Hedge Funds & Liquid Alternatives

Introduction

This guide describes the main hedge fund strategies, each by the mechanism that produces its return and the ways it can lose money. It sets out how hedge fund fees work, with a hypothetical worked example, and the two main structures through which these strategies are offered in Canada: exempt hedge funds and alternative mutual funds. It closes with the risks, how hedge fund performance is reported and read, and diligence questions.

What a hedge fund is

A hedge fund is a pooled investment fund whose manager may use tools that conventional mutual funds use sparingly or not at all. The name comes from hedging, holding offsetting positions so that some of the market's movement cancels out. Today the term covers a wide range of strategies, many of which hedge little.

• Short selling. The fund borrows a security, sells it, and later buys it back to return to the lender. It gains if the price falls and loses if the price rises.
• Leverage. The fund borrows money, or uses derivatives, to hold positions larger than its own capital. Gains and losses are both magnified.
• Derivatives. Futures, options and swaps give exposure to a price, or offset a move in it, without owning the underlying asset.
• Concentration and less liquid holdings. Larger positions in fewer holdings, and securities that trade infrequently, where the strategy calls for them.

These tools change the shape of returns; they do not, by themselves, make returns higher.

How the strategies work

The label "hedge fund" says little about how a fund behaves. The strategy says most of what there is to know about how it makes and loses money.

Long/short equity

The manager buys shares expected to rise (the long book) and sells short shares expected to fall (the short book). Return comes from the longs outperforming the shorts, plus or minus whatever the market does to the net position.

Net exposure is the long book minus the short book, as a share of the fund's capital. A fund 100% long and 40% short is 60% net long: it still rises and falls with the market, by less. Gross exposure is the two added together, here 140%, and measures how much capital is at work in total.

How it loses money: the longs fall while the shorts rise; a heavily shorted share rises sharply and short sellers are forced to buy it back (a short squeeze); the lender recalls borrowed shares; or both books share an unintended common exposure, such as company size or industry, that moves against them at once.

Market neutral and relative value

A market-neutral fund holds long and short positions of roughly equal size, so that net exposure is near zero and return is meant to come only from the relative performance of the positions. Many are systematic, using statistical models to hold hundreds of small positions. Relative-value strategies apply the same idea to other securities: convertible arbitrage buys a company's convertible bonds and sells short its shares; fixed-income arbitrage trades small pricing differences between related bonds.

How it loses money: the price relationships the strategy depends on widen instead of narrowing. Because the expected gain on each position is small, these strategies commonly use leverage, so a widening that would be minor unlevered can become a large loss. Funds running similar models can hold similar positions, and when several sell at once the losses feed on each other. Financing can be withdrawn at the moment it is most needed.

Event-driven

Event-driven strategies trade on corporate events. In merger arbitrage, after an acquisition is announced the target's shares usually trade below the offer price, because the transaction may not close; the fund buys the target and, where the offer is paid in the acquirer's shares, sells the acquirer short, earning the spread if the transaction closes. Activist funds take large stakes in public companies and press for change: asset sales, a new strategy, different management or a return of capital.

How it loses money: a merger arbitrage position gains a little if the transaction closes and loses a lot if it fails, because the target's shares tend to fall back toward their pre-announcement price. Regulatory refusals, failed financing and shareholder votes can all end a transaction. Activist positions are concentrated, can take years to resolve, and the campaign can fail.

Credit

Credit strategies trade corporate debt. A long/short credit fund buys bonds or loans it expects to hold their value and sells short, or buys default protection on, those it expects to weaken. Distressed funds buy the debt of companies in or near default, often well below face value, and seek to recover more than they paid through a restructuring or insolvency.

How it loses money: borrowers default and recoveries come in lower than expected; courts and creditor negotiations take longer, or rank claims differently, than the fund assumed; and many credit instruments trade infrequently, so positions can be hard to sell and to value in a falling market.

Global macro

Global macro managers take long or short positions on broad economic outcomes, in interest rates, currencies, equity indices and commodities, usually through futures, forwards and options. Some managers decide each position themselves (discretionary); others follow rules built into models (systematic).

How it loses money: the economic view is wrong, or right too early. Positions are often leveraged through derivatives, and a policy decision, such as a central bank changing course, can move markets abruptly against them. Results depend heavily on a few decision-makers.

Managed futures

Managed futures funds trade futures across asset classes, most often by following trends: buying markets that have been rising and selling short markets that have been falling. The managers are often called CTAs, after the US registration category for commodity trading advisors. Because the strategy can be short as easily as long, it can gain in a sustained decline in a market, including an equity market.

How it loses money: in markets that move sideways or reverse often, the strategy repeatedly enters a trend as it ends and exits after the reversal. These whipsaw losses can run for long periods.

Multi-strategy

A multi-strategy fund runs several strategies in one vehicle and moves capital between them. Some allocate to many separate trading teams, each with capital and loss limits set centrally.

How it loses money: positions held by different teams can turn out to be the same bet, so losses arrive together when they were expected to offset. The structure commonly uses leverage across the whole fund. Some funds charge operating costs, including staff compensation, to the fund in addition to a management fee, which raises the total cost.

How hedge fund fees work

The traditional structure is "2 and 20": a management fee of 2% a year on the fund's assets, and a performance fee of 20% of its gains. Many funds charge less, and the terms that apply are those in a fund's own documents. Three features decide what the performance fee takes:

• High-water mark. The fee is charged only on gains that take the fund above its previous peak, measured at the dates the fee is calculated. After a loss, the fund has to recover before any further performance fee is due.
• Hurdle. Some funds charge the fee only on returns above a set rate or a benchmark. Many hedge funds have no hurdle.
• Basis and frequency. Whether the fee is calculated on gains before or after the management fee, and how often it is calculated and paid (crystallized). Quarterly and annual are common.

The management fee is charged whatever the fund earns. Funds may also charge expenses such as administration, audit, legal and trading costs to the fund, and the offering documents list them.

Worked example: what fees take from a gross return

Hypothetical, round numbers, no real fund. Assumptions: 100 invested at the start of one year; the fund starts at its high-water mark; no hurdle; a management fee of 2% of the opening value, charged once at the year end; a performance fee of 20% of the gain remaining after the management fee; no other expenses.

At an 8% gross return the same steps give 8 − 2 = 6, then 6 − (20% × 6) = 4.8, a net return of 4.8%.

Three points follow from the assumptions:

1. The lower the gross return, the larger the share fees take, because the management fee is fixed. At a gross return of zero, the investor loses the management fee.
2. The basis matters. Calculated on the gain before the management fee, the performance fee in the first column would be 20% × 10 = 2.0, and the net return 10 − 2 − 2 = 6.0%. With a 5% hard hurdle (the fee applies only to the gain above it, with no catch-up) measured on the gain after the management fee, it would be 20% × (8 − 5) = 0.6, and the net return 8 − 0.6 = 7.4%.
3. The high-water mark carries forward. If the fund in the first column ends year one at 106.4 and falls below it in year two, no performance fee is charged in year three on the recovery up to 106.4, only on gains above it.

In practice management fees usually accrue through the year on net asset value, and the same steps can be run on any fund's own terms.

Two structures in Canada

Exempt hedge funds

An exempt hedge fund is sold without a prospectus, under one of the exemptions from the prospectus requirement in National Instrument 45-106. Which exemption is used depends on the investor and the province; the investor categories page sets out the categories the exemptions rely on. Exempt hedge funds are commonly structured as trusts or limited partnerships.

Because the fund is not publicly offered, the investment restrictions in National Instrument 81-102 do not apply to it. Its offering documents set its limits on leverage, short selling, concentration and illiquid holdings, and those limits can be wide. The same documents set redemption terms. Monthly and quarterly redemptions are both common, usually with a notice period, and some funds add an initial lock-up, a gate limiting how much can be redeemed at one time, or a right to suspend redemptions. Minimum subscriptions are set by each fund and are commonly higher than for mutual funds.

Alternative mutual funds

An alternative mutual fund, often called a liquid alternative, is a mutual fund sold under a prospectus that may use hedge fund tools within set limits. No prospectus exemption is needed to buy one, and it is held in the same kinds of accounts as conventional mutual funds.

The regime came into force on January 3, 2019, through amendments to NI 81-102 and related instruments. Before then, a narrower group of prospectus-qualified funds, called commodity pools, could create leverage only indirectly, through derivatives; the amendments renamed them alternative mutual funds and widened what they may do (Canadian Securities Administrators, CSA Notice of Amendments to NI 81-102 and related instruments, October 4, 2018). Under the amendments, an alternative mutual fund may:

• short sell securities worth up to 50% of its net asset value, against 20% for conventional mutual funds, and up to 10% in a single issuer;
• borrow cash up to 50% of its net asset value, with cash borrowing and short selling combined limited to 50%;
• hold aggregate exposure of up to 300% of its net asset value, counting outstanding loans, short positions and the notional value of derivatives other than hedges;
• invest up to 20% of its net asset value in a single issuer at the time of purchase, against 10% for conventional mutual funds.

Limits on illiquid assets stayed the same as for conventional mutual funds. An unlisted alternative mutual fund delivers a Fund Facts document at the point of sale; a listed one delivers ETF Facts. NI 81-102 also sets conditions on how an alternative mutual fund may charge a performance fee (same source). Individual funds can apply to the regulators for exemptive relief from some limits, and some have. Within these limits a strategy runs in a more constrained form than an exempt fund may use, so the same strategy name can describe quite different levels of leverage and short exposure in the two structures.

The two compared

Risks and how they show up

Short selling. A share bought can fall at most to zero; a share sold short can rise without limit, so the potential loss on a short has no ceiling. Shorts also carry borrowing costs, recall risk and squeeze risk.

Leverage. Borrowing magnifies losses as well as gains. When losses mount, lenders ask for more collateral, and a fund without it must sell positions, often into a falling market, which deepens the loss.

Derivatives. A derivative depends on the counterparty paying what it owes, and a hedge may not move as expected against the position it was meant to offset (basis risk).

Liquidity mismatch. A fund offering monthly or quarterly redemptions but holding positions that take longer to sell can face more requests than it can meet at fair prices. Gates, suspensions and side pockets (accounts that separate hard-to-sell holdings until they can be sold) are the tools fund documents provide, and they leave investors waiting for their capital.

Valuation, key people and operations. Positions that do not trade are valued by models or estimates, so who calculates net asset value, and whether an independent administrator does, matters. Many funds depend on one or two decision-makers. Prime brokerage, margin and derivative documentation can fail in ways unrelated to the strategy.

Hedge fund failures that drew wide attention have often combined leverage, concentration and positions that could not be sold quickly under stress. One widely studied case is Long-Term Capital Management. The fund had levered its capital through repurchase agreements and derivatives, often in thinly traded instruments, and by the end of August 1998 it had lost half its capital. On September 23, 1998, its private creditors and counterparties agreed to recapitalize it, in an arrangement the Federal Reserve Bank of New York facilitated without putting Federal Reserve funds at risk. The concern behind the arrangement was that forcing the fund to unwind would distort market prices and produce large losses for its creditors and other market participants (Board of Governors of the Federal Reserve System, testimony of Chairman Alan Greenspan to the House Committee on Banking and Financial Services, October 1, 1998). Diligence practice therefore spends as much time on a fund's financing and liquidity terms as on its strategy.

Reading hedge fund performance

Results vary widely between managers and strategies, so an average says little about any one fund. Broad hedge fund indices, such as the HFRI Fund Weighted Composite Index, are built from databases of returns that funds report voluntarily. Databases built this way carry known biases: funds that close stop reporting, so the surviving record looks better than the full one (survivorship bias), and funds often begin reporting after a good start, so where earlier returns are added the history looks better than investors experienced at the time (backfill bias). How far these reach a given index depends on its construction rules.

Three distinctions matter in any performance figure:

• Gross or net of management fees, performance fees and expenses; the worked example shows the size of the gap.
• Absolute or risk-adjusted. A lower return with much lower volatility is a different result from a higher one with large swings.
• Market exposure or skill. A net-long fund that rose with the market may have earned little beyond its exposure. Alpha is the part of return not explained by the market or other common factors.

How the class is held

Allocation frameworks have commonly treated hedge fund strategies as diversifiers rather than as a substitute for equities, and the thinking behind it was that strategies with low net market exposure would behave differently from stocks and bonds and smooth a portfolio's overall path. Frameworks commonly give strategies different roles: low-net strategies to reduce volatility, trend-following and macro for their ability to be short in a sustained decline, long/short equity as a lower-volatility form of equity exposure. Whether a strategy plays its role depends on the strategy and the period: in broad sell-offs, strategies with net long exposure or reliance on borrowed money have tended to fall alongside markets as correlations rise. Because results differ so widely, frameworks that use the class commonly spread holdings across several managers and strategies.

Holding the class involves a manager and a strategy that can be hard to observe from outside; in exempt funds, notice periods, lock-ups and possible gates; and fee terms that take a larger share of gross returns than in most conventional funds, which is why diligence practice reads them closely.

An exempt hedge fund reaches investors through several channels, among them these four. A subscription made directly with the manager adds no intermediary's fee and leaves the whole review with the investor. A fund of hedge funds spreads one investment across several managers and adds a second layer of fees. An exempt market dealer distributes securities sold under prospectus exemptions and is paid through commissions, sometimes with trailing fees. An online platform presents a range of offerings, with costs that vary by platform. Each channel has its own conflicts, and none removes the need for the investor's own review. An alternative mutual fund is bought through the same accounts that hold conventional mutual funds and exchange-traded funds.

Tax and registered accounts

Tax follows structure. A limited partnership allocates its income to the partners, who report it with its character intact on a T5013 slip. A trust generally distributes its income to unitholders, and certain kinds of income, such as capital gains and Canadian dividends, can keep their character when the trust designates them.

Registered accounts such as RRSPs and TFSAs can hold only qualified investments. Units of a limited partnership are not qualified investments; units of a mutual fund trust can be (Canada Revenue Agency, Income Tax Folio S3-F10-C1, Qualified Investments). Diligence practice is to see the basis for an offering's stated position in writing.

Questions to ask

• How does the fund make money, and in what market conditions has the strategy lost money?
• What are its typical and maximum gross and net exposure, and how much of its return has come from market exposure rather than security selection?
• How is leverage obtained, from whom, and on what terms can the financing be changed or withdrawn?
• How is the performance fee calculated: on what basis, against what high-water mark or hurdle, and how often is it crystallized?
• What expenses does the fund charge beyond the management and performance fees, and what did they total last year?
• How often can units be redeemed, with what notice, and what provisions allow gates, suspensions or side pockets? Have any been used?
• Who calculates the net asset value, how are hard-to-value positions priced, and who audits the fund?
• Who are the key decision-makers, and what happens if one of them leaves?
• Is the track record audited, net of all fees, and does it cover the strategy as it is run today?
• For an alternative mutual fund: how does the strategy differ from an unconstrained version of it, given the limits in NI 81-102?

Key terms

• Short selling: selling a borrowed security in the expectation of buying it back later at a lower price.
• Leverage: the use of borrowed money or derivatives to hold positions larger than a fund's own capital.
• Net exposure: a fund's long positions minus its short positions, as a share of its capital, which measures its sensitivity to market direction.
• Alternative mutual fund: a prospectus-qualified mutual fund permitted by NI 81-102 to short sell, borrow and use leverage within set limits.
• Exempt market: the market for securities sold under exemptions from the prospectus requirement.
• NAV: net asset value, a fund's assets minus its liabilities, the basis on which units are bought, redeemed and charged fees.
• Performance fee: a share of a fund's gains paid to the manager, commonly subject to a high-water mark.
• High-water mark: the previous peak value above which a fund must rise before a further performance fee is charged.
• Drawdown: the decline in a fund's value from a peak to a subsequent low.
• Gate: a provision that limits how much of a fund can be redeemed at one redemption date.

Related reading

• Private Credit
• Venture Capital