Hedge funds come with a subtle risk

Hedge funds have been getting a lot of press lately. None of it addresses this very real issue. Proponents of hedge funds often ask: “Why should you make money only in rising markets?” Hedge funds, after all, can employ strategies that profit when stock prices fall. So you can make money in bull markets and in bear markets.

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Hedge funds come with a subtle risk

To explain, we need first to look at the essence of mutual funds. The securities commission of Canada’s provinces have agreed on a set of laws governing the investment strategies permitted by mutual fund companies and their portfolio managers.

Amidst paragraph after paragraph of legalistic prose, the essence of mutual-fund regulations lies in the philosophy that the retail investor should never be exposed to a situation where a loss might exceed the original investment.

That means mutual funds can’t sell stocks short. The risk, at least theoretically, is unlimited. And many short-sellers have indeed lost far more than their original investment. Mutual fund managers can’t borrow money to invest. They can’t write naked options or enter into futures contracts on margin.

The idea of a hedge is to reduce risk. For example, the wheat farmer may sell his production ahead of time on the futures market, (almost) certain in the knowledge that he will be able to deliver the product at harvest time. But the speculator, buying say, a contract for 5,000 bushels of wheat with a margin deposit of $2,000, could easily lose more than $2,000. So the farmer is protected from falling prices before harvest. That’s a hedged position. The speculator contracts to take the risk from the farmer.

In the stock market, the idea of a hedge may be to buy an undervalued stock and sell short an overvalued stock in the same industry. The use of derivatives such as options, index futures and a myriad of others quickly make for potentially complex strategies. But one side of many hedges involves a position that, taken separately, can result in a loss that’s greater than the original investment.

Therein lies our concern for hedge funds. There’s no law saying a portfolio manager must take both sides of a hedged position. That’s merely a fund’s mandate or a fund-company’s policy. But for years, we’ve observed disparities between mutual-fund mandates and their corresponding portfolios.

Managers often stray

We see little to reassure us that portfolio managers can resist the urge to pursue perceived opportunities, almost regardless of risk. What’s more, a little success at shaving corners — say, lifting half a hedged position early — often leads to increasing confidence on the part of many portfolio managers. And before you know it, those same managers have entered a position with unlimited potential for loss, confident that it won’t happen to their fund.

To invest in a hedge fund, you must satisfy criteria that qualify you as an accredited or sophisticated investor. That means you must earn or have a lot of money. And typically , minimum investments in these securities start at $150,000 in Canada.

In the end, hedge funds are subject to potentially huge losses, they tend to be much less liquid than ordinary mutual funds, and you typically have to commit your money for a period of years.
We don’t disparage hedge funds for those who fully understand them. And for those who have the confidence their manager won’t get carried away from pure hedging to wild gambling. For the rest of us, we consider these funds high risk.

This is an edited version of an article that was originally published for subscribers in the September 2, 2022, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.

Money Reporter, MPL Communications Inc.
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