HEDGE FUNDS OFTEN ARE treated as an asset class, but in actuality they’re a heterogeneous assortment of distinct investment strategies that invest in various underlying asset classes ranging from bonds to stocks to commodities.
What hedge funds do share in common is a broader arsenal of investment tactics than those available to traditional, long-only portfolio managers, including the ability to short securities, employ leverage and use derivatives.
With the publication of the KCS Canadian hedge fund index and its underlying subindices by KCS Fund Strategies Inc., it now is possible to dig deeper into the performance of individual hedge fund strategies. With an inception date of January 2003 and covering more than 300 Canadian hedge funds, KCS classifies each fund into one of seven strategy subindices, including equity market-neutral, equity long/short (which is further classified into equity hedge and equity directional), event-driven, fixed-income, global macro, managed futures and multi-strategy.
In terms of outright return performance, the “winning” strategy was event-driven, with a compound annualized return of 14.8% from January 2003 through November 2013. Equity directional came in second, with a 13.3% return. Both of these strategies handily outpaced the 9.4% return of the S&P/TSX capped composite index.
The volatility of these strategies was less inspiring. Event-driven and equity directional strategies had annualized standard deviation of 13.9% and 16.8%, respectively, placing them in the same high-volatility range as Canadian stocks with their 15% standard deviation.
The poorest performer was the global macro strategy, with a 2.6% annualized return. There are only a handful of global macro hedge funds managed by Canadian firms, and it appears they haven’t had any luck at reading the tea leaves of the global economy.
The leader in risk-adjusted performance, as measured by Sharpe ratio comparisons, was the fixed-income strategy. With an annualized return of 9.3% and standard deviation of only 5.2%, this strategy posted impressive statistics.
However, many fixed-income strategies are highly leveraged, and several Canadian hedge fund portfolio managers have suffered stunning losses. Due diligence and portfolio manager selection in this category are critical.
The equity market-neutral strategy took the top ranking in low volatility and minimal downside risk, with annualized standard deviation of 3.7% and a maximum decline of 6% (as measured at monthends).
This performance is quite respectable, considering that investment-grade Canadian bonds, as measured by the DEX universe bond index, had standard deviation of 3.6% and a maximum decline of 3.9% and the Canadian stock market suffered a maximum decline of 43.4%. The price of this contained downside risk was lower returns – the equity market-neutral strategy had an annualized return of 4.1%.
The overall leader, in terms of portfolio diversification impact, was managed futures. Its 0.15 correlation with Canadian stocks, positive returns during the global credit crisis, annualized return of 9.6% and standard deviation of 10.1% combined to make this strategy the winner in diversification effect. However, performance over the past several years has been poor, so patience is vital when using this strategy.
Advisors need to consider the distinctive return and risk profiles of these varying hedge fund strategies before making recommendations to clients.
Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The firm, its principals, employees and clients may own securities mentioned in this article.
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