ALTitude

Canadian hedge fund strategies: A primer

Interview with Claire Van Wyk-Allan, CAIA, Managing Director, Head of Canada & Investor Engagement, Alternative Investment Management Association (AIMA)

January 21, 2025

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Alternative assets are at a unique crossroads in Canada. Through a combination of innovation and regulatory changes, what were once walled off investments for all but a few, mostly large investors are becoming ever more accessible to clients across the wealth spectrum. This evolution includes hedge funds and the underlying strategies they employ to provide a portfolio-stabilizing source of diversified, uncorrelated, and in many cases elevated risk-adjusted return.

For many Advisors and private wealth clients, the shift offers the opportunity to better understand what hedge funds do, the range of investment strategies offered, and the role they can play in comprehensive portfolio construction.

Lillian Ferndriger, Director, Alternatives Distribution, BMO Global Asset Management, sat down with Claire Van Wyk-Allan, Managing Director, Head of Canada & Investor Engagement, AIMA, to discuss the state of hedge funds in Canada, their evolution as investable vehicles, as well as some due diligence perspectives for investors and Advisors to consider.

LF Let’s first answer the question of what a hedge fund is—and isn’t, and how it differs from other allocations in public and private markets.

CV Hedge funds are an asset class of alternative investments to traditional public market securities such as long-only strategies like you might find in a conventional balanced portfolio of stocks and bonds. Within the hedge fund asset class, there are a variety of strategies. These strategies invest in a host of predominantly publicly traded assets, and might include derivatives, shorting and leverage in order to achieve specific risk/return objectives. Hedge funds should not be viewed as a single asset class given their diverse mix of exposures and investment techniques, much like you would not consider all equity funds to be the same. Based on the strategy, managers may have more investment latitude or flexibility to magnify return potential or to protect through volatility. As performance data shows, investors have benefitted from these expertly managed investments by providing diversification, non-correlated returns and downside protection over time.

Typically, hedge fund managers are also significant investors in their own funds, demonstrating alignment of interest with their clients. Often, hedge funds charge a fixed fee to manage the fund as well as a performance fee to further align interests. Among alternative assets overall, hedge funds tend to be more liquid than private markets (credit or equity) or real assets such as infrastructure or real estate. Depending on the fund structure, redemptions may be available weekly, monthly (most common) or quarterly, though there is usually a minimum notice period of 30 days advance notice prior to the applicable redemption date. While gating is not often used, when it is employed, it is done so thoughtfully to treat all investors of the fund fairly.1

A flow chart depicting the relative liquidity of private market asset classes.

LF Let’s pull back the veil on the Canadian hedge fund market. What is the state of play for the industry—and what are the opportunities?

CV Hedge funds have been available in Canada for more than two decades and the opportunity set is only increasing with more products becoming available. At present, total reported assets under management is approaching $200 billion, according to Preqin,2 while the market is home to more than 246 funds managed by 130 different managers.3 That positions Canada’s weighting in the global hedge fund space at approximately 2.4%,4 closely aligning with the country's 3.06% weight in the MSCI World Index.

However, Canadian private wealth clients are generally far less invested in alternative investments, including hedge funds, compared to U.S. and other global counterparts; a recent study found that American wealth clients hold on average about 11% in alternatives.5 Canadian private wealth allocations are much, much lower by comparison, but we are continuing to see positive change. Managers and dealers generally are increasing not only the number of products on their shelves, but working to educate investors and advisors about the benefits and risks of these strategies, and what products might be best suited for them. There is a great opportunity for Canadian investors to use hedge fund strategies for diversification, non-correlated returns, and downside protection benefits they provide through market cycles.

LF Let’s go under the hood. As we’ve briefly alluded to, hedge funds are not viewed as a single asset class but rather a diverse set of strategies that differ considerably according to the method of portfolio construction and risk management technique. What are some to be aware of?

CV While no two hedge funds are identical, each generates returns by investing in line with a specific, carefully considered strategy as outlined in the offering memorandum. To name a few, for example:

  • Equity long/short strategies buy equities that are expected to go up in value and sell short equities expected to fall.

  • Global macro strategies invest in securities around the globe to capitalize on macroeconomic or geopolitical themes.

  • Relative value arbitrage strategies buy and sell securities based on an educated view on a price discrepancy.

  • Event-driven strategies take advantage of pricing inefficiencies before or after a corporate event, like an earnings call or merger.

  • Market-neutral equity strategies have neutral investment exposure to equities by sector, market cap or region, often employing pair trading, which matches a long position with a short position with high correlation.

  • Multi-strategy funds are a combination of several hedge fund strategies, meant to provide a more balanced approach.

Strategy execution will vary greatly by manager, with differing parameters for managing things like shorting, leverage, liquidity, counter-parties, concentration, currency and more. In Canada, funds focused on equity, credit, and relative value strategies are the most prevalent. Table 1 shows us that equity and credit strategies are the two most popular globally. Multi-strategy is among the most in-demand as well, given its flexibility to tie together different exposures.

Table 1. Proportion of global active hedge funds by strategy

A square pie chart showing the percentage of overall global hedge fund assets allocated to individual strategies.

Source: Preqin, 2023.

LF Let’s look at performance in terms of risk-adjusted return. Decades ago, hedge funds may have been perceived as the “Wild West,” delivering big but volatile alpha.6 Since the GFC, that seems to have switched, with these funds being risk diversifiers and more ballast-oriented. How have these strategies performed over more recent cycles?

CV Many hedge funds act as portfolio insurance, a ballast as you say to the portfolio though of course, every manager and strategy will be different. In general, the industry overall has provided positive risk-adjusted returns over the past two decades, but there has been a gradual move to emphasis diversification, downside protection, and lower correlation to traditional markets. As an example, the Scotiabank Canadian Hedge Fund Asset-Weighted index over that time exhibited less than two-thirds of the volatility of the S&P/TSX Composite and only a 0.29 correlation to the S&P 500.7 More recently, as public markets whipsawed at times violently through COVID-19 and the aggressive monetary tightening cycle in 2022-23, we saw both the three- and five-year Sharpe ratios of Canadian hedge funds slightly outperform the S&P 500 PR Index in both time intervals.8

Since 2015, cumulative returns from domestic hedge fund strategies reporting to Preqin have been positive (see Chart 1). It underscores the fact that these kinds of investments can consistently demonstrate an ability to mitigate downside risk by participating less in market downturns, while generating gains across market cycles.

Chart 1. Cumulative returns, Canadian hedge funds by strategy: January 2015‒December 2023

A line graph showing the relative returns of various hedge fund strategies between 2015 and April 2024.

Source: Prequin, as of April 30, 2024.

LF Hedge fund strategies can come in different wrappers, including liquid alternative funds and offering memorandums (OMs). BMO GAM considers both formats important to overall portfolio composition. What are some Know Your Product (KYP) and Know Your Customer (KYC) considerations to be aware of?

CV As you know, AIMA has provided industry-standard guidance through our Due Diligence Questionnaires (DDQs) dating back to 1997, including our public 2-page DDQ for advisors to help them assess fund managers and their funds. When we’re assessing structure, whether its OM or an alternative ETF or mutual fund, it’s important to understand what constraints or rules bind each. There are liquidity considerations with mutual funds and liquid alts, while OMs may have more levers to pull and greater investment flexibility. But at a high level, what we’re really talking about is just the vehicle. What is paramount for investors and Advisors, in our view is this: they are buying the manager first, and the strategy second. Manager pedigree, operational controls, culture, and expression of strategy over the time are extremely important. Use the due diligence tools available to assess the strategy and those operating it; lean into what's in the portfolio. There's going to be a lot more transparency than investors or Advisors may likely imagine, even if reporting isn’t readily searchable online. Historical data clearly shows these investment strategies can offer diversification, risk reduction and non-correlated returns across portfolios.

LF How should advisors think about hedge fund allocations in their portfolios?

CV Many Advisors consider adding an alternatives sleeve to complement an existing balanced portfolio. They may create this bucket by taking both from their equity and fixed income, or from one or the other. Using U.S. private wealth clients as a proxy with their approximate 11%5 allocation in alts, this might be a great similar starting point for Canadian wealth clients, again depending on KYC/KYP alignment. The Canada Pension Plan (CPP) is another great comparison. Not only is CPP Investments significantly invested in alternatives in general, it has over $14 billion invested with external managers, including an allocation to hedge funds—meaning Canadians are already investing in the strategies through their national retirement portfolio.

For more information, contact your Regional BMO Global Asset Management Representative or the BMO GAM Alternatives Team at bmogamalts@bmo.com.

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Source

1Fund gating: A restriction on the amount of capital that can be redeemed from a fund at any given time.

2CAD, as of September 30, 2024. Non-reported AUM is estimated to be higher given approximately 50% of Canadian funds do not disclose financial assets under management.

3Fundata, 2024.

4AIMA, September 30, 2024.

5Bank of America Private Bank, June 18, 2024.

6Alpha: The excess return of an investment compared to its expected return, adjusted for risk.

7The Scotiabank Canadian Hedge Fund Asset-Weighted index, as of January, 2024.

8The Sharpe ratio compares the return of an investment with its risk, dividing a portfolio's excess returns by a measure of its volatility to assess risk-adjusted performance. Excess returns are those above an industry benchmark, or the risk-free rate of return.

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