Time to try hedge funds

Many investors became extremely discouraged by the long bear market. They watched their savings dwindle away for the better part of three years and some finally gave up and bailed out. Of course, not all stocks and equity funds lost money during that time, but the majority did.

It may be that the bear market culminated last October, with a final sell-off. Stocks have been trending up since that time. But no one can say with certainty that the worst is behind us. There are signs that the U.S. economy may finally be gaining some strength, but they are inconclusive at this point. If America continues to sputter, we could see another sharp stock market correction in the months ahead.

All this uncertainty has prompted many people to look at alternatives. In some cases, they’ve retreated back to the perceived safety of GICs, even though the big banks are currently paying less than 3 per cent on five-year terms. More adventurous investors are showing interest in the concept of hedge funds. Until recently, these funds were seen as the preserves of large institutions and the super-rich but now average investors can get in on the action. The question is: should u do so?

The ultimate answer to that question is between you and your financial advisor. But here’s a way to dip a toe into the murky pond of hedge funds without spending a fortune and taking on an unacceptable degree of risk.

It’s called the Northwater Market-Neutral Trust and it trades on the TSX under the symbol NMN.UN. This fund-of-funds invests in various types of hedge funds from around the world (about 40 funds at present), thereby employing a wide range of managers and strategies. The fund has a record of good performance, high tax-advantaged distributions in recent years, and low volatility.

The trust was launched in 1997 under the name Newcastle Market-Neutral Trust. That was subsequently changed to Northwater for marketing reasons, but the management has remained the same throughout.

The first year was rough. The Russian currency collapse of 1998 and the subsequent moratorium placed on debt payments by the government put immense pressure on many hedge funds.

Although Northwater’s diversification as a fund-of-funds diminished the impact on its shareholders, they did not escape unscathed. The fund lost 9.3 per cent in 1998, the only calendar year since it was created that it finished in the red. Worse, distributions had to be suspended for 18 months, and the trust did not resume payments until the end of December 1999.

However, investors had one important factor working in their favour. Unlike most income trusts, the Northwater Trust has a clause that requires it to pay distributions of at least 40c per unit every quarter, or $1.60 a year. If any payment is missed, the amount owing is accrued. The managers are not paid any fees until all accruals have been paid out.

As a result, no management fees have been collected by Northwater since 1998. Over the three-year period from 2000-02, the average annual distribution to investors was $2.05 a unit as the trust caught up on missed payments. So far this year, shareholders have received $1.37 per unit.

The trust is still 43c in arrears on its payments, and that amount is likely to be made up within the next year or so at the current pace. Once that is done, the accrued managerial fees, which totaled just under $8.7 million at the end of March, will have to be repaid before quarterly distributions can exceed 40c. This will take some time, so investors should not expect future distributions in excess of $1.60 a year once the remaining 43c still in arrears has been paid. Of course, that $1.60 is not guaranteed; a major global financial crisis could produce a repeat of the 1998 scenario. But right now, the trust appears to be doing well.

So far, all the distributions have been classified as “return of capital” for tax purposes. That means investors pay no tax in the year the money is received, but the total of all payments is subtracted from their cost base for purposes of calculating capital gains (or losses) when the shares are sold.

One other important point about the distributions: they are not consistent. You cannot count on predictable cash flow from this security. The 40c figure is a target only; the last four quarterly distributions have been in amounts of 62c, 75c, 45c, and 8c.

Despite the setback in 1998, overall results for this trust have been very good. Since inception, it has shown an average annual compound rate of return of 8.13 per cent (to June 30). The average standard deviation over that time was 6.49 per cent. That’s considered to be very low, which means that this trust is not highly volatile. Over the past year, the return was 11.64 per cent, with an extremely low standard deviation of 2.96 per cent. Especially impressive is the fact that investors have made a profit in every year since 1999, so the bear market did not bite here.

The NAV of the trust units at the end of June was $18.94 (it is valued monthly). At the recent price of $18.75, it is trading at a small 1 per cent discount to NAV. Assuming on-going annual distributions of $1.60, the projected yield is 8.5 per cent.

The trust is scheduled to be terminated at the end of December 2007, with all assets to be distributed to shareholders at that time.

Investors who are looking for a combination of good cash flow, capital gains potential, and an alternative to the stock markets should discuss this trust with their advisors. Although the volatility is very low, the impact of the 1998 Russian financial collapse on returns indicates that there can be considerable risk here under certain circumstances. Therefore, this security is best suited to more aggressive investors. The shares should be held outside a registered plan to maximize tax efficiency.