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To hedge or not to hedge

If volatile equity markets have you shying away from buying stocks for your registered retirement savings plan, and you are not satisfied with low interest rates on fixed income securities that give you a negative return when inflation is factored in, then it may be time to look at alternative strategies.

Alternative strategies, now an official mutual fund category, covers a growing number of hedge funds. These funds seek to provide positive returns using a mix of investment strategies and derivative products. Craig Ellis, a portfolio manager at Charles Schwab Canada in Toronto, says derivative is a "dirty word" for investors, thanks to investing flame-outs such as Long-Term Capital Management LP, a hedge fund that bet and lost on the Russian economy, and Barings Bank, which lost billions of dollars in the hands of a rogue derivative trader. However, Mr. Ellis believes that, "used properly, [hedging is] a capital-preserving strategy and is actually defensive." In the United States, hedge funds have proliferated, and assets under management in the sector have grown to US$500-billion from US$25-billion in 1990.

"Up until very recently it was difficult for the average investor [in Canada] to access hedge fund management," Mr. Ellis says. The reason is most hedge funds required a minimum investment of $150,000. Yet, for some time now, this type of investment has been lucrative. The RRSP eligible iPerform Canadian Opportunities Fund has a one-year return of 27.6% and the Goodwood Fund 25%, according to fund rating agency Morningstar.ca. The Argentum Canadian Long/Short Equity Portfolio, which has a minimum RRSP investment of $500, has a one-year return of 13.8%.

Steve Abrams, an analyst at Morningstar, says the problem with hedge funds is "they require high minimums and are pricey for average investors."

That is changing as financial institutions prepare to launch a range of hedge products geared to the middle market. The United States has "opened the doors for hedge funds to be available to a broader market. We haven't given investors that opportunity, yet," says Paul Dinelle, executive vice-president of Triax Capital Holdings Ltd. in Toronto.

His firm recently launched GPR Hedge Fund Notes, which target a 10% compound rate of return and provide a guaranteed repayment of principal at maturity in 2011. He says the manager aims for low volatility and consistency in returns. It is not a "shoot-the-lights-out strategy."

When it comes to buying into hedge funds, there are several things to consider, ranging from management style to fees to the sum an investor commits. Jim Fraser, senior vice-president of marketing at Mackenize Financial Services in Toronto, which recently launched the Mackenzie Long/Short Equity Fund, follows the axiom of not putting all your eggs in one basket. The Mackenzie fund deploys a fund-of-fund-managers approach, drawing on a roster of top U.S. hedge fund managers, a strategy also used in the Triax GPR Notes. By calling on a range of managers, investors get exposure to "different strategies, different expertise," he says.

Another thing to watch is fees, says Kevin Joh, vice-president of investments at Aim Funds Management Inc. in Toronto. Mr. Joh -- who is responsible for derivative activities at Aim, which is set to launch a hedge fund -- says some issues in the market can be "very expensive from an investment point of view. That's one thing you have to be very careful about," especially if there is a guarantee of principal. "All income products are not created equal. You need to look at who the manager is and how sound the structure is and how fairly priced it is."

As to how much of a retirement plan should go into alternative strategies, opinions range from 5% to 25%, depending on how diversified the offering is. Investors who do not want to add a hedge fund to their RRSPs can use an options strategy.

The Canada Customs and Revenue Agency prohibits using puts in an RRSP and frowns on naked calls because it is "speculative in nature and inconsistent with the intent behind the concept of qualified investments for RRSPs."

Investors can sell covered calls if they own the shares of the underlying stock and are willing to sell if it hits a certain price. A premium is paid for writing the option and if a call is not exercised the shares remain in the investor's hands.

Nancy Cobban, an advisor at RBC Investments in Toronto, says "writing covered calls is a viable strategy for your RRSP." It is a "bona fide conservative investment strategy" that enhances returns, allows extra cash flow in the account and "provides some downside protection.

"It's not something that is widely used," she says. "Many investors really don't understand options."

Before writing covered calls, Ms. Cobban says, investors need to assess whether they still want to own the stock. If not, they should sell it. Those who are bullish on its potential should avoid covered calls, because they could lose the stock and the upside potential.

"You generally want to write at-the-money calls," -- something close to the trading price, with a two- to six-month period, rather than "something deep in the money or deep out of the money." That provides an "optimum balance between downside protection and upside potential."