The term “hedge fund” has come to epitomize alternative investments in the financial industry – high risk, accessible only by a select few, and low on details about structure, strategy, and positions. A large degree of mysticism and myth has built up around these funds as a result. One thing is often true: Hedge funds do not publish full holdings. Even if you are an investor, you will not have access to this information. Certainly, this is understandable from the perspective of the funds’ management, which is aiming to protect their investing “edge” from competitors seeking to profit from that knowledge. From the perspective of an investor, however, it is less understandable. How can you make an informed choice about which fund to invest in?

How can you determine if a fund fits within the overall asset allocation strategy of your portfolio? Imagine trying to answer these questions with little more than the offering and marketing documents. The little quantitative data you are given, in the form of past performance, is immediately followed by a disclaimer that “past performance does not guarantee future returns.” That sounds more like a bad joke than actionable information.


It turns out that there is one method that has some success in answering these questions: Returns Based Style Analysis (RBSA). I showed in a previous article how to look at a mutual fund through the RBSA lens, but where this method really has potential is in evaluating funds where holdings information is not available. It is a well suited, then, to look at hedge funds, but analyzing hedge fund style presents challenges.

In fact, further refinement is necessary before we can tackle truly esoteric strategies like “long/short” and “market neutral strategies.” Thus, the choice of
Hillsdale Canadian Performance Equity Fund for analysis, a long-only Canadian small-cap equity fund, based in part on the relatively “classic” attributes of the strategy and the wide availability of data.

But make no mistake, this fund is a powerhouse. An 8.1% average annual compounded rate of return for the three years ending Feb. 28 handily beats the Canadian Small/Mid Cap category average return of 2.3%. Hillsdale lists this fund as a “high alpha small cap” strategy that seeks to earn a return greater than the S&P/TSX Small Cap Index using a diversified selection of securities from the S&P/TSX Composite Index, ranked with a proprietary approach.” I think we can provide greater insight into how this fund is actually investing and some factors influencing its success by looking at its behaviour compared with the S&P/TSX Composite Sector Indices using three years of daily returns.


Before continuing, it will be helpful to create an average portfolio from a fund category (as defined by the Canadian Investment Funds Standards Committee, or CIFSC) against which to compare results. The fund description mentions the TSX Composite and Small Cap indices, which correspond to the Canadian Equity (87 mutual funds) and Canadian Small/Mid Cap Equity (191 mutual funds) CIFSC categories.

Looking at the entire set of data over three years for each of the funds, the one period RBSA and subsequent regression reveals that the indexes explain 69% of the performance of the Hillsdale Canadian Performance Equity RBSA Portfolio (Hillsdale RBSA), measured by adjusted R2. We are left to speculate about the source of the remainder of the returns, but a good guess is that it consists largely of alpha from successful security selection and timing on the part of the manager. The graph below, showing growth of $1,000, best summarizes the equivalent results of the Canadian Small/Mid Cap Average portfolio and the Canadian Equity Average RBSA Portfolio (Canadian Equity RBSA).



The attempt to recreate the performance of the Hillsdale Canadian Performance Equity Fund from a set of indices (red) was fairly successful, with a 69% fit, but it is missing exposure to alpha or other factors affecting the actual fund’s performance (blue). Of the two average portfolios, the Canadian Equity RBSA (green) is our choice as it better represents by far the investable universe (99% fit) and more closely tracks the Hillsdale RBSA (79% vs 74%), compared with the Small/Mid Cap Average (purple). An interesting conclusion we could draw from this is that at least over the most recent three-year period, the S&P/TSX Composite Index appears to be a more appropriate benchmark than the manager’s choice of the S&P/TSX Small Cap Index.


With our chosen average, Canadian Equity RBSA, we can compare the differences in allocations between it and the Hillsdale RBSA over the three-year period. The over/underweight pie chart below provides more information than looking at the Hillsdale RBSA allocations alone because it allows us to see where the hedge fund differs compared with an average fund.



As shown in the pie chart, the Hillsdale RBSA is underweight the most in the Energy (-15%) and Financials (-26%) sectors compared with the category average, and overweight the most in Materials (19%) and Real Estate (11%). These differences may be a tactical choice by the manager or they may just be the systematic sector style of the fund.

The Canadian Equity RBSA has a very high allocation to Financials, at 35%, so the difference between it and the Hillsdale RBSA may simply be that the Hillsdale Canadian Performance Equity Fund is more diversified than the broad market. To determine the reason for the differences, we can use a rolling analysis and look at how the same data changes over shorter, 252-day segments, as shown in the following graph.



Each point on the graph considers the previous 252 days. Looking at the mean, standard deviation, and percentage change over time provides details about the largest sector styles. Although Materials (dark green), Real Estate (teal), and Financials (light blue) have some of the highest absolute differences from the Canadian Equity RBSA weights, the standard deviations range in the bottom half and have the lowest percentage change of all style weights.

These allocations are stable across the sample and indicate a systematic rather than a tactical choice by the manager. On the other hand, Energy (light purple) is the most volatile of all the sector styles of the Hillsdale RBSA. Some of this is due to the volatility in the market sector, but the fact that the fund ranges from 20% to 0 implies that the moves are tactical.

Returns Based Style Analysis takes a bit of work to set up and does present some challenges when looking at complex strategies that hedge funds employ. If conclusions are drawn carefully, though, it has the ability to provide insight into the style of funds in cases where that information is otherwise not available. These data can be used to evaluate the performance of the fund or determine if it would be an appropriate holding in a portfolio.

John Krisko, CFA, BBA, is Manager, Analytics & Data, at Fundata Canada Inc., a leading source for investment fund information. He is also Vice-Chair of the Canadian Investment Funds Standards Committee (CIFSC). This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice. No guarantee of performance is made or implied.