Hedge funds venture into the unknown

Hedge funds have been the target of some tough criticism in recent times. Benjamin Levy examines what is being done to restore confidence in the sector.

Hedge funds are the among the most unpopular strategies you can find at the moment. Complex, expensive and opaque, not even the industry regulators are sure how to define them. They almost seem constructed in a way that ensures no financial planner would touch them with a ten-foot pole.

But fund managers are adamant that the only thing financial planners need is a discerning eye. Some strategies are liquid, transparent, low-fee and can provide great returns for investors. Education, and a lot of it, is called for. Financial planners must be taught, and it is up to the fund managers to teach them.

Financial planners wary

Hedge fund managers are trying to attract investors with promises of good returns and strong future performance, but financial planners are blocking their ears.

Hedge funds may have recovered from the global financial crisis (GFC), but the terrible performance of some at the time exposed a myriad of structural problems and excessive investment risks — all of which have combined in different ways to make financial planners extremely wary of investing.

Hedge funds are derided for being impenetrable and delivering patchy results that investors cannot rely upon with any consistency.

“We are not satisfied with the transparency, the cost, the fee structure and the mysterious structure that some of these funds go through. We can’t understand why it needs to be so complex and so expensive to deliver outcomes that simply haven’t been forthcoming,” says Fiducian head of financial planning Alan Hinde.

Hedge fund managers are becoming increasingly aware of the disquiet among financial planners.

Zenith Investment Partners associate director Ben Davis noted last year that managers such as Jana Investment Advisers, Select Asset Management and Financial Risk Management were taking steps to address liquidity problems, fee inefficiencies and transparency in their hedge fund products.

Simpler fee structures are being created, offering better risk-adjusted outcomes for investors and a better chance for managers to hit their performance targets.

“Based on these changes, we believe we have a better suite of retail alternative products to select from now [than] before the GFC,” Davis said.

However, financial planners seem to be unaware of the efforts being made by managers. Or maybe it is a case of too little, too late.

Rick Capel, managing director of financial planning practice Capel and Associates, abandoned the sector in 2007 when it became clear that hedge fund liquidity would become a real concern.

“I thought the overall concept of liquidity was a worry. It was so hard to get in properly, that I began to worry what it would be like in a market run,” Capel says.

Capel hasn’t touched the hedge fund sector since then, labelling funds with partial guarantees, or hybrid funds, as “tainted”.

Clients in Capel and Associates are encouraged to place money for secure investments into funds which are guaranteed to return original capital and deliver fixed returns, allowing them to have a more generous exposure to pure equities without the need for hedge fund hybrids.

“I’m very glad I left,” Capel says.

Gavin Fernando, director of financial services for Prosperity Advisers, says his practice abandoned the sector due to investment risks. “We don’t think we were well enough rewarded for the risk involved. I haven’t heard of anyone jumping out of their skin to back them in, and I think it’s for the same reason — the risk relative to reward is not there,” he says.

A lack of protective controls also discouraged Prosperity from continuing to invest their clients’ funds in the sector.

Concerns about the active management of hedge funds haunt the strategy. Active managers have come under heavy criticism in the last couple of years.

Recent Mercer research showed that active funds underperformed the index in the last financial year, while also underperforming index funds over five years.

“Unless there are some serious control mechanisms within the mandates of the fund, you can have too large an exposure to a single strategy, and that could be catastrophic for the fund,” Fernando says.

Many hedge funds follow a single strategy that relies on the performance of one fund manager to make money in certain market environments. It is difficult to ask financial planners to invest in an actively managed hedge fund — which has a complicated structure, is expensive and non-transparent — at a time when active managers are seen to underperform.

While Fernando accepted that the right hedge fund strategy could theoretically make money even when the market was falling, the fund manager risk of those strategies was too high for him.

Financial planners’ instincts would appear to be spot on. A 2009 research paper by Professor Stephen Brown of New York University’s Stem School of Business found that one in five hedge funds lied about or misrepresented their results. Responding to the paper, VanMac Global Funds Consultants said the results underscored the need to find a trustworthy manager and have them independently verified.

With such behaviour occurring overseas, there is no doubt that hearing about such events will raise doubts in the advice industry about the wisdom of investing in the sector.

Hedge funds versus financial planners

The wider hedge fund industry is trying desperately to counter the antipathy that financial planners harbour towards the sector.

There is a growing appetite for hedge funds and other alternative strategies among dealer groups who are looking to broaden their portfolios, according to some fund managers.

“Now’s as good a time to invest in hedge funds as any as there are a raft of different strategies inside the hedge fund spectrum,” says Blue Sky Apeiron managing director David Hobart.

Part of the reason for Hobart’s optimism may be due to the relative performance of the global macro sector compared to other hedge fund strategies (Blue Sky Apeiron is a global macro fund).

According to the Dow Jones Credit Suisse hedge fund index, global macro was one of the top two performers in the first half of 2010, returning 4.2 per cent. It was also able to largely limit its losses, finishing the financial year down 0.63 per cent.

“The strategy works reasonably well across most market environments so you don’t need a bull market in asset prices, because we trade across four different asset classes,” Hobart says.

Other strategies haven’t been so lucky. Independent alternative research houses provide monthly statistics on the hedge fund sector, and their results are showing a sector in turmoil, with extreme volatility and sharp price changes since the GFC.

According to an EDHEC Risk Institute Analysis of hedge fund returns, no strategy other than short selling managed a positive return in May last year.

That month was marked by a sharp decline in share markets, with the S&P500 registering a loss of nearly 8 per cent since early 2009, with implied volatility ‘skyrocketing’ past the 30 per cent mark, according to the analysis.

The Credit Suisse/Tremont hedge fund index painted an even nastier picture, recording the largest drop for hedge funds since November 2008.

In June, Islamic hedge funds were the biggest problem, with returns of minus 1.13 per cent, closely followed by fund of funds at minus 1.11 per cent and long only absolute return funds on minus 0.79 per cent, according to a Eurekahedge hedge fund index report.

Sharp trend reversals and erratic price movements marked continued volatility in the hedge fund space, the report stated.

Despite heavy volatility and a hostile reception by financial planners, the research houses are taking pains to point out supposed long-term positive trends for the sector.

The EDHEC-Risk Institute noted that despite the fact that all hedge fund strategies underperformed the S&P500 index, hedge funds served investors well in dealing with the GFC.

All strategies except for fund of funds outperformed over the last three years, including during the GFC, and a wave of optimism had dominated the share market and generated a drop in volatility in December 2010, the institute said.

The Australian Securities and Investments Commission (ASIC) is holding out another carrot to lure investors back into the hedge fund sector, by trying to improve the regulation of hedge funds for investors. Following the collapse of Astarra Asset Management, ASIC is currently surveying large and significant hedge fund managers to identify fringe operators with potential fraud risk.

ASIC is also seeking to provide further disclosure to retail investors by introducing disclosure principles and benchmarks for hedge funds, which would be addressed in Product Disclosure Statements.

Increased disclosure would help investors make more straightforward comparisons between products and business models of different issuers, according to the regulator.

But several experts agree that the sector is already highly regulated, and this raises the question of what ASIC is trying to achieve — other than increasing compliance costs.

The hedge fund industry in Australia is significantly smaller than its counterparts overseas, and there are very few hedge funds in Australia that pose any sort of risk to the financial system, according to experts.

Hobart admits he hadn’t heard any talk in the industry about needing more regulation of the hedge fund sector.

“The Australian hedge fund industry has been quite heavily regulated for years. We still fit under the same regulatory regime as most of the long-only managers out there.

“I think Australia has been seen for some time as an example of global best practice, from a governance, licensing and regulation perspective,” Hobart says.

Kim Ivey, president of the Alternative Investment Management Association of Australia, believes the measures are more prevention than cure.

“The biggest risk we have is a lack of confidence that investors may have if there is malfeasance, or if there is too much fraud. More interest being taken by regulators around the world should improve the perception of confidence in the industry,” he says.

But despite the efforts to make the hedge fund industry ‘safe’ for investors, financial planners don’t trust them, with Fiducian’s Hinde yet to be convinced that they can add value.

There is such a bad track record for hedge funds, for so long a period, that the risk of absolute capital losses and severe underperformance isn’t worth the returns that clients can get, according to Hinde.

“They simply don’t have a record that we can point to with any confidence,” he says.

Hinde urges financial planners to invest in the actual underlying asset class, rather than through a hedge fund, where the full light of the likely performance of those assets can be seen.

“You can only invest in a certain number of asset classes, whether it’s fixed interest or cash, shares, or property. Now, whether you cobble that together and wrap it up in a hedge fund or another structure, and have layers of fees that get sucked out the back of it, you’re still investing in those underlying assets,” he says.

Education of financial planners

At the root of financial planners’ wariness about hedge funds is a lack of insight into how they work. After all, advisers are only human, and humans fear what they don’t understand.

“It’s a black box effect. And I think an adviser has a responsibility, that if they don’t quite understand the black box, then how can you explain it to your clients and how can you justify even being in there?” Capel asks.

The structure of some hedge funds is such that if even one funds management company in Australia promotes a hedge fund, then after building gearing into the product it will outsource the hedge fund to another company — frequently an overseas one — which a financial planner may never even have heard of.

At that point, where a clients’ funds are actually being housed and what fees are going to which company is enough to addle the brains of any adviser.

“If you talk about an Australian share fund, people have a concept of what you’re going to invest their money in. If you talk about hedge funds, the very nature of them is that you don’t know what the hell they are,” Hinde says.

Even the industry regulators seem to be a little lost when it comes to hedge funds. The Australian Prudential Regulation Authority (APRA) admitted to a parliamentary committee last year that it hasn’t specifically defined what constitutes a hedge fund.

APRA executive general manager Keith Chapman told the Senate Economic Committee the regulator had struggled for years with the problem.

“For part of our data collection on super we have a category called ‘other’,” he said.

Part of the consequences of APRA’s inability to define a hedge fund is that it cannot specifically measure the level of exposure that certain superannuation funds have to the sector, Chapman said.

By any measure, that is a dangerous situation. Planners need look no further than the sub-prime mortgage crisis for an example of what happens when a financial services industry doesn’t know how its products work.

So if even the regulator has given up on trying to define a hedge fund, then it is no wonder that the industry is keeping its distance.

That goes a long way towards explaining why ASIC is working to introduce increased disclosure to investors of hedge fund business models and product comparisons. Someone has to do the explaining.

Hedge funds have traditionally been placed in the alternative investment basket because of their claims to generate positive returns regardless of market performance, but some financial planners appear to see it as an attempt by the industry to explain away the drawbacks of the strategy.

“Dubbing something an alternative investment doesn’t give it credibility. Calling it something doesn’t make it good. Going to the racetrack and gambling is an alternative way of investing your money. Just because it’s an alternative doesn’t give it some sort of mystical power,” Hinde says.

Some fund managers also disagree with the label.

Hedge funds deserve their own asset class separate to the alternative asset class, according to Andrew Landman, chief executive of Ascalon Capital.

Thankfully, some progress is being made towards understanding the difference between a hedge fund and other alternatives, Landman says.

Hedge fund managers have to take the blame here. No one better than a hedge fund manager would know how to define their own products, but many planners believe fund managers aren’t doing anything to explain how they work and lump them together.

“They get dubbed ‘hedge funds’, but in fact they are a range, a whole wide range of different underlying strategies and structures,” Hinde says.

“It’s the confused nature of the industry, which doesn’t really promote itself and explain itself. It means that many are simply cautious about using these confusing and rather ill-defined kind of funds,” he adds.

The result is that advisers are mixing up different types of hedge funds with each other, and certain hedge funds that should only be used in certain situations are being used at the wrong time and for the wrong type of investor.

Perry Wilkey, adviser and chair of Financial Services Partners’ (FSP’s) investment committee, says things become more difficult for the industry when hedge funds are lumped in together.

FSP invests heavily in Platinum International, as well as investing in global macro to take advantage of both up and down markets that feature flat growth and high volatility.

Their choice of hedge fund is a careful decision to invest in a specific type of hedge fund that can take advantage of certain markets. The diversified hedge funds sector is a no-go area for them, according to Wilkey.

“There’s hedge funds and then there’s hedge funds. You really need to break them down into their various little sections because they all have very, very specific targets that they are trying to achieve,” Wilkey says.

This confusion could partly explain why planners have accused hedge funds of not doing what they are supposed to and not providing the returns they said they would.

Not knowing anything about how and when they are supposed to be used, planners simply discard them as faulty investment products with unrealistic performance expectations.

This is where education of the masses comes in. Educating financial planners about the characteristics and structures of different hedge funds will help them separate real hedge funds from fake ones.

“Everyone puts in a whole lot of stuff into hedge fund land, and true hedge funds that manage their downside risk first and get performance afterwards, are performing very well,” says Landman.

Landman agrees that it is up to hedge fund managers to do the hard yards on educating financial planners and investors about the way that hedge funds work.

Advisers are gravitating to more transparent, liquid hedge funds as part of a general trend post-GFC to find more transparency in investment products, but because they are uneducated about how hedge funds work they labour under the misconception that a more transparent hedge fund equals a more simple one. It often doesn’t.

“A lot of people link transparency to complexity, then suddenly to liquidity as well, so what I would say is that they can be fully transparent on their fee structures, fully transparent on their positions and their price, but that doesn’t mean they cannot be complex in their investment process,” Landman says.

But a beginning is being made on education.

Ascalon is beginning to openly educate their clients about not confusing transparency, liquidity and complexity in the hedge fund space.

More due diligence is being performed on hedge funds, more transparency is being sought on the exposures they hold to different asset classes, and more knowledge is being generated about the sector itself.

“I think there is a far greater improvement in knowledge in adviser land of the risks and the due diligence that they should look into when looking to allocate to hedge funds,” Landman says.

“Regulation is coming in, and I hope that with it comes a bit more education that hedge funds aren’t these evil things that created the GFC.”