Hedge funds finally gain momentum

In March this year theAustralian Prudential Regulation Authority(APRA) issued a warning to superannuation trustees against the hasty use of hedge funds as an investment choice within their funds.

APRA said at the time that hedge funds were quickly growing in popularity among superannuation trustees, as they seemed to offer new avenues to allay losses in falling markets.

However, the regulator cautioned against the rush, saying that although these products offered diversification during tough times, they could still lead to significant losses in a relatively short time.

But has the take-up of hedge funds in the Australian funds market been as hasty as widely purported?

APRA followed its comments with a survey that found only 15 per cent of trustees reported making hedge fund investments, with these investments accounting for just over 4 per cent of their portfolios on average.

The regulator says this is evidence that take-up is still very much in its early days, with trustees in particular still testing the waters to see if there is any real value on offer in the sector.

However,Deutschehead of absolute return strategies Glen Poswell says growth in hedge fund numbers has been marked over the last three years, estimating a 20 per cent per annum growth over the period.

Select Asset Managementchief investment officer Dominic McCormick argues that the take-up of hedge funds in the Australian market has been relatively slow for a number of reasons.

He says it has taken a while to educate the market of hedge fund benefits, and there has been implementation issues such as the slow process of including them on some platforms.

“I also think there is almost an element of hope that things will get better with traditional asset classes, that markets will bounce back and conventional products will deliver returns,” McCormick says.

“Because hedge funds have been harder to access, implement and understand, there is a hope that the need for them will go away.”

McCormick argues that take-up has been hindered by the fact that a large number of advisers are waiting for their dealer groups or research houses to give them more direction on the asset class.

Zenith Investment Partners partner David Wright says the problem is a lack of understanding about the asset class. He thinks education could show what these strategies are, how to use them within portfolios and the clients they are suitable for. He says that hedge funds suffer from a perception problem and conjure up the idea they have high levels of leverage and large swings in volatility, and that this is not necessarily the case.

Some hedge funds, he argues, are relatively conservative and demonstrate defensive qualities and this is something that could add spice to a portfolio.

McCormick questions how much an investor really needs to understand about hedge funds, because in practice they would find it hard to make “head or tail” of a detailed breakdown. What is important, he says, is that investors are able to build trust with the manager, as well as understand the broad types of strategies being employed and the quality of people who are managing them.

But, while hedge funds have not been as enthusiastically embraced as expected, have they been delivering on the promises they made when they first entered the market?

APRA says there was a lot of talk by hedge fund managers about projected returns, which have proven a little optimistic, with many investors not seeing the returns they expected.

McCormick says there is definitely an element of the benefits of hedge fund-of-funds being oversold, and although they have delivered from a risk perspective, they haven’t quite delivered from an absolute return perspective.

According tovan Eyk Research, on average in the three years to March 2003, absolute return/market neutral managers returned 21 per cent accompanied by a volatility of 7.7 per cent. This compares to the average return of 10.1 per cent for relative return managers with a volatility of 16.4 per cent over the same period.

Van Eyk says the risk and reward ratios have also been significantly higher for absolute return managers than for relative return managers.

However, the research house cautions that the falling and volatile market environment over the last three years has been almost ideal for absolute return/market neutral strategies. The next three years are likely to be less favourable, according to van Eyk, as the equity market reverts back to more normal conditions.

Wright says it is difficult to generalise on the performance of the hedge funds sector because it covers such a huge range of different strategies, with some quite specific to certain market conditions.

He says there is also a problem measuring long-term performance because of a shortage in long-term data and “survivorship bias”, with those hedge funds that have fallen over no longer being included in measurements.

However, Wright says Zenith Investment Partners feels strongly that hedge funds will become a mainstream asset class given investor movement toward using absolute return strategies.

McCormick agrees, saying that as research houses slowly come around to rating them in response to the demands of financial planners, interest in hedge funds will accelerate.