Hedge Fund World Australia 2007

The number of attendees on day 1 was down on previous years, presumably as a result of the overnight volatility in global sharemarkets that followed the 9% fall in Shanghai the previous day. Day 2 numbers recovered.

The subject matter at the conference is quite diverse and not having attended all sessions it was difficult to extract the key themes. Nevertheless some interesting points were discussed which are summarised below:

1. Retail Investors
The panel members discussing retail interest in hedge funds had long historys of using hedge funds for HNW investors - diversified hedge funds as a bond substitute and long/short equity as a defensive equity component of portfolio. Allocations were in the order of 10/15% of portfolio. The proliferation of 130/30, 120/20 funds were noted with only mderate enthusiasm, including in later panels. While not positioned as a hedge fund there were many references to Platinum as a leader in introducing short selling to retail investors.

Risk in hedge funds is notoriously difficult to explain to retail investors. Volatility is a proxy for risk, but risk also needs to be explained in terms of net exposure or other measures of leverage. Importantly, risk and other notions specific to hedge funds need to be explained in simple uncomplicated ways, preferably by way of examples.

The main difficulties advisors have with hedge funds are lack of transparency, poor liquidity and for offshore products, FIF. Most popular strategies are equity long/short, including market neutral.

2. Institutional Investors

The two institutional panelists, Frances Magill (Statewide Super) and Robin Burns (Equipsuper) provided a sharp contrast to the retail panel with their lack of commitment to hedge funds. Both had very low weightings to hedge funds (less than 1%?) that were introduced as "toes in the water" and in the case of Statewide was likely to cut the position on the advice of their asset consultant Access Economics. Frances and Robin acknowledged their governance structures inhibited their hedge fund appetite. Also concerns were also raised about fees, transparency, the research effort in identifying attractive strategies/managers and the difficulty in explaining to trustees, especially if something went wrong. It is far easier to explain a failed investment in a toll road for example, than a failed investment in a hedge fund.

This approach to hedge funds doesn't appear to be representative of Australian institutional investors generally, although the concerns raised will likely impact all institutional investors. A Jan 2006 survey conducted by the University of NSW and the Australian chapter of AIMA suggested institutional investors are looking to increase their weight to hedge funds from under 3% to over 4% over the next 2 - 5 years. This survey was discussed in an earlier post on this blog titled "Australian Superannuation Funds Use of Hedge Funds".

A high profile exception in Australia is ARIA ( the new name for the PSS/CSS schemes) that has 15% invested in equity market neutral and market neutral hedge funds, both fund of funds and direct investments. Ephraim Grunhard explained the ARIA approach at an Ernst&Young event in January this year; a summary titled Ernst & Young Hedge Fund Symposium is posted on this blog.

By contrast, in the US where pension fund regulation (ERISA - Employee Retirement Income Security Act) is more onerous than in Australia, hedge fund allocations are generally higher than in Australia; 7.7% in 2005 projected to rise to 9.1% by 2007. Endowments and foundations have been particularly big supporters; 13% in 2005. The high profile Yale and Harvard endowment funds have been remarkably successful which has encouraged others to try and emulate their success.

Investor approaches that are best suited to hedge funds have a low cost passive base with a range of higher priced active strategies, including hedge funds.

The institutional side was also represented in an earlier panel by Tim Hughes (Catholic Superannuation Fund) and Tim Unger (Watson Wyatt). There was concern raised about the beta that is delivered by hedge funds, but general support for funds that delivered uncorrelated after fee returns. While also raising fees as an issue, it was acknowledged that the higher fees attracted talent and thus the prospect of better returns than for lower fee products. One panel member encouraged investors to count their returns rather than the manager's fees.

3. Replication Strategies
While there is a growing number of proponents of hedge fund replication strategies, these seemed to find little interest among panel members and amongst audience members in the refreshment break discussions. At best the replication seeks to track the beta mix of hedge fund strategies with unremarkable returns. Of course, investors are seeking to identify the alpha producers and deliver higher returns than this.

4. Hedge Fund Returns & Fees

A number of speakers raised the issue of investment returns. Recent returns are lower than in the past. Quoting David Hsieh of Duke University, Albert Hsu of Anchor Point Capital put it down to a fixed amount of available alpha being shared by a larger number of hedge funds. This may have the effect of eventually slowing hedge fund growth, although why available alpha should be fixed as markets grow is not clear.

The job is particularly tough for fund of funds that have the additional layer of fees. Fund of funds delivered 6-8% with 2% volatility in 2006. While the low volatility is attractive, the returns are below expectations. When hedge fund returns are lower than equity returns, fees come into question.

Morgan Stanley research in 2006 indicated average fees of 2% management fee and 20% performance fee ie 2+20. The swing towards institutional investors with more buying power will likely have an effect on reducing fees, although for many hedge fund businesses the emphasis is on delivering returns (and receiving performance fees) rather than simply gathering new funds which may have the effect of dampening investment returns. In the near term, successful firms will demand and receive high fees. If net returns are high and are not correlated with sharemarkets, then both manager and investor will be satisfied.

5. Hedge Fund Incubation and Seeding

There is a continual flow of new manager teams with ambitions to be a hedge fund. When these groups present they usually do so with a stellar, albeit short, investment track record and seeders have the challenge of determining what is luck and what is skill. Most prospective start-ups are poorly equipped on the business management side, with limited infrastructure and thus high operational risks.

The two main economic models for seeding are equity and share of economics. The latter is typically more popular because it is less complex and does not require so much involvement and overview of the hedge fund by the seeder.

Richard Keary, whose departure from BT Funds Management coincided with the conference, was of the view that it was simpler to take a view of a manager without a track record and early in the development of the fund.

The panel cautioned potential start-ups to be sure to have sufficient capital to survive the early period of low funds under management. Capital of $500,000 - $1,000,000 may be required to ensure viability. FUM of $50 million is a level from which to build a business, but without a track record of at least 36 mths it would be difficult to attract interest.