Diversification risks of Canadian hedge fund strategies

Large institutions have become increasingly disappointed with hedge funds.[1]

Institutional investors have been struggling to understand how alternative assets may fit into their portfolios, leaving them asking “Why Hedge Funds?” in a recent CFA publication.[2] According to the Editor,

“In hindsight, it is quite understandable that institutional investors are fleeing hedge funds, which provided neither the high returns nor the protection from downside risk that were promised to investors before the financial crisis”

One plausible reason for equity, bonds, real estate and private assets performing relatively well following the global financial crisis, whereas cash and hedge fund assets have not, is that long-duration assets have benefited tremendously from falling discount rates. Falling discount rates have increased the present value of long duration assets, however, not necessarily the cash flow of these assets.[3] The risk of the discount rate increasing too quickly could be severe for an institutional portfolio that consists of a combination of long-duration assets (say, some combination of stocks, bonds,real estate and private equity). A shift by institutions into shorter duration assets such as hedge funds may be a good tactic, but investors will need to carefully consider the risks of adding Canadian hedge fund strategies into a multi-asset portfolio because some of these strategies may not behave differently during the same market conditions. In this paper, we examine the strategies that minimize downside risk when traditional market indices decline, and the strategies that most uncorrelated to those broad market indices and other hedge fund strategies.

There are three additional points worth highlighting. Firstly, the term “hedge fund” does not refer to a homogenous asset class; hedge funds have very disparate strategies. Research[4] on US hedge funds have shown that about 20% of the cross-sectional dispersion of annual hedge fund returns can be attributed to strategy style. What this implies is that about a quarter of annual hedge fund returns can be explained by strategy, promoting the need for better classification schemes and/or due diligence processes. Secondly, diversification across hedge funds is no protection from hedge fund tail risk. We saw this during the global financial crisis. This is equivalent to diversifying into offshore equity when the general equity market at home experiences a significant decline. Thirdly, large institutions are asking whether hedge funds are simply a thinly veiled ploy to better structure performance fees in an industry where traditional mutual fund margins are under extreme pressure, partly because of the popularity of passive products.

Research has shown that Canadian hedge funds have performed better, on average, than European and US hedge funds.[5] However, given that discount rates are rising, which Canadian hedge fund strategies will provide enough diversification benefit relative to more traditional asset classes?

In this brief article we present results from an initial study that asks the following:

1. Where is the value-add coming from for Canadian hedge funds? Have Canadian hedge funds provided investors with sufficient downside protection under different market conditions? The risk to an institution selecting a hedge fund strategy based on its long-term beta to a broad market index is that it does not reflect how a strategy protects the downside under various market conditions and within different market cycles.
2. How correlated are sources of alpha within the Canadian hedge fund universe? Do Canadian hedge fund strategies have exposure to the same broad underlying bets? The risk of not understanding the broad drivers/risk factors of various hedge fund strategies is investing in different hedge fund strategies with the same underlying bets?
3. How correlated are fund strategies within the Canadian hedge fund universe? How does a large institutional investor deal with highly correlated hedge fund styles? If there is more diversification in hedge fund strategies, then allocating capital to a hedge fund strategy may be a good challenge.