According to the Fund Library, there are over 16,000 investment funds in Canada managed by 422 asset management companies. It is therefore not surprising that investors, even financially literate individuals, may feel lost and confused looking at the Canadian Fund landscape.

To add to the noise, some asset management institutions have marketing budgets of biblical proportion and can flood potential investors with flattering information about their fund in order to convince them to invest. The asset management industry in the U.S. and Canada is a very competitive and many investors do not have the tools to select the adequate fund for their portfolio. Instead, they opt for a mixture of convenience, availability and trust. For instance, since most of us are already dealing with one of the major 6 Canadian financial institutions for our banking services, it is therefore convenient to also invest in their in house mutual funds despite their higher fees  and lower performance. The resulting picture is illustrated in the chart below where we can see that if we believe that the fund managers performance are normally distributed, the fees would push the curve to the left which means that most funds underperform net of fees.

fund-underperform

In the hedge fund world, although investors tend to be more sophisticated and knowledgeable, there is still a fair amount of confusion. This confusion is exacerbated by the variety of strategies used by alternative asset managers.

In order to help investors make an informed decision about their fund selection, we came up with seven questions one has to ask himself when selecting a fund. This applies to both the selection of a mutual fund and a hedge fund. The answer to those questions will indicate to the investor whether the fund is adequate or not.

Question 1: Is the fund manager investing in his/her own fund?

The fact that an investment manager has his own money invested in the fund is an excellent measure of the commitment of that manager to the fund. First, this should instill confidence that the manager will not act recklessly and take unnecessary risks with the capital. Second, if the manager has “skin in the game”, he is arguably more motivated to produce a better return for the fund. In our opinion, the more the fund manager has capital in the fund as a proportion to his overall liquid assets, the better it is for investors. Conversely, if the fund manager is not personally invested in the fund, it should be a red flag and we would advise investors to steer away from such a fund.

Question 2: How large is the fund?

In our opinion, in the Canadian market, any fund with over $1 billion becomes unwieldy and the returns of the fund will likely suffer. Many investors wrongly believe that a large fund is preferable since it is more stable and is less likely to disappear. However, we believe that at a certain size, investment opportunities start to disappear. This article explains some of the difficulties which arises from a fund being too large. These problems are intensified if the fund invests in thinly traded small capitalization equities where there is usually more opportunities for larger risk-adjusted returns. The Canadian investment management market is very concentrated and most people invest in one of the few large financial institutions. It makes it more difficult to outperform the benchmark when investing with these institutions so we suggest that investors find smaller, performance oriented funds.

Question 3: Does the money manager believe in the theory of efficient markets?

The theory of efficient market states that all information about a company is priced in the stock as it becomes public. It is therefore impossible to make abnormal return by using the information available to the public. The corollary to this is the impossibility to beat the benchmark.

If an hedge fund manager believes that the market are efficient, he might as well invest in Exchange Traded Funds (ETFs) since there is no point in sifting through information about a company and spending hours analyzing financial statements.

On the other hand, if the manager believes that there are inefficiencies inherent in the market, they will likely strive to identify those pockets of inefficiencies and profit from them on the long or the short side. In other words, we would advise investors to steer away from funds who believe in market efficiency since they will likely “hug” the benchmark instead of trying to find opportunities.

Question 4: Do the fund manager have a global perspective?

We believe a global perspective is essential since growth will increasingly come from oversees. When we say global focus we mean investing in companies who are growing internationally or are planning to grow into new markets. This could be achieved regardless of the investment mandate. For example, it is possible to invest in Canadian stocks and still take advantage of emerging market growth by investing in firms who have global operations and activities in emerging countries.

In order to really understand this global perspective and international opportunities, we think that the management team should have actual experience in a foreign country. For instance, a fund manager who has lived in India or China would have a much better grasp of the relevant investment themes and be arguably prepared to take advantage of global investment opportunities for the fund.

Question 5: Can the fund use leverage?

As we have seen in the last financial crisis, leverage can be very dangerous when the situation becomes critical. In Canada, leverage in investment fund is much lower than in the U.S. but it still can be an indicator of risk. We recommend selecting a fund who have rules in place which restricts the use of leverage. Although leverage can magnify returns in good times, we believe that it is not worth the risk of a collapse in bad times. Leverage is a large part of the reason hedge funds are usually seen as risky instruments. When it comes to leverage, remember: the lower the better!

Question 6: Do the manager perform sector rotations?

We think that a fund manager should not always stay in the same sector and should perform sector rotations when his outlook changes. The manager may end up being wrong about his sector rotation, but the point here is that if the sector allocation is largely fixed, you may be dealing with a closet indexer. These type of managers will try to replicate the benchmark and will likely never outperform. Remember that you are paying management fees to have the fund manager perform analysis and try his hardest to provide a better risk adjusted return than the index, otherwise you would simply invest in an ETF and pay minuscule fees.

Question 7: Do they have a performance track record of over 5 years and are they beating the benchmark net of fees?

This is one of the most important aspect in a fund selection since it is an objective way to make a decision. The bottom line is: are you getting a better performance than the benchmark net of fees? It is true that the track record is not indicative of the future and a manager who has had a stellar performance may subsequently underperform. This is why, you should perform due diligence when you find a good track record to asses, among other things, the risk of the fund. However, if the performance over five years is inferior, this gives you a good indication to move on.

 

Although it is difficult to identify a fund worthy of an investment, by asking those seven questions, you will be able to eliminate a plethora of sub-par funds. This will make the decision making simpler since you will have a smaller pool of investment funds in which to perform due diligence. Of course, there are many other criteria which comes into play when selecting a fund and we plan on writing in the future about some of the other important aspects such as risk measurement and performance attribution.


 

BT Global Growth offers a long-short hedge fund for institutional and high net worth investors. For more information about our Global Growth Fund, we invite you to contact us today by email at info@btglobal.com or by telephone at +1 (514) 907-8070.