Despite their reputation, hedge funds can protect your stash

When it comes to preserving capital, you have alternatives to sitting in cash or investing your savings in low-interest guaranteed certificates. These alternative strategies are loosely referred to as hedge funds.

The classic long-short equity "hedged" fund, created by Alfred Winslow Jones in 1949, aimed to earn outsized returns in the stock market while keeping risk to a minimum. Mr. Jones used two tools: leverage, or borrowing, and selling "short" - or selling stock he didn't own in hopes of buying it back later at a lower price. He bought stocks he thought would rise and sold short those he thought would fall. The results were outstanding.

More recently, hedge funds have been associated with big risks and even bigger returns. Mind you, not all of these more aggressive funds actually hedge their bold bets. Having genuine hedged long-short equity funds in your portfolio should lower risk, says Gary Ostoich, president of Spartan Fund Management in Toronto and chairman of the Alternative Investment Management Association of Canada.

Classic long-short equity strategies are designed to eliminate market risk and focus instead on the investment's return. Hedged or not, alternative strategies bring diversification to a portfolio because commodity, currency or interest rate futures may rise in price while the stock market falls.

"You want to create a portfolio of investments that don't act all the same," Mr. Ostoich says. "If you're all in fixed income [bonds] and interest rates rise dramatically, your portfolio will be hurt."

Long-short equity funds belong to a larger category of "market neutral" strategies that attempt to turn a profit for investors no matter what the stock market does.

Strategies that use options to smooth and capitalize on market volatility, like the Spartan funds, are another type.

"I'm a big fan of market neutral strategies," says Craig Machel, associate portfolio manager at Macquarie Private Wealth in Toronto. "Clients in the protecting capital stage want consistent returns without volatility."

The problem with hedge funds is that you need a fair amount of money, under securities rules, to be allowed to buy them. While the regulations vary from province to province, two main requirements are universal. You need either a good salary - $200,000 for an individual or $300,000 including a spouse - or $1-million in liquid, investable assets, says Mr. Machel. That doesn't include the value of your house.

If you qualify, you can invest as little as $5,000 in a strategy. If not, you need at least $150,000 in most provinces, although in British Columbia you can buy several different funds for that amount.

Ideally, you would engage an investment adviser at a money management or brokerage firm to help you build a portfolio of funds that fit together to limit your risk, proponents say. Fees can be high for hedge funds, with the manager typically taking a 20 per cent performance fee on top of the 2 per cent management fee.

In investing terms, this is the opposite pole to passive, low-cost index mutual funds or even lower cost exchange-traded funds that simply track a market index.

"I'm a huge believer in active management as long as you're getting value," Mr. Machel says. "There were some talented managers in Canada who made money in 2008 when the world fell apart."

Indeed, in 2008, when panic infected financial markets, the main hedge fund indexes fell half that of major stock indexes, Mr. Ostoich notes.

One strategy, the CI Trident Global Opportunities Fund managed by Nandu Narayanan, was up 43.6 per cent.

Last year, as the market continued to climb, many hedge funds did well. The Scotia Capital Canadian Hedge Fund Performance Index ended 2010 up 20.2 per cent, easily beating the S&P/TSX Composite Index, up 14.5 per cent.

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THE SMOOTHER PATH

Known for big gains, hedge funds often underperform when the stock market roars. Smoothing out the highs and lows is part of the strategy.

The Spartan Multi-Strategy Fund returned 10.36 per cent for the year to March 31, 2011, substantially less than the S&P/TSX composite index's 17.27 per cent. For the past two years, the fund returned 30.99 per cent, compared with a whopping 61.87 per cent for the TSX.

The comparison shifts radically when the 2008-2009 market meltdown is considered. For the three years ended March 31, 2011, the Spartan fund returned 39.84 per cent, compared with a scant 5.74 per cent for the TSX. Quite a difference. And for the period since the fund's inception in May of 2006, it has returned 91.66 per cent, compared with 15.67 per cent for the TSX.

Dianne Maley