The Globe and Mail, Report on Business
Published December 1, 2006

I was talking to a friend last weekend about our new mutual fund company. After I took him through the fund lineup, he asked me what our hedging strategy would be. I thought he was referring to currency hedging, but he wasn't. He was asking whether we were going to eliminate, or hedge away, the market risk from our equity funds. My answer came very quickly, but let me keep you in suspense for a moment while I provide some context.

Despite the robust markets we've been experiencing, protection against downside risk still seems to be front and center in investors' minds. That's evident when you see how much ink and money hedge funds are receiving, even though their fees are high and overall returns have been modest. Closer to home, evidence of this focus on downside risk is demonstrated by the immense popularity of principal-protected notes (PPNs). PPNs reduce long-term returns in exchange for the comfort of knowing that the saver (I can't bring myself to call PPNs investment products) is protected from a highly unlikely occurrence (negative market returns over five to seven years). As an aside, if I was the supreme ruler of capital markets (I'm available if anyone should ask), I wouldn't let anyone under 60 years of age buy a product with principal protection. But that's for another column.

“Risk/reward” is a business term that has crept into our vernacular. I find myself using it when I'm talking about sports, cards and traffic avoidance. But it's an unfortunate term because I think the two “R” words are in the wrong order. It should be “reward/risk”. I know, it doesn't sound right. I've tried to change it, but people just look at me funny when I do.

In any case, reward is not a dirty word. In today's investment dialogue, however, it is a forgotten word. What does reward mean to an investor? It means that if you invest $100,000 in a registered retirement savings plan and it compounds at 8 per cent a year for 20 years, you will have $466,096 in your account. To be sure, you will have experienced some zigs and zags along the way. That compares to strategies that are designed to avoid short-term volatility (the other R word). If they compound at 6 per cent a year, you will have $320,714 after 20 years. The result is less sleepless nights, but less money to spend in retirement.

Now back to my friend. I should tell you that he works in the U.S. and is surrounded by hedge fund managers. In that world, exposure to the overall market, or what we call beta, has become a dirty word. Everyone talks about “market-neutral” strategies. Therefore, it was natural that he would ask if we are going to hedge away the market risk inherent in our equity funds.

So what was my answer? I said, “Hell no! I want the market return.” I told him that despite all its ups and downs, over the long haul the market provides the most reliable return available. I don't want to hedge it away. Bring on the beta.

My response may strike you, and my friend, as odd given that “alpha” is the glamour word in the investment world today, not beta. Alpha is a fancy word for added-value, or excess return over and above the market return. It is beta's rich, plugged-in and very cool cousin. It has lots of cachet, while beta has none. Indeed, beta can be bought through any investment dealer and the fee is rock bottom. In Canada, you can exactly replicate the return of the S&P/TSX 60 by buying the iShares XIU units, which have an annual management fee of 17 basis points (A basis point is 1/100th of a percentage point).

But who wouldn't want alpha? The problem with beta's rich cousin is that there is no guarantee that a money manager is going to produce it. Alpha can be positive or negative. No matter how good the money manager, it will come and go. Unfortunately, we all get lazy and after we've thrown the term “alpha” around a few times, it starts to sound like a given. And that's reinforced when we read about the alpha that people like Eric Sprott has produced for investors. We just assume if we buy a hedge fund, the alpha will be there.

But what we don't read about is the managers that failed to deliver - the anti-Eric's. If your take a look at the Globefund performance standings and go to the Alternative Strategy category, you'll see what I mean. The median return for three years is 7.1 per cent and for five years it's 5.6 per cent. For both time periods, there are a slew of funds with negative returns.

The point of this column is not to trash alternative strategies or discourage investors and money managers from pursuing alpha (Steadyhand will pursue alpha vigorously), but to point out that taking on market risk is not such a bad thing. It will cause pain from time to time, but it is the path to a better retirement.