With volatile and unpredictable markets buffeting client portfolios, a measure of stability may be found by investing some assets in a well-diversified hedge fund of funds.

Because of these funds’ greater flexibility and freedom to employ both short and long equity investing strategies, such funds have the potential to take advantage of different market trends and are capable of producing positive returns even in bear markets. They may be riskier than regular equity funds because they can leverage and purchase securities in less regulated markets, but by investing in a mixed basket of hedge funds, that risk is spread among various strategies, markets and managers.

Dynamic Funds Management Ltd. of Toronto has recently launched a fund of hedge funds that gives retail investors a basket of seven Dynamic hedge funds in one package. Called Dynamic Alternative Opportunities Fund, the multi-pronged hedge fund also has the ability to invest in externally managed hedge funds and private funds that may not be easily accessible to the investing public; there are, however, no immediate plans to venture outside the Dynamic family, says Todd Beallor, executive vice president of Dynamic.

The new fund package joins a relatively small handful of fund of hedge funds in Canada that includes Arrow Multi-Strategy Fund, sponsored by Arrow Partners Inc.of Toronto, and Mackenzie Alternative Strategies Fund, sponsored by Mackenzie Financial Corp.

“We are seeing growing interest in hedge funds and are continuing to add to our lineup,” says Beallor. “Given the difficulties in financial markets, the ability of hedge funds to be flexible and take advantage of a multitude of strategies may be fortuitous. The fund of funds is like a ‘greatest hits’ album.”

The seven funds in the new Dynamic offering include: Dynamic Power Hedge and Dynamic Power Emerging Markets, both managed by Dynamic vice president and chief investment strategist Rohit Sehgal; Dynamic Alpha Performance, managed by vice president Noah Blackstein; Dynamic Contrarian, managed by vice president David Taylor; Dynamic Income Opportunities, managed by vice president Oscar Belaiche; Dynamic Strategic Value, managed by vice president David Fingold; and Dynamic Focus+ Alternative Fund, managed by Adam Donsky.

Like most hedge funds, Dynamic Alternative Opportunities is sold by offering memorandum and therefore requires a high minimum investment unless the client is an accredited investor. For example, in Ontario, the fund requires a minimum investment of $150,000 unless the investor is accredited, in which case the minimum is $25,000.

“With one ticket, investors have access to seven different funds at Dynamic,” says Beallor. “Investors have access to a mix of managers, strategies and skill sets. The funds have access to a greater number of strategies than regular mutual funds, including the ability to sell securities short, use leverage and derivatives, and invest in private placements.”

Al Kellett, an analyst with Morningstar Canada in Toronto, says a fund of hedge funds has several advantages over a single hedge fund. Typically, a portfolio of funds assembles a group of managers with complementary strategies, providing a more even performance over time as their particular strengths come to the fore in different market conditions. Managers invited to be part of the fund mix are carefully assessed by the sponsoring company, and their funds are monitored on a continuing basis, he says. The hedge fund of funds may also offer inves-tors access to hedge fund managers that cater to large institutions and would not normally be accessible to a retail investor due to investment minimums.

“Many hedge funds operate in some esoteric markets,” Kellett says, “so the due diligence in overseeing managers is particularly important.”

He also points out that, because of the high minimums required by hedge funds, a retail investor would need a huge pile of money to be able to invest in a variety of funds and achieve comparable diversification. “A fund of funds is diversified by manager as well as strategy,” he says. “Because of hedge funds’ ability to employ a multitude of strategies, including short-selling, they can be non-correlated to stock and bond markets, and their inclusion in a balanced portfolio can result in better and more even performance overall.”

The $136-million Arrow Multi-Strategy, for example, was introduced in January 2002 and may invest in up to 30 hedge funds around the globe, including 15 sponsored by Arrow. It is the biggest hedge fund of funds offered by Arrow, although the company offers three others: Arrow Global Long Short; Arrow Enhanced Income; and Arrow Special Opportunities.

@page_break@For the five years ended July 31, Arrow Multi-Strategy had an average annual compound return of 5.8%, underperforming the S&P/TSX composite index’s return of 15.8%. However, during the month of July, when the S&P/TSX dropped 5.9%, the fund dropped by only 1.3%.

The $61-million Mackenzie Alternative Strategies Fund, introduced in January 2001, contains 20 to 25 funds at any given time selected by subadvi-sor Tremont Capital Management Corp. of Toronto through its global network of offices. This fund shows a five-year average annual return of 3.45%, which also failed to beat the index; however, the fund’s 2.7% loss in July was a smaller loss than that of the index.

“A multi-strategy fund of hedge funds is like an all-weather fund, and will include some funds that will do well in a bear market,” says Jim McGovern, Arrow’s CEO. “Hedge fund managers have a much bigger tool box available to them, and the returns can be less volatile than the overall market.”

McGovern says each component of a portfolio has different risks, but the primary risk common to all hedge funds is the capability of the manager. The key is to have competent hedge fund managers investing with a team of good people. He says it’s also important to assemble the right mix of funds in a multi-fund portfolio, and that the overall manager of a hedge fund of funds can add value by tactically tilting toward particular strategies under the right market conditions. He estimates that about 25% of the value of Arrow Multi-Strategy is provided by this kind of shifting, while 75% comes from picking the right hedge fund managers. In Arrow Multi-Strategy, the biggest position in any one fund could be 7%, but McGovern says it’s typically 2%- 5%.

Initially, Dynamic Alternative Opportunities will have an equal weighting of 10% in each of the seven funds, Beallor says, with broad exposure to domestic and foreign assets, large-cap and small-cap companies, and growth and value investment styles. The biggest and best known fund in the mix is Dynamic Power Hedge Fund. With $226 million in AUM since its inception in October 2004, that fund’s best 12-month period shows a gain of 157.6%, while its worst 12-month period still shows a gain, albeit only 2.63%. The fund shows a three-year average annual compound return of 40.6% to July 31, but lost 18.1% in July — considerably worse than the S&P/TSX composite’s loss of 5.9%.

“Ultimately, a hedge fund of funds is as good as its underlying components,” says Rudy Luukko, investment funds editor with Morningstar Canada. “Dynamic has put together an impressive roster of managers with different style disciplines.”

Luukko says Dynamic has developed a “performance-driven culture” and leads the fund industry in terms of the number of funds carrying Morningstar’s top rating for risk-adjusted returns.

Sceptre Investment Counsel Ltd. of Toronto has recently made an arrangement to bring a hedge fund of funds to its Canadian high net-worth and institutional clients through a co-operative venture with New York-based Fairfield Greenwich Group, a hedge fund management firm, and will probably introduce a product for sale through the advisor channel.

“We are exploring the advisor channel and plan to introduce a product as soon as possible,” says Tom Czitron, Sceptre’s managing director. “Fairfield Greenwich has sophisticated and robust risk-management protocols in place for hedge fund management, and we believe the fund of funds concept is the most efficient for investors.”

Funds of hedge funds may have higher fees than a single hedge fund, due to the costs associated with assembling, managing and monitoring the portfolio. Arrow, for example, charges an additional 25 basis points on top of the management fees charged by each individual fund. Dynamic Alternative Opportunities charges an overall management expense ratio of 2.5% in addition to the fees charged by the underlying funds. IE