Are hedge funds set for a revival of fortunes?
Janine Mace writes that despite the mixed reputation they acquired in recent years, hedge funds may be in for a revival of interest among some investors.
Related: Hedge funds - to regulate or not to regulate
Although the global financial crisis (GFC) may be an increasingly distant memory, the words ‘hedge fund’ still have the power to strike fear into the hearts of many advisers and retail clients.
It’s a fear largely undeserved and unreasonable, but that doesn’t stop it from occurring.
Hedge funds have been used as the whipping boy for the failures of the broader investment industry and it’s a tag they are finding hard to shake, according to Paul Chadwick, chairman of the Australian chapter of the Alternative Investment Management Association (AIMA) and director of Nanuk Asset Management.
“Hedge funds are often used as a scapegoat and yet in Australia they are better regulated than anywhere else in the world. With hedge funds when something goes wrong, these days it is usually a really weird one, like when an airplane crashes,” he says.
“Hedge funds collectively have a risk/return profile that is very attractive and there is more upside than downside.
"The reason they perform is what they are doing is interesting, so if you regulate that away or standardise it, they won’t perform as well.”
The lingering suspicions are unlikely to disappear any time soon, explains Lonsec senior investment analyst Stewart Gault.
“In the retail market, people were hurt by the GFC and they have long memories. Occasionally planners will still ring and mention hedge fund disasters, especially those hedge funds that were wrapped in structured products.”
The fear comes despite good long-term performance from the hedge fund sector, according to Chris Gosselin, CEO of specialist hedge fund research firm, Australian Fund Monitors (AFM).
“Over the 10-year period, compared with the S&P/ASX200 Accumulation Index, hedge funds have significantly outperformed.”
From January 2003 to June 2013, the AFM Equity Fund Index returned 11.53 per cent compared with 9.22 per cent from the S&P/ASX200, with lower risk or standard deviation.
Education and greater understanding will be needed to change the views of investors, Gosselin believes.
“Interest is very adviser specific and only some are willing to spend the time to understand them and explain them to clients.”
Time for change?
Fee concerns have also held back use of hedge funds in the superannuation industry – particularly following introduction of the Stronger Super reforms.
“The initial take by the industry meant MySuper offerings had to be low fee offerings, so almost by definition, hedge funds were out. But that is missing the boat, as the patterns of returns from hedge funds means they should be in a super fund,” Chadwick argues.
The belief high fees go hand-in-hand with hedge funds is a myth, according to Bennelong Funds Management CEO, Jarrod Brown.
“The good news is that the AFM data shows that Australian hedge funds are generally cheaper than offshore-based funds.
"The average fee charged on funds in the AFM database was 1.3 per cent pa for management, whereas the typical formula for overseas funds is ‘2 plus 20’, which means a 2 per cent management fee and a 20 per cent performance fee if performance hurdles are met,” he notes.
In Australia, performance fees for hedge funds in the AFM database tend to average 13 per cent when specific performance hurdles are met or exceeded.
With large superannuation funds not embracing hedge funds, many AIMA members are shifting their focus to the retail market, according to Nikki Bentley, honorary legal counsel for AIMA Australia and a partner at Henry Davis York.
“Some hedge funds on platforms get a reasonable level of inflows – especially from the SMSF market which is more sophisticated.”
The growing regulatory comfort with hedge fund strategies will increase their appeal among retail investors, Bentley says.
“Once the regulatory focus abates, people can get back to looking at performance and the benefits of hedge funds.”
In fact, not updating your view of hedge funds may mean missing out on the return opportunities successful hedge fund managers like Platinum can provide – despite the fact its funds have never been labelled as such.
“This is an important point, as these strategies can work if they are managed properly and they can play an important role in the investor’s portfolio. So it can be worth spending the time to get educated on them, as there could be another Platinum out there,” Gault notes.
Lonsec advocates a diversified portfolio with a small allocation to alternatives and many of its model portfolios include small allocations to hedge funds. It’s a view being embraced by a number of providers.
“Some multi-manager multi-asset funds such as those from OnePath, Optimix, IOOF and Advance have increased their alternatives allocation over the past year. There is strong interest in understanding alternatives and their benefits at that space,” Gault notes.
Persuasive performance
Although many investors view hedge funds as a vehicle for achieving high returns, in fact, their performance tends to be fairly normal, with the major benefit being reduced return volatility.
According to Gosselin, the sector’s performance over the 12 months to the end of September 2013 has generally been in line with the market, but with lower volatility.
“Overall, the average performance has been 16.29 per cent, but equity-based hedge funds returned 21.63 per cent. This compares with the S&P/ASX200 total return, which was 24 per cent.”
Within AFM’s universe, 27 per cent of funds outperformed the S&P/ASX200 and the vast majority (83.7 per cent) returned a positive performance.
Gosselin believes it is misleading to generalise about the ‘average’ return in the hedge fund sector, due to the huge difference in results between strategies.
“Although hedge funds underperformed as a whole, the range of returns is considerable across the 338 funds in our universe. The returns range from negative 40 per cent to positive 69 per cent,” he says (see Figure 1).
This wide return dispersion is something advisers and investors need to keep in mind.
“The divergence in performance shows you need to do your research very carefully to understand the good, bad and indifferent hedge funds,” Gosselin notes.
To 30 September 2013, the top 12-month performance for a hedge fund strategy was 34.8 per cent for equity 130/30 funds, significantly outperformed the overall market.
“Equity-long funds had a 28.22 per cent return and they also outperformed. They outperformed with significant cash holdings of 20-30 per cent, so the return was due to good stock selection,” Gosselin notes (see Figure 3).
Market conditions suited this style of hedge fund, Gault says.
“The stronger equity market has led to better performance by equity long/short funds (especially net long), event driven and distressed debt funds due to the stronger US corporate position.”
Among the universe of hedge funds Lonsec rates, performance in the managed futures/CTA sector by established managers such as Winton and Man Investments has been “relatively disappointing”, with the exception being the new offering from AQR.
The underperformance by commodities and global macro hedge funds has largely been driven by the investment and political environment, including the US and European political crises and events in the Middle East, explains Gault.
“CTA funds had no medium to long-term trends to pick up profits and with risk on/risk off, they have not been able to ride a trend for any length of time.”
Managed futures are affected by the same factors and the increasing correlation of asset classes means there are less benefits for hedge fund managers to exploit, he notes.
Gathering the assets
Although market conditions have allowed most hedge fund managers to perform reasonably well, they still face a number of hurdles, according to the September 2013 State Street Alternative Fund Manager Survey of almost 400 hedge fund managers around the world.
According to respondents, the top challenges they face over the next five years are fundraising (80 per cent), generating performance (53 per cent) and adapting to regulation (41 per cent).
The struggle to lift inflows is not being helped by strong returns from equity markets.
“It is a challenge when the equity market is doing well, as it is hard to get people to invest in alternatives. It is also difficult for planners to allocate to alternatives if equity performance is good,” Gault notes.
For hedge funds, the uphill battle to attract inflows is unlikely to get any easier, he says.
“The challenge for small hedge funds is the difficulty in reaching a critical mass and there have been fund closures due to small AUM in the past 12 months. Being small is tough, as smaller managers are facing increasing regulatory and compliance costs.”
This is a global problem for the industry, according to a new study produced by AIMA, the Managed Funds Association and KPMG International.
It found internationally hedge fund managers are spending anywhere between 5 per cent and upwards of 10 per cent of operating costs on compliance technology, headcount and strategy.
Smaller firms in particular are suffering, with more than a third of managers with less than US$250 million in AUM saying compliance requirements were consuming more than 10 per cent of their total operating costs.
Gosselin believes many Australian hedge funds are finding it difficult to raise capital and achieve solid inflows.
“Adviser distribution is very expensive and a specialist approach is required, but most hedge funds are small. You need significant expertise and big funds under management to enter and distribute into the retail marketplace,” he says.
Costs such as research reports, placement on a retail platform and marketing and business development support are often prohibitively expensive.
“Retail money attraction requires significant performance and operational infrastructure which is a challenge for smaller funds,” Gosselin explains.
In response, many smaller managers are becoming boutiques within larger investment management houses. Examples include Challenger’s Fidante Partners, Bennelong’s Kardinia Capital and Ascalon Capital Managers’ investment in Singapore-based RV Capital Management.
“By banding together and grouping hedge fund managers, big investment managers can provide the infrastructure and let the manager get on with managing the money. Both Platinum and Majellan have done well due to their successful and well-structured marketing effort,” Gosselin says.
Performance faces challenges
In Gault’s view, the most significant challenge facing the hedge fund industry is the volatile and complex forces currently buffeting investment markets.
“Politics is driving the market – not fundamentals – at the moment and that makes it very challenging for many strategies. When fundamentals are not driving the market, managers get concerned as their models break down.”
Gosselin agrees performance is a huge challenge at the moment.
“The markets are very changeable and adapting from positive to negative is very difficult for managers, as they have established strategies.”
Increasing demands for transparency by retail investors and regulators are also making life tough.
The State Street survey found the top drivers of change in the hedge fund sector were investor demand for greater transparency around risk and performance (54 per cent) and increased regulatory scrutiny (41 per cent).
In response, hedge funds claimed to be providing more information to investors, with 39 per cent increasing their holdings, risks and performance data; 23 per cent increasing reporting frequency and 18 per cent using new techniques to assess their performance and risk relative to their peers.
“Whilst transparency is improving there is still a way to go. Some managers have made the effort to improve their reporting, but others are slower to respond,” Gault notes.
“This may be acceptable in the wholesale market, but if they want to be operating in the retail space, they need to be more transparent.”
Although hedge funds remain on the outer in many investment portfolios, it has not stopped providers from developing their products and looking for new investors.
“We are always seeing large overseas managers testing the Australian market,” Gault notes.
New hedge fund strategies are also being launched, with beta replication or liquid alternatives funds increasingly popular.
“We are seeing a lot of product development in that space. These products provide exposure to hedge fund factors in a liquid, transparent and low cost way. However, there are risks with this and the biggest is the higher exposure to equity markets,” Gault says.
In Gosselin’s view, the sector most likely to catch investor interest is 130/30 strategies, which are helping blur the line between different types of investment funds.
“We are seeing a move by some long-only managers to adopt 130/30 strategies due to requests by institutions.”
This blurring is part of a trend towards the hedge fund industry becoming far more mainstream as it seeks to gather more retail assets and to comply with new regulatory requirements.
“Many hedge funds are becoming more plain vanilla and many long-only funds have written options, but this has not really been recognised until recently.
"Funds are increasingly meeting in the middle between index type funds at one end and absolute returns at the other,” Gosselin notes.
Some hedge fund managers are even attempting to improve their performance by taking a closer – and more active – approach towards their investments.
“Overseas we are seeing a slight emergence of activist hedge funds – especially in small to medium-cap companies. This is extensive overseas, but not so much here as yet,” Gosselin says.
“Among local hedge fund managers, Wilson Asset Management, Cadence and Sandon Capital have taken a more activist approach to small cap specialised situations.”
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