Are Australian hedge funds, which have more in common with local managed funds than their UK and US counterparts, a viable investment? PAUL ALI and MARTIN GOLD scrutinise the recent performance ofthis $1.1 billion industry

There are 65 hedge funds available to investors in the Australian market, with an estimated $1.1 billion in assets under management (as at 30 June 2002). The majority of these funds (63 per cent) are ‘funds of hedge funds’ – that is, managed investment funds that invest in hedge funds. The proliferation of funds of hedge funds in Australia, although disproportionately high compared with more mature hedge fund markets in the United States and the United Kingdom, is consistent with international trends reflecting the increasing institutionalisation of hedge funds.

Funds of hedge funds aim to deliver investors increased liquidity, diversification benefits (by creating exposure to different hedge fund investment strategies), and other benefits such as fund selection and monitoring. These features, however, come at a significant cost to investors – in particular, the layering of fees, since the investor will in effect be paying two sets of management fees: to the manager of the fund of hedge funds and also to the managers of the underlying hedge funds.

The vast majority of Australian hedge funds are indistinguishable from conventional managed funds. Local hedge funds are subject to the same licensing and disclosure requirements as conventional managed funds (unlike overseas hedge funds which are deliberately structured to take advantage of the licensing safe-harbours and reduced disclosure obligations provided for the securities laws of their home markets). Almost all Australian hedge funds share the same legal domicile with their investment manager – Australia. Again, this is in contrast to overseas hedge funds where the hedge fund is jurisdictionally bifurcated (divided) from the hedge fund manager.

Finally, while overseas hedge funds target high-net-worth and institutional investors, retail investors form the target market for the majority of Australian hedge funds. Only 31 per cent of Australian hedge funds are targeted at institutional investors, with the remainder targeted at personal and non-institutional investors.

Hedge versus managed funds

Hedge funds, in common with the majority of managed funds in Australia, pursue active investment strategies (that is, they seek to generate investment returns by exploiting market inefficiencies and (R) security pricings). This is particularly significant because the majority of hedge funds, including those on offer to Australian investors, invest in the United States equity and bond markets, which are regarded as the most efficient markets in the world – meaning that not only will there be fewer opportunities to exploit inefficiencies but also that such inefficiencies are likely to be eradicated quicker by arbitrage and profit-taking compared to other markets.

Performance of hedge funds years ending 31 December

The success of hedge funds in generating above-market returns is dependent upon ‘trading edges’ which utilise:

* superior information and research;

* superior investment strategies; and

* lower transaction and execution costs.

Clearly, it’s reasonable to expect that the managers of conventional managed funds should also be able to create similar trading edges routinely, given: their infrastructure; their more dominant presence in the same markets as hedge funds; and the pricing power, delivered by a quantum of assets under management, with brokers, custodians and other market participants.

Hedge funds, however, enjoy one significant advantage over conventional managed funds: while they operate in the same equity and bond markets as conventional managed funds, hedge funds enjoy largely unrestricted investment mandates in relation to investment strategies, the quantum and concentration of individual investments, market timing decisions and the use of leverage. In contrast, the portfolios of actively managed conventional managed funds are anchored around a major index (such as the S&P/ASX 200 index), which reduces the likelihood of significant outperformance relative to the index and also ties the performance of conventional managed funds to prevailing market conditions.

Performance

The major attraction of hedge funds is the claim made by hedge fund promoters that hedge funds can deliver ‘absolute returns’ which are not correlated to the performance of conventional asset classes. More specifically, most hedge funds aim to beat money market returns while also delivering an ‘equity upside’ from the capital markets.

The ability of hedge funds to outperform risk-free money market assets is readily verifiable but comparing the performance of hedge funds with the major equity indices reveals mixed results.

Importantly, for those Australian investors, such as superannuation trustees, who have been entrusted with the management of assets on behalf of others, the returns from lower-risk Australian bank bills have consistently outstripped the returns from higher-risk hedge funds over the last three years. Further, industry surveys reveal an increased willingness on the part of hedge fund managers to avoid negative returns during periods of high market volatility (as is currently the case) by allocating funds to money market investments.

Australian hedge funds share few of the characteristics of their overseas counterparts. Indeed, for the most part, local hedge funds are indistinguishable from conventional managed investment funds. The difficulties of differentiating hedge funds from other investment products in the Australian financial services sector is likely to be further compounded by the poor performance of hedge funds worldwide. Hedge funds have, in particular, struggled to outperform money returns suggesting that, on average, Australian investors may have been better off investing in the money market than hedge funds. It remains to be seen whether the recent convergence between hedge fund and money market returns will continue or whether there will be a reversion to the earlier observed pattern of significant outperformance of hedge fund returns over money market returns.

WHAT IS A HEDGE FUND?

Hedge funds are pooled investment vehicles that pursue ‘alternative’ or ‘absolute return’ strategies. They aim to generate above-market investment returns, irrespective of market conditions. This stated objective of hedge funds, combined with the apparent mystique of hedge funds, has made them an increasingly attractive investment for institutional as well as retail investors in Australia, in the current climate of diminishing returns from traditional investments such as shares and bonds.

PAUL ALI AND MARTIN GOLD ARE PRINCIPALS OF STELLAR CAPITAL, SYDNEY, A PRIVATE INVESTMENT FIRM. PAUL ALI IS ALSO A MEMBER OF THE CENTRE FOR CORPORATE LAW AND SECURITIES REGULATION AT THE UNIVERSITY OF MELBOURNE. THIS ARTICLE IS EXTRACTED FROM THEIR STUDY OF THE AUSTRALIAN HEDGE FUNDS INDUSTRY IN CORPORATE GOVERNANCE AND INVESTMENT FIDUCIARIES (THOMSON LEGAL & REGULATORY, APRIL 2003)

Copyright CPA Australia Jul 2003