Investor enthusiasm for hedge funds — hot items in the early 2000s — has ebbed in the past year or so, according to Earl Bederman, president of Investor Economics Inc. of Toronto. The key reason is that “market volatility is at historic lows,” says Pierre Novak, managing director at BluMont Capital Corp. in Montreal.

However, many forecasters expect the markets will be more volatile over the next few months, and that should be good news for hedge funds, which grew rapidly in the first half of this decade. Total assets had vaulted to $15.4 billion by the end of 2004, compared with $2.5 billion in 1999, says Investor Economics.

The advisor’s task is to ensure clients understand how hedge funds work and the investment risks involved. Many experts says that hedge funds should not make up more than 10%-20% of a portfolio.

Most hedge fund strategies are designed to win whether a market rises or falls. They typically “buy long” a specific asset — a stock, bond or currency, for example — and “short sell” a negatively correlated asset that stands a reasonable chance of offsetting any loss on their “buy” position. (Short selling involves selling borrowed stock with the hope that it can be bought back at a lower price later on.)

The logic goes something like this: if a corporate bond that a fund has bought loses value, typically the stock of the same company will also decline. Having shorted the stock, the investor makes a profit that offsets his loss on the bond. The name of the game is to increase gains on both sides of the equation.

There are many different styles of hedge funds but the most common is the long/short equity hedge fund, in which managers “long” and “short” stocks whose characteristics offset each other. Funds employing this technique closely resemble mutual funds and use investment strategies typical of mutual funds: value, growth, growth at a reasonable price, and momentum, for example. The key difference is that a mutual fund manager is generally not permitted to short-sell a stock.

Leveraging is another typical characteristic of hedge funds, and the risk involved is the main reason regulatory agencies restrict hedge fund access to “knowledgeable” investors who can afford the required minimal investment, which ranges from $25,000 to $150,000. Leveraging varies widely among hedge fund categories. In most categories, ratios remain within a tame 2-to-1 range, in which the manager does not borrow more than $1 for each $1 he receives from investors. But in the global macro and managed futures, leverage ratios can be much higher; it is not unusual to see funds leverage 10 to 20 times their positions.

In recent years, multi-strategy funds have emerged (often referred to as funds of hedge funds) that invest in 30 or more hedge funds across all categories. They are the category most accessible to investors, sold by familiar fund families such as Toronto-based Mackenzie Financial Corp. , which offers the Mackenzie Alternative Strategies fund, or Arrow Hedge Partners Inc. of Toronto, with its Global Long/Short fund. Many of these funds, like Arrow’s Global Long/Short or BluMont Capital’s Market Neutral fund, require $25,000 initial investments, which makes them more accessible to regular investors.

Of course, all the strategizing costs money. A basic fund typically charges a 3%-4% fee, onto which is added the manager’s performance bonus of 10% to 20%. Above that, funds of funds add a management fee hovering between 3% and 3.5%.

In the early ’90s, hedge funds were sold on their “absolute return” virtues, because a good number of them had very virtuous returns ranging in the 30% to 40% level. But those returns now have come down to earth. One reason is that, in certain key categories, there are now many funds (more than 8,000 in North America) running after too few opportunities.

Performance numbers show that in years in which the stock market is weak, hedge funds usually do much better. When the stock market rises, hedge funds shine less, but still perform well. IE