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Hedge Funds February 11, 2005

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Hedge Funds February 11, 2005 Alternative Investment Spotlight: Hedge Funds February 11, 2005 Report Prepared by: Research Marketing Group TD Waterhouse Private Investment Advice TD Bank Tower 66 Wellington Street West, 7th Floor Toronto, ON M5K 1A2 • The purpose of this report is to provide clients an introduction to hedge funds. • We provide an overview of hedge fund strategies and their structure, and outline the benefits and drawbacks to investing in hedge funds. • The goal of this report is to communicate the diversification and risk reduction benefits available to high net worth clients by employing hedge funds in portfolio construction. • In making our case for hedge funds, we introduce our approach of maintaining two hedge fund lists — 1 for equity-oriented investors and another for more conservative clients. • Our fund selections will be reviewed and updated on a quarterly basis. Full disclosure on any securities mentioned in this report are available from your Investment Advisor. This newsletter is for distribution to Canadian clients only. Please see the final pages of this report for important disclosures. Private Investment Advice For some time, institutions have used alternative investments such as hedge funds to diversify their portfolios, help reduce risk and generate returns. While universities such as Harvard and Yale were early adopters of alternative investments, increased interest from corporate pension plans and other institutions, as well as heightened media attention, have prompted individual investors to ask themselves whether hedge funds are the answer to immunize their portfolios from the volatility of equity investing, while seeking to bolster the paltry returns currently offered by fixed income markets. While there is no doubt that many institutions are moving aggressively to add alternative investments to their existing portfolios, a lack of understanding among individuals has largely kept higher net worth investors from capitalizing on what we believe to be an attractive opportunity to help reduce portfolio risk and increase diversification by adding a non-correlated asset to a traditional portfolio of stocks and bonds. The focus of this report will be to both explain alternative investment funds (specifically, hedge funds) and present our case for their inclusion in individual high net worth client portfolios. What are Hedge Funds? The term hedge fund dates back to 1949 when a sociologist by the name of Alfred Winslow Jones, while working on a project for Fortune Magazine, devised a system of investing that involved buying securities while selling short other companies to neutralize overall exposure to the market. Mr. Jones’s goal was to purchase undervalued equities, while hedging his market exposure by selling shares in less attractive companies with similar attributes. His success was touted by Fortune Magazine, his former employer, in a 1966 article which highlighted his unique investment style and other factors that are still prominent in hedge funds today. These included his performance based compensation, the investment of nearly his entire net worth in his own fund and most importantly, his stunning outperformance of his long-only peers and the index. Comment: Long-only pertains to investors, who do not short stocks, and only hold long positons — mutual funds Today, the term hedge fund has become a homogenous term that has been used to label are long-only investments. investment pools that utilize strategies that are not eligible to be used in the strictly regulated mutual fund industry. These strategies include the use of leverage, derivatives and short selling. Comment: Leverage is calculated by While many people view the use of these investment tools as being speculative in nature, the taking the net assets invested in the fund and dividing it by the fund’s capital base. funds we highlight will focus on funds that use alternative strategies to help reduce risk in a portfolio — not add to it. Comment: Derivatives of equity and bond markets include options and futures. By buying an option or a future, one is Hedge funds have been largely unregulated and have been known to provide little in the way receiving levered exposure to the returns of transparency to investors. While a push by the Securities and Exchange Commission in the or losses of an underlying security. United States is forcing every hedge fund to register itself with the agency and follow more Comment: Short selling involves borrowing an asset in the hope that its stringent reporting rules, the lack of transparency in the area continues, as many hedge fund price will decline. In hedge funds, managers believe that disclosing their holdings and current trades will rob them of their however, short selling can be used as a competitive advantage. tool to mitigate risk on another position that is held in the portfolio. With nearly a trillion dollars in assets and an estimated 7000 funds globally, alternative investment funds are on the cusp of becoming mainstream in Canada. Hedge fund providers have answered the demand and interest in hedge funds with, literally, thousands of new products globally. While many talented investment managers have started up hedge funds in the past, there have also been a number of companies in the hedge fund space that are looking to capitalize on the current market trend. TD Waterhouse Private Investment Advice – Research Marketing Group 2 Private Investment Advice Global Hedge Fund Industry - Assets and Funds $1,000 8000 Estimate Dec 2004; $900 7000 7000 Funds, USD1 Trillion $800 6000 ) $700 5000 $600 $500 4000 $400 Estimate 3000 Assets (000,000 USD (000,000 Assets $300 2000 $200 1000 $100 $- 0 1990 1992 1994 1996 1998 2000 2002 2004 Source: Hedge Fund Research Inc. & Research Marketing Group For investors looking to invest in hedge funds, we believe a disciplined and stringent due diligence process of both the manager and the potential benefits of a strategy should precede any thoughts of investment. The Anatomy of a Hedge Fund While it is true that hedge funds differ significantly from mutual funds, investors’ familiarity with mutual funds allows us an opportunity for comparison. Factor Hedge Funds Mutual Funds Return Targets Absolute Relative Strategies Flexible (leverage, shorting) Constrained by a Benchmark Diversification Benefits Low Correlation to Market High Correlation to Benchmark Liquidity Less Liquid Daily Liquidity Regulation Less Transparent Strictly Regulated Fees Performance Based Asset Based Source: Research Marketing Group Absolute Returns The central reason that investors are contemplating investing in hedge funds is the potential Comment: Page: 2 for absolute, positive returns through all market environments. Equity mutual funds tend to be A statistic that measures the strength of highly levered to the returns of the stock market. Certain hedge fund’s strategies aim to generate the relationship between two series of data. Strong positive correlation (close to absolute returns with low correlation through the use of alternative strategies such as shorting, the +1) indicates assets whose prices move in use of derivatives for hedging purposes, and leverage. the same direction. Conversely, negative correlation indicates assets whose price move in opposite directions. Low correlation (close to 0) is optimal for diversification purposes. TD Waterhouse Private Investment Advice – Research Marketing Group 3 Private Investment Advice In the mutual fund arena, portfolio managers’ performance is typically measured against a benchmark index, such as the S&P/TSX Composite or the S&P 500. For this reason, mutual fund managers tend to make investments in companies and sectors relative to their tracking benchmark. A manager can be deemed successful, having lost money, if they lose less than their tracking benchmark. Losing only 10% when the index a fund manager is tracking has lost 20% is an example of value being added on a relative basis. Typically, value is attempted to be added as the fund manager will have a view of over, or underweighting certain companies or sectors relative to their weighting in the index. Hedge fund managers tend to pay far less attention to the benchmark weighting of companies as they are focused, and compensated on absolute returns, not their performance compared to an index. Flexibility The flexibility afforded alternative investment fund managers, shorting specifically, allows managers to diversify the source of their returns away from that of the stock market by neutralizing the systematic risk in a portfolio by offsetting market exposure with appropriate Comment: Idiosyncratic risk is the short positions. Hedge managers can employ a diverse number of strategies including unique risk of a specific security. Systematic risk is the risk inherent in the capitalizing on corporate events and arbitrage opportunities as a means of generating return. entire market. Equity long/short strategies, despite having varying levels of market exposure, use the ability to short securities as a means to immunize a portfolio from market risk. A prototypical “pairs trade” Comment: A pairs trade involves the for a long/short equity manager could be to purchase the strongest company in a sector while purchase of one security and the simultaneous sale (shorting) of another. shorting a company in the same sector with weaker fundamentals. These companies are generally in the same industry and have similar attributes. These trades are typically viewed as a To carry our example one step further, we could hypothesize that a long/short fund manager market neutral. operating in the Canadian market had a view in March 2003 that Telus would outperform BCE. Due to the fact that the two companies operate in the same environment with similar core businesses, one could argue that their individual businesses would be affected by economic and overall market forces in a similar fashion. The fund manager’s investment return, by being long one telecom company and short the other in the same proportions, would be based on the performance of the firms with respect to one another, and would be insulated, for the most part, from exogenous market factors.
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