been similar to those on equities, and the volatility of commodities is only modestly higher than that of equities. But when commodities are combined with a traditional portfolio the overall risk is reduced.

Another option of investors is to buy the  common shares of companies that produce commodities as a proxy for the underlying commodity. As an example an investor can buy energy stocks instead of oil. The problem with this strategy is that the return is affected by factors other than the commodity’s price. The investor is buying the management talent and financial structure of the companies, but management, based on sound reasoning, may decide to hedge production, limiting the upside move in commodity prices. Generally returns on the stocks of commodity producers are not as highly correlated with the returns on the commodity as they are with the returns on the stock market as a whole.  In other words, commodity-related stocks behave more like other stocks than their underlying commodity.

Until recently, commodity exposure was usually  through commodity futures making it out of reach to all but the most sophisticated investors and institutional traders. These barriers are eliminated for the investor with the advent of diversified commodity fund and exchange traded funds and exchange traed notes. 

Some of the broad based commodity based ETFs include iShares S&P GSCI Commodity-Indexed Trust (GSC), PowerShares DB Commodity Index Tracking Fund (DBC), iPath Dow Jones-UBS Commodity Index Total Return ETN (DJP) and Claymore Broad Commodity ETF (CBR).


The Bottom Line 

There is no question that adding commodities, will improve the diversification of a portfolio. More over the arrival of ETFs and ETNs make it easy for an investor to gain broad commodity exposure. However, if using ETFs fully understand, how they are constructed and ensure they are used properly in your portfolio. 

Big Banks Pursue Big Bucks

Big banks that formally were  known by names like the Royal Bank of Canada, but now are better known as letters and logos want you as clients - if you are a very high net worth individual with assets greater $5,000,000 and especially the uber-wealthy with assets north of $30,000,000.

RBC, BMO, and UBS have all announced recently, that they are making organization changes to target and provide more customized services to the very high net worth and ultra-wealthy  Canadian families.

Their belief is that high net worth people have more complex needs than just managing the investments.  Therefore, rather than an individual using different organizations and advisors, they can get all their advice and service under one roof. The private bankers will offer a full collection of bespoke services including investment management, legal, accounting, estate planning, trust services and philanthropy in an upscale atmosphere.

Depending on the account size and the complexity, each client might work with several advisers, and generate significant fees for the banks. The business of dealing with wealthy families is not only prestigious, but quite lucrative. It is likely that other banks in Canada, will make announcements in the near future that they too, will be targeting the same group of wealthy Canadians.

Competition should be heating up for those investor with significant assets. As a consumer, competition is always good as there will be more options and choices available. Some of those services might even trickle down and become available to a broader client base. The competition  will not likely result in lower costs and fees. It has been my observation that the Canadian banks do not try to attract  more business by chopping prices. They would rather compete on based on “service” and the “brand promise” they make to clients.

We do expect more direct marketing to those very high net clients, as the banks try to retain their own customers and aggressively pursue other bank's clients. As I write this blog, it is likely that they are building a dossier on many potential targets as they try to make a connection with them.

If you are looking for a new investment relationship or a private banker comes knocking at your door, it is important to have a clear understanding your objectives and current requirements. What services do you currently need and are you  properly serviced by your current advisers. As an example, if you have a good lawyer and accountant, do you need one of their lawyers or accountants.

If you want to choose a new relationship with one of the big banks, it is important to get them to compete for your business rather than decide after hearing one sale's presentation. Prepare a  request for proposal and have 3 different banks make their presentation on what specifically they can do to meet your requirements. This process will assure that each participant puts their best foot forward. Also, the proposals can be compared easily. The likelihood of making a good choice improves dramatically. Often hiring an investment consultant  like Ohow Investor Consultants can help manage this process for you and will work with you to ensure you make the correct decision. Often their fees can be recouped through a negotiated discount with the manager.

The Bottom Line
As the big banks  focus is placed on the ultra wealthy, there will be more and more services available to them and other less wealthy investors. Also they are likely to be more aggressively pursued. If you are looking for a new investment relationship, it is important to have a clear understanding your objectives and current requirements and ensure that the potential suitors compete for the business.