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Jump into hedge funds has practical limits for RRSP investors

by Wayne Cheveldayoff, 2005-02-10

When it comes to using hedge funds in an RRSP portfolio, the theory is fine but the practice is still somewhat difficult for the average investor.

There is now a wide choice of hedge funds for the few who have $150,000 to put into a hedge fund or qualify as “accredited” investors – generally individuals with $1 million in financial assets or with pre-tax income of at least $200,000 in the past two years (exact rules vary from province to province).

For the majority of RRSP investors, however, the rules limit the alternatives mainly to special bank-guaranteed deposit notes whose returns are linked to a basket of hedge funds known as a fund of hedge funds.

The main argument for including hedge funds in a portfolio is that the fund-of-funds varieties at least provide reasonably attractive longer run returns comparable with traditional equities but with less volatility and probably less risk.

At the same time, 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.

The essence of portfolio diversification is 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 run. Thus, hedge funds can lead to less volatility in the total value of the portfolio and produce a steadier growth pattern over time.

The reason why hedge funds perform differently is that their managers can do all kinds of things that straight bond and equity mutual fund managers are not allowed to do.

Hedge fund managers can short stocks and other securities, use leverage, speculate in futures and commodities and do whatever else their traders think will make money.

Because of their unorthodox investment strategies, the performance of individual hedge funds can vary greatly, with the potential for big gains but also for big losses (more than 5 per cent of hedge funds go out of business each year).

It makes sense, therefore, to spread the investment risk over several funds, which is what a fund of hedge funds does.

It also can help to have a guarantee that, in case things go wrong, one gets the initial investment back.

This is where the hedge-fund-linked deposit notes come in. An example of such notes being marketed this RRSP season are the Arrow Multi-Strategy Series 6 Notes, with an advertised absolute return objective of 7 to 9 per cent annually.

Investors in these notes get a return linked to the Arrow Multi-Strategy Fund (a fully diversified pool of 20-25 hedge fund managers utilizing different investment strategies) and a guarantee from the Paris-based BNP Paribas bank that they will get at least their initial investment back after 10 years.

But as with all things in the investment world, there are potential drawbacks that buyers of such notes should be aware of. First, the total management fees (covering the hedge fund managers, fund of funds manager and bank guarantee) are pretty high – in the order of 4 to 5 per cent a year plus 20 per cent of any gains – and put a drag on returns.

Second, year-to-year performance may not be attractive compared with stocks or income trusts. For example, the Arrow Series 1 notes, introduced in June 2003, were up only 2.6 per cent in the year ended January 31 and have produced an average annual return of 7.4 per cent since inception (performance information at

This pales in comparison with the gains recorded for the S&P/TSX Composite Index of 26.7 per cent in 2003 and 14.5 per cent in 2004, or with the 20-25 per cent average annual gains for income trusts in the same period.

However, one should keep in mind that hedge funds outperformed during the stock-market meltdown. As measured by the CSFB/Tremont Hedge Fund Index of 300+ hedge funds worldwide (recording an average annual gain of 10.98 per cent since 1994), hedge fund performance was a positive 4.4 per cent in 2001 and 3 per cent in 2002 when the S&P/TSX Composite fell 12.6 per cent and 12.4 per cent, respectively.

Despite their recent lagging performance, hedge funds could once again look good in the near future if rising interest rates trigger a simultaneous slump in stocks, bonds and income trusts.

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 and he can be contacted at

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©2005 Wayne Cheveldayoff