To many investors, hedge funds evoke thoughts of risk, leverage and rogue traders. While hedge funds may have earned a reputation for being frightening, fortunately they are more rewarding than risky.

Hedge fund investing can be considered an extension of active management, where the manager is less constrained in the investment process and focuses on obtaining absolute returns on an annual or shorter basis, regardless of whether markets rise or fall.

Consider a manager who holds two stocks in his portfolio, Royal Bank and Nortel Networks. A manager who is long in these stocks, believing that the value will appreciate, is part of the Canadian equity universe of managers. If the manager is long Royal Bank and short Nortel, why shouldn't that individual be considered an equity manager who uses his or her investment skills to the greatest extent possible?

The majority of hedge funds are investment vehicles that buy and sell based on proprietary trading strategies that reduce exposure to market volatility. The main risks associated with these strategies are poor stock selection, the use of leverage, liquidity or the ability to cash out of a position, changes in the credit rating of the security pairings and the management of the organizations. Most of these risks are similar to those found in other, more common investments.

The risks in other investments are typically managed by having a diversified portfolio of at least 30 securities. Similarly, the risks involved with the use of hedge fund trading strategies are managed with the use of multiple managers and strategies. This structure is commonly known as a fund of hedge funds (FOF).

FOFs have performed well over the last 10 years. Performance has been particularly strong during periods when the markets have had a negative return. Over the past decade, the return on the Hedge Fund Research FOF index has been 14.38% with an annual standard deviation of 6.37% (see "FOF hindsight," page 61). The analysis tracks the annual monthly performance of a large FOF launched in 1987, removing the survivorship bias in the index returns.

FOFs have also achieved positive returns on an annual basis irrespective of the market environment. Over the last 10 years, considering only negative months, the Standard and Poor's 500 composite index lost 64%, while the actual FOF gained 64%. In fact, the FOF outperformed the S&P 500 by 128% during this period, creating an opportunity for pension funds to lower volatility.

Typically, an FOF manager targets a net return of 12% to 16% on an annual basis. Managers believe this goal is achievable as it takes into account that there will always be inefficiencies in the market, and volatility will remain at historic levels. Knowledgeable hedge fund managers will achieve positive returns on specific events as they occur. FOFs can also reduce annual volatility for a portfolio without giving up future returns, and provide protection in down markets.

ALLOCATION, ALLOCATION, ALLOCATION

An important element of determining asset allocation is identifying the primary objective for using FOFs. The objective may be improving the portfolio's return or reducing its volatility. The pension fund's return and risk tolerances will determine the implementation process.

Consider three investment examples, each of which can be implemented through an FOF:

In determining which investment strategy is appropriate for a particular pension fund, it is important to consider the fund's financial objectives. These could include ensuring a solvency-funded ratio of more than 100%, or minimizing the level and volatility of the contributions or pension expense. In most funds, the risks to these objectives are lower equity markets and level or lower long-term interest rates. Although the liabilities can be cushioned with a long bond portfolio, this strategy has not been used extensively.

Most pension funds implement their fixed income portfolio using the ScotiaMcLeod Universe as a benchmark. However, this reduces the importance of the relationship between assets and liabilities. The duration of the liabilities is typically 12 or more years, while the duration of the benchmark is only five years. Under these conditions, an allocation to an FOF would increase the bond return (at a similar risk) or reduce the volatility of the equity component without reducing equity returns over time.

The specific amount allocated to an FOF depends on the comfort level of the plan sponsor. The common sense solution to determine the appropriate allocation is a technical analysis or a qualitative approach that takes the liquidity needs of the fund and the maturity of its liabilities into account.

The expected risk and return for alternative allocations using an FOF can be calculated by examining historic relationships or by making assumptions for the future. These results can then be compared to the allocation with no FOF exposure to determine the improvement in the Sharpe ratio or other measures involving risk and return. Different FOF investment strategies can also be considered.

While there are few Canadian FOFs, one can be implemented by investing in an existing fund, which is then part of the foreign content, or by using a swap process. In the later case, a fixed return is swapped for the total return from the FOF, and the allocation is Canadian content. Alternatively, customized portfolios can meet specific return and risk objectives.

There are a number of questions that institutional investors need to ask when selecting either an FOF or an FOF individual manager. They include:

• What is the investment objective of the fund?
• What is the investment process used?
  
• Why will the manager continue to have an edge on his or her competition?
  
• Why has the manager made money in the past, and why will he or she continue to make money in the future?
  
• Is the edge sustainable under all economic scenarios or does it fail in particular scenarios?
  
• Who performs the back office accounting? This is part of due diligence.
  
• Is there any likelihood of trades outside of the mandate?
  
• Who is the prime broker/auditor? What role does this organization play in checking trades, providing margin assets and providing back up?
  
• What is the background and track record of the management team and what experience does it have in using this strategy?

When an allocation has been made to an FOF, it is necessary to set up an ongoing monitoring process. Although reporting on the various strategies is improving, there is still considerable work to be done in this area. For example, consider an FOF with 20 managers who have 100 securities each. If a listing of the securities were made available, there would still be questions of which security pairings go together for the 2,000 securities. In addition the portfolio can change rapidly making the analysis out of date.

It is worthwhile to spend considerable time with the manager in order to understand the process and discuss what is happening in the portfolio regarding security selection and leverage. This discussion will determine if there has been any drift in the portfolio or if there are any negative signs on the horizon regarding the strategy or the manager. BC