Most investors would consider a loss of, say, 30 per cent in a year a disaster. Many would be completely shocked to lose money over 10 years. But what about a loss of 100 per cent, or even more, in one year?

Hedge funds, with their aim to make money regardless of market direction, catch the imagination of many investors. But these securities are not well suited to most investors.

Navigating Canada’s securities laws and regulations can be a daunting task. But they’re there to protect investors from organizations using arcane concepts without full explanations.

With regard to the regulations covering mutual funds, an important principle is clear. Managers of mutual funds cannot do anything that would result in the investor losing more than his or her initial investment. Borrowing money to invest, for example, exposes you to the potential to lose more than you put up in the first place.

Selling securities short entails a similar risk. That’s because, in theory, a stock can increase in price without limit whereas it can fall no further than zero. If you sell 100 shares short at, say, $10 and the price suddenly shoots up to $50, you would lose $4,000. But if you bought the shares (long) at $10, you could lose no more than your $1,000.

Similarly, buying futures contracts exposes you to leverage unless you put up the full amount of the value of your long position. A contract for 5,000 bushels of wheat at $3, for example, can be entered into by qualified investors with a deposit, or margin, of just $2,000. But to avoid the potential to lose more than that, you would have to put up the full $15,000.

National Instrument 81-102 prohibits these types of activities in mutual funds, though regulators can make exceptions.

Another important feature of the laws and securities governing mutual funds is that they are sold ‘under prospectus’ That means you must receive a document that completely details the nature of the fund in which you plan to invest.

These laws and regulations protect mutual-fund investors from money-management practices that, however well intended, can and sometimes do create financial disaster for investors in non-regulated funds. In fact, the famous Long Term Capital hedge-fund disaster of the late 1990s nearly bankrupted the entire U.S. banking system.

These high-risk tactics have a legitimate place in the investment world for people who understand them and can afford the risks involved. So securities’ laws allow for so-called ‘sophisticated’ or ‘accredited’ investors to buy funds exempt from the rules.

That means anyone who owns, alone or with a spouse, net assets worth more than $1 million, or has a net income before taxes of more than $200,000 ($300,000 if combined with a spouse) in each of the past two years.

Note, however, that hedge funds are usually structured as limited partnerships or trusts. In recent years, though, they have been increasingly structured as something else, such as closed-end funds, commodity pools, and principal protected notes. In this way, hedge funds can be targeted toward the ordinary investor.

All things to all investors

It’s easy to understand why investors may find hedge funds appealing. Their ability to sell securities short, after all, makes it possible for them to profit when share prices fall. In other words, you can make money in bull and bear markets.

And now that many equity markets have reached highs, hedge funds may find it easier to woo investors with that prospect — the ability to offset long positions with short positions.

Ideally, you might expect your hedge fund to follow such a strategy. In the real world, however, it’s not unusual for the loosely-regulated managers of these funds to find themselves in highly speculative and risky positions from time to time. And, of course, the more successful a hedge-fund manager is at manipulating these risky strategies, the more confident he or she becomes at taking riskier, unhedged positions.

So the risk in these funds is that, contrary to initial intent, fund managers may drift into positions of extreme risk and, occasionally, get caught. After all, these positions, while inadvisable, are not necessarily illegal.

It’s unlikely investors in higher-profile hedge funds will ever lose more than than they invest. But it is not unheard of for them to lose all of their initial investment. Because it’s legal.

Money Reporter, MPL Communications Inc.

133 Richmond St.W. Toronto, ON, M5H 3M8. 1-800-804-8846