Alts capitalize on volatile market

By Mark Noble | August 21, 2007 | Last updated on August 21, 2007
4 min read

There’s not a whole lot to cheer about in the markets lately, unless, perhaps, you’re in alternative investments. Market corrections and volatility are the proving grounds for many alternative investment funds to demonstrate why investors need to be wary about maintaining portfolios heavily dependent on the positive performance of equities.

Phil Schmitt, chairman of the Alternative Investment Management Association of Canada (AIMA) says Canadian hedge funds have done well over the past few years, particularly those that were able to take advantage of strong Canadian commodity markets. He admits though that during the bull runs, hedge funds, which tend to structure themselves to be non-correlated — or positioned against the market — can be a tough sell to investors during periods of high returns.

“You can’t see the value proposition of hedge funds when you’re comparing it to positive returns. You can’t substitute equity returns with a hedge fund,” he says. “It’s always the tendency of the investors to look at the strongest return provider and compare things to that.”

Schmitt adds that in periods of volatility though, hedge funds can really demonstrate their value. “There are certain market environments that hedge funds are often structured to do well in, particularly anytime there is corporate activity or volatility, as long as that fund is positioned for that volatility.

“People can be long in volatility or short volatility. People who are short volatility right now are having a particularly difficult time,” he says. “Offsetting that, there are a whole group of people who are poised for these kinds of events or have positioned themselves defensively to await this kind of event.”

A quick glance at some of the top-performing funds from the last month highlights this. According to Morningstar Canada, the top-performing fund as of August 20 was the Friedberg Currency Fund, managed by the Friedburg Mercantile Group. The fund, which is currently closed to new investors, has realized a 17% return over the past month but year-to-date is down 6.9%.

A representative from Friedburg says the currency fund, along with its sister Global Macro-Hedge fund, has profited by taking leveraged positions in the Japanese yen and a short position in the Brazilian real. In addition, the representative says the fund bet on the “right side” of the sub-prime market.

Betting on the sub-prime meltdown has worked with great success for the CI Global Opportunities Fund. The fund, which is also only for accredited investors, was the single most successful retail fund in the month of July according to Morningstar. By month end the fund’s manager, Nandu Narayanan of Trident Investment Management, had steered the fund to a three-month return of 28.66%.

Like many hedge funds, the Global Opportunities Fund experienced only a moderate growth of 6.9% over its five-year existence, though. Narayanan has credited his patience in waiting for the bottom to fall out on sub-prime for much of the fund’s recent success.

“We had one of our best months in July, with our hedge funds all up over 20% on the month. Our significant shorts in credit and real-estate lenders largely contributed to our performance. The credit rocket has just run out of gas, and gravity beckons for the markets,” Narayanan says in his monthly market outlook. “A descent into reality is what we are positioned for.”

But the majority of Canadians are not accredited investors. One investment vehicle available to the broader retail market that has been successful in the current market is BetaPro Management’s Horizon BetaPro S&P/TSX 60 Bear Plus (or “HXB-60”).

Howard Atkinson, president of Horizons Beta-Pro ETFs, says the market downswing has really demonstrated the appeal of having bear-market products in a diversified portfolio. Over the past three months, the HXB-60 has realized returns of 11.8%, and Atkinson says it has been the second most traded ETF in the Canadian market of late.

“We launched in January. The assets have flowed towards the bear fund from our bull-market fund for some time. Many money managers were anticipating a correction,” he says. “Over the last few weeks we’ve seen best trading volumes of our ETF as a group, and last Thursday we traded in 6.5 million shares, which was a record for us on the ETFs.”

BetaPro uses leverage to ramp up the exposure on the fund so that investors get two-to-one exposure, so if it represents 10% of a portfolio’s weight, its actual exposure is double that, or 20%. Atkinson says this is a key feature because it mitigates risk and reduces the capital an investor has to pay to put a market offset in his or her portfolio. Atkinson says downside protection is absolutely essential for portfolios in today’s market, especially since many investors are at a point where they don’t have the time to recoup significant losses.

“Managing portfolio drawdowns has become extremely important because the clients of advisors are getting older and they don’t have the same ability to recover from the market setbacks as they did when they were younger,” he says. “We rebalance our funds and ETFs on a daily basis. They’re RRSP eligible, and you cannot lose more than what you put in.”

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Mark Noble