Hedge fund report allays retail investors’ fears

Australia’shedge fund industry continues to grow at an astonishing pace, but it may take the findings of a new report to convince many that such funds can fit into the portfolio of an average investor.

The report, prepared by Assirt on behalf of the Alternative Investment Management Association (AIMA), paints a picture of a burgeoning local hedge fund industry, which has emerged from almost obscurity a few years ago to take its place in mainstream investment circles.

According to the report, some 14 fund-of-hedge-fund managers were launched in Australia between 1999 and 2001 alone, a period when hedge funds first began to move outside the exclusive realm of highly sophisticated investors and into the sphere of more conventional investors.

The local hedge fund industry is now worth in the order of $5.4 billion. This includes $3.47 billion in fund-of-hedge-fund assets, $1.62 billion in single manager strategies and $300 million allocated to offshore hedge funds.

But perhaps the most significant aspect of the Assirt report is not its measurement of the growth of the hedge fund industry, but rather its attempts to resolve one of the more vexing questions for retail hedge fund investors and their financial advisers: how do hedge funds fit into the portfolio of a retail investor?

The conclusion reached by Assirt is that hedge funds should not be treated as a separate asset class by retail investors.

“The question has emerged as to whether hedge funds should be treated as a separate asset class, in a similar way to equities and bonds. Assirt believes that to be considered a separate asset class, the securities within an asset class need to be more highly correlated with each other than with assets outside this class, which is not the case with hedge funds. This belief comes from the diverse nature of hedge fund strategies,” the report says.

Instead, Assirt argues the choice by retail investors to invest in hedge funds should be made as part of the active versus passive manager selection decision in any particular asset class.

But that still leaves open the question about what part of an existing portfolio investors should give up in order to gain an exposure to hedge funds.

According to modelling carried out by Assirt, if investors allocate 10 per cent of their portfolio to fund-of-hedge-funds, the effect on the return and risk characteristics of the rest of their portfolio differs depending on which asset classes the 10 per cent is allocated from.

The modelling found that if investors allocated 10 per cent to hedge funds from their exposure to equities, the result was a notable reduction in risk, but only a very small increase in returns.

If investors on the other hand chose to replace part of their more conservative fixed interest investments with a hedge fund exposure, the result would be slightly increased risk, but substantially higher returns.

“[The modelling] suggests that most multi-strategy fund-of-hedge-funds with low levels of volatility are better suited to conservative investors rather than aggressive investors, in that they can improve the return potential without significantly increasing risk when replacing fixed interest assets in a defensive investor’s portfolio,” the Assirt report says.

Such analysis will do much to allay the fears of some investors who have always viewed hedge funds as high risk.

But it will not solve the issue of how to promote hedge funds to retail investors, particularly through master trusts and wraps.

“Many hedge funds will value assets monthly or quarterly. Therefore, unit prices will only be available when assets are re-valued. This makes it difficult for master funds and wrap accounts that require daily unit pricing to include hedge funds on their menu,” Assirt says.

However, even this drawback is unlikely to deter the hedge fund market in Australia.

“Assirt believes the current growth trend [in the hedge fund industry] is set to continue as managers from the US and Europe increasingly visit our shores and realise the opportunities for growth prevalent in the Australian marketplace. Several large, brand name managers have also shown interest in launching hedge funds to the retail market in the near future.”