A hedge fund is a pooled investment fund that uses complex trading and risk management techniques, such as short selling, leverage, and derivatives, to aim for improved performance and insulate returns from market risk. In Canada and the United States, these funds are typically marketed only to institutional investors and high-net-worth individuals. The Canadian hedge fund industry, while a small portion of the global total, has grown significantly and offers diversification and return potential for qualified investors. Understanding hedge funds is important for Canadian investors seeking alternative investments beyond traditional mutual funds and ETFs.
What Is a Hedge Fund
A hedge fund is an alternative investment vehicle structured as a pooled fund. Its defining characteristic is the use of sophisticated trading and risk management techniques not typically employed by retail investment funds like mutual funds or exchange-traded funds (ETFs). These techniques include short selling, the use of leverage (borrowed money), and trading in derivative instruments. The goal of these strategies is twofold: to improve investment performance and to insulate returns from general market risk. Hedge funds are considered distinct from private equity funds because they usually invest in relatively liquid assets and are open-ended, meaning investors can typically invest and withdraw capital periodically based on the fund's net asset value. In the United States and similarly in Canada, financial regulations restrict the marketing of hedge funds to institutional investors and high-net-worth individuals, deeming them unsuitable for the general retail public.
There is no single formal or fixed definition of a hedge fund, leading to different views on what constitutes one. What unites them is their status as largely unregulated investment pools for accredited investors, their ability to employ a wide array of financial instruments, and their common fee structure. This structure typically involves a management fee, often 2% per annum of the fund's net asset value, and a performance fee, often 20% of the increase in the fund's net asset value during a year. Many hedge fund strategies aim to achieve a positive return regardless of whether financial markets are rising or falling, an approach known as targeting "absolute return." While hedge funds can be risky, the use of hedging techniques means the expected returns of some strategies can be less volatile than those of retail funds with high exposure to stock markets.
History and Evolution
The concept of the hedge fund has evolved over many decades. The sociologist Alfred W. Jones is credited with coining the phrase "hedged fund" and creating the first recognized hedge fund structure in 1949. Jones also developed the popular 2-and-20 fee structure. Earlier, during the US bull market of the 1920s, private investment vehicles like the Graham-Newman Partnership, cited by Warren Buffett as an early hedge fund, were available to wealthy investors. The industry grew slowly, with many funds closing during the recessions of 1969 to 1970 and 1973 to 1974. Hedge funds received renewed attention in the late 1980s and expanded rapidly during the 1990s stock market rise.
The 21st century saw hedge funds gain massive popularity worldwide. By 2008, the global industry held an estimated US$1.93 trillion in assets under management (AUM). The 2008 financial crisis caused a setback, with many funds restricting withdrawals, but AUM rebounded to nearly $2 trillion by April 2011. The industry reached a record high of US$2.13 trillion in April 2012. By July 2017, hedge funds recorded their eighth consecutive monthly gain, with AUM rising to a record $3.1 trillion. As of 2021, global hedge fund assets totaled approximately $3.8 trillion. The industry has matured, consolidating around larger, established firms. The following list outlines key milestones in hedge fund history.
- 1949: Alfred W. Jones creates the first recognized hedge fund structure and the 2-and-20 fee model.
- 1990s: Number of hedge funds increases significantly during the stock market rise.
- 2008: Global hedge fund AUM reaches an estimated US$1.93 trillion before the financial crisis.
- April 2011: Global AUM rebounds to nearly $2 trillion.
- April 2012: Industry AUM hits a then-record US$2.13 trillion.
- July 2017: AUM reaches a record $3.1 trillion.
- 2021: Global hedge fund assets total approximately $3.8 trillion.
Notable hedge fund managers and their firms have shaped the industry. Ray Dalio's Bridgewater Associates grew to be the world's largest hedge fund firm with US$160 billion in AUM as of 2017. Other major firms have included Man Group, Paulson & Co., Brevan Howard, and Och-Ziff. In more recent years, firms like Citadel, Elliott, and Millennium Management are among the large, established players in the mature industry.
How Hedge Funds Work
Hedge funds operate by pooling capital from investors and employing a designated investment strategy executed by the fund manager. The manager has broad discretion to use a variety of techniques to achieve the fund's objectives, which are detailed in a prospectus or offering memorandum. This document outlines the fund's specific investment strategy, the types of investments it will make, and any limits on the use of leverage. The fund's approach is a combination of its market perspective, the instruments it uses, the sectors it specializes in, its investment selection method, and its level of diversification. Strategies can be discretionary, where managers identify and select investments, or systematic/quantitative, where a computerized system makes selections based on mathematical models.
The classic hedge fund compensation structure aligns the manager's interests with those of the investors. Managers earn a management fee, typically 2% of the fund's net asset value per year, which covers operational costs. They also earn a performance fee, typically 20% of the fund's gains during a year. This structure is intended to incentivize the manager to generate positive returns. Investors in hedge funds are typically institutions like pension and endowment funds or high-net-worth individuals, as regulatory requirements restrict marketing to the general public. Unlike mutual funds, hedge funds often have lock-up periods where capital cannot be withdrawn, and they may restrict withdrawals during periods of market stress to manage liquidity.
Major Hedge Fund Strategies
Hedge fund strategies are generally classified into four major categories, each with distinct risk and return profiles. A single fund may employ one strategy or combine multiple strategies for flexibility and diversification. The four primary categories are global macro, directional, event-driven, and relative value (arbitrage). Global macro strategies take large positions in markets like shares, bonds, or currencies based on anticipated global macroeconomic events. These can be discretionary or systematic and are often executed by commodity trading advisors (CTAs) trading in futures and swaps. Directional strategies seek to profit from market movements, trends, or inconsistencies, with greater exposure to overall market fluctuations than market-neutral approaches.
Event-driven strategies focus on corporate transactional events such as mergers, acquisitions, bankruptcies, or spin-offs. Managers aim to capitalize on valuation inconsistencies before or after such events. Sub-strategies include distressed securities (investing in bonds of financially troubled companies), risk arbitrage (betting on the outcome of mergers), and special situations (catalyst-oriented events like share buybacks). Relative value or arbitrage strategies exploit price discrepancies between related securities. These are often market-neutral, meaning they have little directional exposure to the overall market. A common sub-strategy is fixed income arbitrage, which seeks pricing inefficiencies in bond markets. The table below summarizes the core strategy categories and their general focus.
| Strategy Category | Primary Focus |
|---|---|
| Global Macro | Anticipating global macroeconomic events. |
| Directional | Profiting from market trends and movements. |
| Event-Driven | Capitalizing on corporate transactional events. |
| Relative Value (Arbitrage) | Exploiting price discrepancies between securities. |
Funds are also described by their return objectives. "Absolute return" strategies aim for positive returns in any market condition. "Market neutral" funds seek to have minimal correlation to overall market performance, while "directional" funds embrace market exposure. The specific strategy profoundly influences a fund's risk, volatility, and potential return profile.
The Hedge Fund Industry in Canada
The Canadian hedge fund industry, while a micro portion of the global total, has experienced significant growth and development. As of December 2005, hedge fund assets under management in Canada stood at $16.4 billion, with estimates for 2006 reaching approximately $35 billion. At that time, there were over 150 hedge fund managers in the country, with about 10% managing assets over $100 million. Industry observers, such as James McGovern, then CEO of Arrow Hedge Partners and chairman of AIMA, suggested the industry could triple in size within five years, driven by demand from high-net-worth individuals, local institutions, and European investors. The economic fundamentals were strong, with Canada experiencing a long expansion, low inflation, and healthy corporate profits.
The Toronto Stock Exchange (TSX), the third largest in North America, provides a key venue for hedge fund activity. Predominantly trading small to mid-cap stocks, the TSX was historically seen as somewhat inefficient and illiquid, creating potential opportunities for hedge fund managers. A survey indicated that hedge fund trading velocity accounted for nearly one-third of market activity on Canadian equity markets, with turnover rates far exceeding those of mutual funds, making hedge funds important providers of liquidity. The TSX Venture Exchange, with a heavy focus on oil, gas, and mining stocks, also offers opportunities, particularly in the resource sector which is a key attribute of the Canadian market. However, this specialization also introduces specific risks, as demonstrated by past events in the energy sector.
The industry is tracked by indexes such as the Canadian Hedge Fund Index, which monitors the performance of Canadian-domiciled hedge funds. To be included, funds must have a minimum AUM of C$15 million and at least a 12-month track record. The most comprehensive directory of hedge funds in Canada lists 355 funds across categories like Credit Focused, Equity Focused, Market Neutral, Global Macro/Managed Futures/Multi Strategy, Private Debt, Private Equity, and Mortgage Funds. These funds are considered for the annual Canadian Hedge Fund Awards.
Regulation and Notable Events in Canada
Canada's financial regulation is considered stringent, even compared to the United States in some aspects. Canadian investors can access hedge funds through managed accounts, pooled funds, and derivatives, but there are mandatory registration requirements for portfolio managers along with additional provincial regulations. A portfolio manager must be registered as an adviser or rely on a registration exemption. Fund managers trading in securities are generally required to comply with securities laws, even with no direct investor contact. The regulatory commitment to greater transparency has been regularly voiced by officials like the Chairman of the Ontario Securities Commission (OSC).
The Canadian industry has not been without scandal, which has tested its regulatory framework. In 2005, the Ontario Securities Commission withdrew the trading licence of Toronto-based Portus Alternative Asset Management amid allegations that sales were made to unauthorized investors. Portus had raised $800 million from 26,000 investors for principal-protected notes, but the protection was allegedly non-existent and funds went missing. Shortly after, in June 2005, one of Canada's largest funds of funds, Norshield, went into receivership. These events highlighted risks but also reinforced the regulatory focus on investor protection and sound corporate governance structures within the Canadian market.
Risks and Considerations for Investors
Investing in hedge funds carries several inherent risks that distinguish them from traditional investments. The use of leverage amplifies both gains and losses, potentially leading to significant volatility or even fund failure, as seen in historical collapses. The complexity of strategies and instruments, such as derivatives, can make risks difficult to assess fully. Liquidity risk is also a major concern. Hedge funds often impose lock-up periods restricting withdrawals, and they may gate redemptions during market stress, preventing investors from accessing their capital when most needed. Furthermore, the lack of transparency compared to regulated retail funds means investors may have limited insight into the fund's exact holdings or risk exposures.
The high fee structure is another critical consideration. The typical 2% management fee and 20% performance fee create a high hurdle for the fund to overcome to deliver net-of-fee returns that justify the risk. Performance fees also incentivize managers to take greater risks to achieve outsized gains. For Canadian investors, accessing hedge funds often requires working with a registered portfolio manager or adviser who can evaluate the suitability of these complex products. The benefits of hedge funds, such as portfolio diversification and the potential for absolute returns uncorrelated to markets, must be weighed against these substantial risks, high costs, and lower liquidity.
Frequently asked questions
What is a hedge fund in simple terms?
A hedge fund is a pooled investment fund that uses complex trading and risk management techniques. These techniques include short selling, leverage, and derivatives. Hedge funds are marketed only to institutional investors and high net worth individuals. They are considered alternative investments distinct from regulated retail funds like mutual funds.
How do hedge funds work in Canada?
In Canada, hedge funds operate similarly to global funds, employing various strategies and catering primarily to institutional investors and high-net-worth individuals. The industry is tracked by indexes like the Canadian Hedge Fund Index, which includes funds with at least C$15 million in assets. Canadian hedge funds are active on the Toronto Stock Exchange and often specialize in sectors like energy and resources. They are subject to provincial and national securities regulations, including mandatory registration requirements for managers.
Can anyone invest in a hedge fund in Canada?
Hedge funds are not marketed to the general public. Financial regulations require they be offered only to institutional investors and high net worth individuals. This restriction is due to their complex and high risk nature. The regulations are similar to those in the United States.
What are the main types of hedge fund strategies?
The four primary hedge fund strategy categories are global macro, directional, event-driven, and relative value (arbitrage). Global macro funds bet on large economic trends. Directional funds follow market trends. Event-driven funds profit from corporate events like mergers or bankruptcies. Relative value funds seek pricing discrepancies between related securities. Many funds use a combination of these approaches to manage risk and diversify.
What are the risks of investing in hedge funds?
Hedge funds can be considered risky investments due to their use of complex techniques and leverage. Their strategies, risks, volatility, and expected returns can vary greatly between funds. While some strategies aim for positive returns regardless of market conditions, the investments carry inherent risk. Investors should be aware of the specific risk profile of any fund.
How big is the hedge fund industry in Canada?
The Canadian hedge fund industry is a small portion of the global total but has shown significant growth. By 2006, assets under management were estimated at $35 billion, managed by over 150 fund managers. The industry is tracked by a directory listing 355 funds across various strategy categories. While smaller than US or UK markets, it is considered an area with potential for further expansion, particularly in resource-focused strategies.
Sources and further reading
- Hedge fund (Wikipedia) en.wikipedia.org
- Canadian Hedge Funds & Alternative Mutual ... aima.org
- Prime Services: Canadian Hedge Fund Index gbm.scotiabank.com
- THE Canadian Hedge Fund Directory alternativeiq.com
- Canadian Hedge Funds thehedgefundjournal.com
- Hedge Fund Strategies Canada russellinvestments.com
This article explains how things work and is not financial, tax or legal advice. Rules, limits and rates change, so check the current figures with the Canada Revenue Agency, your province or your financial institution before you act.