The Hedge Funds Industry

Products bring indexing to hedge funds for small investors

By ROB CARRICK ... Sat., November 15, 2003 -

Index investing and hedge funds have come together in some new products with special appeal to small investors.

Whereas most index funds track a stock index, these new hedge products mirror the performance of an index based on baskets of hedge funds overseen by Morgan Stanley Capital International and CSFB-Tremont.

With new hedge fund indexes appearing all the time, retail investors are likely to see an increasing number of hedge index products. Canadians have a couple of options for now, both of which are open to small investors as well as the high-net-worth types that are the usual hedge audience.

One is the Tremont Hedge Fund Index Linked Trust, an exchange-traded investment trust that will follow the CFSB-Tremont Investable Hedge Index of 60 global hedge funds. The other is ONE Financial MSCI Hedge Invest Index Notes, which deliver returns linked to the Morgan Stanley Capital International Hedge Invest Index and its 74 underlying hedge funds.

There are already about half a dozen hedge products available to investors of all types, but these two new ones stand out. The reason is their use of indexing, which is as well suited to hedge funds as it is to equity and bond investing.

An obvious benefit of taking an indexing approach to hedge funds is diversification.

The usual reason to buy a hedge fund is to have something in your portfolio that doesn't rise and fall along with the stock and bond markets, and can deliver gains in all market environments.

There are single hedge funds that can do this, but in limiting yourself to just one fund, you open the door to various risks. For example, the investing strategy your fund uses may hit a barren period, or your manager may stumble.

The hedge fund industry's answer to these risks is the fund of funds, which is an ideal entry into the hedge world for most investors. The problem with a fund of funds is hefty fees.

Each constituent hedge fund in these products has its own fees. On top of that, the people packaging the fund take their cut, with additional performance fees for meeting certain return thresholds.

All told, you've got multiple layers of fees that might easily add up to a management expense ratio of 3 or 4 per cent. Put another way, unitholders only start making money after the fund has cleared 3 or 4 per cent.

Indexing cuts these fees significantly because there's a lot less work for the fund managers. Instead of shopping around for the right pieces to put in a fund of funds, they simply buy funds already selected for inclusion in recognized hedge indexes.

For example, the Tremont product will have an MER in the area of about 1.75 per cent.

This fund is now in the preliminary prospectus stage and should be listed for trading in the not-too-distant future.

The ONE Financial notes have an underlying MER of 1.5 per cent. These capital-guaranteed notes are on sale from brokers and fund dealers until Dec. 15, with a $2,000 purchase minimum.

An index fund is only as good as its index, which means you'll have no worries with the CFSB-Tremont and MSCI hedge indexes. Both are considered to be benchmarks for the sector.

The CFSB-Tremont Investable Hedge Fund Index covers 10 hedge categories, including market neutral, long-short, managed futures and emerging markets.

To manage risk, the fund will be rebalanced periodically to cap the weight of any individual fund at 8 per cent.

The ONE Financial hedge notes are based on the returns of the MSCI Hedge Invest Lyxor Tracker Fund, which in turn mimics the MSCI hedge index. There are 11 categories of hedge funds in the index.

Both the CFSB-Tremont and MSCI indexes look good from a returns point of view.

The CFSB-Tremont index generated a cumulative return of 38 per cent from Jan. 1, 2000, through the end of September (these numbers are somewhat hypothetical because the index didn't get going until this past August), while the MSCI Index has made about 50 per cent. By contrast, the Dow Jones Industrial Average lost 19.3 per cent over the same period.

Tremont Hedge Fund Index Linked Trust should give you the return of its underlying index, minus the MER. This is a tax-advantaged fund, which means that it's considered Canadian content for registered retirement plans and that taxes are deferred until the fund matures after seven years or you sell.

ONE Financial's MSCI Hedge invest index notes guarantee that you'll receive your capital back at the end of the 10-year term, and that you'll receive a minimum 10-per-cent return (the guarantees are backed by the large French bank Société Générale).

Returns are calculated as 150 per cent of the average monthly net asset value of the fund over the term of the investment. This formula ends up giving you the returns of the index minus a couple of percentage points to pay for the capital guarantee.

The next avenue for hedge index products will probably focus on specific hedge strategies, but for most investors these will be a luxury. If you want hedge exposure, a broad-based approach works best.

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