The good, the bad and the ugly

In the wake of the recent investment market turmoil, people were quick to look for scapegoats, with hedge funds among the first to be condemned in Australia.

Just as elsewhere, market declines were blamed on hedge fund trading, and the ‘shorting’ of shares came in for particular criticism. In Australia, the collapse of single strategy hedge funds such as Basis Capital added fuel to the fire.

But the hedge fund industry came out swinging.

The chief executive of the international hedge fund group Alternative Investment Management Association (AIMA), Florence Lombard, claimed hedge funds were facing “a renewed wave of unwarranted criticism at a time when many hedge fund managers are doing what they set out to do — deliver absolute returns for investors during extreme market volatility and falling asset prices”.

She pointed out that if hedge funds were viewed as a single asset class, they had preserved capital over the past 12 months whilst global equities had fallen by over 10 per cent.

Local hedge fund managers also pointed to some good returns, although they said results varied given the diversity of strategies used in hedge funds.

HFA Asset Management joint managing director Oscar Martinis said the different strategies led to different results.

“Some strategies have struggled but others have done quite well. They all behave differently,” he noted, adding it was “important to communicate that not all hedge funds are the same. When a hedge fund blows up, it is usually a single manager and a single strategy.”

HSBC global head of sales and marketing, alternative investment group, Patrick Tuohy argued focusing on the mishaps of single hedge funds was very misleading.

“Advisers would never recommend only one fund or one stock, so why the focus on only one fund?” he said. “There have been some losers, but there have been an equal number of winners among hedge funds.”

Very different animals

This very diversity is the main message hedge fund experts are now trying to get out to financial planners and retail clients.

The chair of the Australian chapter of AIMA, Kim Ivey, stressed the differences between individual hedge funds to Money Management.

“They are quite heterogeneous. The 12 strategies commonly referred to as hedge funds all behave very differently.”

Among the individual strategies, he said both global macro and short selling strategies had performed well. The long/short equity deployed by many Australian hedge funds had “a wide distribution of returns, so some have done quite well, but not many have shot the lights out”.

AMP Capital Investors senior investment specialist David Dix agreed hedge funds have experienced variable results.

“The hedge fund space is not generic and with that comes multiple outcomes.”

Globally, performance within the hedge fund universe has been variable.

According to Greenwich Alternative Investments, which manages one of the world’s largest hedge fund databases, its Greenwich Global Hedge Fund Index (GGHFI) returned 1.68 per cent in April, rebounding from a -2.05 per cent loss in March.

On a year to date basis, the GGHFI posted a return of -1.40 per cent, outperforming the major international indices such the S&P 500 (-5.03 per cent), MSCI World Equity (-5.03 per cent) and FTSE100 (-5.72 per cent).

According to Man Investment executive director of bank relations Sam Yates, the outperformance of major indices highlighted the different qualities of hedge funds compared to traditional asset classes.

“It shows their ability to provide very different returns,” he said.

At the fund level, figures from HFA Asset Management illustrate the lack of correlation with traditional equity markets.

Over the six-month period between October 2007 to March 2008, the MSCI return was -11 per cent, the Dow Jones achieved -12 per cent and the ASX/S&P 200 returned -16.7 per cent.

On the other hand, the HFA Diversified Investment Fund only slipped -0.28 per cent.

By way of explanation, Martinis said hedge funds provided “a true level of diversification that traditional managers can’t provide”.

AMP Capital Investors’ Total Return Fund experienced a similarly good performance, with the fund returning over 19 per cent in the 12 months to the end of April 2008 and over 6 per cent for the year to date.

Performance dispersion

According to the experts, the recent market volatility highlighted the performance differences between hedge fund strategies (see table on p20). Return differences between the various strategies reflect the different manager approaches and the impact of various market factors.

“Managed futures have done very well as this strategy likes strong, clear trends in the market. They have a history of doing well through difficult equity market trends,” Yates said.

“Managed futures are a good complement for those investors who are very overweight equities. To the end of March, this style has returned 28.1 per cent over the previous 12 months, which reflects the strength of the underlying style.”

According to Tuohy, many of the recent market problems for hedge funds are due to excessive use of leverage.

“Like in 1998, if your only source of return is leverage, then you will be in a very difficult position if things go wrong.”

Despite disappointing performances from some strategies, most Australian retail hedge fund investors access the asset class through fund of hedge fund (FoHF) arrangements. According to the Federal Government’s publication The Hedge Funds Industry in Australia 2008, the local $70.3 billion hedge fund industry is the largest in Asia. It covers 71 hedge funds and 24 FoHF managers, with 139 single strategy funds and 61 FoHF products.

According to Martinis, using a FoHF has protected most local investors from the worst of the market problems.

“In Australia, most exposure to the hedge fund universe is through FoHFs, so the impact has been negligible and most managers have been able to preserve investors’ capital,” he noted.

Dix agreed the FoHF has largely been immune.

“Some single strategy funds are likely to be down, but FoHFs have performed fairly well,” he said. “[They] generally have been able to sail through, although returns have been lower.”

Diversifying for protection

Tuohy said the FoHF structure has provided the diversification protection they were meant to in the recent volatile conditions.

“The objective for a portfolio is to blend styles and strategies to achieve diversification, and a FoHF can provide that.”

In fact, Dix said some of the AMP’s Total Return Fund managers were beneficiaries of the market turmoil following the collapse of the sub-prime market. He argued these structures provided a valuable opportunity to “diversify manager risk through diversifying manager styles and sectors”.

However, as with any asset class, Dix said investors needed to be selective about manager selection in the FoHF space.

“Diversification equals risk management,” he said.

“It minimises exposure to a particular manager or the performance of one particular style.”

While some people see these structures as adding an extra layer of fees, hedge fund advocates claim they provide an extra layer of protection.

As Tuohy said: “Some funds will blow up, but a FoHF largely offers the due diligence into individual hedge fund managers that would cost millions to do.”

In addition, FoHFs provide a way to access hedge fund managers that would otherwise be out of reach for most planners and retail investors.

According to Yates, investing in hedge funds is all about chasing manager skill.

“Good hedge fund managers are often choosey about who they allow into the pool and the amount of money they will manage,” he said.

“You need to access them through a manager that has access to the better end of the market.”

Benefits for retail investors

Hedge fund advocates argue hedge funds carry real benefits for investors, in particular their lack of correlation with traditional asset classes.

“[They] provide the only truly independent income stream that planners achieve from a portfolio with a long-only investment allocation,” Martinis said.

Yates believes it is important for advisers to explain the benefits of hedge funds when talking to clients.

“This asset class is primarily about diversification and it behaves differently to equities.”

To demonstrate these benefits, the Australian chapter of AIMA is currently working with Zenith Research on a report for financial advisers outlining how to combine hedge funds with a traditional basket of diversified assets.

According to Yates, the non-correlation element brings important diversification benefits to a retail portfolio.

“They provide financial planners with access to an asset class with different performance characteristics to equity markets,” he said.

They also reduce return volatility. The standard deviation of HFA’s diversified fund was three, according to Martinis. This compares to the ASX’s standard deviation of around 10.

“In times of extreme market dislocation events, hedge funds offer real benefits through reduced volatility,” he said.

“The risk-adjusted returns from hedge funds are very good.”

According to Tuohy, the key message to clients about hedge funds remains positive. “A diversified portfolio of hedge funds has delivered significantly better returns than equity markets over the past three to 24 months — with less volatility.”

Planners and clients need to focus on the medium term, “as the short-term does not give you a fair representation … To invest in hedge funds, you need to look at rolling 12-month returns”, he said.

Looking to the future

In Tuohy’s view, the environment for hedge funds is “more attractive than for many years” and this is due to real volatility returning to markets, the current global de-leveraging creating winners and losers and ongoing capital restructuring, which will see distressed and special situations funds do very well.

“Looking forward, things are very bright, but financial planners must manage clients’ expectations,” he said.

Dix agreed the new volatile market environment would create opportunities. He said high volatility environments suited options trading strategies, but managers using long/short equity strategies were finding volatile markets difficult.

For Yates, managed futures and global macro managers were likely to be the winners in the months ahead.

“Distressed securities are also starting to look attractive and managers will capitalise on the residual value in those companies [in distress],” Yates said. “There will be very good opportunities going forward for stock pickers.”

He also agreed that the conditions for hedge funds were now very good.

“The managers are looking to take advantage of the high level of volatility and return dispersion, and this is an opportunity that has not been there over the past few years,” Yates said.

According to Ivey, the current market conditions would allow hedge fund managers to really show their mettle.

“Strong equity markets have been a double-edged sword for hedge funds in Australia. They didn’t require people to look at risk management as the returns were so good,” he said.

“Hedge funds had not been able to demonstrate their skill and ability to preserve capital until we had a falling market, and now they will be able to do that.”

Benefits for retail allocations

Given the benefits, most hedge fund adherents believe they remain a suitable investment strategy for retail investors.

As Dix pointed out: “Anything that reduces risk in a portfolio and achieves the return objectives is of value. They are not for everyone, but there is a place for them.

“Hedge funds benefit portfolio construction in terms of reducing volatility, but also in adding useful return.”

Martinis told Money Management that financial planners needed to rethink their approach.

“Many planners — if they are honest — will admit most Australian investors are underweight to hedge funds,” he said.

“This is a $2 trillion industry globally and a legitimate asset class. It is the end of an era in financial markets, so financial advisers need to do justice to their clients and look outside the long-only market.”

He said the industry had used the same investment strategy for the past 20 years, but there were now legitimate questions about whether it would work as well for the next two decades.

Hedge funds are totally appropriate for retail clients, according to Tuohy.

“Financial planners need to revisit the whole asset allocation question, as there is enough evidence now that when you have periods of market stress, hedge funds have delivered what they said they were going to do,” he said.