A recent comparative study of the performance of Canada’s hedge funds and mutual funds makes the case that both have outperformed benchmarks over the course of the business cycle, and that the two fund classes produce “almost the same returns” in bull markets, but that Canada’s hedge funds are markedly superior to its mutual funds in level or bearish markets.
The comparison, prepared by Amitesh Kapoor, of India’s Lovely Professional University, relies on data from Hedge Fund Research Inc., with its 100 indexes of performance which (as Kapoor puts it) range “from industry-aggregate levels down to specific, niche areas of sub-strategy and regional investment focus.”
His data on the mutual funds comes from the Morningstar Database, whence he “extracted 581 mutual funds investing in [the] Canadian equity market.”
In order to determine alpha for either mutual or hedge funds he needed data for benchmarks. As you can see above, he employs several: the TSX/S&P500 and the TSX/S&P60 provide equity market proxies. The other benchmarks are constructed on the basis of factor models. For example, SMB stands for “small minus big” and it refers to the spread in returns between large and small cap firms. Likewise, “high minus low” (HML) captures the Fama-French view that value stocks regularly outperform growth stocks. The data for constructing such indexes – and one for momentum (MOM) – in the Canadian context comes, too, from Morningstar.
Risk and Return
Kapoor corrects his raw numbers to adjust for biases by eliminating from consideration the hedge funds to which he considers the biases may apply, leaving him with a sample size of 87 hedge funds, a bit of a contrast to his wider panoply of 581 mutual funds.
As the above table shows, hedge funds and mutual funds both exhibit a negative skewness and a positive kurtosis.
Hedge funds provide much higher returns than do mutual funds (0.79 and 0.22 percent, respectively), while also showing a lower standard deviation (2.77 and 4.06 percent, respectively).
As Kapoor says, this is similar to what Martin Eling and Roger Faust found in European data.
He then broke down the data into two periods: 2000 – 2006 and January 2007 – May 2009. The latter period was one of recession for the broad economy, and perhaps unsurprisingly the performance of both hedge funds and mutual funds dropped during this period compared to the earlier one.
But, though mutual and hedge funds both had negative excess returns in this period, the fall in the return on mutual funds is much greater than its analog for the hedge funds. Also, the only benchmark index that beat the hedge funds in mean return in this period was SMB.
Table 5 shows the return measures after adjustments for risk. Of course, the literature on measuring results provides several ratios: Sharpe’s, Treynor’s, and the Information ratio. Kapoor uses them all.
Hedge funds outperform mutual funds by any of these measures.
Pick a Measure, Any Measure
Quick Review: the Sharpe ratio is return over the standard deviation. The Sortino ratio measures return against downside volatility only. The Information Ratio is the expected value of the active return against the standard deviation.
Kapoor treats the Sharpe ratio as the default measure, but describes the Treynor ratio as useful “if the portfolio under consideration is part of [a] larger fully diversified portfolio” and the IR as often employed to determine the skill of managers.
The bottom line, though, is that the superiority of hedge funds “is robust among these measures.”
The relationship between the results of mutual and hedge funds varies from one phase to another of the business cycle.
In the most bearish periods, mutual funds do somewhat better than the market as a whole. In the most bullish periods, they provide a lesser return than the market. Furthermore, in bullish periods the hedge funds, too, underperform the markets. But it is in bearish periods that hedge funds earn their keep outperforming both the market and the mutual funds.
Thus, hedge funds also earn their name. They work as a hedge, they “profit from non-directional and unconventional strategies which … give some kind of downside protection in [a] bear market,” Kapoor writes.