Observer: APRA loses its way in hedge fund debate

Last month,APRAissued a press release outlining its concerns over the use of hedge funds in superannuation.

APRA’s main concerns are that hedge funds:

• rely heavily on a single strategy;

• have broad delegations for the use of gearing and derivatives;

• rely on a single individual to execute the investment management process;

• are characterised by relatively short trading history; and

• are characterised by an absolute return rather than a benchmark return.

Reliance on a single strategy

Some individual hedge funds do rely heavily on one strategy. However, this is partly the point.

A specialist manager deploying a modest amount of capital on a particular strategy develops expertise beyond more generalist investors and is therefore in a better position to add value.

However, a developing trend for many more established hedge fund groups is to offer multi-strategy funds, sometimes hiring separate teams to implement each strategy. Moreover, the vehicle of choice of most hedge fund investors — diversified fund of hedge funds — by their very nature are diversified across a range of strategies and managers.

Broad delegations for use ofgearing and derivatives

Gearing.Many hedge funds use gearing, but around 30 per cent do not. Gearing is neither good nor bad, nor is there a precise level of gearing that is appropriate across all investment strategies.

Gearing five times (four dollars borrowed for every one dollar invested) into a relatively certain seven per cent return while borrowing at five per cent may not be risky at all whereas two times gearing or even not gearing at all with a possible gain or loss of 50 per cent can be extremely risky.

Derivatives.As with gearing, while many hedge funds use derivatives, around 30 per cent do not. Many traditional funds also use derivatives. And in using derivatives, hedge funds usually have an offsetting position, which may or may not be another derivative.

A systemic problem with derivatives would negatively impact some hedge funds. However, the extent of this impact would vary widely across both hedge fund strategies and managers and would also have possible negative effects on mainstream assets and funds.

Reliance on a single individual

This is increasingly less likely to be true as the industry matures. Most hedge funds today have more than one investment decision maker and fund of hedge funds rely on a multitude of investment decision makers.

Short trading history

An increasing number of hedge funds have been around 10 years or more. Many funds of hedge funds have been around for five to 10 years.

Absolute versus benchmarkreturn

Hedge funds have an ‘absolute’ benchmark, typically to beat cash. There is no relative benchmark because part of the rationale for hedge funds is to move away from the relative return benchmark obsession that dominates the broader investment industry.

The APRA paper talks mostly about individual hedge funds even though diversified fund of hedge funds are the way most investors are accessing hedge funds, particularly for strategies other than long/short equities.

The major considerations for fund of hedge funds are somewhat different. The key is to understand the broad strategies and to ensure that the fund of hedge funds provider has rigorous process and quality people.

Alluding to long-term capital management (LTCM), APRA states that: “Events in the late 1990s have shown that even the most carefully constructed strategies are not foolproof.”

LTCM was a special case involving extreme levels of gearing colliding with an extreme investment scenario.

The APRA statement could also apply to the conventional ‘buy and hold’ approach of investing in mainstream assets only, which is almost totally dependent on the assumption that equities will always outperform other investments over the long-term.

APRA, in stating that superannuation trustees are looking for alternatives “when faced with weak equity markets and low interest rates over the short-medium term”, seems to indicate total faith in the view that weak performance of equities over the long term is impossible. Research suggests otherwise, particularly when investing at times when market valuations are high and interest rates low.

A standard retail balanced/ growth fund would have generally underperformed or performed in line with cash over all periods up to 10 years to February 2003. Perhaps these conventional “carefully constructed portfolios” are also not foolproof.

APRA says “…while some hedge funds are professionally managed and regulated, they can still lead to significant losses in a relatively short space of time, particularly where gearing is used”.

This comment may apply to some higher risk individual strategies, but it is neither obvious nor valid when talking about a large number of lower risk funds and particularly fund of hedge funds.

By their very nature most fund of hedge funds are structured such that significant losses in a short period of time are extremely unlikely.

If one is concerned about significant short-term losses they are more likely to be found in traditional investments.

In fact, one could be forgiven for asking where the warnings were in 2000 and 2001 when superannuation and other investors were aggressively increasing their international exposure at a time of overvaluation of markets and undervaluation of the Australian dollar. These investors have experienced losses in these areas of more than 50 per cent in the last two years.

Where also were the warnings against the use of instalment warrants or geared share funds that were aggressively marketed as easy ways to obtain leverage in super funds, but which have since caused losses of 50 per cent or more?

In contrast, virtually all diversified fund of hedge funds offered in Australia have managed to preserve capital over rolling one-year periods since they became available a few years ago.

Returns may not have been as good in absolute terms as people expected with the majority returning two to five per cent last year, however, the better fund of hedge funds returned seven per cent or more and they have done so with volatility of three to six per cent compared to around 15 per cent for equity markets.

More importantly there is little to suggest that such hedge fund returns or risks should be substantially different looking forward.

Can I think of extreme one-off scenarios where some hedge funds perform badly? Of course.

However, in most of these scenarios traditional investments in equities and even bonds are likely to do as bad or possibly much worse.

It is next to impossible to envisage scenarios in which the hedge fund industry as a whole or most diversified fund of hedge funds produce anywhere near the losses that many equity related sharemarket investments have delivered in recent years.

There are things worth worrying about with regard to hedge funds but they are generally not those raised by APRA.

I worry that returns will not meet some of the more optimistic expectations being promoted by some funds. I worry that too much money will chase hedge funds making some strategies less profitable and restricting access to the best managers. I worry that too many fund of hedge funds are being set up, many of which take a very backward-looking approach to portfolio construction.

APRA questions whether hedge funds are appropriate for retirement savings. Some higher risk individual strategies and funds are not. However, a well-run conservative fund of hedge funds that can deliver consistent absolute returns and is less dependent on rising equity markets is an ideal component in a retirement portfolio. However, it would be a major problem if all super funds decided to invest in hedge funds tomorrow because of the capacity limits in many strategies and funds.

APRA says: “It is questionable whether superannuation monies should be at the cutting edge of financial innovation.” Why not? Super funds are the largest pool of professionally run money in the country and are the key to Australians’ financial security in retirement.

Furthermore, looking forward, it is likely to continue to be a tough environment to generate reasonable returns with modest risk in traditional assets only. Super funds should be doing their best to produce more efficient portfolios and there is a strong case that hedge funds should be a component of these.

In today’s environment of corporate failures and scandals, regulatory bodies worldwide are under pressure to be seen as proactive in terms of investor protection.

There is no doubt that some individual hedge funds will have problems or ‘blow up’ in the future. But that is the nature of the industry. The collapse of HIH did not mean one should not invest in shares and the collapse of a few individual hedge funds does not mean one should not invest in hedge funds.

The APRA comments would be welcomed if they encouraged the need for greater due diligence from investors (or outsourcing this to a quality fund of hedge funds).

However, if they scare potential investors away from an area that can make a significant contribution to decreasing risk and potentially increasing returns in their portfolios they may have done investors a considerable disservice.