Hedge funds: not all they’re cracked up to be

There are 65 hedge funds available in the local market, with an estimated $1.1 billion in assets under management. In Australia’s nascent hedge fund industry, the majority of products offered — 41 out of 65, or 63 per cent — are a fund of hedge funds. This is consistent with trends in the major international hedge fund markets, reflecting the institutionalisation of hedge funds and the supply-driven nature of the industry.

By packaging several underlying strategies, these fund of hedge fund products aim to deliver investors increased liquidity, diversification and other benefits (such as fund selection and monitoring). However, these features come at significant cost to investors. These costs include layering of fees that are not readily discernible from published product Management Expense Ratios (MERs), which exclude the management costs of underlying investments.

Almost all Australian hedge funds are domiciled locally, in the same jurisdiction as the managers of those funds, in marked contrast to overseas hedge funds where the hedge fund is jurisdictionally separated from its fund manager.

While overseas hedge funds target high-net-worth and institutional investors, retail investors form the target market for the majority of Australian hedge funds. Only 31 per cent of Australian hedge funds are targeted at institutional investors, with the remainder targeted at personal and non-institutional investors.

Performance characteristics

Hedge funds have historically offered investors significantly different investment characteristics to those of conventional funds. However, investors need to be aware that the returns of hedge funds are derived from the same underlying assets — shares and bonds — as conventional funds.

Hedge funds derive their returns predominantly from the United States fixed income and equity markets and are therefore not insulated from the volatility in those markets.

The major attraction of hedge funds is the claim made by hedge fund promoters that hedge funds can deliver “absolute returns” which are not correlated to the performance of conventional asset classes. More specifically, most hedge funds aim to beat money market returns while also delivering an ‘equity upside’ from the capital markets — the ‘best of both worlds’.

The ability of hedge funds to outperform risk-free money market assets is readily verifiable, but comparing the performance of hedge funds with the major equity indices reveals mixed results.

In Table 1, the hedge fund sector is represented by the returns of the composite hedge fund indices published by Hedge Fund Research Inc, and CSFB/Tremont.

A comparison with the returns from the United States and Australian money market proxies (the US 90 day Treasury Bill and UBS Warburg Australia Bank Bills Index respectively) reveals a marked change in the performance characteristics of hedge funds.

The convergence of hedge fund and money market returns is especially apparent over the last three years (see Figure 1). Importantly, for Australian fiduciary investors, the returns from bank bills have consistently outstripped hedge fund returns over this period without incurring any risk (see Table 1).

It remains to be seen whether the recent trend of convergence between hedge fund and money market returns continues or whether there is a reversion to the earlier observed pattern of outperformance.

Unbundling investment skills

Hedge funds essentially pursue actively managed skill-based strategies. The rationale for active investing flows from the belief that conventional investment paradigms are flawed or invalid. Hedge funds claim to capitalise on market inefficiencies and security mispricings to generate superior returns. This claim is particularly significant because the majority of skill-based strategies are implemented in the United States fixed income and equity markets, which are typically regarded as the world’s most sophisticated and informationally efficient capital markets.

The success of hedge funds is dependent on exploiting “trading edges” that allow them to generate abnormal returns from:

• superior information and research;

• superior strategies; and

• lower transaction and execution costs.

It is reasonable to expect that conventional investment managers should also be able to exploit trading edges routinely given their infrastructure, market presence, and pricing power, delivered by quantum of assets under management, with brokers, custodians and other market participants. What causes this apparent “skill shortfall”? We believe that the likely answer can be found in the highly constrained nature of the investment mandates of conventional investment managers.

While hedge funds operate in the same markets as conventional funds, hedge funds enjoy largely unrestricted investment mandates with regard to bet sizes and market timing decisions. In contrast, the portfolios of conventional funds are generally anchored around indices, thus reducing the likelihood of significant performance variations relative to the index.

Statistical (un)certainty

Many investment advisers and product managers use portfolio optimisation techniques to justify investment in hedge funds. Typically, these arguments are framed in terms of generating a more efficient risk/return profile for a portfolio containing conventional assets. These optimisation techniques, however, make several important assumptions regarding the underlying data.

The dynamic behaviour of hedge funds at both fund and aggregate (that is, hedge fund index) levels, violates most of these assumptions.

The risks inherent in skill-based strategies cannot be adequately captured by conventional measures such as the volatility of returns. Critical correlation statistics are highly volatile and unstable over time, making meaningful decisions based upon this data virtually impossible. Representations of ‘normalised’ performance using past returns should therefore be ignored or taken with a truck load of salt.

Industry practice recognises the shortcomings of the data. Investment advisers and fund of hedge fund managers often do not employ rigorous asset allocation approaches and ignore optimisation outcomes, which are unsaleable from a marketing perspective. Hedge fund promoters prefer, instead, qualitative assessments of managers, and advisers generally recommend modest arbitrary portfolio allocations to hedge funds (typically five to 10 per cent of the total portfolio).

Considerations for fiduciaries

The law requires fund managers, trustees and other parties entrusted with the investment of assets on behalf of others, to invest those assets “prudently”. This requirement of prudential investment incorporates the principles of modern portfolio theory.

However, it is clear that conventional optimisation techniques cannot be employed to allocate funds to hedge funds, which have unpredictable performance characteristics. Fiduciary investors that claim to adhere to the “whole of portfolio” approach required by modern portfolio theory but which adopt arbitrary exposures to hedge funds are likely to make their overall investment strategies legally less defensible.

The bottom line is that fiduciary investors must adopt a definitive position of either embracing absolute return strategies — by investing in skill-based strategies or expanding existing mandates to permit investment decisions to be ‘leveraged’ from conventional fund managers — or rejecting hedge funds and other absolute return strategies entirely.

For investment advisers, there is considerable doubt whether arbitrary allocations to hedge funds based on conventional optimisation techniques provide a legally defensible basis for recommending hedge funds to their clients.

Martin Gold and Paul Ali are directors ofStellar Capital, which provides investment services to professional and institutional investors. This material isextracted from a forthcoming bookCorporate Governance and Investment Fiduciarieswritten by Stellar Capital’s principals and published by Thomson Legal& Regulatory, Sydney.