Keavney answers his critics

I must readily concede a key point made in the responses to my article on hedge funds (Money Management, May 24). The article dealt with only certain types of funds and consequently generalised too widely. The article dealt with the fundamental differences between physical assets and derivatives but it is important to acknowledge that many hedge funds do invest in physical assets.

However, I did not argue that all hedge funds must be inherently poor investments. In fact, I clearly stated that I did not "totally exclude hedge funds as an investment option" and that "there is a broad range of vehicles included under this term".

I suspect that the heading "Hedge funds fail the asset class test" and the picture of an exam paper marked "D" - neither of which are under my control - may have added an extreme tone.

I argued that hedge funds are not, in themselves, an alternative asset class. This has led to some fruitful discussion about the nature of an asset class and the role of different investment types in diversified portfolios. I think we all agree that the inclusion of investments with different behavioural characteristics is a contributor to sound diversification and hedge funds have characteristics which differ from those of other investments. This is a possible basis for the inclusion in portfolios of hedge funds or other alternative investment strategies.

This raises the question of how funds differ regarding the relative contributions of manager skill versus asset class behaviour towards investment returns. Manager skill can vary widely both in conventional managed funds (from index funds where the manager's contribution is zero to actively managed diversified funds) and in hedge funds.

As various types of assets, physical or derivatives, can play a role in hedge or traditional managed funds, it may be more useful to concentrate on the differences between these assets rather than on types of funds. This will highlight the significant issues, which will apply to any fund to the extent that it invests in those assets. Many funds will have combinations of both asset types, eg international equity trusts with full currency hedging.

In Australia, it is traditionally said that there are three main asset classes: property, shares and interest bearing securities. What is it that differentiates these from other physical assets such as precious metals or collectibles? One key item is the payment of a regular income stream.

Investors in gold are speculating entirely that the price of gold will rise. Failing this, no profit can be made. Stock market investors will also wish for the price to increase but, even if it does not do so, they will be paid a dividend income stream. The investment can be profitable even without growth.

This could be said to make equities lower risk than precious metals (ignoring other variables). The three traditional asset classes offer regular dividend, rent or interest income in addition to any capital gains or losses.

Although naïve investors sometimes speak of "gambling in the stock market", investing is very different from gambling. Gamblers, in aggregate, will always make a net long-term loss despite the fact that some individuals will win. The odds are carefully constructed to favour the house. It is a "net-loss" game for the players.

By contrast, for the main asset classes, investment is a "net-profit" game. Property, shares and bonds can all decline for quite long periods but, eventually, they can all be expected to deliver long-term profits. In a sense, it could be said that the odds are stacked in favour of the players.

Certain other assets are a "net-zero-sum" game, for example currencies. It is a tautology that currency A appreciating against currency B is the same as currency B depreciating against A. Any simple contract that involved exchanging A for B would involve an equal profit for one party and loss for the other. The same is true for many, but not all, derivative contracts. In these markets the odds, so to speak, are even.

Of course this does not exclude the reality that there are more and less skilled operators in these markets. The former could make consistent profits at the expense of the latter. Some of these skilled operators could manage profitable funds. It is only in the aggregate that this is a zero-sum game.

Naturally, the underlying asset contributes more and the manager's skill less in a net-profit market compared to a zero-sum market. For example, even bottom quartile performing equity, property and cash/bond funds have been profitable over many time-frames.

This is a reassuring factor in entering such markets and is part of the reason they have wide acceptance. It is also the basis for the cliché: "It's time in, not timing, the markets", which recognises that mere patience, even without skill, is ultimately likely to generate a return.

It is equally true that, over shorter periods during which the market experiences a cyclical decline, even upper quartile managers could produce losses - and these periods can be very extended. It is the existence of these times that can make it appealing to "diversify away from market risk" by exposure to different markets, even if they are zero-sum markets, or to funds which access the same markets in ways which produce lowly correlated returns, or to cash or capital guaranteed investments.

In a zero-sum market, the manager's contribution is more significant as, overall, the underlying market contributes nothing. This makes manager selection absolutely vital. Poor selection is likely to produce, not only a lesser profit, but an actual long-term loss. This is a very significant issue for advisers to understand in evaluating investment funds that operate in zero-sum markets.

To avoid any confusion, I recognise that many hedge funds are not operating in zero-sum markets. My comments apply to any type of fund to the extent that it does invest in these markets. For example, some international equity trusts have done well with their management of equities but have added nil net value with currency overlays. It is also true that some hedge funds operate heavily in these markets.

I accept that only around three-quarters of hedge funds leverage, and the degree to which they do will vary from nil to very high. If Damien Hatfield's assessment is true, that most leverage to the same extent "as the typical margin lending account" then, with those funds that do, planners need to assess the appropriateness to a client of gearing within a product, to the same extent as they would before undertaking margin lending.

The same applies to any traditional fund with internal gearing such as the Colonial First State Geared Share Fund, as it did to "growth" property trusts in the 1980s. The experience of our industry of the latter was that the risks of gearing were then largely unnoticed. People had growth property funds recommended to them when they would never have been put into a margin lending account. Internal gearing is less visible but just as material.

One point where I must take issue with Dominic McCormick is his statement that: "No one argues that [hedge funds] are guaranteed to make money in a bear market". He may not, but one impetus for my first article was the specific representation to me about a particular fund that it would make double digit annual returns, irrespective of market conditions. Certainly this only reflects on the marketing of that one organization, but it is in no-one's interest for any investment type to be presented as capable of such a miracle.

I trust this avoids any over-generalisations yet makes a contribution to understanding some issues created by the emergence of ever more complex investment structures.