Once the exclusive domain of sophisticated, high-net-worth investors, hedge funds are now accessible to the average investor. With the promise of profits no matter how stock markets fare, these so-called absolute-return investments seem like the perfect cure for ailing portfolios. Pension funds use hedge funds to reduce portfolio volatility and enhance returns. Perhaps it’s time for retail investors to kick some hedge fund tires.

A hedge fund is “a private investment program where the manager seeks positive returns by exploiting investment opportunities, while protecting principal from financial loss” according to the Alternative Investment Management Association (AIMA), the trade association for the Canadian hedge fund industry.

Hedge funds differ in several significant ways from mutual funds.

• They strive to make money under all market conditions.
• Investors may need to meet income or net worth tests in order to invest.
• Several different legal structures are possible.
• A higher minimum investment is required: $25,000 or more.
• They are typically sold by offering memorandum; mutual funds mainly issue the more detailed prospectus format.
• The funds are not liquid; notice of a week or longer for redemption is not uncommon.
• After purchase, there can be lock-up periods when the fund cannot be redeemed.
• The manager has fewer restrictions on allowable investments.
• Leverage is frequently used. This increases a fund’s risk level.
• Mandated disclosure requirements are fewer, so the investment strategy, risk level and holdings may not be transparent.
• Investors pay an annual management fee and frequently a performance fee. For example, Sprott Hedge Funds charge a 2 per cent fee plus 20 per cent of all net profits.

Hedge funds are intended to reduce the risk of loss in a portfolio and/or boost returns. The investing strategies used to accomplish this are numerous. While each fund manager will tout his own, often closely-guarded methodology, hedging strategies are generally grouped into three broad styles.

Directional or opportunistic strategies exploit current market trends in the price of equities, commodities, currencies or even interest rates.

1. Long-short equity funds purchase investments they believe will rise in price and short those they believe will fall in price. If the fund manager chooses well, fund holders will earn profits in both rising and falling markets.
2. Global macro funds use a top-down approach to identify investing opportunities globally. They move capital between strategies, countries, stock markets and securities based on expected changes in interest rates, exchange rates and liquidity.
3. Managed futures funds take long and short positions in futures contracts and options and government securities.
4. Emerging markets strategies invest in the equity or debt of emerging market countries.

Arbitrage or relative value strategies take advantage of price discrepancies between closely related securities including equity, fixed income and currencies.

1. Convertible arbitrage funds make money by buying convertible debt; that is, debt that can be converted into the shares of the issuer on a future date, and selling short the underlying shares.
2. Fixed income arbitrage funds take advantage of price anomalies between related fixed income securities.
3. Equity market neutral funds buy stocks that are expected to outperform the market and sell short expected underperformers to minimize the impact of market direction. Profits occur if the long positions outperform the short positions.

Event-driven strategies exploit corporate events such as mergers, takeovers and bankruptcies.

1. Merger arbitrage funds profit from the spread between the current price of a security and its price in the event of a merger, takeover, or other corporate transaction.
2. Distressed securities funds buy the bonds or shares of companies in trouble at prices below their true worth with the objective of reselling them at full value.
3. Special situations funds invest capital with a view to profiting by correctly predicting the outcome of a particular corporate event.

Investors can choose hedge funds with single or multiple investing strategies and funds run by one (or more than one) manager. A fund of hedge funds uses a number of different managers and a variety of hedging strategies. It is a good choice for individual investors because it offers due diligence, diversification and a relatively low minimum investment. However, fees can be high as the managers of both the main and underlying funds must be paid. Exchange-traded hedge funds are a recent development, which should help drive down fees.

Hedge fund returns are highly variable, which is not surprising given the diverse strategies available. In 2008, Canadian hedge fund indices, on average, lost between 7 per cent and 38 per cent but global macro, managed futures, and dedicated short-selling hedge funds posted positive returns. In 2010, the benchmark Scotia Capital Canadian Hedge Fund Performance Index (asset weighted) returned 20.2 per cent while the S&P/TSX Composite was up 14.5 per cent. The recent market selloff has crushed funds using substantial leverage. For example, the Salida Strategic Growth Fund was down 37% in September.

If you decide to invest in hedge funds, you must understand what you are buying and why. Candidate funds can be identified by asking your financial adviser for recommendations or by screening for Aggressive Growth/Alternative Strategies funds using the Globe Investor Fund Filter. Once you have a specific fund in mind, thorough research is compulsory. The AIMA Hedge Fund Investor Checklist is a useful tool to guide your evaluation.

Hedge funds hold the promise of reducing portfolio risk and enhancing returns. The challenge for the individual investor is to sift through the maze of available funds to unearth the few gems that can realize on that promise.