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New income trust fund uses hedge-fund tactics to bolster returns, reduce risk

by Wayne Cheveldayoff, 2005-04-14

A group of Toronto-based portfolio managers is introducing hedge-fund tactics to the income trust market in a way that will allow individual investors to participate.

Front Street Investment Management has filed a prospectus for a new TSX-listed fund that will take long and short positions in individual business, energy and real estate income trusts and do almost anything else the managers think will score returns and reduce risk for unitholders.

The fund, called the Front Street Long/Short Income Fund, breaks new ground. There are no other funds like it in the Canadian income trust sector.

Other choices in the market, such as mutual funds that specialize in income trusts, are plain vanilla Ė only taking long positions. The same is true for their closed-end cousins listed on the TSX, although some closed-end funds investing in income trusts have the authority to borrow up to 20 or 30 per cent of net asset value to achieve improved returns through leverage.

In contrast, the Front Street Long/Short Income Fund, according to the prospectus (available for viewing at, can do anything. It will be able to sell short as well as go long, and it will also be able to use leverage and derivatives where appropriate and invest in preferred shares, corporate and government bonds, and common shares.

This opens up many possibilities. For example, if the managers think one of the business income trusts is about to cut its cash distributions, they could sell the units short, thereby benefiting when the event occurs and the unit price drops.

If they believe the trust market generally is about to rise, they can borrow to buy more units and thereby enhance the capital gains. Borrowing could also bolster distributions since the cost of borrowing is well below the 7-to-10 per cent cash yields for many income trusts.

If the fund is holding oil and gas royalty trusts and the managers expect the price of crude oil to drop, they could hedge the position by selling crude oil futures short.

If the managers expect interest rates to rise significantly and thereby undermine income trust unit values, they could hedge with interest rate futures.

Another tactic might be long-short pairs trading. An example would be to be long an oil and gas royalty trust with a long reserve life while being short one of the trusts where reserves are depleting more quickly.

The prospectus says the Front Street fund intends to pay a steady stream of monthly cash distributions, initially targeted to be $0.05 per unit (or $0.60 per annum), representing a yield of 6 per cent per annum on the original $10 price of the units.

The document also puts ranges on the various strategies to be employed. Income trusts must make up between 50 and 100 per cent of the fund, other equities canít be more than 50 per cent, and both cash and short positions canít be more than 50 per cent. The manager expects leverage employed will initially be between 15 and 25 per cent of net asset value.

With the hedge-fund strategies also come hedge-fund management fees. Like mutual fund managers, the Front Street managers will get a standard 1 per cent annual management fee whatever happens. But they will also be entitled to a bonus worth 20 per cent of the annual return of the fund if the total return to unitholders is at least 12 per cent a year.

Investment advisors selling the fund will get a 5 per cent up-front commission, plus 0.40 per cent a year as a trailer fee.

One thing that may be a comfort to investors is that the Front Street managers, who include industry stalwarts Frank Mersche and Normand Lamarche, intend to invest between $5 million and $10 million of their own money in the new fund.

The group already operates a TSE-listed long/short fund in common equities, known as the Front Street Performance Fund, which to the end of February produced a compound annual rate of growth since inception in May 2002 of 24.4 per cent, which was more than double the 10.7 per cent annual growth rate of the S&P/TSX Composite Index in the same time frame.

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