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RRSP Investors Should Consider Hedge Funds to Better Diversify Their Portfolios

by Wayne Cheveldayoff, 2004-01-30

Most RRSP investors have a mix of stocks and bonds in their portfolios but they would be wise to consider adding hedge funds.

Hedge funds for many years were only available to institutions like pension funds or very wealthy individuals. But new developments now make them available to the average RRSP investor.

The attraction of hedge funds is two-fold. First, they provide attractive returns comparable with traditional equities but with less volatility and probably less risk.

Second, hedge funds have a low correlation to equities and bonds – meaning they tend not to move in the same direction or to the same degree as equities and bonds.

Having a range of assets that perform well over the longer run but whose returns don’t tend to go up and down together in the short-term is the essence of portfolio diversification. It leads to less volatility in the total value of the portfolio and produces a steadier growth pattern over time.

The reason hedge funds perform differently than equity and bond funds is that their managers are allowed to engage in whatever investment strategy they want. Unlike equity mutual fund managers, who can hold only stocks or cash, hedge fund managers can additionally sell stocks short, use derivatives, speculate in commodities or currencies and do whatever else their traders think will make money.

When stocks are trending down, as they were recently, hedge funds can sell stocks short and buy them back later, thereby profiting from the decline.

During the 2000-2002 period, stock markets dropped but hedge funds, on average, still went up.

The CSFB/Tremont Hedge Fund Index, the most comprehensive and referenced measure of hedge fund performance, rose by 4.8 per cent in 2000, 4.4 per cent in 2001 and 3 per cent in 2002.

By contrast, the U.S. S&P 500 stock index fell 9.1 per cent in 2000 and again by 11.9 per cent in 2001 and 22.1 per cent in 2002.

Similarly, the S&P/Toronto Stock Exchange Composite index rose 7.4 per cent in 2000 but then declined 12.6 per cent in 2001 and 12.4 per cent in 2002.

When stock markets recovered in 2003, the average hedge fund rose as well but in a more muted fashion. In 2003, the U.S. S&P 500 index was up 28.7 per cent and the S&P/TSX Composite index climbed 26.6 per cent. However, the CSFB/Tremont Hedge Fund Index rose by a slower 15.4 per cent.

As these numbers illustrate, hedge funds on average are less volatile than equities. On the basis of a common measure of volatility (standard deviation), the CSFB/Tremont Hedge Fund Index had half the volatility of the S&P 500 over the past 10 years (8.5 per cent for hedge funds versus 15.8 per cent for the S&P 500).

Yet, the longer-run performance of hedge funds is quite good. For the past 10 years, the average annual growth rate for the CSFB/Tremont Hedge Fund Index was 11.1 per cent, the same as for the S&P 500. The 10-year average annual growth rate for the S&P/TSE Composite was only 8.6 per cent. The comparable return on U.S. T-Bills was 4.1 per cent.

So, with the longer run numbers looking attractive, hedge funds have earned a place in people’s portfolios, perhaps as much as 20 per cent.

The challenge for average investors, however, is to find the right hedge fund investment product.

There are several ways to include hedge funds in an RRSP – a lot of them quite new.

Investing in a single hedge fund is usually limited to wealthy, sophisticated investors.

In any event, it is better to diversify your investment over several funds because the performance of any single hedge fund could be wildly good or bad in any given year. The managers are paid to take unusual risks and sometimes, as they say in the investment community, a portfolio position simply unexpectedly “blows up.”

Special funds of hedge funds – where a fund invests in 10 or more hedge funds – are available to Canadian investors. One advantage to this approach is that the manager of the fund of hedge funds monitors the performance of each component hedge fund and replaces any that are having problems.

In order to make hedge fund investing a reality for many small investors, some hedge fund companies have created deposit notes linked to hedge fund performance. The notes, issued by banks in Canada, guarantee the initial investment and give investors a return linked either to the performance of a hedge fund index, or the performance of a fund of hedge funds. Minimum investment is as low as $2,000 in some cases.

However, hedge fund products are quite complicated in the way they work and there is a large variation in the fees attached. Reading the fine print is essential.

Therefore, in making their hedge fund choices, most RRSP investors should consult with a knowledgeable investment advisor who is keeping up with all new developments in the sector.

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. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2004 Wayne Cheveldayoff