Are hedge funds living up to the hype?

According to research houseAssirt, hedge fund managers in Australia manage in excess of $5 billion on behalf of institutional and retail investors. Most of the growth in the industry within Australia has occurred since 1999, particularly for retail investors.

Until 2002 this expansion was accompanied by a good deal of hype, with forecast annual returns as high as 25 per cent. There were also claims that hedge funds constituted a separate asset class, like property or shares, and warranted an allocation of up to 30 per cent of an investment portfolio.

However, many hedge funds have been found not to be the universal remedy for negative sharemarket returns that their promoters advertised.

Fund of funds vs single strategy funds

When evaluating hedge funds it is appropriate to distinguish between fund of hedge funds (FOFs) on the one hand and single strategy and multi-strategy funds on the other.

There are at least 14 distinct hedge fund strategies, for example, long/short equity, convertible arbitrage, merger arbitrage, fixed interest arbitrage, and distressed securities.

A hedge fund manager may choose to specialise in one or more of these areas. If it specialises in one area, the fund is a single strategy fund, if it specialises in several areas, it is a multi-strategy fund.

An important feature in either case is that there is only one fund manager. This is different from a FOF where a hedge fund manager invests with other hedge fund managers, for example, 20 individual funds.

The funds in which it invests are usually single or multi-strategy funds, but they can also be other FOFs. The first FOF was launched in 1999 and, according to Assirt, 14 FOFs were established in the period from 1999 to 2001. Most FOFs are retail funds.

Hedge fund annual returns

The table below shows selected hedge fund performance figures for the years to June 30, 2002, and to June 30, 2003. Where noted, the figures given are from the inception of a fund rather than for 12 months.

Note that past performance is no guarantee of future performance. Minimum investment amounts are also given. In some cases it is possible to invest by way of master trusts and wrap accounts.

It is generally accepted that FOFs carry less risk than single and multi-strategy funds because if one of the underlying managers fails, the overall return is not significantly affected.

However, returns will, on average, be lower in FOFs because fees are paid at two levels — firstly to the FOF manager and secondly to the underlying managers. When a single or multi-strategy manager gets it right or wrong it tends to do so in a big way. Hence the range of returns is greater for single and multi-strategy funds than for FOFs.

The table also shows that returns for the year ending June 30, 2003, for FOFs tend to be higher than for the year ending June 30, 2002.

This trend is not so evident with single and multi-strategy funds. It also should be noted that hedge funds have performed respectably compared with the performance of Australian and international shares over the same period.

The Australian sharemarket was down 4.5 per cent in the 12 months to June 30, 2002, and down 1.6 per cent in the 12 months to June 30, 2003. Because there is a lot of hedge fund activity overseas it has been argued that the performance of international shares should be the benchmark; the returns from this sector were, respectively, -24.5 per cent and -18.2 per cent.

Part of the hype associated with the launch of new hedge funds after 1999 was that they focused on absolute returns and could profit in falling as well as rising sharemarkets. Hence many investors were attracted to them when sharemarkets soured in 2000.

However, the reality is that many hedge funds were not market neutral in the sense that they would profit from falling markets just as easily as from rising ones. It is therefore no coincidence that the hedge funds that performed creditably in the year to June 30, 2003, benefited from better sharemarkets in the last few months.

Being market neutral is an area where investors are entitled to expect hedge fund managers to be astute. There has been improvement in this regard in the last six months. It should be noted that some argue that it is invalid to compare hedge fund performance with any benchmark, for example, international shares, because, by their own choosing, hedge funds are absolute return funds and do not have benchmarks.

Here to stay

Although many hedge funds have not been in existence for long periods, it is clear that as a category of investment they are here to stay. However, there are capacity constraints in that there is not an infinite number of good managers in the investment marketplace. As a result you have to be selective.

The line between what is and what is not a hedge fund is beginning to blur. One fund calling itself an absolute return fund and engaging in a long/short equity strategy goes to great lengths to differentiate itself from hedge funds. Also the hedge fund industry as a whole argued the Australia Fund that failed last year was not a hedge fund.

Hedge funds tended to over promise in the beginning, but along with boutique investment firms have attracted highly competent management talent.

As a result, fees tend to be higher than in traditional managed funds. Claims that hedge funds should be considered a separate asset class have been diluted and an allocation of 5 to 10 per cent of a portfolio is considered more appropriate than much higher percentages proposed initially. This sector is a credible area of investment, but there remain wide discrepancies between firms.

Charles Beelaerts is author of Hedge Funds: Cutting Through the Hype, published by Wrightbooks.