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Hedge Fund Investing With a ‘Peace-of Mind’ Twist: A Bank Guarantee on the Initial Investment

by Wayne Cheveldayoff, 2003-06-06

The financial engineers of the Canadian investment community are making it increasingly easy for individuals to invest in hedge funds, which have earned their standing as a legitimate asset class by outperforming equity funds over the past three years. The latest innovative examples are two different hedge fund notes that allow individuals to invest as little as $2,500 and carry the added benefit of a bank guarantee on the initial investment. The bank guarantee provides a substantial amount of “peace of mind” for investors and in a disaster scenario could be worth a lot more than the extra fees involved.

The two notes, offered only through investment advisors, have a similar overall structure. The funds are allocated (to spread the risk) to several hedge fund managers for a specific term, around 7 years. At the end of the term, the investors get back their original investment plus any additional returns. These returns will be roughly the same as those produced by the underlying hedge funds, less the extra fees involved (which go for the guarantee to the bank, the commissions paid to advisors to sell the notes, and a profit for the financial engineers).

The notes are 100% eligible as Canadian content for registered plans, such as RRSPs, and are tax efficient in that returns are not taxed until the notes are redeemed. If investors want to get out of the notes before the end of the term, they can, once a month, for full accumulated value, less any redemption fees that are applied on a declining scale in the first few years.

However, this is where the similarities end. The notes are quite different in the details, and investors would be wise to get the help of an investment advisor to sort through the fine print when doing their due diligence.

The Arrow Multi-Strategy Notes, Series 1, are being offered by Arrow Hedge Partners Inc. (www.arrowhedge.com). The notes are issued by BNP Paribas (Canada) and guaranteed by parent BNP Paribas SA, the largest banking group in France with a relatively high ‘AA’ rating from Standard and Poor’s and Moody’s. Minimum investment is $5,000.

The note’s performance is linked to the Arrow Multi-Strategy Hedge Fund, “which has an annual absolute return objective of 7% to 9%, after all fees.” Arrow Hedge Partners says its fund had an annualized return of 9.7% from January 2001 to March 2003, compared with minus 16.6% for the S&P500.

For diversification, Arrow expects to allocate the invested funds to 20 hedge fund managers across nine difference investment strategies, including “long/short equity, equity market neutral, high yield hedge, risk arbitrage, convertible arbitrage, fixed income arbitrage, distressed securities, managed futures and global macro. Each underlying hedge fund manager employs stringent risk management procedures. In addition, Arrow performs qualitative and quantitative analysis, rigorous manager due diligence and ongoing monitoring at both the individual and fund of funds level.”

The fees, like the structure, are somewhat complicated. The underlying hedge fund fee is 3.5% annually, plus 20% of any returns earned each year. In addition, BNP charges 1.05% for the guarantee and to swap any income earned into more tax-advantaged capital gains.

The other guaranteed notes currently being marketed to investors, known as Pro-Hedge Principal Protected Notes, Univest Series 1, are offered by Pro-Hedge Funds Inc. (www.pro-hedge.com). The 100% principal guarantee at maturity is provided by French-owned Societe General, one of the world’s 20 largest banks (also with a ‘AA’ rating). Minimum investment is $2,500.

The performance of the notes is linked to the Univest Ltd. Fund managed by Norshield Asset Management based in Montreal. According to Pro-Hedge, the fund produced a 19.45% annualized gain from inception (April 1991) to January 2003, versus 11.96% annualized return for the S&P 500 over that period. The Univest fund is a multi-strategy, multi-manager fund of hedge funds consisting of 9 styles and 14 managers.

One difference from the Arrow notes is that the Pro-Hedge notes have a “dynamic leverage policy” which permits a minimum 100% and a maximum 150% exposure to the underlying hedge fund. If this is used to boost leverage, the Pro-Hedge notes could end up outperforming the underlying Univest fund.

This is an advantage Pro-Hedge points to in discussing how the fees, which appear higher than the Arrow fees, will be offset. The Univest fund carries fees of 2% annually plus a 25% performance fee on gains. In addition, Pro-Hedge takes a management fee of 1.8% plus a 5% performance fee. The guarantee costs U.S. 3-month Libor plus 0.35 percentage point annually (currently totaling 1.63%).

Hedge fund fees are normally higher than those of traditional equity funds. But is it worth it to pay additional fees for the guarantee? For most individual investors, it would be, just to protect against some type of disaster.

Similar bank-guaranteed notes were issued in 1999 and 2000 for equity mutual funds. Investors in those equity linked notes were protected as the equity markets tumbled for three years in a row.

While hedge fund of funds like those underlying the guaranteed notes described above are supposed to show steady gains whatever is happening in the markets, one never knows what the future will bring. It would certainly help “peace of mind” to buy some insurance.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. He can be contacted at wcheveldayoff@yahoo.ca.

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©2003 Wayne Cheveldayoff