Hedge funds irked by stock market benchmark comparisons

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Frustrated with frequent comparisons to broad stock market indexes, hedge funds are pushing back against a benchmarking practice they say unfairly assesses their returns.

Because hedge funds – now commonly referred to as "alternative funds" – often buy and sell stocks, their performance is routinely compared to that of the S&P/TSX composite index or the S&P 500, depending on the fund's home base and the composition of its investments.

In hot markets, such comparisons can hurt. During the the first quarter of 2014, Canadian hedge funds earned an average of 3.96 per cent, according to Bank of Nova Scotia's Canadian Hedge Fund Index, while the TSX benchmark earned 5.24 per cent. Last year, Canadian hedge funds returned an average of 4.39 per cent, while the S&P/TSX gained 9.55 per cent.

Hedge funds argue this relative performance shouldn't be put under the spotlight, and Canadians aren't the only ones saying so. Taking up the cause, the Alternative Investment Management Association (AIMA), a global body based in London, has put out a report that argues simple benchmarking shouldn't be the main means of judging performance.

"These comparisons may have made sense at one point," AIMA wrote in the report, adding that alternative investing strategies used to be more bare bones and almost strictly tied to stocks. "But the hedge fund sector today is now more diverse … and more global – investors have a choice of at least 20 different investment strategies, many of them designed to be uncorrelated to equity markets."

In the 1990s, most funds employed long/short strategies, where money managers would buy one stock and then short another from the same sector. When doing so, the portfolio manager can negate industry risk and make money so long as the stock he or she bought performs better than the one that was shorted.

Today, however, there are a range of strategies, and some funds state right in their mandates that they aren't meant to beat the broad market – they are designed to truly hedge risk and lose less money in a down market. For that reason, the industry argues risk-adjusted returns are a better measure.

"Many institutional investors take advantage of alternatives to achieve steadier returns in their portfolios with lower volatility, as opposed to chasing indices for higher returns achieved with greater volatility or risk," Gary Ostoich, president of Spartan Fund Management and chair of Canada's AIMA chapter, wrote in an e-mail.

Convincing investors of these distinctions hasn't been easy, which is why the industry gets riled up when the media reports on its performance relative to benchmarks. But in some ways, hedge funds only have themselves to blame.

Despite the growing diversity of investing strategies, bad returns from high-profile funds that once promoted their ability to beat the market have stuck in investors' minds. In Canada, well-known fund mangers such as Salida Capital and Sprott Asset Management employed investing strategies that borrowed money to juice returns, and invested in illiquid small-capitalization stocks that saw their valuations plummet when the commodity supercycle went bust. Over the year that ended March 31, Sprott's flagship hedge fund lost 39.5 per cent.

The task now is to educate investors on the differences among funds. Rob Wessel, who runs Hamilton Capital Partners, an investor in financials, says none of his four funds uses financial leverage. Hamilton also only invests in exchange-traded stocks, so liquidity is less of a concern.

But as he educates investors, Mr. Wessel doesn't try to deflect all criticism of alternative funds because he believes in a healthy dialogue. "There are legitimate questions about hedge funds, including perceived high fees and funds becoming too large, that are worthy of honourable debate," he said.