The Canadian Hedge Fund Industry: Performance and Market Timing

• Author: Alexander Vedrashko,Isaac Schweigert,Peter Klein,Daryl Purdy
• Published date: 01 September 2015
• DOI: http://doi.org/10.1111/irfi.12055
• Date: 01 September 2015

The Canadian Hedge Fund

Industry: Performance and

Market Timing*

PETER KLEIN†‡,DARYL PURDY‡,ISAAC SCHWEIGERT‡AND

ALEXANDER VEDRASHKO†

†Simon Fraser University, Burnaby, BC, Canada and

‡KCS Fund Strategies Inc., Vancouver, BC, Canada

ABSTRACT

We analyze the risk and return characteristics of Canadian hedge funds based

on a comprehensive database we compiled. We find that Canadian hedge

funds have higher risk-adjusted performance and different distributional

characteristics relative to the global hedge fund indices. We investigate

market timing by Canadian hedge funds and find that they do not time the

Canadian or global stock and bond markets, but hedge funds in the Managed

Futures strategy group time the commodity market. These results are robust

to parameter instability and structural changes in the model. We also illus-

trate the impact of using local and global risk factors to analyze the perfor-

mance of local investment firms.

JEL Classification: G11, G12, G23

There is a large body of academic literature analyzing the risk and return

characteristics of the hedge fund industry. One of the main topics of this

research has been identifying factors that can explain hedge fund performance

and provide insights into hedge fund investment strategies (Lo 2010). Our paper

contributes to the currently small literature on the performance of international

hedge funds and reports geographical differentiation in the performance of

investment strategies by hedge funds.

We find that Canadian hedge funds tend to outperform their global peers

(i.e., hedge funds from all over the world) in the corresponding strategy cat-

egories. Next, we follow the literature on hedge funds’ nonlinear exposure to

risk factors and study option-like features of Canadian hedge fund strategies,

such as market timing (Fung and Hsieh 1997a). Although measuring hedge

funds’ timing ability is an important question by itself, hedge fund performance

is measured more reliably if it is adjusted for timing strategies as Jensen’s alphas

* We thank the KCS Fund Strategies for the data and the editor, Hong Yan, the associate editor,

anonymous referees, and the discussants at the 2012 NFA meeting in Niagara Falls and the Bank of

Canada for their helpful comments.

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International Review of Finance, 15:3, 2015: pp. 283–320

DOI: 10.1111/irfi.12055

© 2015 International Review of Finance Ltd. 2015

can be negatively biased in the presence of market timing (e.g., Grinblatt and

Titman, 1989). Because the resource sector is the key sector for Canadian capital

markets, we conjecture that Canadian hedge funds are relatively strongly

exposed to the commodity market and can also attempt to time this market. We

find little evidence of stock, corporate bond, and government bond market

timing strategies for Canadian hedge funds.

We suggest three possible sources of the outperformance of Canadian hedge

funds. The Canadian hedge funds can be exploiting the relative inefficiency of

the Canadian markets. It has been reported in the literature that Canadian

financial markets are less efficient than the US ones, where the majority of

global hedge funds are located, in terms of the lower informativeness of trading

(Eun and Sabherwal 2003), higher transaction costs (Tannous and Zhang 2008),

and weaker investor protection (King and Segal, 2003). Our findings of superior

performance of Canadian hedge funds and commodity market timing can also

be driven in part by the Canadian hedge funds having a local information

advantage by being in Canada.1Their advantage is further boosted by a relative

lack of large foreign hedge funds investing in Canada and lower competition

among Canadian hedge funds themselves due to their relatively small number.

This study represents the first comprehensive overview of the risk and return

characteristics of the Canadian hedge fund industry. In contrast to the literature

in the United States and global hedge funds, very little research has yet been

conducted on the Canadian hedge fund industry. Capital markets in Canada

have typically been slower to develop than in other industrialized countries,

and the hedge fund industry appears to be no exception to this general rule.

Unlike the global hedge fund industry, which has been well developed since the

1990s, the Canadian industry has shown signs of growth only after the start of

the millennium. According to Gregoriou (2004), there were only nine hedge

funds in Canada that had 5-year performance figures at the end of 2002. This

contrasts sharply with the thousands of hedge funds that were operating suc-

cessfully around the globe at that time.

The absence of academic studies of the Canadian hedge fund industry can be

partially explained by the short history of the domestic market, but another

obstacle is that there is no single reliable source of data on which to conduct a

reasonable analysis. Return information on indices of Canadian hedge funds

has been available from two organizations, Scotia Capital (SC) and Canadian

Hedge Watch (CHW), although neither of these indices has been analyzed in

detailed studies. In this study, we introduce a new database of approximately

1 The impact of geographical proximity on investment performance was reported by Teo (2009)

for hedge funds investing in the Asian markets, as well as Coval and Moskowitz (2001) for

mutual funds, Ivkovic and Weisbenner (2005) for individual investors, and Baik et al. (2010)

for various types of institutional investors. Because the geographical focus category for

Canada is not present in the global hedge fund databases, foreign hedge funds investing in

Canada cannot be identified. This prevents us from testing the local bias hypothesis by

comparing local and global hedge funds investing in Canada, in contrast with Teo (2009)

where both local and foreign samples with the Asian geographical focus are populated and

compared.

International Review of Finance

284 © 2015 International Review of Finance Ltd. 2015

200 different Canadian hedge funds that we have compiled. The dataset is used

to create what we call the KPSV Composite index and its subindices for eight

investment strategy categories in Canada. Our approach to constructing the

indices alleviates the survivorship bias problem in a sense that currently dead or

nonreporting funds are not dropped from the index, so that their performance

is reflected in the index during the period when these funds were reporting.2In

addition to being more comprehensive than the SC and CHW datasets, our

database includes only those Canadian-domiciled hedge funds whose managers

are located in Canada. This makes our dataset a better tool for studying the

distinct features of Canadian hedge fund industry than the alternative indices.

It also resolves the problem than none of the existing hedge fund databases lists

Canada as the funds’ geographical focus.

Using data from 2003 to 2011, we compare and contrast the risk and return

characteristics of the Canadian hedge fund sector with those of the existing

Canadian hedge fund indices and the global hedge fund industry more gener-

ally. We also compare these characteristics with those of commonly used equity

and bond indices in order to put the true risk of Canadian hedge funds into

perspective. We find that the range of risk and returns for individual hedge

funds varies widely, but there are significant gains to diversification by taking a

portfolio approach to hedge fund investing. We also find that the risk and

return characteristics of the Canadian hedge funds in our database are on

average different than what is reported by the SC and CHW Canadian hedge

fund indices. This can be partially due to our database arguably being better

representative of the Canadian hedge fund industry. A notable pattern among

individual hedge fund strategy sectors is that Canadian hedge funds tend to

outperform global hedge funds in terms of average returns and Sharpe ratios

across all strategy sectors.

In addition to the univariate measures of Canadian hedge fund performance,

this study is the first to report the exposures of Canadian hedge funds to the

Canadian and global risk factors. The importance of using country-specific risk

factors has been recognized in the literature (Griffin 2002). We demonstrate the

advantages of using country-specific factors to examine the performance of

hedge fund indices. Our model estimating the risk-adjusted returns of hedge

fund indices and strategy subindices also includes the commodity risk factor,

which has been shown to influence hedge fund returns in the literature. Con-

sistent with the place of the resource industry in the Canadian economy, we

find that the commodity risk factor plays a prominent role in explaining

Canadian hedge fund performance compared with the performance of the

global hedge funds.

We also consider whether Canadian hedge funds time the stock, bond, or

commodity markets. Because the resource sector is the key sector for the Cana-

dian capital markets, we conjecture that Canadian hedge funds time this

2 Major hedge fund datasets used in the literature, for example, TASS, exclude such hedge funds

from their indices (Fung and Hsieh 2000; Malkiel and Saha 2005), thereby generating addi-

tional survivorship bias.

Canadian Hedge Fund Industry

285© 2015 International Review of Finance Ltd. 2015