CANADIAN HEDGE FUNDS LOST 4.7% in 2012, as measured by the asset-weighted Scotiabank Canadian hedge fund index (SCHFI), which tracks the 70 domestic hedge funds that constitute the bulk of the sector in Canada. In comparison, the S&P/TSX composite index returned 7.2%.

This is the third year since 2005 that Canadian hedge fund returns have lagged those of stocks, and the performance gap is the largest on record. This raises the question: why have Canadian hedge funds lost their mojo?

The long-term record of Canada’s hedge funds remains intact. Since the SCHFI began tracking hedge fund performance in January 2005, its annualized return of 8.2% has outpaced the 6.6% return of Canadian stocks. Hedge funds achieved this with less volatility and better downside performance than for stocks. During the global credit crisis of 2008-09, hedge funds had a drawdown – a measure of peak-to-trough decline – of 26.7%, much better than the 43.3% drawdown for stocks.

However, over the past three years, Canadian stocks have had the edge in absolute performance. The S&P/TSX composite index’s annualized return of 4.8% bested the SCHFI’s 3.3% return. Hedge funds continued to be less volatile, but their maximum drawdown of 14.1% was not much better than the 16.6% drawdown for stocks.

The reason for hedge funds’ performance lag lies in the sectoral concentration of most Canadian hedge funds. Their returns are strongly correlated with those of the materials and energy sectors. Since 2005, the SCHFI has had a 0.75 correlation with the S&P/TSX materials subindex and a 0.66 correlation with the S&P/TSX energy subindex. In comparison, the correlation of Canadian hedge fund returns with those of the S&P/TSX capped financial subindex, the largest single sector in the Canadian market, was a negligible 0.14.

From 2005-09, the strong performance of the materials and energy sectors drove hedge funds. The annualized return of Canadian hedge funds of 11.2% in that period was due primarily to the 15.7% and 11.6% returns of the material and energy sectors, respectively. In contrast, the financial sector had a lukewarm return of 6.1%, helping to dampen the S&P/TSX composite index’s return to 7.7%.

Over the past three years, sector leadership has changed. The financial sector returned 8.1% on an annualized basis, far outpacing the 0.5% return of both the materials and energy sectors. Add in the recovery in consumer discretionary and staples stocks, as well as the strong return from the telecommunications sector, and it’s no surprise that Canadian stocks have outpaced Canadian hedge funds recently.

Unfortunately, the average Canadian hedge fund investor, in seeking to hedge market risk, was instead delivered a healthy serving of sectoral concentration risk. This heightened risk illustrates why it is critical to undertake thorough due diligence on any hedge fund before investing and to identify its sources of risk.

One way to diversify risk is to consider hedge funds that invest in the U.S. or globally. In 2012, the Morningstar MSCI composite index, an asset-weighted index of almost 1,000 global hedge funds, was up by 6.1% – in stark contrast to the losses of many Canada-centric, domestic hedge funds. An assortment of global hedge strategies is available in Canada.

Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm. The company, its principals, employees and clients may own the securities mentioned in this article.

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