In pursuit of more diver-sified portfolios, leading U.S. investors have increased their portfolio allocations in hedge funds. Canadian investors have been much slower to follow suit, leaving the performance of Canadian hedge funds largely unscrutinized — until now.

To shed some light on this product, my firm, Tacita Capital Inc. of Toronto, analysed the monthly returns of the Scotia Capital Canadian hedge fund performance index since its inception in January 2005 through to July 2008. The equal-weighted index was selected, as opposed to the asset-weighted index, to minimize the impact of the results of a handful of relatively large funds. Our findings should be treated with caution, given the limited time period, sample biases and the heterogeneity of hedge funds, but a picture does emerge.

Canadian hedge funds were invested in the right sectors with the right directional weightings, concentrating on materials and energy while underweighting or even shorting other sectors. This was a great call for most of the period.

Unfortunately, Canadian hedge funds concentrated on smaller, growth-oriented stocks. This not only undercut their performance during the 2005-08 period but, preliminary results indicate, many funds were subsequently unable to move off this trade as liquidity evaporated for small-cap stocks. We await index results for October to assess the damage, but some former high-fliers are off by 60% or more.

Yet, most Canadian hedge funds don’t appear to be trying to hit the “return” ball out of the park. The 9.8% annualized geometric return of Canadian hedge funds was behind the returns of the S&P/TSX composite index (13.9%) and the Dow Jones Canada growth (17.4%) and value (12.9%) indices.

Canadian hedge funds did outperform the 8.2% return of the S&P/TSX financials subindex, but by very little. The performance gain relative to the 7.4% return of U.S. hedge funds and the 3.8% return of Canadian small-cap stocks was more respectable.

It is in volatility management, not performance, that Canadian hedge funds led. Only U.S. hedge funds had a lower standard deviation. In fact, on most measures of downside risk, such as number of drawdowns and maximum return decline, Canadian hedge funds ranked either first or second against the previously mentioned indices.

But most disappointing was the ranking of Canadian hedge funds on a risk-adjusted basis. With a Sharpe ratio of only 0.19, Canadian funds ranked seventh. Only financial services stocks and Canadian small-cap stocks performed more poorly. Notably, U.S. hedge funds outperformed Canadian funds in these measures, probably reflecting the former’s greater diversity. This low ranking for Canadian hedge funds indicates that investors were not getting enough reward for the risks taken. Unquestionably, the high fees of hedge fund managers are a major factor impairing performance.

Another problematic area was the high 0.80 correlation of Canadian hedge funds with the S&P/TSX composite index. This correlation, combined with Canadian hedge funds’ lower returns, reduced the role they played in a well-diversified portfolio. Our historical optimization runs found that only taxable investors who reduced both bond and stock exposure for a modest allocation to Canadian hedge funds or investors who used Canadian hedge funds as a replacement for Canadian small-cap stocks were rewarded for their decisions. Overall, the portfolio role of Canadian hedge funds is not nearly as prominent as some zealous advocates proclaim. Stock-like returns with bond-like volatility is a marketing claim, not a reality. IE



Michael Nairne is president of Tacita Capital Inc. of Toronto, a private family office and investment-counselling firm.