Are Australian Hedge Funds Risky?

The notification to investors by Basis Capital this week that it was in default on margin loans and faced a forced sale of assets raises the question of hedge fund risk.

Industry icon, Damian Hatfield of Hatfield Liptak, says the majority of Australian hedge funds are either fund of hedge funds, which invest in a wide range of sub-funds, and long-short funds, which are equity funds that short-sell stocks. He said hedge funds in Australia that invested in structured credit portfolios, along the lines of the Basis Yield Fund, were extremely rare.

That's true, but in fact the key point of difference highlighted by the Basis Capital experience is the difference between funds that invest in listed securities compared with those that invest in unlisted securities. Where a fund's investments are not listed, valuation is necessarily subjective.

Liquidity and valuation matters were a key element of a recent survey by Deloittes that has been addressed in an earlier blog on this site titled "Deloitte Hedge Fund Survey".

An inhibited secondary market price discovery means funds that invest in unlisted fixed income securities may elect to value these securities based on debt ratings in 'perfect-world' valuation models that ignore liquidity and leverage effects. Given the backward looking nature of debt ratings, this can continue for some time after the market is indicating difficulties that might have a price impact.

While reported returns on the funds may therefore be high, and smoothed (low volatility), this can mask the increasing risk and volatility that becomes apparent as liquidity dries up. This is similar to the situation involving unlisted property funds in Australia in the 1980's, where illiquidity was exaggerated by the lumpy nature of the assets. In the case of structured credit funds the difficulties can be amplified by leverage, as prime brokers will insist on selling securities when prices fall to cover their risks as a lender.

The smoothed nature of returns means that many of the commonly accepted risk measures of a fund are distorted while the volatility of published returns is low

The big winners, if there are any in such a situation, are those that redeemed from such a fund ahead of a breakdown in valuations or somehow shorted the instruments involved.

ASIC has clearly had concerns about these valuation matters and, after providing the industry with a suitable period to implement, now requires Responsible Entities of funds to have and make available a Unit Pricing Discretions Policy that is expected to deal with such manners in an open and transparent way.

It is not altogether surprising that structured credit hedge funds that have been rated based on the low default experience of the past few years are likely to have received high ratings from fund research firms. This was the case for Basis Capital that prior to their recent announcement carried a 5 star managed fund rating from Standard & Poors, a highly recommended rating from Zenith Investment Partners and a highly recommended rating from Lonsec; in each case these are the highest ratings achievable by these research houses. A rating firm would need to base its assessment on forward-looking scenarios based on assessments of likely changes in adjustable rate mortgage resets, leverage and property price cycles.

In summary:

There is a VERY big difference between hedge funds that invest in liquid vanilla listed securities and those that invest in unlisted securities. By marking to market, the volatility of funds investing in listed securities may well be higher than in funds that have fewer valuation events, but volatility in such cases is a far more realistic measure of risk.