Capacity for growth

The hedge fund industry in Australia has to defend itself against many charges, some justified, but most not.

In recent years, hedge funds have started to see some solid inflows from the retail market and this has raised concerns among planners that the funds are reaching capacity.

Capacity restraints

Officially, hedge funds are supposed to be small and nimble enough to take advantage of opportunities in markets. But industry insiders believe that does not necessarily mean they will have capacity constraints once they start to grow.

Vertex Capital Management associate director Rebecca Jacques says the issue of whether funds reach capacity is related to the investment strategy being run by the managers.

“Most managers have a four-year track record before they approach becoming full in their funds,” she says.

“Our Australian equities fund is three-quarters full, but we have launched a different type of strategy fund.”

Jacques says long/short Australian equities managers have considerable capacity in their funds and it will be a long time before they are full. The increased number of these types of funds being launched in Australia will also help stretch capacity limits, as there is more than enough money to go around.

“Capital for hedge funds in Australia is not drying up,” she says.

Macquarie Bank director equity markets group Cathy Kovacs also says capacity depends on the strategy run by the fund manager.

“An equity long/short fund can be quite large because it has the ASX 300 index to play with,” she says.

“The same applies to funds dealing in futures. Global macro futures are very liquid so you can have quite a large fund.”

Kovacs says it is only where you have a sector specific fund that capacity can be a problem, but the manager can launch another strategy fund in the sector to soak up some excess capacity.

“Capacity is not an issue in Australia if the investor is going through a fund-of-fund product,” she says.

“There are still some opportunities in Australia for hedge funds that might not be available in the US.”

Benefits of size

Credit Suisse First Boston (CSFB) investment specialist Asia Pacific Tim Schuler says some hedge funds need to be large to handle the administration required to run such a product.

“Some funds have to be large to house the infrastructure to manage them, and that includes a big team of analysts,” he says.

“When you have an organisation that has a team of 20 people upwards, you can’t have a small fund. However, you can still be nimble in your investment strategy.”

Schuler says a multi-strategy fund, which might be offering arbitrage, could be conscious of what capacity it could go to and the amount of movement beyond the cut-off, to benefit from some opportunities in the market.

“A manager should know what their capacity is before they trade,” he says.

“If we find a manager that is exceeding their capacity, we go and visit them to find out why. Sometimes there are good reasons for exceeding capacity, such as a distressed debt fund.”

Schuler says exceeding capacity creates many problems for some types of funds.

“It all depends on what the manager is trading and the particular sector they are working in,” he says.

“If they are day trading, and lose control of the options, it is to the detriment of the manager if they get too large.

“It is the dance we do all the time. We might be aware of the problem, but it is a moving target.”

A multi-manager strategy, which spreads funds across a number of managers, can also help to overcome capacity constraints, Schuler says.

“We cap our portfolios with these managers at a size which is smaller than the overall portfolio,” he says.

“So, if the flagship fund is capped at $1.5 billion, we can put sums of $50 million with a manager and not exceed capacity.”

HFA senior portfolio manager Peter Coates also agrees the amount of capacity a manager has depends on their investment strategy and what asset class they are working in.

“If you are looking at long/short equity markets, the capacity is very deep,” he says.

“There is still plenty of space in this sector and plenty of depth.”

Historical performance

As hedge fund managers develop their skills in Australia, they will create a lot more divergence in returns from sectors such as long-short equities.

However, Coates says there is a shortage of skilled managers, despite new groups entering the sector.

When a manager reaches capacity, he says, they will close the doors for a while and reappear when there are better opportunities in the markets.

When hedge funds first arrived in Australia there were predictions from some quarters of unrealistically high returns.

However, despite many hedge funds achieving positive returns for the past five years, some investors feel let down as the mythical targets were not met.

Kovacs says Macquarie never offered inflated returns, preferring investors to understand that the returns would be in line with market expectations.

“We now market hedge funds as giving returns like equities, but with low-style risks,” she says.

“The retail investor should be using them as part of a portfolio to reduce risk.”

Kovacs says there are more volatile hedge funds, with higher returns, but not many are available in Australia.

Jacques adds that Vertex works in the equities space where returns have been harder to achieve in the recent vibrant times that the markets have been enjoying.

“What happens with hedge funds returns depends on the market system,” she says.

“There is much more room to do well with volatility.”

Long-term prospects

With all stocks rising, it is harder for hedge fund managers to find opportunities and Jacques says the manager is looking for mis-pricing in a misunderstood stock. But when everything is going up, there are no opportunities.

“In the long-term, hedge funds outperform, but the difference is in the nature of the return and its effect on volatility,” she says.

“Hedge funds can be counter-cyclical and they are good at stripping out market risk.

“Short-term returns are what people expect from hedge funds, but it is really for the long-term.

“The investors stay with you, but they shouldn’t be putting all their money with a hedge fund.”

Schuler says CSFB is trying to deliver realistic returns to its investors that are consistent.

“We believe a hedge fund is a risk-adjusted return,” he says.

“We might have a targeted return of 8.5 per cent, which is measured against the MSCI of 8.5 per cent, but the hedge fund will have half the volatility of the index fund.”

He says the fund manager is trying to avoid delivering a positive 25 per cent return one-year and a negative 25 per cent return the next.

Schuler says fund-of-funds can earn a consistent return in a portfolio of traditional products, while Coates adds that HFA has never offered high returns, just consistent performance.

“We look to minimise the downside with a fund-of-funds and the aim is to produce consistent returns,” he says.

“There are hedge funds with single managers who have high risks and returns, but the investor needs to understand what these exposures are.”

Coates says it is difficult to produce consistent returns; a broad exposure to various sectors is the key.

Fund-of-funds managers have created a way of minimising the risk while taking advantage of the returns in a sector, he says.

“We look at our exposure to equities/credit spread and minimise market traction to get consistent annual returns,” Coates says.

“If we got a high return, we wouldn’t be doing our job as we wouldn’t be sure of the risk factor.”

HFA wants returns that fit into a tight range to reduce volatility and help investors with timing their investing.

Coates says if a fund is swinging between positive and negative each alternate month, it is very hard for an investor to time entering or leaving a fund.

Fund offerings

Australia mainly has fund-of-fund offerings in hedge funds, unlike US and European markets, which have lots of specialist single-manager hedge funds.

The most popular type of hedge fund in Australia is the long/short equity product and Jacques says more are on the way.

“In the past year we have seen 16 long/short Australian equity funds launched and the question is how many the market can stand,” she says.

“We are going to see some consolidation in this area although some small business start-ups will survive with the expansion of capacity for the sector.”

Jacques says hedge fund managers make their money with performance fees. The question is whether the start-ups have enough capital to get them through the years when they don’t earn such fees.

“For instance, if we go through a down cycle, there is the possibility that these managers may not have built up enough capital to keep them going. It is the performance that delivers the profitability in a hedge fund manager,” she says.

Existing managers will spread their wings and move into other asset classes to create a point of difference from the start-ups.

Kovacs also believes more diversified fund-of-funds will be launched in Australia along with capital-protected funds, which she describes as “hedge funds with training wheels”.

“However, there will be more single funds launched — which will be designed for the sophisticated investor,” she says.

Schuler warns against individual hedge funds in Australia as investors are not sophisticated at picking managers yet.

“One of the problems of running a fund-of-funds is manager selection,” he says.

“We look at a manager for at least five years and at the risks involved with them.”

Schuler says he is not sure how the layman can look at the managers and not pick the wrong one.

“Most of our group has seen what can go wrong with hedge fund managers.

“To analyse these fund managers takes time and I doubt the average investor would be willing to spend 50 per cent of their time looking at what is going to be 5 per cent of their portfolio.”