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Structured products lure investors

Higher risk yields better returns for those fed up with equity markets

MUTUAL FUNDS REPORTER

Short-selling, derivatives, puts and calls -- the investing tools of the traditionally conservative mutual fund are undergoing a radical overhaul.

Fed up with weak equity markets, investors are flocking to the retail structured products industry, innovative higher-risk investments that promise better returns. The fund industry has warmed up to the new competition and its tactics. A handful of fund companies are adding structured product strategies to their funds, snapping up boutique firms and launching new investment vehicles.

"When you say 'buy and hold,' you don't always prosper," said Gavin Graham, director of investments at Guardian Group of Funds Ltd. The Toronto unit of BMO Nesbitt Burns Inc. uses structured product strategies, such as currency hedging and clone derivative contracts, in about a dozen mutual funds,

"It's adding to the toolbox of mutual fund managers," Mr. Graham said. "You don't have to bet the farm. You can do it on an individual fund basis and see how it goes and if there is some value added."

Since 2000, choppy equity markets have made some investors rethink mutual funds and look to structured products to maximize yield, protect capital and cut their tax bill. Sales of these products, a vast mix of complex closed end funds, notes and limited partnerships, have risen steadily, reaching $5.7-billion in 2003, compared with $607-million in mutual fund net redemptions. It's expected that as many as 15 issuers will go to market this month seeking to raise $25-million to $100-million each from Canadian investors.

"Everyone is looking for good risk-reward alternative products," said Ian McPherson, president of Criterion Investments, the new structured products division of Toronto's VenGrowth Capital Partners Inc. The mutual fund industry has no choice but to consider "a change in their mandate, a change with the times," said Stuart McKinnon, president and chief executive officer of Pro-Hedge Funds Inc. Since July, 2003, the little-known Mississauga-based company has raised more than $120-million for its funds of hedge funds.

"Many [mutual fund companies] are in net redemptions now. They need to bring out new strategies to grow their business and get rid of that statement shock at the end of the month," Mr. McKinnon said.

Indeed, the use of options, derivatives and covered calls have become increasingly common tools for traditional funds to limit risk. Four companies have sought and received regulatory approval to short-sell up to 10 per cent of a fund's net assets.

"More and more . . . of what used to be traditional mutual funds' share of the market is going towards structured products. We wanted to get into the business," said Bill Holland, president and CEO of Toronto-based CI Fund Management Inc. Acquisition-friendly CI agreed to buy structured products firm Skylon Capital Corp. for $32-million last year. Since November, about $700-million in new business has come through Skylon's door.

"Yield seems to be of primary interest to investors. They are just looking for places that have the highest yield," Mr. Holland said.

Dynamic Mutual Funds Ltd., AIC Ltd. and AIM Funds Management Inc. are among the firms that have opted to launch their own structured products with decidedly mixed results. In general, investment risk is high and performance volatile.

For example, the returns of Dynamic's two hedge funds -- the Dynamic Power Hedge Fund and the Dynamic Equity Hedge Fund -- are starkly different. Since inception, Power Hedge has an average annual return of 33.9 per cent while Equity Hedge has eked out a dismal 2.1 per cent.

Even favourable conditions do not guarantee success. AIM Funds' AIM Canada Income Class Fund uses covered call options to provide unitholders with steady income. In theory, the fund outperforms during down markets and underperforms in a big market upswing. But the fund has repeatedly lagged the total returns of the S&P/TSX composite index and the dividend shrank last year to 36 cents annually from the 45 cents delivered since the fund's inception in 1996.

The embrace of structured product strategies, and the introduction of new investor products by the fund companies has added another layer of complexity for investors, said Dan Hallett, president of Dan Hallett & Associates Inc., a mutual fund research firm.

"There so many unknowns," he said. "There are some good products out there and there are some I wouldn't go near at all. It's a difficult assessment because you don't have the same level of transparency you have with traditional mutual funds."

And while the bulk of fund managers interviewed claim investors have a good understanding of what they're buying and the risks involved, several fund company executives concede said the balance of unitholders haven't got a clue.

"There's not a chance all these people understand what they're buying," said one senior manager. "Remember the only risk-free return is a 2-per-cent [U.S.] Treasury bill. Everything above that has duration risk or credit risk. When some of these things are yielding 10 to 12 per cent, they are going to default. They have, too."

Nevertheless, there's some agreement that the marriage of the mutual fund and the structured product will continue, for better or worse. Investors will always chase better returns and the risks be damned.

"I think it is hard enough for people to understand the mainstream markets and do the right things for themselves," said Edgar Legzdins, BMO Investments Inc. president and CEO. "I would fear that people are getting themselves into the kind of situation they got themselves into five years ago where they were investing in things they don't understand. They were in for a nasty surprise," he said referring to the mania surrounding the tech bubble.

© 2007 The Globe and Mail. All rights reserved.

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