Charities are typically looking for portfolios with good returns but limited volatility. These criteria are important because a consistent stream of healthy returns increases the probability of a charity being able to continue to meet its spending goals. Any asset class to be considered as part of a charity’s overall investment program should be evaluated in this way. Based on these criteria, hedge funds are a good choice – particularly Canadian hedge funds. Let me tell you why.
THE ROLE OF A HEDGE FUND MANAGER
A hedge fund manager’s main job is to study a pricing relationship, or “spread,” between two securities, or a portfolio of securities. These securities or portfolios usually consist of equities or bonds, but can also include other instruments such as foreign exchange, commodities and derivatives. In all cases, the key to success is to recognize that a temporary change in a well-established
pricing relationship may provide a profitable trading opportunity. For example, if one security becomes cheap relative to the other, it may be a good time to buy that security and to short-sell the other security that is now relatively expensive. Once the normal pricing relationship returns, these two positions – long and short – would be closed, resulting in a profit.
This is why hedge funds are generally good additions to portfolios aiming to limit volatility. It implies that the profitability of a hedge fund trading strategy depends on the volatility of the spread and not the movement or volatility of the overall market. In many hedge fund strategies, the spread is less volatile than that of the overall market, which implies returns from these hedge funds should be less variable than returns from the assets in which they’re trading. Furthermore, the spread does not always move in the same way as the overall market. This implies that the returns from many hedge funds should have low correlations with the returns on traditional investments. Thus their inclusion in an investment program can reduce the risk of the entire portfolio.
CANADIAN HEDGE FUNDS
At BULLWEALTH, we think hedge fund strategies will continue to be profitable and, hence, continue to offer attractive returns as compared to traditional investments. We think this is particularly true for Canadian hedge funds. This is because Canadian securities markets are typically less efficiently priced compared to security markets elsewhere, as well as because Canada’s hedge fund industry is fairly small.
These points – the low volatility, low correlation and attractive returns – should make an allocation to Canadian hedge funds a good addition to the investment strategy of most charities.
Have these insights been supported by actual investment results? Figure 1 (below) provides clear evidence that they have. It shows the growth in the value of $1,000 invested over the past 10 years in diversified portfolios of the three traditional asset classes held by many charities (global equities, Canadian equities, and Canadian bonds). It also shows a similar line for $1,000 invested in a diversified portfolio of Canadian hedge funds (marked BULLWEALTH Canadian Hedge Fund). Clearly, the line for Canadian hedge funds demonstrates the attractive properties of this asset class. Over the past 10 years, this portfolio would have produced growth that was superior to bonds and similar to equities. Canadian hedge funds provided that growth with less variability than equities, especially during the difficult periods (in 2008 and 2011). In addition, movements in the line for Canadian hedge funds sometimes offset movements in the lines for the other asset classes.
SO HOW CAN ONE IMPLEMENT THIS IDEA?
It’s important to recognize the asset class performance comparison discussed in this article is for diversified portfolios. As with equities and bonds, the professional guidance of a portfolio manager is critical to a successful hedge fund investment program. Since hedge funds are a complex asset class, we highly recommend enlisting the support of an advisor with experience in this specific field.