There's a great deal of mystery surrounding hedge funds - lack of transparency , aggressive trading strategies that apply leverage and short selling and high fees make them the bad boys of the managed fund industry. But is this criticism fair? Without good data its hard to say.
As if to support the sub-title of this blog "throwing light on the Australian hedge fund industry", Rainmaker has completed a detailed survey of the Australian hedge fund industry and with co-author Jon Glass will be presenting their findings at a Sydney briefing on Monday, 26th February 2007.
I have seen an early version of the report and there are some interesting findings.
* While the hedge fund industry in Australia is relatively new, its growth rate has been dramatic over the past four years.
* Typically, Australian hedge fund businesses are boutiques, with relatively low personnel numbers, low numbers of specialised investment products and are manager-owned.
* The overwhelming source of hedge fund capital flows in Australia is from the wholesale sector, particularly superannuation funds. Rainmaker records show 164 Australian superannuation funds have some form of investment into hedge funds.
* There is still significant capacity available in the Australian hedge fund industry suggesting continued growth, although some strategies are closer to capacity than others.
* There was evidence in the survey of a highly stable hedge fund workforce, a key factor in businesses that depend so much on the skills of individual investors.
* Of particular interest to investors (and regulators) fee benchmarks were established for each of the 7 main hedge fund investment strategy groupings. For example, the long short equity products were found to have average base fees of 1.27% and average performance fees of 19.3%. This level of fees doesn't warrant the high fee tag often associated with hedge funds, particualrly if they deliver results.
* While Sydney was found to be the home city of the Australian hedge fund businesses one of the largest sources of hedge fund clients is actually Melbourne.
* The research also included analysis of the main service providers to the hedge fund industry, prime brokers, administrators, auditors and lawyers, showing interesting trends such as concentration among a few in each category.
This is a great first step and I hope the survey is completed regularly to better guage changes in the industry through time. However, there is still a need for data that addresses questions short selling and leverage and other details of strategies that will help us to make judgements about the investment risk and systemic financial system risk associated with the hedge fund industry. Nevertheless, for anyone with a active interest in hedge funds in Australia, it sounds like the briefing is worth attending.
Wednesday, January 31, 2007
Wednesday, January 24, 2007
Deutsche Bank Alternative 2006 Investment Survey
Well timed to assist those planning for 2007, Deutsche Bank has conducted a survey of more than 200 institutions representing more than two thirds of investors in the global hedge fund industry (USD900 billion of USD1.4 trillion) across 30 countries.
In summary, the survey pointed to expectations of average strategy returns of 10%, additional inflows of USD110 billion and importantly for the Australian hedge fund industry, increased focus on Asia.
The report included Australia (grouped with Asia) and many of the trends observed will be relevant to participants in the Australian hedge fund industry. Highlights include:
1. Most firms reduced the NUMBER of allocations to hedge funds in 2006 (median of 13 in 2005 compared with median of 10 in 2006), but increased the SIZE of initial allocations (by 50% over 1 year).
2. About 25% of investors have a due diligence period of 3 mths or less and a further 50% take 3 to 6 mths to make an investment decision.
3. 25% of investors (and mostly US FoF's) will consider seeding start-up hedge funds in return for equity stakes, discounted fees or economic participation in the fund.
4. Median return expectations for 2007 of 10% with best outlook among regions in Emerging Markets Asia and products equity long/short.
5. Funds with China exposure expected to be hotly pursued with flows expected to rise 38% and also Emerging Market Asia. Funds focused on the US expected to have modest outflows. Notably, multi-strategy has slipped from top of the list of most favoured products.
6. Investors expressed concern about hedge funds adding private equity components (in side pockets) to traditional hedge fund offerings.
7. A subtle but important distinction was made between flows into Long/Short Equity (6% outflow expected from a large product group in which 89% of respondents invested) and Market Neutral (14% inflow to a relatively small product group). This may reflect investor concern about the contribution of beta in long/short equity and the risk these funds face if sharemarkets decline in future. This was raised in an earlier post to this blog titled Ernst & Young Hedge Fund Symposium
8. survey respondents highlighted the challenge of identifying managers capable of meeting performance objectives. Funds that can deliver consistent alpha will be in high demand.
In summary, the survey pointed to expectations of average strategy returns of 10%, additional inflows of USD110 billion and importantly for the Australian hedge fund industry, increased focus on Asia.
The report included Australia (grouped with Asia) and many of the trends observed will be relevant to participants in the Australian hedge fund industry. Highlights include:
1. Most firms reduced the NUMBER of allocations to hedge funds in 2006 (median of 13 in 2005 compared with median of 10 in 2006), but increased the SIZE of initial allocations (by 50% over 1 year).
2. About 25% of investors have a due diligence period of 3 mths or less and a further 50% take 3 to 6 mths to make an investment decision.
3. 25% of investors (and mostly US FoF's) will consider seeding start-up hedge funds in return for equity stakes, discounted fees or economic participation in the fund.
4. Median return expectations for 2007 of 10% with best outlook among regions in Emerging Markets Asia and products equity long/short.
5. Funds with China exposure expected to be hotly pursued with flows expected to rise 38% and also Emerging Market Asia. Funds focused on the US expected to have modest outflows. Notably, multi-strategy has slipped from top of the list of most favoured products.
6. Investors expressed concern about hedge funds adding private equity components (in side pockets) to traditional hedge fund offerings.
7. A subtle but important distinction was made between flows into Long/Short Equity (6% outflow expected from a large product group in which 89% of respondents invested) and Market Neutral (14% inflow to a relatively small product group). This may reflect investor concern about the contribution of beta in long/short equity and the risk these funds face if sharemarkets decline in future. This was raised in an earlier post to this blog titled Ernst & Young Hedge Fund Symposium
8. survey respondents highlighted the challenge of identifying managers capable of meeting performance objectives. Funds that can deliver consistent alpha will be in high demand.
Friday, January 19, 2007
Ernst & Young Hedge Fund Symposium
Ernst & Young held a Hedge Fund Symposium in their Sydney office on 18 January 2007. More than 100 people attended and while there was a strong contingent from EY itself, this highlights the interest being generated in hedge funds in Australia. The split of non-EY attendees was Hedge Fund Managers (47%), Service Providers (33%), Advisers (10%) and Investors (10%).
Because a lot of ground was covered in the 2 hour Symposium, each speaker was by necessity brief. There are a number of hedge events held in the region, most are multi day and very expensive. Given the time allocated, it had to be pitched at a high level, yet covered good ground. As one of the speakers pointed out, there were a large number of "suits" in the audience for a hedge fund event.
After a brief intro from Mark O'Sullivan of Ernst and Young, the Symposium was led off by 3 members of EY's global hedge fund steering committee, Derek Stapley (Bermuda), David Sung (San Francisco) and Don MacNeal (NY) who have delivered their thoughts around the world at similar events in about 10 locations.
Their main observation was the growing institutional interest in hedge funds and the impact of institutions on the business practices of hedge funds - the institutionalisation of hedge funds. In 2006, 50% of Australian institutions invested in hedge funds, compared with just 20% in 2003.
Globally, there are 9 - 10,000 hedge funds with US$2 trillion Assets Under Management (AUM) and is expected to grow to US$4 trillion by 2008.The US has 50% of AUM and has grown 50% in 2 yrs. Europe with 20% of AUM has grown 80% and Asia with 5% has grown 240% over the same period. FoF products represent US$600 billion and carry the advantage of diversification and access to capacity, but also the burden of a second layer of fees.
Hedge funds have delivered to expectations in recent years. Over the past 5 years the CSFB Tremont Hedge Fund Index has returned 11% which has been in excess of sharemarket indices. This helped lift the institutional interest in hedge funds and has prompted a number of investment banks to buy or build hedge fund businesses eg Bank of NY purchased hedge FoF manager Ivy Asset Management.
Also reflecting the more institutional nature of hedge funds, start-ups are launching with greater capital, more sophisticated business practices and higher initial AUM - some with as much as several US$ billions of AUM. Shoe-string start-ups are less popular now. Many start-ups are equipped with CFO's, Compliance Managers, Operating Officers, IT professionals and Risk Managers.
Side-letters and lock-ups/gates were specifically addressed. Side-letters have attracted the attention of the SEC, particularly in relation to preferential transparency and exit. Side-letters that give fee preference are less of an issue.
In Australia, Product Disclosure Statements (PDS's) overseen by ASIC provide the perfect platform for dealing with these matters. Many PDS's already acknowledge that differential fee arrangements may apply in certain circumstances (eg lower fees for higher investments). Larger investors may also have a requirement for greater transparency than small investors such as to incorporate holdings in global risk management systems (provided this is dislosed hedge funds can avoid publishing positions to world at large). However, there are no clear grounds for providing preferred exit to some investors whether it is disclosed or not. In fact in Australia, PDS's often include guidance on the treatment of large redemptions that involves freezing future redemptions and applying pro rata redemptions as market liquidity dictates.
Liquidity is a particular issue for FoF's that offer liquidity in their funds. Incorporate lock-ups and gates that reflect the underlying managers would be administratively very difficult (impossible?) to engineer. Rather than attempt this FoF's may choose to put such manager assets in "side-pockets" with different terms attached.
Managers generally resist publishing positions. Under pressure from influential investors they may seek to sign a side letter to give that manager access to positions but publish to all investors (and publicly). In lieu of seeking published holdings investors are now conducting due diligence on the manager's business practices and process. Some managers have adopted independent directors and advisory committees.
Fees were actively discussed with two of the very small number of questions able to be asked at the event relating to fees. In Australia, traditional managed fund fees are under downward pressure. However, reflecting the value of alpha and the added complexity of generating it, fees for hedge funds have risen in some cases. Typically, hedge fund fees are 2 + 20, with performance fees significantly higher in some cases.
Key note speaker Ephraim Grunhard from ARIA (see comments on Ephraim's presentation below) noted that the ARIA board of trustees had great difficulty coming to grips with fees for hedge funds particularly for FoF's where two layers of fees applied. Ephraim noted (in answer to a question) that he had no problem with performance fees provided they were properly aligned ie reflecting the appropriate hurdle. Equity-biased funds with a zero hurdle are simply inequitable. This is a very fair criticism.
The big news from a regulatory front for hedge funds was the failure of the SEC to enforce registration following Goldstein's successful challenge. Nevertheless, reflecting the influence of institutions that value registrations and the lower than expected cost of compliance (less than US$100,00) most US hedge funds have retained their registration.
Despite a number of very public failures such as Amaranth there has been a limited increase in enforcement actions in the US; 4 in 1998 rising to 90 in 2006. (90 does seem a high number?) As discussed in previous posts on this site, failures of course make great press headlines and have disguised the growth and success of hedge funds in Australia.
The best performing hedge fund sector in 2006 was Emerging Markets. The Eureka Hedge Emerging Market Index was +20.8% ad the Eastern Europe and Russia Index +39.0%. This compares with the aggregate hedge fund industry return of +12.9%. The popular equity long/short return was +14.4% and market neutral +11.1%. The danger with the Emerging Market returns is that with the absence of prevalent methods of hedging market risk the returns reflect high levels of beta. In the event of a market downturn this may limit the ability of these funds to deliver the key objective of hedge funds - to show positive returns in down markets.
While most hedge fund monies are in long/short equity and market neutral, hedge fund products have continued to evolve in debt, energy derivatives and catastrophe re-insurance and private equity (it is the product of the moment!). For FoF providers these less liquid products have often had to be held in "side pockets" with different liquidity conditions. Security pricing responsibility is shifting from independent third parties to the investment manager who knows more about the asset but is potentially conflicted by the performance implications of the valuation responsibility. Valuation rules and valuation committees are emerging.
John Currie from Henry Davis York who is a member of AIMA Australia's Regulatory Committee gave a quick snapshot of the Australian regulatory position of hedge funds.
1. Hedge funds are part of the overall regulation of all managed investment schemes. This is a major advantage that Australia has over other jurisdictions, providing certainty and clarity to promoters and investors alike.
2. In particular, retail investors have the benefit/requirement of adequate disclosure via Product Dislcoure Statements and Financial Service Guides.
3. All hedge fund (managed investment scheme) providers must be licensed with ASIC.
4. Wholesale products are not required to be registered with ASIC.
5. Hedge fund providers looking to offer their funds overseas face a complex regulatory backdrop. Some of the difficulties faced by Australian managers were addressed in an earlier post titled Australia as a Centre for Hedge Funds. A number of jurisdictions have exclusion and safe harbour provisions that make them superior locations to set up and develop hedge funds.
Key note speaker was Ephraim Grunhard from ARIA that oversees $16 bill of Australian govt super funds. Ephraim was frank and to the point. He showed ARIA's target asset allocation and highlighted the weight to hedge funds (15% or $2.4 billion) which would be one of the highest if not the highest dollar weight to this class by an Australian institution:
Australian Equities 30%
International Equities 22%
Long/Short Equity 5%
Market Neutral 10%
Bonds 16%
Property 15%
Cash 2%
Ephraim defined hedge funds as alternative strategies using traditional markets (as against alternative investments which rely on non-traditional markets). ARIA introduced hedge funds in late 2000 after an extensive 6 mth examination at Board level. The main reason for the inroduction was to provide equity market protection in the event that sharemarkets went "pear-shaped" (as the periodically do).
During the investigation process the Board discovered a reluctance by FoF promotors to provide a history of manager selection and manager performance. The Board selected 2 FoF's with global household names at the outset, rather than direct strategies, on the basis of the diversification they provided and the access to capacity they enabled. A third FoF was added later.
The results of the exercise provide some interesting insights:
In line with the main objective for introducing hedge funds, both the market neutral and long/short equity portfolios outperformed sharemarkets in all periods when sharemarket returns were negative and returns over periods since inception of hedge funds carried substantially lower volatility than sharemarkets. However, the long/short equity portfolio was highly correlated with sharemarkets, suggesting that returns (of 14.4% pa) were achieved with the assistance of market beta in a generally postive investment period for sharemarkets. Even the market neutral portfolio had a correlation with sharemarkets of 0.34, suggesting the returns were a mix of both alpha and beta. Given the costs involved of using hedge funds (relatively high fees) and risks of sharemarket declines in future, these are clearly matters to be managed going forward.
In recent times ARIA has introduced direct investments in hedge funds although, as with the FoF investments, sticking with global household names to minimise business risk. Ephraim indicated this may change in the future and lesser known Australian names may even be introduced if the funds carry the right characteristics. ARIA's investment team will need to be further developed before this can occur as, while equity oriented hedge funds may be able to be assessed, they are not yet properly equipped to assess other funds at this stage.
In summary, this first hedge fund industry event in 2007, hosted by Ernst and Young, shows that the momentum of growth in hedge funds in Australia is expected to continue. In particular, further interest from institutional investors is expected in 2007 as hedge funds carve out a risk reduction role in portfolios. This will impact product offerings as institutions will require higher levels of transparency and possibly lower fees. However, continued cooperation is required between regulators, hedge fund promotors and service providers to foster the growth of Australian hedge funds globally.
Because a lot of ground was covered in the 2 hour Symposium, each speaker was by necessity brief. There are a number of hedge events held in the region, most are multi day and very expensive. Given the time allocated, it had to be pitched at a high level, yet covered good ground. As one of the speakers pointed out, there were a large number of "suits" in the audience for a hedge fund event.
After a brief intro from Mark O'Sullivan of Ernst and Young, the Symposium was led off by 3 members of EY's global hedge fund steering committee, Derek Stapley (Bermuda), David Sung (San Francisco) and Don MacNeal (NY) who have delivered their thoughts around the world at similar events in about 10 locations.
Their main observation was the growing institutional interest in hedge funds and the impact of institutions on the business practices of hedge funds - the institutionalisation of hedge funds. In 2006, 50% of Australian institutions invested in hedge funds, compared with just 20% in 2003.
Globally, there are 9 - 10,000 hedge funds with US$2 trillion Assets Under Management (AUM) and is expected to grow to US$4 trillion by 2008.The US has 50% of AUM and has grown 50% in 2 yrs. Europe with 20% of AUM has grown 80% and Asia with 5% has grown 240% over the same period. FoF products represent US$600 billion and carry the advantage of diversification and access to capacity, but also the burden of a second layer of fees.
Hedge funds have delivered to expectations in recent years. Over the past 5 years the CSFB Tremont Hedge Fund Index has returned 11% which has been in excess of sharemarket indices. This helped lift the institutional interest in hedge funds and has prompted a number of investment banks to buy or build hedge fund businesses eg Bank of NY purchased hedge FoF manager Ivy Asset Management.
Also reflecting the more institutional nature of hedge funds, start-ups are launching with greater capital, more sophisticated business practices and higher initial AUM - some with as much as several US$ billions of AUM. Shoe-string start-ups are less popular now. Many start-ups are equipped with CFO's, Compliance Managers, Operating Officers, IT professionals and Risk Managers.
Side-letters and lock-ups/gates were specifically addressed. Side-letters have attracted the attention of the SEC, particularly in relation to preferential transparency and exit. Side-letters that give fee preference are less of an issue.
In Australia, Product Disclosure Statements (PDS's) overseen by ASIC provide the perfect platform for dealing with these matters. Many PDS's already acknowledge that differential fee arrangements may apply in certain circumstances (eg lower fees for higher investments). Larger investors may also have a requirement for greater transparency than small investors such as to incorporate holdings in global risk management systems (provided this is dislosed hedge funds can avoid publishing positions to world at large). However, there are no clear grounds for providing preferred exit to some investors whether it is disclosed or not. In fact in Australia, PDS's often include guidance on the treatment of large redemptions that involves freezing future redemptions and applying pro rata redemptions as market liquidity dictates.
Liquidity is a particular issue for FoF's that offer liquidity in their funds. Incorporate lock-ups and gates that reflect the underlying managers would be administratively very difficult (impossible?) to engineer. Rather than attempt this FoF's may choose to put such manager assets in "side-pockets" with different terms attached.
Managers generally resist publishing positions. Under pressure from influential investors they may seek to sign a side letter to give that manager access to positions but publish to all investors (and publicly). In lieu of seeking published holdings investors are now conducting due diligence on the manager's business practices and process. Some managers have adopted independent directors and advisory committees.
Fees were actively discussed with two of the very small number of questions able to be asked at the event relating to fees. In Australia, traditional managed fund fees are under downward pressure. However, reflecting the value of alpha and the added complexity of generating it, fees for hedge funds have risen in some cases. Typically, hedge fund fees are 2 + 20, with performance fees significantly higher in some cases.
Key note speaker Ephraim Grunhard from ARIA (see comments on Ephraim's presentation below) noted that the ARIA board of trustees had great difficulty coming to grips with fees for hedge funds particularly for FoF's where two layers of fees applied. Ephraim noted (in answer to a question) that he had no problem with performance fees provided they were properly aligned ie reflecting the appropriate hurdle. Equity-biased funds with a zero hurdle are simply inequitable. This is a very fair criticism.
The big news from a regulatory front for hedge funds was the failure of the SEC to enforce registration following Goldstein's successful challenge. Nevertheless, reflecting the influence of institutions that value registrations and the lower than expected cost of compliance (less than US$100,00) most US hedge funds have retained their registration.
Despite a number of very public failures such as Amaranth there has been a limited increase in enforcement actions in the US; 4 in 1998 rising to 90 in 2006. (90 does seem a high number?) As discussed in previous posts on this site, failures of course make great press headlines and have disguised the growth and success of hedge funds in Australia.
The best performing hedge fund sector in 2006 was Emerging Markets. The Eureka Hedge Emerging Market Index was +20.8% ad the Eastern Europe and Russia Index +39.0%. This compares with the aggregate hedge fund industry return of +12.9%. The popular equity long/short return was +14.4% and market neutral +11.1%. The danger with the Emerging Market returns is that with the absence of prevalent methods of hedging market risk the returns reflect high levels of beta. In the event of a market downturn this may limit the ability of these funds to deliver the key objective of hedge funds - to show positive returns in down markets.
While most hedge fund monies are in long/short equity and market neutral, hedge fund products have continued to evolve in debt, energy derivatives and catastrophe re-insurance and private equity (it is the product of the moment!). For FoF providers these less liquid products have often had to be held in "side pockets" with different liquidity conditions. Security pricing responsibility is shifting from independent third parties to the investment manager who knows more about the asset but is potentially conflicted by the performance implications of the valuation responsibility. Valuation rules and valuation committees are emerging.
John Currie from Henry Davis York who is a member of AIMA Australia's Regulatory Committee gave a quick snapshot of the Australian regulatory position of hedge funds.
1. Hedge funds are part of the overall regulation of all managed investment schemes. This is a major advantage that Australia has over other jurisdictions, providing certainty and clarity to promoters and investors alike.
2. In particular, retail investors have the benefit/requirement of adequate disclosure via Product Dislcoure Statements and Financial Service Guides.
3. All hedge fund (managed investment scheme) providers must be licensed with ASIC.
4. Wholesale products are not required to be registered with ASIC.
5. Hedge fund providers looking to offer their funds overseas face a complex regulatory backdrop. Some of the difficulties faced by Australian managers were addressed in an earlier post titled Australia as a Centre for Hedge Funds. A number of jurisdictions have exclusion and safe harbour provisions that make them superior locations to set up and develop hedge funds.
Key note speaker was Ephraim Grunhard from ARIA that oversees $16 bill of Australian govt super funds. Ephraim was frank and to the point. He showed ARIA's target asset allocation and highlighted the weight to hedge funds (15% or $2.4 billion) which would be one of the highest if not the highest dollar weight to this class by an Australian institution:
Australian Equities 30%
International Equities 22%
Long/Short Equity 5%
Market Neutral 10%
Bonds 16%
Property 15%
Cash 2%
Ephraim defined hedge funds as alternative strategies using traditional markets (as against alternative investments which rely on non-traditional markets). ARIA introduced hedge funds in late 2000 after an extensive 6 mth examination at Board level. The main reason for the inroduction was to provide equity market protection in the event that sharemarkets went "pear-shaped" (as the periodically do).
During the investigation process the Board discovered a reluctance by FoF promotors to provide a history of manager selection and manager performance. The Board selected 2 FoF's with global household names at the outset, rather than direct strategies, on the basis of the diversification they provided and the access to capacity they enabled. A third FoF was added later.
The results of the exercise provide some interesting insights:
In line with the main objective for introducing hedge funds, both the market neutral and long/short equity portfolios outperformed sharemarkets in all periods when sharemarket returns were negative and returns over periods since inception of hedge funds carried substantially lower volatility than sharemarkets. However, the long/short equity portfolio was highly correlated with sharemarkets, suggesting that returns (of 14.4% pa) were achieved with the assistance of market beta in a generally postive investment period for sharemarkets. Even the market neutral portfolio had a correlation with sharemarkets of 0.34, suggesting the returns were a mix of both alpha and beta. Given the costs involved of using hedge funds (relatively high fees) and risks of sharemarket declines in future, these are clearly matters to be managed going forward.
In recent times ARIA has introduced direct investments in hedge funds although, as with the FoF investments, sticking with global household names to minimise business risk. Ephraim indicated this may change in the future and lesser known Australian names may even be introduced if the funds carry the right characteristics. ARIA's investment team will need to be further developed before this can occur as, while equity oriented hedge funds may be able to be assessed, they are not yet properly equipped to assess other funds at this stage.
In summary, this first hedge fund industry event in 2007, hosted by Ernst and Young, shows that the momentum of growth in hedge funds in Australia is expected to continue. In particular, further interest from institutional investors is expected in 2007 as hedge funds carve out a risk reduction role in portfolios. This will impact product offerings as institutions will require higher levels of transparency and possibly lower fees. However, continued cooperation is required between regulators, hedge fund promotors and service providers to foster the growth of Australian hedge funds globally.
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