“In practice I find these concepts hard to implement; to date I have yet to find hedge funds in Canada able to generate positive alpha aside from some mutual fund alpha managers like Eric Sprott, Francis Chou and Tom Stanley.”

Mr. Whang notes the following problems when dealing with hedge funds;

• Usually high costs in terms of MERs, hedge fund consultant fees and performance bonuses

• Poor disclosure for the investment structure; often involving a tax haven that puts money at risk because it is in a different jurisdiction

• Dismal or average performance

• High profile failures like PORTUS, NORSHILD, and perhaps others that have yet to be discovered, issues of trust, integrity and governance.

If we separate the wheat from the chaff, we have to recognize that hedge funds are usually quite innovative, and can provide a level of diversification within a portfolio. But they are complex, and in cases like PORTUS, silly.

The latter point bears some discussion, because products like PORTUS exist, and when the dust settles around this particular offering, I am sure we will see this type of product again being offered as a GIC alternative.

PORTUS was marketed as a low risk alternative to GICs because at worst, investors were “guaranteed” that their principal would be returned within five years. I never understood why that appeals to anyone, because the return of principal simply guarantees that you will lose any return on your investment over five years.

In order for PORTUS to deliver on the “guarantee,” the manager must deposit client assets into guaranteed investments such as strip bonds. Strip bonds are purchased at a discount and mature at par, in this example, five years into the future.

Assuming that the risk free rate of return was 3.5% (remember the bank guaranteeing this return of principal needs to profit from it as well), the manager of this type of product must, on a $10,000 investment, set aside at least $8,420 to provide the principal protection. That would leave only $1,580 that would be available to invest in the core strategy, which in the case of PORTUS, was suppose to be an investment in a basket of hedge funds.

However, before PORTUS could invest anything in the hedge fund market, they had to pay advisors a commission for selling the product. The commission equaled 5% (give or take 1%) to the advisor, which in our example, would require a $700 payment up front. That would leave only $1080 to invest in the hedge fund strategy.

But that amount does not account for the 1% annual trailer fees paid to advisors. That too would have to be set aside by the manager, which on a present value basis might equal another, lets call it, $450. Leaving only $630 to invest in the hedge fund strategy.

But before that could happen, we must account for management fee paid to PORTUS, which was another let’s call it 1% per annum, which was paid on the full $10,000 investment. If we add another $500 to the costs, that leaves at best, $130 to invest in the hedge fund strategy. And I am being very generous on this point. To me, this implies that PORTUS was a product designed to provide advisors with a good payout, and “guarantee” clients that within five years, they would get their money back.

In fairness, these are only approximations, and do not account for other issues – including the possibility of fraud – which are quite rightly being examined by various regulators. Before you pen an e-mail on the PORTUS cost structure please note that my intent is to simply, by way of an example, support Mr. Whang’s observations regarding costs, investment structure and performance.

Having said that, let’s return to the concept of using some type of hedge to mitigate downside risk. In that regard, Mr. Whang offers some alternatives;

• Implement an option strategy, which carries a cost to the hedge and hope that the strategy bear fruits before time decay sets in.

• Short equity futures contracts against equity assets in the portfolio

• Or simply raise cash in a long only market

The problem of course is that the first and second option are complex, require a sophisticated investor to implement them, and there is no guarantee of success.

For the average investor that leaves the third option, which implies, if you cannot find value in the market, raise your cash holdings. The problem here is that it requires active management, and a recognition as to whether or not value actually exists in the market. Not to mention tax considerations, when making the change. If you sell equity to raies cash in a non-registered account, you will likely trigger capital gains.

Perhaps the real issue comes down to your tolerance as an investor to withstand the volatility inherent in equity assets. Which has more to do with financial planning than with market timing. In the end, constructing an asset mix that gets you where you want to go, and mitigates volatility to the point that allows you to remain invested until you get there, may be the right answer for most investors.

In next week’s column, we will look more closely at that issue, and attempt to tie asset mix to the returns and risk of various asset classes.