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Innovative funds can hedge fixed income volatility

As you watch your bond investments stumble against rising interest rates, you're probably on the lookout for fixed income options that aren't so interest sensitive.

As it happens, two of Canada's best-known hedge fund providers offer innovative fixed income funds that afford some protection in just this situation.

Picton Mahoney Asset Management's Income Opportunities Fund and Gluskin Sheff + Associates Inc.'s Credit Arbitrage Fund are designed to try to generate moderate and relatively steady returns similar to traditional bond funds, but without the traditional bond fund's notorious vulnerability to rising rates. However, they carry other risks, and are typically available only to wealthier investors.

"We think conventional fixed income investors who are buying long only bonds are at more risk than they've been for many, many years," says William Webb, chief investment officer at Gluskin Sheff, which was established in 1984 and has $6.1-billion in assets under management.

"Your traditional bond investments are going to have a tough time delivering going forward," says Philip Mesman, portfolio manager fixed income at Picton Mahoney, established in 2004, with $7.2-billion in assets under management.

Some hedge funds use large amounts of leverage to pursue sky-high returns at great risk. However, these are among the relatively conservative funds that follow the original hedge fund concept of pursuing moderate returns while hedging against risks that aren't easily covered by conventional stock and bond investments. As is typical for hedge funds, they charge higher fees than most conventional fixed income mutual funds.

Bond prices move inversely to interest rates, so prices fall when rates rise. Both these funds buy and hold bonds they think are relatively attractively priced (known as "long" positions) and then sell bonds "short" that they think are relatively unattractively priced, so as to roughly balance overall interest rate sensitivity on both sides.

With the help of a moderate amount of leverage, the fund portfolios are constructed so that the long bonds generate more yield than the short bonds, resulting in built-in yield on a net basis. In addition, some bonds will perform better than others for reasons other than overall movements in interest rates. These funds make a bit more money if the long bonds they hold perform relatively well compared withthe bonds they've shorted - in other words if interest-rate spreads narrow between the two. But they also run the risk of losing money if spreads widen or the long bonds they hold run into serious credit problems.

While overall strategies are somewhat similar, Gluskin Sheff holds investment-grade corporate bonds long and shorts high-grade government bonds. With relatively little default risk involved, their strategy depends to a large extent on buying relatively well-priced corporate bonds and then harvesting the interest rate spread that generally occurs between corporate and government bonds, without those spreads increasing.

They believe the risk of spreads widening is relatively modest because those spreads are fairly wide by historical standards. If anything, they think spreads will tend to narrow somewhat over time. Gluskin Sheff introduced this fund at the start of 2009. The firm doesn't offer individual funds directly to investors, but manages portfolios for high net worth investors with at least $3-million to invest.

In contrast, Picton Mahoney holds high yield as well as the lower end of investment grade corporate bonds in both long and short positions, in addition to shorting government bonds. With many lower-rated bonds, its strategy tends to rely more heavily on making good individual credit assessments both long and short. "We're credit pickers," says Mr. Mesman.

Picton Mahoney launched this fund at the start of 2010 and offers it through investment advisers. The minimum initial investment is $25,000 in British Columbia, New Brunswick, Nova Scotia, and Newfoundland in the less regulated "exempt" market. But in other provinces investors need to invest $150,000, or have sufficient wealth to warrant "accredited investor" status, due to provincial securities legislation.

In each case, these hedge funds are normally held in diversified portfolios alongside conventional stock and bond investments.

In recent years, both funds have often done reasonably well when overall investment grade bonds are performing poorly and vice versa. This year they've been off to a decent start - year-to-date returns net of fees are 3.3 per cent with Gluskin Sheff's fund and 1.8 per cent with Picton Mahoney to the end of June. That compares well to the DEX Universe Bond Index, a broad measure of the Canadian investment-grade bond market, which is down 1.7 per cent in the same period. Both funds had double digit returns in 2012, but lost a small amount of money in 2011.

David Aston, CFA, MA, is a freelance writer specializing in financial topics.



Total returns, with comparisons to a broad investment grade bond market index
2013 (YTD)20122011
Gluskin Sheff Credit Arbitrage Fund3.3%11.2%-1.5%
Picton Mahoney Income Opportunities Fund A1.8%10.7%-2.6%
DEX Universe Bond Index *-1.7%3.6%9.7%
Notes: Annual returns except for 2013, which is for six months year-to-date to the end of June and is not annualized. Returns are net of fees. Gluskin Sheff charges 1.5%, plus a 10% performance fee on positive returns. Picton Mahoney charges 2%, plus a 20% performance fee on returns exceeding 5% for the 'A' Fund, which pays a trailer fee to advisers. 'F' fund fees are less but advisers charge an additional fee. Sources: Gluskin Sheff + Associates, Picton Mahoney Asset Management.* For broad comparisons only. Not used by either fund as a 'relative' benchmark of performance.

© 2007 The Globe and Mail. All rights reserved.

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