Looking For Mr. GoodFund: Chapter 2 - Creating A Workable List of Hedge Funds

Finding a good hedge fund is by far more difficult than finding any other traditional fund or manager. The industry in Canada is both diverse and fragmented, with many small funds. There is no concise and universal definition of a “hedge fund”. Furthermore, hedge funds are marketed through two different markets - the exempt market (for high net worth and institutional investors) and the retail market. Consequently there isn’t a central data base or directory with all of the information readily available.

Our first goal is to identify the hedge funds available in Canada and find some basic information on them. Information on hedge funds can sometimes be found in the mutual fund data bases of Morningstar and Globe Fund under ‘Alternative Strategies’. Also, the Alternative Investment Management Association of Canada’s (AIMA) website contains a directory of members. Subscription services like Global Manager Research Database (GMRD) has additional information on alternative strategies. Pulling names from these places, and including multiple asset class mutual funds, we arrived at a list of about 250 alternative strategy funds.

Creating A Workable List

A list of 250 different funds is both unwieldy and unworkable. The next step is to quickly create a working list of about 40 hedge funds by applying various ‘screens’ or ‘filters’. First we want to eliminate all those alternative strategies that are not hedge funds. This includes precious metals, private equity, distressed securities, high-yield bonds, real estate, and any other fund that is predominately long. Next, we eliminated all those strategies that were structured as principle protected notes or offered to institutional investors only. We wanted hedge funds that have an established track record, so we eliminated all those funds that have been in existence for less than 3 years. Finally, we wanted to eliminate the poor performing funds; therefore we filtered out funds with negative performance for the past three years.

In the end we had a list of 45 different funds. Some basic characteristics of the list follows:

• Only 6 had been in existence for over 10 years
• About 65% had a minimum purchase requirement of $150,000 and above
• Most were based in Toronto

• About 50% followed long/short equity or market neutral strategies
• Some were relatively low risk strategies and others have exceptionally high levels of volatility
• In 2009 the best performing fund was up 160.6% and the poorest was down -29.0%
• In 2008 the best performing fund was up 61.2% and the worse was down -72.1%
• There were 11 funds that were positive in both 2008 and 2009
• Over 3 years ending September 2010, the best performing hedge fund returned over 35% annually. 

Another observation was that many funds were closed down over the last couple of years and went out of existence. Also, most of the hedge fund managers are relatively unknown and quite small compared to those who manage the traditional asset classes.

The Bottom Line
Before an investor rushes to buy the latest hot hedge fund it is important that they do their due diligence to ensure that it is appropriate for them and they understand the risks. A good start is to create a workable list of funds.