The Canadian Source Of Employee Pension Fund Investment And Benefits Plan Management

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August 2007

Hedge Fund Of Funds Offers Great Opportunities

By: Wasyl Saluchok

Canadian investment returns have generally met and exceeded expectations over the past few years, but pension funds have to be concerned about how they’ll meet future liabilities, especially if and when Canadian equity returns revert to more modest levels in keeping with their long-range averages.

hedge funds opportunities

Why Hedge Funds?

Despite some negative publicity in recent years, hedge funds have a lot to offer within a diversified institutional investment portfolio. Two prime attributes are their low correlation with the risks and returns of traditional asset classes, such as equities and fixed income securities, and their potential to earn positive absolute returns regardless of the market’s direction.

Both of these qualities can add diversification to almost any portfolio, thereby lowering risk even as they may boost returns. Clearly, hedge funds are worth considering and including in a well-rounded portfolio.

Hedge funds still conjure up images of the Wild, Wild West, especially when compared with the very tightly regulated mutual fund industry. Much of this reputation relates to several fairly isolated, but spectacular, blowups. Also worth noting is that recent efforts to establish greater regulation within the hedge fund industry are expected to have a positive impact.

Alfred Jones formed the first hedge fund almost 60 years ago. As a writer for Fortune magazine, he was familiar with investment strategies and trends and was inspired to roll up his sleeves and try his hand at managing money in 1948. After an initial foray into long/short investing, and employing leverage in order to enhance returns, he converted his fund from a general partnership to a limited partnership in 1952. As managing partner, he was eligible to earn a 20 per cent incentive performance fee – a feature that is standard in hedge funds today.

Boom And Bust

Over the past half century, hedge funds have gone through several boom and bust cycles. Strong performance for a period has tended to attract attention along with new investment money, some of which may have been ill-considered or opportunistically employed. For example, after a mini-boom in the late 1960s, many funds went bust when they encountered market turbulence, particularly in the 1973/74 bear market. However, hedge funds helped protect equity investors during the 2000/02 bear market.

More recently, hedge funds have attracted speculators as well as more cautious or sophisticated investors. Spectacular returns and heightened risks lead to the 1998 collapse of the Long Term Capital Management hedge fund. And Canadian investors are well aware of the Portus Alternative Asset Management hedge fund scandal and the collapse of the volatile Amaranth Advisors hedge fund, which fell victim to its highly risky directional bets on natural gas prices last year.

Hedge Fund Strategies

Where does that leave hedge fund investors today? They are older and wiser, perhaps, if not necessarily wealthier. We know well that risk and return go hand in hand. We understand that hedge funds are a part of the market where we would all be better off heeding the caution ‘buyer beware.’ But the choices aren’t limited to accepting the risk or walking away. We can try to manage the risks presented by hedge funds, first by arriving at a thorough understanding of the major hedge fund strategies and then selecting the one or ones that best suit our needs.

There are multiple strategies within the hedge fund universe. They tend to follow several core themes including arbitrage, event-driven, and directional strategies. Arbitrage strategies seek to take advantage of price inefficiencies. Event-driven strategies are based on announcements or one-time events. And directional strategies take positions based on anticipated broad market movements.

hedge funds

Fixed income arbitrage funds try to capitalize on the relative values, or mispricings, between related fixed income securities such as government bonds, government agency securities, investment-grade corporate bonds, and derivatives such as swaps, futures, and options.

Convertible arbitrage funds try to exploit mispricings in convertible securities. A fund might buy a corporate convertible bond while selling short the common stock of the company that issued the bond, seeking to take advantage of the relative prices of the two securities if the bond and the embedded call option are considered to be cheap and the stock expensive.

Merger arbitrage involves taking positions in companies that are, or are likely to be, involved in an acquisition or merger. Typically, a merger arbitrage fund buys shares in the target company and sells short shares in the acquiring company. This strategy assumes the merger or acquisition will take place and the price of the target company will rise to the purchase price to be paid by the acquirer.

Event-driven and special-situation strategies are based on individual events that have a significant impact on a company and the value of its securities. These events include spin-offs, acquisitions, leveraged buyouts, special dividends, management changes, reorganizations, bankruptcies, recapitalizations, and share buybacks. As with merger arbitrage, an event-driven strategy might be to purchase shares of a company about to be taken over and sell short the stock of the acquirer.

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