Why hedge funds are back in the spotlight
Given the new investment environment, flexibility is essential. This might create perfect conditions for the growth of the hedge fund sector, writes Janine Mace.
In an investment world where flexibility and the ability to respond quickly are increasingly important, fleet-footed hedge funds may be finding their time in the sun has finally arrived.
Although many long-only equity managers found market conditions in 2011 very challenging, several hedge fund strategies revelled in the unsettled conditions. And their nimble response has left traditional long-only managers scurrying to catch up.
Chris Gosselin, chief executive of Australian Fund Monitors (AFM) which tracks the performance of Australian hedge funds, believes adaptability is now an essential quality in the face of ongoing market volatility.
“Traditional long-only managers are moving more towards the hedge fund approach as they are finding increasing flexibility is essential. They can’t perform with one hand tied behind their back,” he says.
“In this type of volatility, long-only is not the way to go, and we are increasingly seeing the blurring of the definition of hedge funds and absolute return funds and long-only approaches. Some managers are taking very concentrated positions with hedging to cope.”
Flexibility is now an essential for successful funds management, Gosselin argues. “Set and forget was great in 2003-07, but in a volatile environment it causes great damage.”
This explains the introduction of more tactical products.
“Multi-strategy and multi-asset funds are a response to market conditions and fund managers not wanting to be as locked into the market as they were in 2008 and 2009,” he says.
“Active management is completely the way to go at the moment.”
Daniel Liptak, head of alternatives research at Zenith Investment Partners, agrees the new investment landscape favours hedge funds and managers who are not tied to a set asset allocation.
“For the next five years we are likely to be in a low return environment and so investors need to look elsewhere for returns,” he says.
Elsewhere may mean hedge funds, so traditional managers are not going to be left without an offering.
Several firms have already taken the plunge.
In February, Money Management reported Perpetual had announced plans to build a long/short equity fund in response to client demand.
Caledonia Investments is also gearing up for the March launch of a new long/short equity strategy focused on Asian and Chinese economic growth. This complements its new global resources long/short fund.
“We are seeing a number of announcements that traditional managers are launching long/short products to handle volatile markets,” Gosselin notes.
“The question is, do long-only managers have the shorting skills to run these funds? Shorting is a very different skill set.”
Hedge fund performance
Much of the current interest in hedge funds is due to their performance during 2011.
While not turning in stellar results, they performed better than many other asset classes, explains Deanne Fuller, senior investment analyst at Lonsec.
“In an absolute sense they have done well, particularly compared to equities – and especially high risk equities such as emerging markets.”
Gosselin agrees the performance was good in a very difficult year. “The hedge fund industry as a whole, on average, was marginally negative in 2011, but the market itself was down 14 per cent,” he notes.
“The overall hedge fund industry in 2011 for the AFM All Funds Index saw a -3.86 per cent return, while the ASX200 had a -14.51 per cent return.
The platform was negative, which is never good, but performance was good compared to the underlying market.”
Complicating matters, some hedge fund strategies found the going tougher than others, explains Gosselin.
“There has been a wide range of performances over the past 12 months, from plus 31 per cent to negative 37 per cent to the end of December, which is a mammoth range,” he says.
“This creates an issue for financial planners, as there are 200-250 hedge funds in our database with different styles, strategies and sizes. They range from Platinum with $15 billion to an emerging manager with only $5-$10 million.”
Fuller acknowledges there was a broad spread of results.
“We have seen a greater dispersion than in previous years due to the risk-on/risk-off market in 2011. However, the result is a good performance given what equity markets have done during the year.”
Although many local hedge funds turned in good results, managers pursuing one investment strategy in particular found conditions to their liking, according to Liptak.
“In the Australian market neutral space, we have seen a 20 per cent plus increase to December 2011. Over the past five to ten years, we have seen around 15 per cent with no liquidity issues or redemption gates,” he says.
With institutions moving to increase their allocations to these funds, Liptak expects to see more market neutral start-ups this year due to the “wall of dollars that is flowing into these strategies”.
Other strategies are also gaining favour. “Long/short equity funds have also done very well, and we have seen them produce very good numbers,” Liptak notes.
Growing international interest
Offshore, the picture is a little less attractive. According to BarclayHedge – a US provider of alternative investment databases which tracks 1,600 US hedge funds and fund of hedge funds – the sector underperformed the S&P500 in the year to 30 December 2011.
Industry assets also declined 7.7 per cent, falling to US$1.64 trillion – their lowest level since February 2010.
In performance terms, only three of the 14 major hedge fund categories tracked by BarclayHedge (market neutral equity, merger arbitrage and fixed income) showed positive returns.
Despite this, the good performance compared to long-only equity managers is translating into fresh investor interest.
A recent Barclays Capital report surveying 165 investors managing approximately US$4 trillion in assets under management (AUM) found 56 per cent of respondents planned to increase their hedge fund allocations over the next 12 months – more than seven times the number planning to decrease their allocation.
These findings are backed by reports the US$228 billion California Public Employees’ Retirement System (CALPERS) is likely to increase or maintain its hedge fund investments, which already total around US$5.2 billion or 2 per cent of its total AUM.
Institutional investors are not the only ones showing renewed interest, according to Liptak, who has received many calls from direct investors asking which managers to consider.
“We are definitely seeing a lot of demand for good quality hedge funds. There is a change to people dipping their toes back into alternatives.”
Nikki Bentley, a partner at Henry Davis York and chair of the Alternative Investment Management Association’s Regulatory Committee agrees.
“Good hedge fund performance has shown the value of hedge funds to investors,” she says.
“Hedge fund managers are meant to manage the downside risk and the performance in 2011 has been a good indication of that.”
Liptak believes sentiment towards hedge funds is different in Australia compared to many offshore markets.
“People were very negative on everything post GFC, but in Australia it is not really true of the top hedge funds like Platinum, which hardly saw a drop in inflows.”
Gosselin agrees views are slowly changing.
“Hedge funds were really vilified after the GFC but their reputation is improving as once the failed funds – such as Astarra – have been dealt with, their performance can be the focus,” he says.
Fuller is another who sees interest increasing.
“Institutional inflows are still solid, but retail funds less so. Anecdotally, we have seen increasing financial adviser interest, but whether that has resulted in fund flows is still doubtful, especially given term deposit rates in Australia.”
Key challenges ahead
The growing interest is bringing its own challenges for managers.
“There is a capacity problem as local hedge funds cannot accept huge allocation into their strategies,” Gosselin explains.
“This is a major issue for hedge funds, as by definition, they are smaller and boutique. If an institutional investor has $200 million and wants to invest into a $500 million fund, then that is a real problem. Such concentration is a real danger for both the investor and the fund.”
Liptak agrees: “Capacity is the biggest issue for the hedge fund space, and it will be difficult to get access to the good managers – some of which are already closing to new money.”
Fees are also a massive issue at the moment, according to Gosselin.
“But in my view, it depends on what the performance is. If you receive a 5 per cent return net of fees when the market is down 10 per cent to 15 per cent, then I would be happy to pay.”
He also points out the debate over fees has led to questions about the use of fund of hedge funds (FoHF) structures, as these involve two levels of fees.
Fuller agrees the fee question is very divisive, but notes “we have yet to see any significant decline in fees”.
While agreeing the higher nominal fees of hedge funds are an issue, Liptak argues they are often justified. For example, he points out investors in Australian market neutral funds received $2.54 of alpha for every $1 paid in fees.
This compares to $0.05 of alpha for every $1 in fees paid to the average long-only Australian manager.
“The current debate sees investment managers as an industrial input, not as a value add from skill or other IP related activities. It also ignores the outcome for investors,” he argues.
The arrival of new ‘passive’ or beta hedge fund strategies onto the market may provide a partial solution to the fee problem.
“With hedge fund performance, the reality is not all of it is alpha and some of the trades can be replicated, so there is a lot of beta in it,” Fuller explains.
“If more beta market strategies come to market, we will see increased fee pressure in this market space. We expect to see hedge fund beta start to gain traction in the next year or two.”
The entrance of beta strategies also reflects a new-found level of transparency among hedge funds.
“We have been seeing increasing transparency in recent years and it is now excellent. Often monthly performance reports can be two to ten pages long,” Gosselin explains.
While he believes hedge fund transparency is now often better than in many long-only funds, pressure remains on liquidity.
“We have seen growing pressure from platforms to increase the underlying level of liquidity in some strategies. However, we believe the optimum approach is where liquidity matches the underlying assets,” Fuller notes.
“Better liquidity can compromise the strategy’s performance.”
Gosselin believes liquidity is improving.
“There have been changes to the lock-up and liquidity, and very few funds now have less than monthly liquidity. In retail products, they now have daily liquidity in funds such as Aurora Fortitude and Bennelong.”
Role in client portfolios
Gosselin believes market conditions will encourage many high net worth investors with allocations of $200,000 plus to move into hedge funds this year.
“Many self-directed investors who have been making their own decisions have been finding conditions very difficult, so they are now looking to use hedge funds’ expertise instead,” he explains.
“They believe this is a market where it is so difficult to make money it is better to give it to a hedge fund.”
While retail investors may be interested, the task for financial advisers is not an easy one.
“The diversity of hedge fund performance, style and strategy is extraordinary, and that makes it very difficult for the investor and financial planner to sort the wheat from the chaff,” explains Gosselin.
“From one year to the next, the performance is very different. In 2008, 23.5 per cent of the AFM universe was positive in the wipe-out, but they didn’t necessarily do well in 2009 and 2010.
"The key for financial planners is to find managers which have performed across a range of conditions.”
He also believes high quality, timely research is vital. “In the hedge fund space once a year is not often enough, as managers and performance can change quickly.”
Liptak agrees financial advisers have an important role to play. “In the hedge fund space, manager selection is very important. You need to identify the strategy first and then select the best manager for that strategy.”
When it comes to portfolio construction, Gosselin favours a blend of managers.
“We recommend not investing in a single fund, but in a blended portfolio.
"A tightly blended portfolio helps as no manager is immune to negative months, and you want a slightly different strategy at different times – so if the manager suffers in one month, it is offset by one of the others,” he says.
However, a blended portfolio can be a problem with smaller investors. “The majority, but not all, hedge funds have a minimum investment of up to $500,000, so they are really for sophisticated investors,” Gosselin notes.
For this reason, Fuller still supports the FoHF approach. “A FoHF can be good for retail investors, notwithstanding the high fees, as it is a type of one-stop-shop. However, it is not really suitable for bigger investors.”
She believes there is a strong case for including hedge funds in a retail portfolio. “Hedge funds can help smooth out the ride in this type of investment market, although we acknowledge they are not suitable for all clients.”
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