Advisors may have years of experience and a great track record at picking mutual funds for their clients. But hedge funds are a very different animal. So, choosing one is a vastly different challenge.

“Hedge funds are where mutual funds were 10 or 15 years ago,” suggests Paul Perrow, president and CEO ofBluMont Capital Corp. in Toronto. “People talk about them as if they are all the same.”

Adds James Fox, director and vice president of sales and marketing at Sprott Asset Management Inc. in Toronto: “Hedge funds are misinterpreted in the marketplace.”

The differences are many. Hedge fund managers have access to more tools, including leverage and shorting, than a traditional money manager. Only accredited inves-tors can buy hedge funds and, as such, the minimum investment is often significantly higher than it is for a mutual fund.

And although they might use the same set of tools, certain types of hedge funds “are not necessarily hedged,” Fox says. Rather, aggressive, directional and opportunistic funds are leveraged to amplify profits. For each of these fund types, there are equity market-neutral funds, which are hedged in the true sense of limiting exposure to market risk.

In the hedge fund world, directional funds are the most aggressive variety, as they use greater leverage to achieve high returns, thereby exposing the client to more risk. Both macro trading, which trades in international markets and currencies, and discretionary trading, which pits sectors against each other, fall under that heading.

Arbitrage strategies, on the other hand, seek returns by exploiting price differences between similar securities, exposing the fund to less risk than directional funds.

Funds using a stock-selection strategy buy what they believe to be undervalued stocks and short the stocks they believe are overvalued in order to minimize market exposure and hedge risk — the original hedge fund strategy. Depending on the balance of long and short positions, such a fund can be market-neutral.

Additionally, hedge funds are not chained to a strategy in the way mutual funds are. Their strategies may shift as markets evolve and new opportunities present themselves. A hedge fund essentially empowers the managers to invest as they see fit. So, historical performance does not necessarily have any bearing on future strategies.

Along with the vast array of strategies that advisors must understand as they navigate the hedge fund world, they must also contend with a very different disclosure regime. Instead of issuing a prospectus on SEDAR, the system for electronic document analysis and retrieval, as a mutual fund would, a hedge fund issues an offering memorandum that describes the strategies, core techniques and tools its manager will use. Disclosure requirements are less demanding for an OM than for a prospectus, but an OM still provides insight into the strategies of a fund at its outset.

When examining an OM, Fox suggests advisors ask themselves whether it is “a marketing ploy — or does the portfolio manager have the expertise [to follow through on the proposed strategy]?

“You should also be aware of the leverage employed by the strategy,” Fox adds, and whether it fits with the level of risk your client is prepared to take on.

Because of the complexity of the tools and techniques that hedge fund managers may employ, Fox emphasizes that it is important to understand the fund’s strategy and how that would integrate into and add value to a portfolio.

And, Perrow adds, if, as an advi-sor, you cannot understand a manager’s strategy and it cannot be explained, then it probably is not the right place for your client to invest.

Because hedge funds are prospectus-exempt, less regulated and, therefore, less transparent than traditional investments, thorough research and a sound understanding of the fund manager is also paramount. Small companies and smaller funds can be “more nimble,” Fox says, but large firms can provide added value in other ways, such as clout, experience and contingency plans for rough times.

The availability of performance reporting is also key. Regular reporting will make a fund’s management more accountable and make it tougher for managers to hide any trouble in their portfolios.

Advisors must also be conscious of the redemption restrictions that many hedge funds employ to “minimize the impact on the limited partnership” when investors want out, Fox says. Hedge funds are less liquid than mutual funds, and the advisor must take into account “how much a client can afford to invest in a product that cannot be redeemed for 30, 60 or 90 days,” he says.

@page_break@If the nuts and bolts of a fund and the fund company are acceptable, the advisor must subsequently take a good look at the individual portfolio manager. BluMont manages funds of hedge funds, so Perrow keeps a close eye on a number of managers. When assessing a manager’s skill, Perrow suggests looking at how the manager has protected the assets in a portfolio in a down market. Hedge funds are expected to make money in bear markets because “you can’t eat relative returns,” as Perrow points out.

“If I were a broker doing due diligence,” Fox adds, “I would not only ask for their track record, but their assets under management.”

The reason? Earlier successes may have been in a lower asset class. “Managing $20 million, even $150 million,” he says, “is completely different than managing $1.5 billion.”

It also does not hurt to know what is going on in the manager’s personal life — such as the birth of a new baby or the burden of a nasty divorce — that might make the manager take his or her eye “off the ball,” Perrow says. This does not just apply to important events in their personal lives but extends to their working lives as well — when their business is growing very rapidly, a manager could get caught up managing the business instead of the fund.

As with any investment, picking the right time to get out is also important. As a hedge fund manager is not tied to a strategy, the fund a client is holding may no longer be the fund that was bought.

Also, a fund can be too successful. “If a portfolio can go up 30%-40% in a month, to what kind of risk is the manager exposing him- or herself to make that return?” says Perrow. It may no longer be the appropriate level or risk for the client holding it.

In addition, there is always the issue of bad trades by a portfolio manager. When judging a blunder, Perrow suggests looking back at the strategy and asking whether the manager was following it when he or she fumbled. “Did they do the wrong thing for the right reason,” he says — i.e., following the strategy — or was the manager grabbing at market-generated opportunities? If the decision reflects a loss of faith in the strategy your client bought into, it may be time to move on. IE