Hedge Fund Assembly

It's Fact - Short Sales Don't Drive Share Prices Down

2010-02-24T16:20:00.005+11:00

At last - a piece of research has been published that examines the relationship between the level of short sales and adverse share prices.

Writing for the newly re-launched London-based Alternative Investment Management Association Journal, Emily Stewart has lead-authored the paper "Short Selling Impact on Australian Stock Prices". (Note: the author of this blog post is also a co-author on the paper).

One of the side benefits of the Australian Securities and Investments Commission's conservative approach, in which the ban on short selling was applied for an extended period compared to other jurisdictions, was that it delivered a rich data set of 127 observations.

Stewart collected the Gross Short Sales data that was published each day and applied her analysis to the S&P/ASX20, which represented almost 60% of total All Ordinaries market capitalisation. She was able to distinguish between the so-called financial stocks and the non-financial stocks, as the periods each were banned differed.

Stewart's results either debunk the conventional wisdom that declining share prices are associated with short selling or indicate that the Gross Short Sales data, for all the effort required to collect it, is a poor measure of the impact of short selling.

Australian 2010 Intergenerational Report

2010-02-02T15:31:00.004+11:00

The Australian Government has released its well foreshadowed Intergenerational Report titled "Australia to 2050: Future Challenges". The Overview runs to 22 pages while the full document is 190 pages (1MB). No real surprises here, but it provides a good basis to reflect on the policy choices facing Australia.

The primary driver of the outcomes contained in the report are demographic in nature ie the number of working age Australians supporting each retiree is expected to fall from 5 people today to 2.7 people in 2050. Without any action this will result in a deteriorating fiscal position to a deficit of 3.75% of GDP. Capping real government spending growth to 2%, reduces the fiscal gap to 2.75%.

The key to addressing this imbalance (and thus maintaining living standards) is productivity. Unfortunately productivity growth has declined in the past decade to 1.4% compared with 2.1% in the 1990's. The report highlights the benefit of raising productivity and points to increased spending on education, infrastructure (eg National Broadband Network) and regulatory and tax reform as sources of productivity.

The main source of growth in spending relates to health care, driven by an older population and resulting pressure on services, as well as demand for higher standards of care and technology innovation. Spending on health is expected to almost double as a percentage of GDP from today through to 2050 and account for two thirds of the increase in government spending over the period.

Climate change has listed as a threat and policies designed to lower pollution and increase use of renewable energy noted. However, in a world where energy costs will necessarily be higher than when relying on fossil fuels, it will be difficult to deliver the productivity gains required to address the looming fiscal gap and maintain living standards.

Migration policy is the elephant in the room. While global demographics are difficult to turn around quickly, a small country such as Australia can alter net migration as a matter of policy and increase the proportion of working age Australians to retirees.

Short Sales Bans - Help or Hinderance?

2009-12-01T13:15:00.002+11:00

Now that the dust has settled on the action taken to limit short selling during the financial crisis, The Centre for Economic Policy Research has prepared a report that examines how effective the bans were.

The Centre sifted through the evidence generated by the various regime changes to investigate the impact of the bans on liquidity, price discovery and stock returns.

Since the bans were enacted and lifted at different dates in different countries, and in some countries applied to financial stocks only, they were able to identify their effects with panel data techniques ie data containing observations on multiple phenomena observed over multiple time periods.

In summary, they have concluded that the bans:

were detrimental for liquidity, especially for stocks with small market capitalization and high volatility;
slowed down price discovery, especially in bear market phases, and
failed to support stock prices

Short Selling Disclosure Regulations

2009-10-02T12:28:00.007+10:00

Financial Services Minister Chris Bowen has released Short Selling Disclosure Regulations attached to the Corporations Amendment (Short Selling) Act 2008. The Regulations require that share investors report covered short sale transactions to brokers as is currently the case, and in addition, effective 1 April 2010, report positional short positions to ASIC which will be aggregated and reported with a 4 day lag.

The acknowledgement of the value of positional reporting is commendable. However, retaining the transactional reporting requirement is difficult to understand given the cost involved and in view of the fact that it is partial and misleading (see earlier post).

The announcement is silent on how the positional information is to be conveyed, whether it is direct or via prime brokers/custodians as discussed in the 6 March Treasury Consultation Paper. How will foreign investors be enforced to provide data and how will ASIC achieve the aggregation task?

All this effort and expense to justify a mechanism designed to report positions that according to the Australian Treasury represent an upper limit of 4% of total market capitalisation. Once a record of short positions is established and proper analysis is conducted will the cost of this dual reporting approach be seen to be justified?

The 7 Habits of Highly Suspicious Hedge Funds

2009-10-01T08:29:00.004+10:00

In a post-Madoff world this blog post from Rick Bookstabber titled "The 7 Habits of Highly Suspicious Hedge Funds" makes good reading.

It confirms my thinking that hedge funds will fall into two broad groups going forward. First, those that operate under a veil of secrecy and use leverage and sometimes unlisted securities. And then there are those that rely on an open and transparent process with listed securities and no leverage.

The key safety factor for investors is the separation of custody and administration from investment management. Not just Chinese wall separation, but real separation. In Australia, the role of independent Responsible Entity provides that separation for retail investors and other investors participating in an ASIC registered Product Disclosure Statement. For institutional investors using managed accounts, the role of custody and investment management is clearly separated.

For investment managers that are also Responsible Entity and perform custody and administration functions, the burden of ensuring separation of roles is necessarily greater.

Funds that have open and transparent processes, that don't require leverage to produce returns and are prepared to publish holdings (even with a lag) will be more likely to gain the confidence of investors.

ASIC Removes Short Sale Ban

2009-05-29T11:29:00.003+10:00

The short selling ban on Australian listed financial securities was finally lifted by the Australian Securities & Exchange Commission (ASIC) effective 25 May 2009. The ban on financials extended beyond the two month ban placed on all securities that was lifted on 19 November 2009, because of concerns about systemic risk associoated with financial securities.

With some stability resuming in financial markets, and presumably assured by the benefit of the new reporting on gross short sales introduced on 19 November 2009, ASIC weighed up the market efficiency benefits in lifting the ban.

ASIC reserved the right to reimpose the short sale ban without consultation if they deemed it necessary. Disturbingly, ASIC referred specifically to activity by "hedge funds and similar institutions" in the same paragraph, suggesting that hedge fund activity was somehow a potential threat to an orderly market. Yet there is no such evidence that short selling does have an adverse impact on share prices, let alone that hedge funds are specifically involved in such activities.

Still on the horizon is clarification about the the form of short selling reporting that will be adopted going forward and whether the partial and potentially misleading current gross short selling regime will be persisted with.

Australian Treasury Short Selling Consultation Paper

2009-03-08T13:55:00.011+11:00

The Australian Treasury released a consultation paper titled "Short Selling Regime" on Friday 6 March. The paper calls for comments no later than 3 April 2009.

The Treasury paper follows the enactment of the Corporations Amendment (Short Selling) Act 2008 in December 2008 and presumably will assist in the drafting of regulations supporting the Act. Given the objective of the new legislation is to "enhance market confidence and integrity by providing greater transparency to both investors and regulatory bodies about short selling activity on Australian financial markets" its success will be dominated by the successful drafting of the regulations. So this is definitely a paper that is worth commenting on!

The paper refers to the improvement in confidence that might be generated by the short selling information and the reduced potential for rumour and speculation surrounding the activities of short sellers. The reporting should answer once and for all whether short selling really is a tool for market manipulators or not.

The paper makes the distinction between two methods of reporting of short sales; transactional (currently known as gross short sales and represented by the interim disclosure requirements imposed by ASIC) and positional (net short sales).

Positional reporting is more accurate than transactional reporting because it also takes into account transactions that close-out short positions. This is a very important difference. There is a high likelihood that transactional reporting can be misleading, making it unsuitable for reporting.

Treasury note that the Reserve Bank of Australia are pursuing additional disclosure of stock lending information as a complement to other short selling information, even though it is widely accepted that security lending data is a poor proxy for short selling. The risk here is that a second partial source of short selling data is added that also has a high likelihood of being misleading.

Layering ad hoc and partial measures of short selling is the worst of all worlds particularly, as will likely be discovered once sufficient information is collected, short selling is not so influential an impact on share prices as regulators and commentators believe. If we follow this course we will have constructed a costly and misleading infrastructure of reporting mechanisms that add little to market integrity. Transactional reporting should be dismantled once a superior method is in place, and the new RBA security lending reporting should not be pursued so that the focus can be on delivering the best possible solution.

While there will be difficulties in implementing a positional reporting regime, such difficulties are not sufficient reason to rely on poor and misleading proxies instead. Treasury refer to two such potential issues - implementing threshold reporting and dealing with investors in other jurisdictions.

Threshold reporting means excluding investors with only small short positions from the obligation to report. While in theory this would appear to be a sensible and practical initiative, and has been adopted in the UK, in practice it has serious shortcomings:

It will not be as accurate as collecting total data and therefore risk being misleading as is the case for transactional and security lending reporting; and
It is likely to be easier for investors to report total positions than to extract positions above a threshold, without significant system development

Positional reporting puts the onus on investors or their agents to provide short selling data. While in theory offshore investors may not be able to be easily compelled to provide information, they will operate with sub-custodians in the Australian market that may be able to be compelled to do so.

There is some discussion of the timing and frequency of reported data.

On timing, fairness (and thus market efficiency) dictates that only aggregate security data is released, and is released with a lag so as not to encourage front running strategies (akin to encouraging trading on rumour) or discourage short selling activities.
Cost is a major factor in determining frequency, although unless short sale positions are expected to be highly variable, frequent reporting would not be justified. (Note there is an expectation among regulators and commentators that short sale positions are highly variable. This is not borne out by experience overseas and should not be assumed without evidence in developing the Australian reporting regime.)

Discussion to date on short sale reporting, including this consultation paper, has generally assumed that short selling is a dominant influence on share price movements. Thus, greater transparency of reporting is warranted. However, this is not supported by any evidence. Consideration of the cost of implementing enhanced disclosure should also include the possibility that the additional information resulting from the short selling regime will not improve market effectiveness, because short selling has been dramatically overstated as a source of share price movements. (Note: while short selling as been under the spotlight for its potential to disrupt markets in fact it has been the ban on short sales itself that has been associated with reduced market confidence, reduced market liquidity and reduced market integrity.)

Nevertheless, there will be enhanced short sale reporting as this is what is dictated by the new legislation. The first benefit will be that if not already removed, the current ban on financials will finally be lifted. Then, if positional reporting is adopted, there will be the benefit that it will be clear for all to see what impact, if any, short selling might be having on a security price, rather than unfounded accusations that short sellers are the root cause of share price declines.

In summary, we should work towards a single best method for reporting sales that is consistent with global practice (and dismantle current partial misleading reporting) that enables aggregate short sale positions to be reported periodically with a lag. For the record I expect this data to show that the impact of short selling on share price movements, and thus the need for this additional reporting, has been dramatically overstated.

In answer to the issues for comment in the Treasury paper;

A. Positional reporting should be used in isolation because the current transactional reporting is misleading.

B. The stock lending reporting proposed by the RBA should not be pursued because it is likely to be a misleading source of short sale information.

C. Investors or their agents should be responsible for reporting short sale information because this information is already to hand and while it will take effort to effect the resulting positional reporting will deliver best available short sale information.

D. Custodian/prime brokers carry sufficient information about client's short sale data. The majority of short sellers will have some custodian/prime broker relationship in place to effect settlements and hold securities.

E. Offshore investors will generally operate with custodians that in turn have sub-custodian arrangements in Australia to effect settlements and hold securities.

F. Market operator will carry other relevant information about securities such as market capitalisation and likely be in a position to add short sale information easier than the regulator.

G. I believe that a threshold for reporting will be more difficult to implement than full reporting and will be more accurate. The costs for full reporting could be minimised by appropriate periodic reporting.

H. Refers to number of short positions excluded if various thresholds applied. Will disadvantage large managers who will more likely have positions above the threshold.

I. Current US position is for fortnightly reporting via market operator. Adopt lag in keeping with global practice. If the lag is reduced to 1 week globally adopt 1 week otherwise retain fortnightly.

J. Banded disclosure is difficult and costly to administer and relates to the influence of individual investors. The key is influence at the aggregate security level.

K. There should be a delay to avoid front running and to respect the effort that short sellers have invested in the decision they are making on behalf of their clients. Otherwise short selling is likely to be discouraged to the detriment of market integrity.

L. The data should be disclosed on an aggregate basis. As with K. above disclosing investor positions will encourage front running, fan rumour and discourage investors from short selling on behalf of their clients to the detriment of market integrity.

M. I agree aggregate disclosure could be misleading if a threshold is applied. As stated in G above more accurate reporting will result if no threshold is applied.

N. The identity of short sellers should not be disclosed whether threshold approach is applied or not. As with K and L above such an approach will encourage from running, fan rumours and discourage the use of short selling on behalf of clients to the detriment of market integrity.

O. Transactional reporting is misleading and should be dismantled as soon as a superior method of reporting is implemented. It is not a complement to position reporting.

P. Transactional reporting is flawed from the perspective of data collection (by way of brokers who are in a position to trade and profit from the additional reporting provided) and output (increased/decreased reported short sale activity may not be associated with a net increase/decrease in short sale positions and thus is misleading).

Q. If positional reporting is made mandatory then all other misleading proxies should be removed.

R. The lag in reporting should reflect international practice. The lag should be sufficient to stem front running and fanning of rumour. Assuming data is aggregated the lag could be as short as 1 week.

S. It is difficult for individual investors to see evidence of front running from current reporting.

T. The current transactional reporting will mislead whenever material short sales are closed as these are not reported. It is also confusing to investors to see financials short sales reported when they are banned from being short sold.

U. - Z. seek responses on the cost of compliance. The two elements of cost will be system development and the cost of providing the data ongoing.

AA. The cost of compliance would be minimised if the best reporting approach was adopted and other misleading approaches dismantled or not pursued.

Reflections on the Extension on Short Selling Ban

2009-03-06T12:03:00.002+11:00

The odd thing about the extension of the ban on short selling is that the major Australian banks have re-capitalised, won market market share and are well positioned compared to their international counterparts. Yet, financials are not protected from short selling in other developed markets.

Does the Government know something about the strength of the Australian banks that the market does not know? Unlikely. Are they worried about some financial institutions in particular and the systemic risk of a bank failure? Possibly.

Then, putting aside the fact that there is no evidence to support the effectiveness of the ban, the resulting market inefficiency can be considered a tax on investors. Rather than lay the cost of this support on investors, it would be fairer to make specific provision by providing direct capital support to the organisation(s) they believe carry systemic risk. As the ban on short selling is likely to be ineffective, this is a likely eventuality in any case.

The markets could then be left to find equilibrium, operate effectively and re-build the confidence that has been lost as a result of the short selling bans applied to date.

ASIC Extends Short Selling Ban on Financials Again

2009-03-05T16:09:00.004+11:00

Oh dear again. ASIC has again bowed to market rumours of potential predatory short selling, announcing today that it has extended the ban on covered short selling of financial securities until 31 May 2009.

This decision was made despite the fact that:

Australia stands alone among the developed markets in maintaining any ban on short selling;
derivative or exposure based short selling is not banned, thus allowing alternative (though potentially more expensive) avenues for selling; and
the share prices of financials have underperformed the broader market over the period they have been afforded special short selling protection - All Ordinaries -14.3% vs Financials -21.7% 13 November 2008 to 5 March 2009.

ASIC does acknowledge that there may be a possible loss of market efficiency or price discovery as the result of the continuation of the ban, but that this is justified given the current market circumstances. The assumption here is that the ban will actually have an impact on the share prices of the companies being protected.

The decision was based on discussions with other regulators and market participants (including those who might naively expect to benefit from a continuation of the ban), but was not accompanied by any factual evidence that might support the decision.

Lets hope that by the time this decision is reviewed again, there is some reliable data available to help ASIC make a better informed decision.

AIMA Hedge Fund Booklet

2009-02-25T09:43:00.002+11:00

In conjunction with Zenith Partners, the Alternative Investment Management Association (Australia Branch) has published the Hedge Fund Booklet.

The booklet is a valuable resource for anyone with an interest in hedge funds whether an investor, adviser, regulator, the general public and even managers themselves.

Amongst other things, it covers investment strategies and return attributes and discusses the impact on broader portfolios of allocating to hedge fund strategies. There is a very useful glossary of terms.

The booklet is another important step in demystifying hedge funds and allowing investors and their advisers to make better qualified portfolio management decisions.

Australia Extends Short Selling Ban on Financials

2009-01-22T08:26:00.004+11:00

Oh dear. The Australian Securities and Investments Commission has extended the ban on short-selling financials to 6 March 2009.

But what were they thinking?

ASIC has described the decision as a cautious one, responding to the renewed selling in financials in London and New York that coincided with the lifting of the ban on short selling financials in the UK on 16 January 2009.

But by acting differently to other regulators globally, and in view of Australia's large weight to financials, it is a risky decision that is likely to further tarnish our reputation as a reliable financial market.

There is no evidence that such bans have been effective in achieving higher share prices, or that when not in place, have resulted in lower share prices. A relative outperformance of financials in Australia of 8 percentage points over the period since the ban on non-financials was lifted has been touted as evidence that the ban has worked. But there are many factors at work in determining share prices not just short selling. The influence of short selling on share prices is just unsubstantiated heresay based on a fear of predatory practices; we need some solid evidence.

And what is the regulator, supposedly responsible for ensuring free and fair markets, doing trying to rig higher share prices for financial stocks? At the least they are terribly conflicted. At worst they are driving out investors (who want fair prices and access to short selling as a tool to manage risk), reducing market liquidity and the attractivess of the Australian market to raise capital and contributing to the undermining of Australia as a regional financial centre.

Impact of Short Sales Restrictions on Share Prices

2009-01-06T14:57:00.010+11:00

A recent paper by Ian Marsh and Norman Niemer dated 30 November 2008 titled "The Impact of Short Sales Restrictions" is a timely one given some governments and regulators, including in Australia, are still forming views on the appropriate regulatory approach.

The authors were expecting to see an increase in skewness and a decrease in kurtosis as a measure of whether the short sale prohibition had been effective.

They found that the imposition of short selling restrictions had no discernible impact on the behaviour of stock returns.

The analysis was limited by the small number of observations when the restrictions were in place. In Australia of course the bans were in place longer and remain in place for financials. This may make further analysis more useful.

The study highlights the extreme position adopted by Australian regulators. The following table taken from p22 of the paper shows that Australia was the only country among the 17 developed countries in the sample that banned covered short sales of non-financial stocks as well as financial stocks - see highlighted column.

SEC's Cox Regrets Short Selling Ban

2009-01-05T08:52:00.006+11:00

US Securities and Exchange Commission (SEC) Chariman Christopher Cox said he regrets his handling of the financial crisis and in particular the banning of short selling financial stocks.

The SEC and the UK's Financial Services Authority (FSA) introduced a temporay ban on short selling financial stocks like Morgan Stanley and Citigroup on 19 September 2008. The ban was lifted on 9 October 2008.

The SEC's office of economic analysis is still evaluating data from the temporary ban on short-selling. Importantly, Cox conceded that preliminary findings point to several unintended market consequences and side effects caused by the ban, such as reduced market liquidity.

"While the actual effects of this temporary action will not be fully understood for many more months, if not years, knowing what we know now, I believe on balance the commission would not do it again," Cox told Reuters in a telephone interview from the SEC's Los Angeles office late on Tuesday. "The costs (of the short selling ban on financials) appear to outweigh the benefits."

The SEC imposed the temporary ban under intense pressure from the Federal Reserve and Treasury Department which insisted it was crucial to the short-term survival of these institutions, Cox said.

A few weeks after the temporary ban was lifted, global markets were again dropping precipitously, U.S. banks were begging the SEC to reinstate its short-sale ban and there was talk of shutting the markets down.

Australia faced a simliar set of circumstances to the US, except that the the Australian financial sector was in relatively stronger shape. The Australian regulator, the Austrailan Securities and Exchange Commission (ASIC), was under intense pressure from Australian banks, government agencies and the press to follow the lead of the US and UK regulators.

ASIC did respond on Friday 19 September 2008 in concert with the US and UK regulators and then, remarkably, imposed a sharper regulatory response on 21 September 2008, imposing a total ban on short selling. This temporary ban on short selling was not lifted until 13 November 2008 (over a month after the ban in the US was lifted), and the ban on financials remains, with a lift being foreshadowed (but not promised) for 27 January 2009.

How will history judge Australia's policy response? Given the deeper and more protracted bans, will the unintended consequences of these actions be even greater than Cox is indicating for the US?

ASIC's New Short Sale Reporting Regime

2008-10-29T10:09:00.005+11:00

ASIC has announced that it will lift the ban on short selling of non-financial stocks from 19 November 2008 to coincide with a new reporting regime for short sales.

The new arrangements require trading participants (brokers) to report short sales by security to the ASX on a daily traded (not settled) basis. Trading participants will rely on their clients providing this information at the time of the order.

The ASX will then report this information after 9:00am each trading day. The report will show the volume of short sales executed on the previous day (except for financials which are still banned) and a ratio of short sales traded to issued capital for each security.

ASIC and ASX will use the data to assist in detecting market manipulation and other non-compliance with existing obligations.

Comment:

The focus on daily information is understandable and reflects current fears about the impact of short selling in stock prices. However, in practice daily reporting is likely to be seen to be unwarranted if global experiences are any guide. In the US, short interest is reported fortnightly and changes little from fortnight to fortnight. See the short interest report on Microsoft for example which shows one year of data for Short Interest, Avg Daily Share Volume and Days To Cover.

More importantly, the data collected is unusual in that it compiles transactions. This is not how information is presented on international exchanges - global best practice - which shows short interest positions in securities. If short interest positions were collected, then they could be compared with transaction volume in the security and answer such questions as how many days of trading volume does this short interest represent and how much does this short interest represent as a percentage of issued capital. This was highlighted in my post of 14 October titled "Exposure Drfat of the Corporations Amendment (Short Selling) Bill 2008".

Investors will find the publication of short interest positions valuable in their portfolio construction and risk management. Securities with high levels of short interest are at risk of a short squeeze in the event of new positive information. Some managers will be able to implement have risk limits that prohibit further short selling when short interest reaches certain threshold levels.

Unfortunately, to use the information gathered by the ASX to produce short interest positions would be a massive (impossible) exercise. There has to be another solution.

The natural reporting solution is to require short sellers or their custodians acting as agent to provide position information to the exchange.

This information would then be then compiled by the ASX for publication. As there will be fewer parties involved as compared with the current solution because custodians will represent many short sellers, the reporting process will likely be less of a burden and will provide more useful information.

2008-10-22T12:01:00.004+11:00

Alphaville has published a very good article in FT.com titled "In Defence of Hedge Funds". A brief summary of the article is shown below.

The article quotes Dick Fuld recounting the position of the US Treasury towards hedge funds, "…kill the bad HFnds + heavily regulate the rest" that came from an email between Fuld and Lehman’s general counsel, Thomas Russo, recently made public by US Congress.

The banks were clearly successful in convincing the US Treasury that the banks were not to blame and that more liquidity and more confidence was needed, not more capital. While Paulson eventually came around to the view that the banks needed recapitalising, hedge funds are still in the target sights of regulators.

The BBC’s business editor Robert Peston is quoted as saying:

"…the (hedge fund) industry as a whole hasn’t even begun to address the central charges against it: namely, that it helped to stoke up the credit bubble by providing a market for toxic investments; and that it has brought disorder to the puncturing of that bubble, through the poisonous combination of deliberate strategies to destroy the credibility of weaker financial firms, and through massive automatic sales of assets in a falling market.

Really?

The article explains:

Firstly - on “providing a market for toxic instruments”.

It’s right to say, as Peston does, that hedge funds were often the happy buyers of the lowest tranches of mortgage backed CDO's: the mezz and equity pieces that support above them a far greater number of AAA-rated senior tranches. In fact, the “toxicity” of CDOs relates to the AAA tranches which holders thought had little or no chance of default.

Smart money stopped buying the senior pieces a long time ago. Banks still wanted to issue CDOs though and needed AAA tranche buyers and built securities to carry these risks, some of which were held on their own balance sheets and have since taken large writedowns and suffered capital impairment charges. Greedy banks were the cause of their own demise.

Secondly - on “the poisonous combination of deliberate strategies to destroy the credibility of weaker financial firms”.

The article points out that you don’t need shorting to make people panic about banking confidence. It shows how the FTSE fared after the FSA banned shorting financials (indicated below by the vertical blue line):

Volatility increased and, after an initial rally, the market simply continued on its secular trend. This was the case in Australia also, as shown in my earlier post titled "Australia's Short Selling Ban - One Day Wonder?"

Thirdly - on “massive automatic sales of assets in a falling market”.

The article makes the point that sales by hedge funds have been driven by redemptions that in turn have been adversley impacted by falling confidence. Another cause of the fall has been margin calls made by the banks themselves.

The article concludes that the investment banks are the arhitects of this crisis, not hedge funds.

Exposure Draft of the Corporations Amendment (Short Selling) Bill 2008

2008-10-14T22:36:00.004+11:00

The Australian Treasury are seeking comments on their short selling exposure draft. The current legislation around short selling is complex and unclear and the absence of reporting covered short selling has heightened uncertainty about its real impact and contributed to a 30 day temporary ban being imposed on 21 September 2008.

I believe that concerns about the impact of short selling on the general level of sharemarkets is overstated, and that while there are benefits in producing clearer legislation in the area, it will do little to address the current difficulties facing the Australian and global financial systems.

I am concerned that para 14 says "The Bill will replace ASIC's interim reporting requirements for covered short sales ..." If the temporary ban on short selling remains in place until the Bill becomes an Act, then the Australian financial system will be seriously impacted in the meantime.

Notwithstanding these high level comments, the draft is well balanced and shows a good understanding of the issues. I note para 16 in particular which says that "The Government is not seeking to prohibit or discourage covered short selling activity." That's good.

The draft distinguishes between naked and covered short sales. This distinction is relevant in relation to the current interpretation of the reporting requirement for short sales. Beyond that, a short sale is a short sale and the economic impact of being naked or covered is not relevant. This is a red herring in the argument.

Para 16 uses stock lending activity to estimate an upper limit of short selling in Australian listed securities of 4%. It notes that stock lending can be used for other purposes than short selling. However, there is no discussion of the likelihood that stock lending transactions may pass through many hands (it is a deep and liquid market) before it finally reaches a short seller. I have no evidence to support this, but typically a fund manager will ask their prime broker for stock availability. The prime broker may draw the stock from their own/their client's inventory or go to the market to borrow the stock for the manager. To the extent this occurs, stock lending activity will further overestimate short selling.

Para 22 argues that the absence of transparency in short selling may adversely impact investor confidence and market integrity, increasing the cost of capital and reducing investment activity. I would argue that the absence of short selling brought about by the temporary ban will also have this impact.

Para 23 discusses objectives. The first two points are side benefits to investors, but are inappropriate as objectives for any legislation. Providing information that is hard earned by one set of participants freely to others is unfair and unbalanced. In the case of the first point, "to provide a signal that individual securities may be overvalued", assumes that short sellers are better judges of share value than other investors ie those holding the investments long. This is not necessarily the case. If it is the case, then why should legislation be introduced that makes it easier for poorer judges of value?

The discussion of gross or net reporting of short sales is not relevant. Only net short selling will have an economic impact.

The main weakness of option two (para 26) is that reporting will be made on a trade basis. This implies a significant accounting requirement to follow through the impact of the sale on existing positions and to correct for any trade failures etc. Is the position opening a new short sale, extending an existing, reducing an existing ie a purchase.

It will be more straight forward to report positions and not trades at designated points of time. This information should be published from the source of truth, which is not the trade advice received by the broker. Typically brokers do not carry a record of holdings for their clients and investors may use multiple brokers to achieve a desired position.

I believe the best source of this information is held by the investor or as is generally the case, the investor's agent, the custodian or sub-custodian. Custodian's that carry short positions on behalf of clients already capture, settle and report this data daily on a traded and settled basis. Positions will also include off-market transactions for which they act as custodian. There are fewer custodians, than either investors or brokers. This alternative was not mentioned at all in the exposure draft, but is likely to be the preferred route and impose lowest regulatory cost.

Also not mentioned is that Short Interest has been captured in other markets for some time. In the US, Short Interest is published by major exchanges fortnightly eg http://www.nasdaq.com/aspxcontent/shortinterests.aspx?symbol=MSFT&selected=MSFT shows Microsoft's Short Interest history. What is the process employed in these markets? Can it be applied in Australia?

Will there be areas of activity not captured by using custodians? Offshore investors will presumably use sub-custodians. Users of direct market access systems will report trades to their custodian for setlement. Broker's principal positions? Anything else?

Para 34 discusses the problem of different trading desk activity in the same firm. Using the custodian approach, each account will be aggregated across every security. The fact that some houses will have offsetting long positions is not relevant. The fact that one group in the house has borrowed stock (or sold in advance of borrowing stock or settling) as principal or for a client is what is required to be captured, and will be captured using this approach.

Para 34 also discusses whether short sale reporting should be delayed. The concern presently is that the data should be provided frequently and quickly as it is believed to be materially important. However, international experience is that data provided fortnightly serves the market well. In fact, there is little movement from one fortnight to the next. But where there is a commercial advantage for short sellers in those markets, I believe it is sufficiently preserved with this level of periodic reporting.

In summary, the use of brokers to collect short sale trade information at the point of the trade is not the most effective way of achieving the desired outcome. Periodic position reporting by custodians, and investors that do not have custodians, is likely to provide adequate transparency of short selling in Australian securities.

Australia's Short Selling Ban - One Day Wonder?

2008-10-12T15:16:00.007+11:00

We are now half way through the 30 day prohibition of covered short selling in Australia. Has it been effective?

On Sunday 21 September 2008, ASIC imposed a total ban on covered short selling securities on the Australian Securities Exchange. (Naked short selling and covered short selling of financial securities were banned on 19 September 2008.) The reasons for the total short selling ban were given as:

short selling of stocks, particularly financial stocks, may be causing unwarranted price fluctuations.
necessary to maintain fair and orderly markets in these exceptional times of global crises of confidence in financial markets.
a circuit breaker to assist in maintaining and restoring confidence

The following table shows the impact on selected financial and materials indices and companies in the day following the ban, 22 September 2008, and the movement in index levels/prices in the period that followed.

Security	Share Price Increase 19/9/08 – 22/9/08	Share Price Decline 22/9/08 – 10/10/08
Financials (XFJ)	+5.1%	-18.5%
ANZ	+8.1%	-20.1%
CBA	+6.0%	-11.3%
MQG	+5.3%	-24.6%
NAB	+5.7%	-14.4%
WBC	+4.9%	-18.3%
Materials (XMJ)	+9.8%	-30.2%
BHP	+12.2%	-30.1%
FMG	+25.4%	-62.5%
RIO	+9.4%	-34.2%
All Ordinaries (XAO)	+4.3%	-22.0%

Not surprisingly, the ban had the desired impact immediately after announcement, but why did it fail to provide support in the two weeks that followed?

The simple reason for this is that as short selling had little to do with the crisis enveloping the Australian sharemarket and other global sharemarkets, imposing a short selling ban was never going to provide the solution. The crisis brought about by financial companies leveraging exposure to falling asset prices continues to unfold.

Now that the short term supply/demand impact of the ban has passed, longer term factors are emerging.

For example, the most prevalent hedge fund strategy in Australia is equity long/short; whereby managers invest in Australian companies expected to outperform and offset these investments with short sales. Most equity long/short managers are net long investors. A small number of managers will seek to be market neutral. Few will carry net short positions, even in exceptional circumstances.

Banning short selling prevents equity long/short managers from effecting their strategy. As these managers abandon the strategy because they cannot manage the short side, they will be closing short sales AND and selling long positions. As these managers are generally net long, this is likely to have a depressing impact on share prices.

Those equity long/short managers holding on to their existing short sales awaiting a lift in the ban, will not be inclined to close those positions as further short sales in other securities cannot be opened to provide cover for long investments. This will have the effect of REDUCING buying in companies under sharemarket pressure, when short sellers would otherwise be buying to cover their positions, further depressing share prices.

Furthermore, the ban has increased uncertainty for many investors reducing their appetite to hold Australian shares and further depressing share prices.

In summary, while the covered short selling ban had the desired impact on the first day of trading following the ban, it appears to have been ineffective in achieving the desired aims of the ban, as we have seen:

heightened fluctuations (falls) in share prices
unfair and disorderly markets
reduced investor confidence

Be Careful What You Wish For ...

2008-09-21T08:21:00.005+10:00

Be careful what you wish for. It might kill you.

This the moral of the Aesop fable the Bee and Jupiter and is an appropriate caution to opponents of short selling. There has been a shrill chorus of opposition to short selling recently, including assigning it the blame for the recent market volatility and the plunge in credit and sharemarkets.

Following a ban on short selling by the UK's Financial Services Authority, the US Securities and Exchange Commission has ordered "In these unusual and extraordinary circumstances, we have concluded that, to prevent substantial disruption in the securities markets, temporarily prohibiting any person from effecting a short sale in the publicly traded securities of certain financial firms ..."

Now the Australian Securities and Investment Commission has banned all forms of short selling for the time being. Mr Tony D’Aloisio said ‘These measures are necessary to maintain fair and orderly markets in these exceptional times of global crises of confidence in financial markets. Because of the relatively small size and the structure of the Australian market, it is necessary to extend the prohibition to all stocks. To limit the prohibition to financial stocks, as has been done in the UK, could subject our other stocks to unwarranted attack given the unknown amount of global money which may be looking for short sell plays’.

I have sympathy with the sentiments - predatory short selling, if it is not illegal, is immoral.

However, short selling in its usual form is a key to the efficient operation of financial markets. Without it market makers (I note that the regulators give market makers relief), fund managers and other market participants would not be able to hedge risk.

The United States economy may have dropped down the international pecking order as it bears the cost of widespread global military intervention, but it still remains the centre of capital markets. It is the most efficient place to raise capital. At least until now.

The decision to ban short selling in certain securities opens the door for alternative markets to take leadership. It is in the interests of listed companies to have a deep and liquid market in their securities. It is also in the interests of investors.

While removing some participants (short sellers) may conjure (manipulate) a higher price in the short term, it will likely cause wider spreads and reduced demand for these securities in the medium term. Investors will prefer to trade securities in freer markets and this will drive companies to raise capital in those markets.

Global companies that list in the United States pay United States tax, will list in other markets and pay tax in other markets. This erosion in the US tax base will further weaken the United States' position in the world. These companies already employ a large number of staff in other countries as production has been outsourced to countries with cheaper sources of labour.

Australia had a remarkable opportunity here. Rather than join Karachi, London and the New York and respond by intervening in security pricing, we could have re-affirmed the principle of free markets.

I would expect that in response, over time, companies that value these attributes would have drifted towards an Australian listing and bring investors with them. Imagine an Australian listing for GE, Google and Exxon Mobil.

Or as Australia has done today we could follow the misguided response of the UK and US policy makers and intervene by placing limits on short selling. There is currently a short selling bill before Parliament. Lets hope this knee jerk response doesn't find itself in the black letter law.

Wishing for limits or prohibitions on short selling may appear to improve the situation in the short term, however as Aesop warns, over time it will shrink the number of participants and kill off any aspirations of Australia being a regional player in financial services.

The decision by ASIC to follow suit with a harsher response puts in jeopardy the fledgling Australian hedge fund industry. Australian funds that use short sales in Australian securities to manage risk will not able to do from Monday. Should these funds be suspended for the period of the limitation? There is a strong argument that they should be closed and monies returned to investors as the funds cannot be managed as specified in their respective product disclosure statements.

Any country that can be brave enough to stand firm in support of free and fair financial markets, while regulators in current leading markets practice their voodoo economics, will have an opportunity to develop a strong financial services industry with a global presence, bringing new jobs and prosperity.

Hedge Funds - Shooting the Messenger

2008-08-29T10:23:00.004+10:00

Hedge funds get a raw deal in the press. Its easy for journalists to point to a few "hedge funds" losing money, and then condemn the asset class as a whole. However, noone seems to make the effort to differentiate between the "hedge fund" label - which is really a synonym for "unregulated investment products" - and various strategies, some of which are highly leveraged and volatile. And in Australia of course, hedge funds are regulated and required to meet the same standards as all managed funds, including licensing and product disclosure statements.

Perhaps investors do need to be more selective of managers and strategies; but the only type of news that is relevant to managed funds as a whole is the level of fraud; which seems no higher for so called hedge funds than with other managed funds. Picking funds which got a strategy or view wrong is always easy in hindsight, but has zero relevance. On the other hand, poor fund returns are significant and probably reflect an illiquid, choppy market.

The same problem occurs globally. Patrick Hosking and Clare Harrison wrote an article in the Times on 20 August 2008 titled "Hedge funds at a loss to cope with mood swing". They reported a list of hedge fund blow ups without reporting poor returns in other mutual funds and without highlighting any success stories. The content of the story is sown below:

"The hedge fund group that took a huge bet on Northern Rock as it was imploding last autumn has reportedly lost 85 per cent of its investors' money, amid evidence of a terrible spell this summer for many hedge funds.

SRM, the Monaco-based group that raised $3 billion from investors in September 2006, is down by 85 per cent, according to The Wall Street Journal, including a minus 77 per cent performance in the past year. Tight lock-up terms prevent investors from withdrawing their money.

SRM, which was founded by Jon Wood, the former UBS investment star, is also thought to have been burnt by disappointing investments in Countrywide Financial, the American mortgage group; Bear Stearns, the investment bank rescued by JP Morgan; and Cheniere Energy, a struggling Houston-based energy company.

The news from SRM, which bought more than 10 per cent of Northern Rock only to see it nationalised, comes as many rival hedge funds post losses after being wrongfooted by the sudden change in sentiment over energy prices, financial stocks and the dollar.

Many alternative asset managers, who pride themselves on their ability to make money regardless of market conditions, posted their worst figures for years in July and most are nursing losses for the year to date.

Paragon Global Opportunities Fund, which is run Polar Capital, the London-based hedge funds group, was down 12.41 per cent in July to $897.2million.

The United States-based Pequot Global Fund is believed to have been badly hit, with one expert claiming that the fund suffered a “significant double-digit” percentage loss in July, which Pequot refused to comment on.

Another big loser is Ospraie Management, which is 20 per cent owned by Lehman Brothers. Reports suggest that it has had $1billion, or 20 per cent, knocked off the value of its Ospraie Fund this year.

For months hedge funds made money positioning themselves for energy prices and mining stocks to rise and financials to fall. But that trend reversed in July. Similarly, the US dollar regained investor popularity two weeks ago, badly burning anyone positioned for it to remain weak.

John Godden, a hedge fund consultant with IGS Group, said: “Commodity trading funds, which had a storming year till June, have been hit by the falls in energy prices. They make money on trends and when trends unwind, they lose money.”

Christopher Fawcett, the head of Fauchier Partners, a London-based hedge funds investment group, said: “There was a tendency for funds that did well in June to do badly in July.” Nevertheless, Absolute Return Trust, Fauchier's listed vehicle, was up 1.8 per cent year to date at the end of July.

Hedge fund returns sank by 2.82 per cent in July, according to the HFR 's index of hedge fund returns, leaving year-to-date returns at minus 3.83 per cent, a poor performance by the standard of recent years. So far in August, returns are down by 1.59 per cent.

Mr Godden said that other hedge funds were doing well, with merger arbitrage funds and dedicated short sellers “making out like bandits”."

If you think hedge funds have disappointed of late take a look at this list of legendary money managers returns published by GuruFocus.com, a web site devoted to the principles of 'value investing'.

	12 Months
Name	The Average Gain* (%)
Seth Klarman	-26.7
Third Avenue M'ment	-23.2
Bill Ackman	-18.6
Martin Whitman	-18.0
Ian Cumming	-17.9
Richard Aster Jr	-17.9
George Soros	-16.0
Robert Rodriguez	-15.7
Joel Greenblatt	-15.1
Tweedy Browne	-14.4
David Winters	-13.0
Glenn Greenberg	-12.8
David Einhorn	-12.5
Wallace Weitz	-12.5
Richard Pzena	-10.8
John Keeley	-9.0
Steve Mandel	-8.6
Jean-Marie Eveillard	-8.3
Michael Price	-8.0
T Boone Pickens	-7.5
Robert Olstein	-7.2
Ron Baron	-7.1
Bruce Berkowitz	-6.9
Ruane Cunniff	-6.8
Ronald Muhlenkamp	-6.7
Chuck Akre	-6.5
Warren Buffett	-6.2
Ken Heebner	-5.7
David Swensen	-5.2
David Dreman	-5.1
David Williams	-4.8
Hotchkis & Wiley	-3.7
Robert Bruce	-3.6
Edward Owens	-3.5
Dodge & Cox	-3.4
Bill Nygren	-2.8
Richard Snow	-2.8
Mason Hawkins	-2.7
Chris Davis	-2.4
Bruce Sherman	-2.4
John Rogers	-1.5
Carl Icahn	-1.3
Tom Gayner	-1.1
Brian Rogers	-0.9
NWQ Managers	-0.8
Charles Brandes	-0.7
Arnold Van Den Berg	0.0
David Tepper	0.0
Edward Lampert	0.2
Arnold Schneider	4.7
Mark Hillman	6.4
Irving Kahn	13.2
Sarah Ketterer	13.6
Mohnish Pabrai	16.3
Bill Miller	29.3

Short Selling a Danger to Free Markets?

2008-08-06T20:25:00.002+10:00

In the Australian Financial Review's letters to the Editor on 4 August 2008, Rohan McJannet asks the rhetorical question “Aren’t these products (short selling) dangerous to a free market?”

The answer Rohan is unequivocally no. The recent fall in sharemarkets has prompted many similar calls. Short sellers are only the messenger.

Short selling is a fundamental element of a properly functioning market. It is used by a wide range of market participants and is critical to efficient operation and risk management in our capital markets. To be efficient a market has to incorporate all information, bad as well as good.

In the case of fund managers, short sellers will borrow securities in companies they believe are overvalued, which in turn they then sell, with a view to buying back later at a profit. There is no free ride to short sellers; if a security price rises, then the short seller is faced with a loss. If they are wrong, they suffer every bit as much (possibly more) than long buyers. But in the process stocks perceived to be “overvalued” are bought and those perceived to be “undervalued” are sold, supporting the very foundations of a free market.

I would argue that the suggestion to somehow place limits on short selling while allowing activities that support the market is “dangerous to a free market”. It would quickly spell an end to Australia’s ambitions to be a regional financial centre, by reducing the ability to raise capital, lowering liquidity and reducing the ability to properly manage risk.

Of course, retail investors will likely have benefited from short selling during the past year, if they had been invested in managed funds that had the ability and skills to short sell.

Cayman Islands Monetary Authority Reports Aggregate Hedge Fund Data

2008-06-11T10:54:00.007+10:00

The Cayman Islands Monetary Authority (CIMA) has released its first report using data gathered by CIMA's new electronic reporting system. The Investment Statistics Digest reviews Cayman Islands-regulated funds for the financial year 2006. It contains aggregate statistics for over 5,000 funds including their financial position, structure, investment strategies, subscription activity, fund administration and investment management services.

Australia investment managers are grouped in the Asian region alongside managers from Bahrain, Mauritius, Israel, India, Indonesia, China, Japan, Singapore, Malaysia, Kuwait, Saudi Arabia, UAE, Thailand and New Zealand.

Report Highlights

1. The aggregate net asset value of the Cayman funds captured was US$1.387 trillion.

2. New York had the largest concentration of net assets held by investment managers with US$388 billion or 28%.

3. The UK, predominantly London, had the second largest concentration of net assets managed with a total of US$250 billion, or 18%.

4. Sixty-one percent of the funds reporting had a minimum subscription of US$500,000 or more.

5. The Cayman Islands was the primary location for the provision of administration services to the funds.

6. Multi-strategy (29%) and Long/short equity (27%) were the top two investment strategies of the reporting funds.

7. A master-feeder structure was used by 50% of the funds.

8. Total subscriptions and redemptions were US$760 billion and US$483 billion respectively.

9. The proportion of funds suspending trading was extremely low at 0.1%.

For an industry often regarded as secretive, this information from the regulator of the dominant offshore hedge fund domicile is very important. CIMA plan to release annual updates.

AIMA's Survey of Superannuation Funds

2008-06-04T10:46:00.003+10:00

AIMA has published an update to its 2004 survey of superannuation funds. The results are posted to its website. Click here to review. In summary while the survey published in 2006 (see my earlier post titled "Australian Superannuation Funds use of Hedge Funds") had indicated that superannuation funds were planning to lift their weight to hedge funds in coming years, in fact in the event 2008 weights were little changed from the weights in 2004.

Given that generally capacity is not a limiting factor the likely reason is likely to be simply the time it takes to implement change or the difficulty coming to terms with (understanding) the opportunities available.

One notable change was the introduction in some respondents of dedicated staff of up to 5 people whose job it is to monitor and evaluate alternatives. This suggests that the forecast increase in weight (from around 2.5% to 3.5% on average) will likely occur over coming years, although the new target is lower than when the last survey was taken.

In terms of quantum, 20% of 200 funds invited to respond did respond. These funds were biased to large funds and represented approx $100 billion of superannuation savings. An increase of 1% would thus add about $1billion to hedge fund investments.

More than 30% of responding funds had allocations in excess of 5%. Reflecting the nature of the respondents, these investments were primarily global and invested with large institutional fund of fund providers. The allocation to Australia was only 10.6% and to boutiques (single or multi strategy) was very small (5.6%). Fund of funds are expected to lose market share compared with single/multi strategy funds in coming years, but not markedly.

Funds regard operational experience, team breadth and business experience most highly (expertise), ahead of transparency and governance and certainly ahead of the brand value of the firm.

Most interest was expressed in long/short equity, distressed and emerging market strategies.

While advisers have the most influence in the hedge fund allocation decision, the survey didn't cast any new light on the role they play.

Short Sellers - Black Knights or White Knights?

2008-03-29T13:16:00.003+11:00

If you read Ian Verrender's article in the SMH Weekend Edition March 29-30 titled "Opes collapse could reveal a sordid tale of short selling super" you could be forgiven for thinking short sellers represent the force of evil, the black knights in the tale. It makes a good headline, but does it make sense?

There has been a decline in sharemarkets globally over the past six months and Australia has been part of that decline. Share prices can rise and fall for lots of reasons, but the key factor in this recent decline has been tighter global credit conditions following a long period of easy credit, both availability and rate.

Yes, the returns from investing in sharemarkets have clearly declined, but to point the finger at short selling is to shoot the messenger. A more believable explanation is that investing in shares above their fair valuation, and in particular borrowing by way of margin lending to invest further in such shares, is the root cause of the problem.

In fact, the presence of a deep and liquid stock borrowing market that supports short selling helps to ensure that an even greater bubble is not created, after which even harsher declines follow, as stocks inevitably retreat to reality. So rather than being the black knights, short sellers are the white knights that provide liquidity and help drive share prices to their equilibrium levels.

Investors and superannuation funds don't always have to depend on sharemarkets to rise and/or to leverage their investments to extract investment returns. They too can benefit from short selling by investing with managers that are trained to take advantage of these opportunities. Managed funds that invest in sharemarkets and adopt a market neutral strategy (see wikipedia's definition of equity market neutral) will typically invest in a diversified portfolio of companies they regard as being prospective and offset the risk of these investments by selling a portfolio of companies they regard as having poor prospects. In this way, good investment managers are able to deliver returns based on their stock picking ability without depending on the sharemarket rising.

The investment industry terminology for returns of this nature is "uncorrelated alpha". If sharemarkets continue to struggle in coming weeks and months, we might hear this term a lot more.

Assistant Treasurer Chris Bowen Blows Winds of Change

2008-02-22T14:39:00.003+11:00

Australia's Assistant Treasurer Chris Bowen spoke to a large audience at an IFSA lunch today. The key to his speech was a desire by the government to remove any impediments to Australia becoming a financial services hub - to create a level playing field. This is a very encouraging development for the Australian financial services industry.

Financial services represents just 3% of Australia's exports. Twenty years from now he sees no reason why financial services cannot generate more export income than the resources sector. But impediments will need to be removed and the Government to step out of the way.

In particular, he foreshadowed a review of Div6C of the Tax Act by The Board of Taxation chaired by Dick Warburton. The review will look for revenue neutral changes and is required to be complete by mid-2009. In the meantime, the Government will consider interim changes. A consultation paper will be released and comments sought over the next 3 weeks. Australia's IFSA will be making a submission.

No mention was made about any changes to superannuation. This will await the budget on 9 May 2008.

ASIC Concerned About Collusion

2008-02-22T10:52:00.003+11:00

The Australian Financial Review reported today that ASIC is concerned that hedge funds might be colluding to drive down share prices to profit from short selling. The concern appears to be around knowledge of potential margin calls.

In particular, there appears to be a concern that share price falls can be exaggerated if it results in margin calls that in turn results in further sales of stock. How much stock is called will depend on the fall in price and the extent of cover held by investors with investments on a margin basis. While share prices are evident to the market, the latter is not. There appears room to increase transparency in this area. I am not aware of any markets in the world where the extent of margin lending against a company is published. However, a good start would be to require that the margin loans and changes of margin loans of related parties in the company be made public along with declaration of holding.

ASIC Chairman Tony D'Aloisio acknowledged the important role that hedge funds play in providing liquidity to markets, however the author of the article Matthew Drummond shows his distrust of short selling by using the term "punting" when explaining the use of short selling by hedge funds and refers to this as "the ability of hedge funds to manipulate the market in this way".

By implication, investing is good and short selling is bad. This is nonsense of course. The real strength of hedge funds is that they are able to invest in companies they consider have good prospects and sell companies they believe have poor prospects thus helping to drive share prices towards fair value.

Yes collusion, if it occurs, is bad and transparency of information is good. But lets not colour short selling with an "evil" tag. That's a mistake.

More About Enhanced Active Equity Strategies

2008-01-16T13:53:00.000+11:00

The CFA Institute Conference Proceedings September 2007, includes a presentation by Gordon B Fowler, Jr entitled "Understanding 130/30 Equity Strategies". It is clearly written piece that covers the subject well.

Introduced as a cross between a typical long-only strategy and a hedge fund strategy, 130/30 funds allow managers to take advantage of research indicating stock underperformance while maintaining a market exposure.

There is discussion about the optimal weight for such a strategy which will depend on the impact on the portfolio's information ratio of increased amounts of the long/short strategy eg 100/0, 110/10, 120/20, etc.

Importantly Fowler notes the additional costs (mainly interest rate diference between the rate earned on amounts held as collateral and rate paid on stocks borrowed for short selling) and risks that are peculiar to short selling. The implication is that for managers with an established long only process, the introduction of short selling poses special risks.

As indicated in the ealier post titled "Myths about Enhanced Active Equity Strategies", such funds still carry market risk that needs to be managed (sharemarkets can decline) and any amount of long/short will count for little if the manager is not able to add alpha in a sustainable manner.

Hedge Fund Standards?

2007-11-09T15:12:00.000+11:00

An influential group of hedge fund managers in the UK calling themselves the Hedge Fund Working Group have published a Consultation Paper that seeks to establish a set of best practice standards for hedge funds. If they are deemed appropriate for the UK, do we need such standards in Australia?

The UK group was Chaired by former Bank of England Monetary Policy Committee member, Sir Andrew Large and supported by 14 hedge fund managers mostly UK-based. Interested the work was commissioned outside the auspices of industry associations such as AIMA, MFA and the CFA Institute which would normally be associated with developments of this nature.

While the standards were set against the backdrop of the UK's Financial Services Authority, the group anticipate the standards will have global relevance and are seeking feedback, including from the Australian hedge fund industry before final publication.

There is a clear defensive purpose to the establishment of the standards; to address what is perceived as unwarranted criticism of hedge funds, to acknowledge responsibilities of hedge fund managers and to prevent poorly thought regulation. However, at the heart of the standards is the importance of transparency particularly where funds and managers are dealing with illiquid and complex instruments. This is commendable.

The group also acknowedges the systemic risks that are often levelled against hedge funds associated with the concentration of holdings in particular strategies/positions and accepts the importance of on-going dialogue with regulators responsible for financial stability. The concerns of the Reserve Bank of Australia on this matter have been addressed in an earlier story on this blog titled "Reserve Bank of Australia's Stevens Flags Australian Hedge Fund Risk", September 2006.

The standards adopt a conform or explain approach and there is an expectation that conformity with the standards would be expected to be posted on a firm's website. To ensure on-going relevance the group expect that ownership of the standards will vest in a Board of Trustees. The group acknowledges the likely role of AIMA in supporting the evolution of the standards by the Trustees.

If Australian hedge fund managers are to adopt the standards there will need to be an acknowledgement of some important differences between the environment in Australia and that of the UK.

The group describes hedge funds generally as "investor access is regulated, but the product itself is lightly regulated". This is very different to the situation in Australia (and the UK), where investor access is not regulated, but the product itself is regulated in the same way as all other managed fund offerings to the retail investing public. Given the almost imposssible task of separately defining a hedge fund (acknowledged to some degree by the group), and given the differences relate more to how instruments are used, not the instruments themselves, the approach of the Australian regulator, ASIC, is both sensible and sustainable.

The areas of concern covered by the group are; disclosure, valuation, risk, fund governance and activism. Within these, important sections relate to valuation of illiquid assets, handling of conflict of interest and investor activism. For the most part disclosure and risk is well acknowledged and dealt with in Australian product disclosure statements. The importance of segregating valuation from portfolio management functions has been highlighted including in recent AIMA publications.

Its not clear whether the standards provide any additional "protection" to investors in Australian managed funds. Neverthless, the spirit of the draft is fair and reasonable. Australian hedge fund managers are encouraged to read the detail of the draft standards and provide comments to the group, particularly where they make the standards more globally applicable. If there are matters that could be applied to improving existing industry association guidelines, such as those provided by the Australian chapter of AIMA, offer documents and hedge fund reporting then they should be considered for adoption.

Myths about Enhanced Active Equity Strategies

2007-10-02T10:28:00.000+10:00

The July/August edition of the Financial Analysts Journal (Vol 63, No 4) leads with an article about enhanced active equity strategies, which are gaining prominence both in Australia and overseas. The article titled "20 Myths About Enganced Active 120-20 Strategies" was written by Bruce I. Jacobs and Kenneth N. Levy, CFA.

Enhanced active strategies such as 130-30 or 120-20 strategies have short positions that offset a certain percentage of long positions. They are facilitated by prime brokers which allow the proceeds from short selling equities to be applied to the purchase of long equity positions. This subject was the topic of an earlier post on this blog where the it was debated at the Absolute Returns Funds Conference in Melbourne 23 August 2007.

Not all the "Myths" raised in the article are directly applicable to Australian investors, but those that deserve highlighting include:

Myth 1: Long-only portfolios can already underweight securities by holding them at less than their benchmark weights, so short selling offers little incremental advantage.

Without short selling, a manager cannot underweight many securities by enough to achieve a meaningful active negative weight, being limited to the difference between a stock's weight in a benchmark (which might itself be zero) and zero.

Myth 7: Enhanced active equity portfolios are inherently much more risky than long-only portfolios because they contain short positions.

Losses on short positions are theoretically unlimited because a security's price can rise without limit. However, with proper diversification, losses in some positions should be mitigated by gains in others. This risk can also be managed by re-balancing position sizes for price changes.

Myth 9: The leverage in an enhanced active equity portfolio results in leveraged market return and risk.

The net exposure in such strategies is generally 100%. The leverage and added flexibility can be expected to increase excess return and residual risk relative to benchmark. So if the manager is skilled at security selection and portfolio selection, any incremental risk borne by the investor should be compensated for by increental excess return.

The article is broadly supportive of enhanced active strategies, particularly when compared with long-only strategies, by offering greater flexibility in portfolio construction and allowing for fuller exploitation of investment insights ie they enable the amplification of a manager's alpha. They don't of course deliver alpha where alpha isn't already present.

Hedge Funds Mis-Fire in August 2007

2007-09-24T16:26:00.000+10:00

Something very odd has happened in global hedge funds in August 2007, with widespread negative returns across a range of investment strategies. Is there something rotten in the woodshed or is it mere coincidence?

Not surprisingly, hedge funds with direct exposure to the US sub-prime market or significantly impacted by the resulting blow-out in credit spreads, delivered negative returns in August 2007. Also not surprising given the adverse move in credit spreads, broader fixed income hedge fund strategies declined, such as represented by Cogent Hedge's Fixed Income Index (-1.0% in August 2007 after declining 0.1% in July 2007).

However, what is surprising is that in a month when global sharemarkets were broadly flat to up (MSCI World Index 0.0%, S&P500 +1.3%), declines in hedge fund strategies were widespread.

The following summarises the results of key hedge fund index providers in August 2007:

Cogent Hedge All Funds Index declined in August (-1.8%), and ALL 10 Cogent's sub-groupings also delivered negative returns;
Credit Suisse|Tremont Hedge Fund Index declined (-1.5%) and ALL 13 sub-groupings declined;
Eurekahedge Hedge Fund Index declined (-1.8%) along with ALL 10 sub-groupings. The Eastern Europe & Russia HF Index declined (-3.2%);
Hedge Fund Research Composite Index declined (-1.3%) and 12 out of 13 sub-groupings declined, the exception being Merger Arbitrage which rose slightly (+0.1%); and
Morningstar's Altvest Hedge Fund Index declined (-1.6%) and 11 out of 13 sub-groupings declined. Two specialist groupings had positive returns - health care (+0.4%) and technology (+0.3%), reflecting the relative sharemarket strength of those industry sectors.

Each of the hedge fund index providers listed above publish a range of sub-groupings. Each cuts the results in different ways; some with a strategy orientation, some with a geographic orientation and others with a sector orientation. Some providers show fund of fund results and others single and multi strategy results. Taking each of the sub-groupings published by the above 5 providers, and recognising that there will be elements of overlap, the following chart shows the results for August 2007.

The widespread declines in the hedge fund sub-groupings in August 2007 (56 declines out of 59 sub-groups) suggests that there is a "hidden factor" or "groupthink" at work that has caused many hedge funds to behave in a similar way, no matter what the strategy being employed. Amongst equity long/short funds, where you would expect there to be little or no correlation with events in the US sub-prime market, only 378 (30%) of the 1,263 funds in the Morningstar (Altvest) Survey showed a positive return.

Could it be that hedge funds have a greater exposure to credit spreads than expected? If so, this makes funds that are able to extract returns which are not influenced by this factor more valuable, as they are more likely to generate returns that are not correlated with hedge fund returns generally.

At the least, it suggests that it would be useful to have more detailed research of this observation, preferably at the fund rather than index sub-group level.

Absolute Returns Funds Conference Melbourne 23 August 2007

2007-08-30T13:16:00.001+10:00

Investment&technology magazine held a well-attended absolute returns conference in Melbourne focusing on investment strategies for the future. Endorsed by AIMA, it had a strong educational bent. Almost half the 200+ attendees were investors, particlarly superannuation funds.

The conference attracted a number of US speakers including Gregor Andrade (AQR Capital Management), Andrew Dempsey (Fortress Investment Group) and Ron Insana (Insana Capital) of CNBC fame.

The conference was held against the backdrop of heightened volatility associated with the fall-out from the sub-prime mortgage collapse in the US. Earlier in the week, former Bankers Trust CEO Rob Ferguson was quoted as saying "the current market turmoil was very unusual because the securitised loans at the heart of the problem were rarely traded and valued in a discretionary way, making it easier for investment managers to obfuscate and delay reporting losses". See also an earlier entry on this blog titled "Are Australian Hedge Funds Risky?" Ferguson went on to say that "This is like a market event where the bodies are washing up on the beach gradually."

While the topic was addresed specifically in the session "New-style bonds: the risk and the rewards", Richard Borysiewicz (Credit Agricole Asset Management) and Andrew Howard (Mercer Global Investments) played down the likely impact on the real economy and the long-term impact on financial markets more broadly. Ron Insana described the use of derivatives and leverage as providing the "transmission wires for risk". While the credit disruption occured in one very specific market, the development and distribution of invesment product meant that the investment risk was widely dispersed. Graeme Miller from (Watson Wyatt) was concerned that in such extreme events, correlations are not stable and true risk diversification may not be achieved.

In a piece of exquisite timing AIMA Australia had earlier in the week launched its updated Risk Disclosure Guidelines for Australian Hedge Funds. While clearly the guidelines themselves would not have reduced the risk of recent events, it is an important guide for fund promoters to help ensure that the risks involved in hedge funds, as with any managed fund, are properly presented.

Amongst the breakout sessions, the two speakers presenting on the increasingly popular 130:30 sessions rated best - Gregor Andrade (AQR Capital Management) and Locheiel Crafter (State Street Global Advisers). For many investors at the Conference 130:30 provide a first step towards true alternative investing; while they don't offer any downside protection, the introduction of short selling potentially improves the information ratio compared with long-only investing. Such funds will have the effect of amplifying the alpha generating capacity of a manager; it won't help if the alpha generating ability is not there in the first place.

Discussion of 130:30 funds skates over the very important differences between investing and short selling. There is no guarantee that a manager skilled in long investing will also be successful in short selling, where research coverage is generally poorer and the maths works very differently. For example, an investment that performs badly reduces in size and risk, whereas a short sale that performs unexpectedly well will increase in size and risk. 130:30 funds are a structure not a strategy. If the manager is skilled at short selling a superior strategy would be to allow the manager more flexibility to short sell rather than adopt a fixed weight short selling of 30% ie a hedge fund mandate.

There was active discussion about fees in The Great Fee Debate. Jon Glass (FinAnswers) questions the alignment that relatively high base fees imply between manager and investors. He felt base fees should be lower. Tim Hughes the CIO (Catholic Super) was "outraged" at the high fees in private equity in particular. As a result, Catholic Super have made no private equity investments. He acknowledged though that it is a commercial matter and high fees were being tolerated. John Nolan (JANA Asset Consultants) delivered ten points on fees - the main one being that it is the ability to produce sustained investment returns that is most important, not fees.

Are Australian Hedge Funds Risky?

2007-07-20T14:55:00.001+10:00

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.

ASIC Financial Services Consultative Committee

2007-04-19T13:44:00.000+10:00

Periodically, the Australian Securities and Investments Commission (ASIC) will front representatives of the financial services industry to work through their position on topical issues. There were around 45 people in attendance, including around 15 ASIC staffers. On this occasion Malcolm Rodgers (Exective Director, Regulation) and Jennifer O'Donnell (Executive Director, Compliance) dispensed with a formal agenda.

The meeting started with Malcolm calling for matters of interest/concern from the flooor. None of the matters raised by attendees had specific relevance to hedge funds and the following presentations by Malcolm and Carole did not highlight hedge funds. This seems to confirm that ASIC is taking the view that hedge funds should be judged against the criteria set for all managed investment schemes. This is both sensible and commendable.

Some of the items discussed/presented included:

1. Mutual securities recognition, particularly NZ (complying with the law in NZ indicates complying with the law in Australia). ASIC can still intervene as regulator.

2. IDPS disclosures to the ultimate client; class order imminent

3. New ASIC website and simplification of future ASIC outputs; now limited to consultation papers, regulatory guides (including all policy statements and guidance notes), information sheets and reports.

4. Breach reporting; reported breaches have risen from 292 in first half 2006 to 508 in second half 2006. Highlighted importance of retaining a breach register.

5. Unit trust pricing; requirement for policy by May 2007 now imminent.

6. Disclosure; generally, risk disclosure not sufficiently prominent or specific, poor compliance with required fee discloure, concerns about "rubbery" forecast returns, clarity of PDS's still not right and concerns about "image" advertising.

2007 Global Custodian Prime Brokerage Survey

2007-03-26T10:57:00.000+10:00

The results of the 14th Global Custodian Prime Brokerage Survey have been released by Global Custodian, a magazine that covers international securities services businesses. A total of 2,826 responses were received in relation to 23 prime brokerage firms, of which 15 had sufficient responses to be rated.

The top rating globally was received by Morgan Stanley, followed by Deutsche Bank and Bear Sterns. More relevant to Australian hedge funds is the rating in Asia (ex Japan) where Deutsche Bank headed the table followed by UBS and Morgan Stanley. Other rated prime brokers in Asia (ex Japan) were Goldman Sachs, Merrill Lynch, Lehman Brothers and Credit Suisse.

Highly rated Morgan Stanley had some below average ratings in reporting and securities lending, while Deutsche Bank scored below average in some areas of reporting and technology. Both had strong results in client service.

55 questions were asked across nine service areas including:

client service
operations
hedge fund business consulting services
financing
securities lending
reporting
capital introductions
technology, and
value

Results were grouped by different sized clients (less than $100 million, $100 million - $1 billion and over $1 billion).

To achieve a top rated service or top rated regional provider required was not too hard a hurdle as it required achieving an overall weighted average score that was equal to or better than the average score for that service or region.

Hedge Fund Conference Presenter Arrested After Visit to Australia

2007-03-14T15:00:00.000+11:00

According the hedge fund newsletter publisher Hedgeweek, the founder, Managing Director and Chief Investment Officer at US hedge fund Anchor Point Capital LLC, Albert Hsu, was arrested on 2 March 2007 and charged with attempted kidnapping and sexual assault. According to the New York Post he was arraigned in the Superior Court in Norwalk Connecticut, and set a bail of $1,000,000.

Mr Hsu was Chairman and Special Address speaker at Day 2 of the 8th annual Hedge Funds World Australia 2007 Conference in Sydney on 1 March 2007, the day before his arrest. Mr Hsu's presentation was mentioned in an earlier post on this blog covering the Hedge Fund World Conference.

Hedgeweek subsequently reported that Anchor Point Capital LLC has told investors it no longer employs Albert Hsu. "Albert would not be able to carry out his business duties and, therefore, is no longer an employee of the firm,'' according to a March 7 letter sent to clients by Timothy Crowe, chief executive officer of Florida-based Anchor Point. Crowe and Hsu started the firm in June 2005.

Deloitte Hedge Fund Survey

2007-03-14T10:01:00.000+11:00

Accounting firms are muscling up for market share in the growing hedge fund industry. Last week Ernst & Young were voted best (hedge fund) accounting firm by the influential Hedge Fund Journal, following the hedge fund symposium they road showed globally earlier in the year.

Now Deloitte, in conjunction with Hedge Fund Research, have issued a research study focused on Risk Management titled "Precautions that Pay Off - Risk Management and Valuation Practices in the Global Hedge Fund Industry." The study was based on 60 mostly US-based groups managing about 244 hedge funds. The survey covered a wide range of hedge fund strategies and hedge fund sizes.

Deloitte conclude that the growing hedge fund industry needs to improve its management of risk. Deloitte said many hedge fund groups - which typically follow more aggressive investment strategies - lacked best practice guidelines, such as independent asset valuation or external administrators.

Deloitte raise the concern that the rapid growth of hedge funds (20% pa over the period from 1995 to 2006) had made it difficult to find "excess returns" and that some hedge funds had adopted higher leverage to meet return expectations and thus required tougher risk management. As noted in the EY symposium, the rise of the institutional investor will act to improve hedge fund risk management. Regulators - concerned to avoid systemic risk - are also watching leverage. The RBA's concerns were covered in an earlier blog on this site titled Reserve Bank of Australia's Stevens Flags Australian Hedge Fund Risk.

A key thread in the study is concern about liquidity and valuation. While these are important matters they tend to relate to the minority of strategies; the majority of hedge funds invest in equity long short or market neutral where investments are made in listed markets. In this sense, liquidity and valuation are more of a concern for private equity funds than they are for hedge funds. In Australia, retail funds are required to meet disclosure standards that should deal with these concerns.

Deloitte found that 78% of respondents used an administrator to calculate NAV and 47% used independent third party pricing. However, it's the intersection of these two that is key - how many funds rely on internal pricing of "hard to value securities" - and this is not clear in the study. Fifty seven percent of respondents had valuation committees, although as with third party pricing, these committees have greatest value where hedge funds are taking on the responsbility of pricing "hard to value securities" internally and have less value where investments are exchange listed and valued by the fund's administrator.

Thus, the emphasis on valuation risks in the study may not be justified as for the 22% of respondents that calculated NAV in-house, no measure of "hard to value securities" were attributed and 15 percentage points of this group relied on a separate back office to strike NAV. The 7% of respondents that relied on the fund manager to value is of concern.

A useful framework for a Valuation Policy was provided in the Survey:

1) to the extent practical, establish a pricing function that is independent of the portfolio management function;

2) describe current valuation methodologies and the process for revisions and sign-offs;

3) establish when exceptions to the pricing policy are appropriate, how such exceptions should be authorised, and ensure that exceptions are documented;

4) provide for backtesting and checking the accuracy of the pricing data that are being captured;

5) establish roles and responsibilities of the valuation committee;

6) establish clear governance and controls structure; and

7) be clear to all parties responsible for its application.

The Survey also covered the use of risk management tools. Here great care needs to be taken in interpretting the results. The use of a particular set of metrics may indicate an awareness of risk, but may not be sufficient. For example, a number of prime brokers include risk metrics as part of their offering. Clients of these prime brokers could argue that they employ say a Value at Risk measure without embracing it as part of the investment process of the firm.

Also, different metrics have different usefulness. For example, 50% of respondents apply country concentration limits. However such a metric may not be applicable for example where investments are global in nature and likely to be highly correlated. Amongst the metrics selected, position limits were most highly relied upon (85%) and with justification.

The study included sensible advise in relation to risk governance, including having a written risk management policy, and operational risk.

In summary, Deloitte have made a positive contribution to the hedge fund industry with the publication of their risk management research study. While the emphasis on valuation risks in the study may not be justified, the authors offer some good advice on improving hedge fund risk management governance.

New Performance Survey of Australian Absolute Return (Hedge) Funds

2007-03-06T15:28:00.000+11:00

The Investment & Technology magazine has published a new performance survey of absolute return (hedge) funds in its 26 March 2007 Issue. The survey has been prepared in association with Standard & Poors, and provides some more colour to participants in the Australian hedge fund industry. The survey shows returns over various periods to 31 December 2006 and two measures of exposure - net exposure (longs - shorts) and gross exposure (longs + shorts). There are 63 funds listed across 30 different managers.

The survey splits single manager funds from fund of funds and bases the classification on the CSFB/Tremont hedge fund strategies adopted in their popular global hedge fund survey. There was some adaption of the strategies such as combining equity based strategies in one grouping.

This survey suffers a little from teething problems around the definition of net and gross exposure (4 funds show net exposure greater than gross exposure) and the 3 year return data where some funds appear to report non-annualised returns while the balance of funds reported annualised returns. One manager showed pre-fee returns which makes comparison difficult. But all these matters are expected to be rectified in future editions which are now expected on a monthly basis.

Focusing on the 1 years returns (post-fee except for one manager) which are likely to be accurate, there is a marked difference in the outcome for single manager funds compared with fund of funds. The median single manager return over the year to 31 December 2006 was 16.8% compared with fund of funds which had a median post-fee return of 10.2% over the same period.

While the returns posted in the survey are good, care needs to be taken to understand the risk taken in delivering these returns - have they been achieved with either net equity market exposure or substantial leverage? Putting aside the data difficulties noted above, it would appear that leverage (as measured by gross exposure) is not particularly high. A typical equity based fund has a long position less than 100% partially offset with a lesser short position.

However, it is the net exposure which may explain a significant part of the return in 2006 and will carry risk in a down market. This is a matter that Peter Smith at van Eyk is expected to focus on in a forthcoming analysis of alpha and beta in Australian hedge funds. Net exposure amongst single manager multi strategy and equity based funds (excluding the 4 funds where net exposure is reported as being higher than gross exposure), where there is a reasonable sample size of 20, was reported as 69% at 31 December 2006. Only 4 funds in the survey appeared to be adopting a market neutral approach (including the TI Intercept Capital Fund with which I am associated). This suggests that the equity based absolute return funds listed in the survey will exhibit positive correlation with the relevant equity market in which they are investing.

Next month the Survey will also include some comparatives with hedge fund index returns.

This Survey is another step towards providing more transparency to absolute return (hedge) funds offered to Australian investors and is to be applauded. It suggests that most funds are operating with limited leverage, although high net exposure to equity markets is a concern for investors looking for portfolio diversification from their hedge fund investment.

Hedge Fund World Australia 2007

2007-03-01T09:33:00.000+11:00

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.

At Last Some Better Data on Australian Hedge Fund Industry

2007-01-31T15:46:00.000+11:00

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.

Deutsche Bank Alternative 2006 Investment Survey

2007-01-24T16:16:00.000+11:00

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.

Ernst & Young Hedge Fund Symposium

2007-01-19T09:22:00.000+11:00

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.

Hedge Funds in Australia - RBA Still on the Case

2006-11-19T18:40:00.000+11:00

The RBA's David Jacobs and Susan Black published an article in the November 2006 RBA Bulletin that provides a good assessment of the current status of the Australian hedge fund industry. This article follows comments by the Governor (see Reserve Bank of Australia's Stevens Flags Australian Hedge Funds Risk). The article was picked up in a story by Fiona Buffini of the Australian Financial Review on 17 November 2006 in which she highlighted the surge of retail investment in hedge funds as being of concern to the RBA.

Buffini's article is headed "RBA Warns on Hedge Funds", but in fact the Jacobs & Black article identifies some real positives for the industry in Australia. Most importantly, the Australian regulatory regime makes no distinction between hedge funds and other managed funds; the same registration, operational and disclosure requirements apply to a fund regardless of whether it is a hedge fund or not. This is a great positive for the hedge funds industry and the financial services industry generally. There is no logic whatsoever in seeking to make special rules for hedge funds given the lack of clarity in what actually defines such a fund and the importance of all investments being treated on a comparable basis so investors can make proper assessments of risk and return. One of the reasons for the public concern about hedge funds in the US is that hedge funds aren't required to be registered with the Securities and Exchange Commission and that as a result transparency is limited.

Also highlighted in the Jacobs & Black article was the growing importance of the hedge fund industry as an exporter of financial services, even though Australian managers have generally not been adopted by Australian institutional investors (see also Australia as a Centre for Hedge Funds?)

Finally, the article notes the powerful diversifying features of hedge funds that are the result of their lack of correlation with sharemarkets and other traditional asset classes eg over the past five years the Australian hedge fund industry has delivered a return in line with local sharemarkets - 12% - but with half the standard deviation, a generally accepted measure of risk. For Australian investors with high weights to Australian shares and property that have performed well in the last several years, investing in assets that are not correlated with Australian shares and property is likely to be VERY important for portfolio diversification.

Jacobs & Black offer hints of concerns about fees and about transparency, but both factors face considerable commercial pressure, particularly among institutional investors. The article also raises the spectre of leverage that is generally adopted by hedge funds (and private equity) and the potential systemic risk this brings to bear on the Australian financial system. This is a matter that does fall directly at the doorstep of the Bank and requires monitoring. However, current investments in hedge funds are currently very low in the total of Australian savings, and though these funds employ leverage, this is not yet a matter that should be of concern.

It would be helpful for policy makers and market participants to have better data on the amount of leverage employed by hedge funds. There are a number of data providers who are developing better information on Australian funds. The LCA Group which was referenced in the Jacobs & Black article have a quarterly publication with news stories and performance tables and Investment & Technology is working on performance reporting. Aggregate leverage and exposure data, as well as other directory information, is expected to be provided by a new industry survey to be published shortly. Leverage information on overseas funds invested in by Australians may be more difficult to determine, particularly given the limited information made available by fund of funds and the weaker requirements for transparency in other jurisdictions.

One important matter omitted from the Jacob & Black article was reference to the amount of retail hedge funds that carry capital guarantees where the risk of capital loss has been limited. In Australia, a large share of Australian retail investor hedge funds offer investments guaranteed at maturity. In these cases, the floor on returns makes them less risky than many naked sharemarket funds and property.

The Jacobs & Black article notes that the proportion of investments by retail investors in Australia is higher than in the US. This is partly the result of the slower uptake by institutional investors in Australia and partly that US hedge fund managers are limited by regulation to offering their products to accredited investors, such as those that have net worth in excess of US$1 million. In an environment where hedge fund managers were licensed, as they are in Australia, and investors are provided with suitable information about the fund and the manager responsible, then naturally one would expect a higher take-up by retail investors. The proportion of investors participating in hedge funds could be reduced in Australia by simply prohibiting such investments and limiting choice, but this is unlikely to be beneficial from a portfolio risk management perspective. In view of the volatility (risk) data provided by the authors removing an asset class with low correlation to traditional asset classes would likely raise the exposure of retail investors to the inevitable correction in share and property markets.

The comment that hedge funds are difficult to assess because they depend on manager skill is a glib one. Broad asset class returns are also difficult to predict, and as noted above, can exhibit far greater volatility (risk) than hedge funds. Buffini quotes financial adviser Rick Capel of Capel & Associates who noted that hedge funds have not been tested in a wholesale market meltdown (decline). The question for investors of course is whether they would be better served by being exposed to sharemarkets or hedge funds in a market meltdown. As Jacobs & Black pointed out, more than half of Australia's hedge funds (and this would be indicative globally) are long/short equity funds including market neutral; these are just the funds that would be expected to perform best in such an environment.

Nevertheless, a market meltdown would impact those hedge funds that carry a long bias to sharemarkets. Just as market returns have contributed to the return of such funds a market decline, unless the fund was particularly nimble, would detract from hedge fund returns and may even contribute to losses. Again, survey data on aggegrate fund market exposure and leverage would help determine whether there was significant market risk in hedge fund portfolios.

In fact it could be argued that the real risk for retail investors is not the complexity and risks associated with hedge funds, but the more traditional risk of constructing investment portfolios based on recent historical returns. Presently, Australian retail investors risk being seduced into raising and even leveraging Australian share exposure, following a period of strong returns over the past three years, and not taking the opportunity to introduce risk-reducing investments such as hedge funds.

With hedge funds, like any investment, investors need to diversify their approach. This appears to have been the case with high profile Amaranth (See Amaranth Losses - Lessons for Australia). Although the fund did lose substantial sums of investors' money, individual investors appear to have been well diversified and generally had other investments against which this loss could be matched.

In summary, the Jacobs & Black article is a good account of the current state of the Australian hedge fund industry. It highlights some important postives for this young and growing industry. Care should be taken not to tar the Australian hedge fund industry with the same brush as overseas funds where there have been a number of high profile collapses and concerns about transparency that can in part be attributed to the unregulated nature of hedge funds. In contrast, Australian hedge funds have the benefit of a regulator that requires the same degree of operational and disclosure requirements as other funds offered to Australian investors. And impending new data on the Australian hedge fund industry should help defray concerns that are simply not warranted at this stage of the industry's development.

Amaranth Losses - Lessons for Australia?

2006-09-25T12:58:00.000+10:00

In an earlier post on this site, I highlighted Reserve Bank of Australia Governor Glen Steven's concerns about hedge fund failure and the adverse impact such failure may have on Australia's financial system. In the same week that Mr Stevens delivered his speech in Hong Hong, prominent US hedge fund manager Amaranth Advisors was facing a major setback in its US$9. 2billion fund, losing US$6 billion on a natural gas investment strategy.

Amaranth manage a multi-strategy fund that delivered strong returns over recent years. There website described their approach as following a "broad spectrum of alternative investment and trading strategies in a highly disciplined, risk-controlled manner." However, according to the New York Times on 23 Sep 2006, a significant part of recent returns had been driven by trading-related profits from energy and commodities; contributions of US$1.26 billion in 2005 and US$2.17 billion Jan to Aug 2006. There was clue to the risk adopted in the fund with a 10% decline in May offset by high returns in April and June.

Apparently, the Fund held a position that would benefit if the spread between the March and April 2007 natural gas contracts rose. In the event they declined, and presumably because the positions were leveraged, the fund then had to meet substantial margin calls and/or close the positions in loss. In the end, the energy book was closed on 20 Sep and the fund realised a US$6 billion loss and a decline of 65% for the month and 55% calendar year to date.

One of the factors contributing to this outcome was liquidity in this commodity market. This was one of the risks raised by Mr Stevens. He said that just when liquidity is needed most, at a point of crisis, it is not available. This might spell trouble for the hedge fund, but what concerned Mr Stevens was the risk of destabilising the financial sysytem as a whole, as was the case with the failure of Long-Term Capital Management in 1998. Surprinsgly, given the size of the losses recorded at Amaranth there has been little flow-on impact observed so far. Its early days in this apparent failure, but this is encouraging.

Are there any lessons for Australia? The surprise is that this occurred in a so-called multi-strategy fund where an investor might expect a diversified set of strategies to drive returns. The fund had disclosed that energy had contributed 78% of year to June results of 20%+, suggesting limited diversification. The size of these gains and the subsequent losses are presumably the result of leverage. If the natural gas strategy was within the mandate for the Fund, and rational investors were aware of this mandate, they could have acted to ensure their own portfolios were suitably diversified and could cope with failure in any one position.

A knee-jerk response would be say that investing in hedge funds is risky and should be limited or prohibited. A more considered response would be to ensure that investment strategies/mandates, including leverage, are clearly set out in ASIC-registered Product Disclosure Statements. Armed with this information indivual investors and their advisers would then be in a position to make appropriate portfolio structuring decisions, that will protect investors from invidual investment failure.

Reserve Bank of Australia's Stevens Flags Australian Hedge Fund Risk

2006-09-19T11:21:00.000+10:00

Pointedly for the fledgling Australian hedge fund industry, incoming Governor of the Reserve Bank of Australia, Glen Stevens has issued a strong warning that hedge funds pose a risk to financial stability which is difficult for regulators to deal with. Mr Stevens was speaking at an event organised by the Hong Kong Monetary Authority and the Hong Kong Association of Banks on 15 September 2006.

According to the ABC, Mr Stevens said that the increased use of debt and the growing complexity of investments could disrupt markets when harder times came, as they surely would. He said it would be under abnormal conditions, when liquidity in markets was under pressure, that difficulties could arise. This post reviews Mr Steven's speech and seeks to identify areas that participants in the hedge fund industry in Australia should be aware of.

In particular, Mr Stevens referred to hedge funds as being "lightly regulated and often highly leveraged." While this might be the case globally, it is less true in Australia where investment managers are licensed under ASIC supervision and disclosure for retail funds at least is required by ASIC to be included in Product Disclosure Statements (PDSs). Admitedly an absence of industry wide data makes it hard to assess, but anecdotely hedge fund products in Australia are generally not highly leveraged.

Hedge funds' record of rapid growth and high reported returns has attracted a lot of attention by investors, Mr Stevens said. Ten years ago hedge funds were regarded as an exotic asset class, but now they are increasingly seen as part of the main stream for pension funds, university endowments and the like. Financial institutions are also increasingly in the habit of establishing in-house vehicles to tap the appetite for hedge-fund-type investments on the part of investors. Mr Stevens is right that awareness of hedge funds has increased dramatically in Australia in recent years, and while holdings of such funds have increased, they still represent a small weight in institutional and retail portfolios. In another post on this blog on 17 August 2006 titled Australian Superannuation Funds Use of Hedge Funds, a survey by the University of NSW and the Australian chapter of AIMA showed that current allocation to hedge funds by Australian superannuation funds of under 3% is expected to rise to over 4% over the next 2-5 years. Similar data for retail has not been compiled, but is likely to be similar.

According to Mr Stevens, the very term 'hedge fund' seems to be used rather more loosley than it used to be: he says we are really talking about any investment vehicle which is willing and able to take advantage of the vast array of financial products, 24-hour trading and ample liquidity to expose the funds of sophsticated investors to virtually any conceivable type of risk. The range of risks and lack of correlation with traditional equity and bond asset classes of course is one of the real attractions of hedge funds.

In Australia, hedge funds are not necessarily lightly regulated; they are treated by the regulator in much the same way as other managed investment vehicles. Around half of Australian hedge funds are retail managed funds that are carried in a PDS and registered with ASIC. Many of the wholesale and overseas investor funds/mandates have strategies that mirror the Australian retail offerings and Australian-based managers operate with an Australian Financial Services Licence.

Mr Stevens observed that by exploiting (and thereby eliminating) pricing anomalies and by being less encumbered by prudential controls than most other financial institutions, hedge funds promote efficiency in the allocation of capital by searching out returns more effectively than others. On the assumption, moreover, that those who put money into hedge funds know what risks they are taking - which might, increasingly, be a big assumption - people might take the view that what investors do with their money is their own business. Rather than being less encumbered by prudential controls imposed by the law, hedge funds are less encumbered by the mandate they have been given by investors and their advisers. The well-intentioned limits that have grown up around more traditionally managed monies have come at cost in terms of flexibility and ultimately return. The shift to hedge funds is a practical acknowledgement that straight-jacketing an investment manager will curb investment returns, and may even increase risk if the limits include limits on the use of hedging.

Critics, on the other hand says Stevens, claim that hedge funds can overwhelm and distort small markets; a tendency for herd behaviour, and application of leverage, amplifies the problem. When hedge funds decide simulataneously to get into or out of a position, they can disrupt market functioning. The entities in question are essentially those financial investment vehicles which are outside the normal pridential regulatory net. The situation that Mr Stevens describes threatens market integrity and is something that the RBA should be very sensitive to and monitor closely. However, it would be useful to know just how many entities are outside the "prudential net" as Mr Stevens put it. Is this a risk presented more by overseas funds that might be larger, better coordinated and more lightly regulated? The failed attempt by the SEC to require hedge fund registration may have been a setback in this respect. Ideally, a system that required registration in each major jurisdiction that was recognised in other jurisdictions with comparable regulation would be most effective.

In Australia, the rapid growth of AIMA's membership suggests a willingness of managers to understand the particular requirements of the Australian jurisdiction as AIMA has a strong regulatory and compliance element, including membership by leading legal and accounting firms in the hedge funds industry.

Mr Stevens highlighted two issues that regulators need to address:

Ensuring there is sufficient disclosure to allow investors to make informed judgements about the risks and returns. In Australia, the regulatory authorities draw no distinction between hedge funds and other investment managers; the regulatory regime is determined by what the entity does, rather than what it is called. This ensures a level playing field.

Ensuring that the activities of investment managers which are not subject to prudential supervision do not threaten the financial viability of firms, such as banks, that are. This approach emphasises to the counterparties of hedge funds and other highly leveraged institutions (such as prime brokers, banks and investment houses) the importance of strong risk management, collateral, knowing their customer and so on. The aim here is to preserve the prudential strength of the core part of the sysstem in the interests of economic financial stability, while allowing the part beyond the prudential net to play its role in taking on risk.

In Australia, given the role of ASIC in supervising the managed funds industry, including hedge funds, it is the second point that is most relevant. Mr Stevens notes that it is difficult, because of the complexity of the strategies adopted for counterparties to really understand the risks they are exposed to. Prime brokers take this risk management very seriously, not least of all because in extreme situations their own capital is potentially at risk. The credit departments of prime brokers play an active role in assessing investment strategies at the outset and ongoing and setting limits that seek to manage this risk. In most cases prime brokers also act as custodian of the assets of the fund, which gives them timely access to portfolio data and the ability to enforce the limits they set on each manager's fund.

Mr Stevens is sceptical of the argument that hedge funds necessarily add to liquidity. Under conditions of pressure, Mr Stevens argues that leveraged investors are more likely to need to use the liquidity of the market than to be able to contribute to it. On such occasions - which is when liquidity is needed most - these funds surely are liquidity takers, not providers he says. This argument, however, doesn't acknowledge one of the real benefits that hedge funds bring to markets - the use of short selling - which provides a natural offset to leveraged investments. This allows both buyers and sellers to express their view no matter what their current holding in a security.

Mr Stevens also suggests that hedge funds might command undue market power because of the brokerage they generate for investment banks. It is brave to suggest that listed markets can be manipulated in this way without risk of loss. In any case, such opportunities would be limited to particular hedge fund strategies and asssumes that for a particular transaction, market forces can somehow be subverted by these financial institutions in favour of hedge funds. This is a risk, but frankly in a properly functioning market unlikely to occur.

In summary, much of the risks that have been put forward by Mr Stevens could be asssessed by simply taking a closer look at the participants in Australia and the strategies they are adopting. In view of the fact that Mr Stevens is the incoming Governor of the RBA his comments deserve to be addressed. As half of the hedge funds in Australia are retail managed funds, their strategies are outlined in PDSs which are registered with ASIC. Public information could be supplemented by surveys that determine how many strategies involve leverage and what amount of everage is used.

Listing Hedge Funds

2006-09-05T16:04:00.000+10:00

There is a vibrant Listed Investment Company community on the Australian Stock Exchange that includes companies managing Australian equities, overseas equities and other specialist funds. Is there a value in listing hedge funds as an alternative to offering hedge funds as retail managed funds?

In other markets, such as Ireland and Singapore, listing is offered as an alternative "structure of convenience" to allow investors to participate that might otherwise be constrained by an unlisted vehicle or the jurisdiction of the particular fund company, particualrly if it is located in a non-tax treaty country such as the Cayman Islands.

What happens in practice in these situations is little different from the unlisted model. Applications and redemptions occur at the posted price for the day rather than a market price struck by the meeting of buyers and sellers as is generally the case in listed markets. As a result, there are net applications and redemptions on a day that are managed by the fund administrator. Prices are published by the exchange, but little additional investor comfort is gained from the listing.

It is possible to list a Cayman fund for example on the Irish Stock Exchange (ISE). This can be done with little additional documentation than required to establish the fund registered with the Cayman Monetary Authority. If the fund has already commenced, trading an Audited Statement of Net Assets will be required at the time of listing, otherwsie no accompanying financials are required. Once the fund is listed, the day-to-day operation of the fund is usually the responsibility of the Administrator. This will include the calculation of the net asset value and processing the subscription and redemption applications.

Because it is not possible to subscribe or redeem shares at any other price other than the net asset value, there is no opportunity for investors to exploit pricing differences ie there is no secondary market for investment funds on the ISE, so a listed fund on the ISE is not actively traded.

The listing of an investment fund on such exchanges as the ISE or Singapore Stock Exchange are simply a "technical listings"; marketing tools to assist a fund access a wider investor base. For example, it is useful where a fund seeks to target institutional investors. A listing can facilitate distribution because some such investors are often prohibited from investing in unlisted securities.

Australia as a Centre for Hedge Funds?

2006-08-25T14:18:00.000+10:00

Australia has a growing hedge fund industry, but the main hedge fund centres remain London and New York. While Australia has the largest amount of hedge funds under management in the region (recently estimated at $40 billion), a respected regulatory regime and high quality people, it is Hong Kong, Singapore and possibly Tokyo that are vying for hedge fund leadership in Asia.

What would it take to set Sydney on a path of hedge fund leadership in the region?

The key stumbling block is tax, in particular withholding tax. While other jurisdictions have strong records in providing hedge fund services the main advantage they carry over Australia is tax. A number of centres, such as the Cayman Islands, Bermuda and British Virgin Islands have established a strong position in servicing hedge funds by offering a tax-free environment for investors and managers. Other developed markets such as the UK, Ireland, Luxembourg, Hong Kong, and Singapore do not impose withholding tax and market this as a key selling point in attracting foreign direct investment.

So what is the logic of withholding tax? Withholding taxes such as PAYE in Australia are designed to limit avoidance and evasion by taxing at the source of income. Withholding tax on non-residents however does not carry the same logic, except to reduce the opportunity for residents to configure their arrangements to appear to be non-residents and avoid domestic taxation. Applying withholding tax on non-residents is a case of cutting off our nose to spite our face; it may be effective in reducing avoidance activities of residents, but it is also effective in turning away genuine non-residents and spurning the development of an Australian hedge fund industry.

Withholding tax has the effect of securing taxation revenue from a small domestic hedge fund industry, but prospective taxation revenue on a new regional or global industry is foregone. Let me explain.

Currently, overseas investors in Australian hedge funds (and investments generally) are subject to withholding tax. While withholding tax is also applied in many countries that might compete with Australia for investors, there are other well-established jurisdictions that do not impose withholding tax and are thus in an advantaged position to offer hedge fund products.

Thus, to meet overseas demand for Australian hedge funds, Australian managers generally develop and offer hedge fund products by way of an offshore-based fund company registered in such jurisdictions as the Cayman Islands. Generally, investment management is conducted by an Australian investment manager team either directly or by way of an advisory agreement with the fund company, although in some cases fund managers are incentivised to set up their entire businesses overseas. In any case, the related services of custody, prime broking, administration, legal, accounting and audit are generally delivered by overseas-appointed providers.

For offshore structured Australian hedge funds, the Australian government does participate in the taxation revenue associated with a fund's earnings remitted to Australian participants. However, there is a substantial leakage of revenue from the absence of withholding tax (because the funds are not located in Australia) and both individual and corporate taxation proceeds from Australian service providers that are NOT being used by the overseas fund company. The Australian government will earn withholding tax on those investors who do choose to invest in Australian products despite the disadvantages of doing so. Withholding tax thus has the unintended impact of shackling jobs growth and lowering potential taxation revenue.

To be a centre for hedge funds, Australia needs to attract all the ancillary hedge fund service providers and to provide an environment that would encourage both Australian and overseas fund managers to set up in Australia rather the current situation of encouraging Australian fund managers to set up overseas. Hedge fund managers are not constrained to investing in domestic assets and so the domicile of a hedge fund business will be driven by factors such as tax, people and regulator.

The BOLD decision would thus be to remove withholding tax on all non-resident financial asset investments in Australia based on the expectation that the withholding tax forgone will be more than outweighed by higher corporate and individual taxation associated with increased exports of financial services and greater jobs growth and of course the collection cost of the withholding tax. Modelling this analysis would be a very worthy exercise.

The application of withholding tax is particularly inappropriate in the case of funds offered to overseas investors that invest primarily in overseas assets in what the authorities term "non-Australian things".

Thus, a SECOND BEST solution is to acknowledge that the current policy to tax Australian-sourced income regardless of residence of the investor will not change. In this event, we should accept that Australia will NEVER be a regional funds management centre and instead look to particular areas where Australia can grow the hedge fund industry on the margin to the mutual benefit of government and industry.

Australian fund managers investing in “Australian things” will continue to require an offshore structured fund company for overseas investors, and if warranted by demand from Australian investors a second fund with Australian service providers as Australian investors are limited by FIF in their investments in offshore fund companies. While this twin structure is costly and inefficient, it is the only practical way to proceed in these circumstances.

However, where a fund’s investors are exclusively non-resident and activities are principally related to “non-Australian things” these non-residents investors should be exempt from a withholding tax to allow Australian fund managers to compete globally.

For clarity, the fund should not be denominated in Australian dollars, Australian FIF rules should not apply, foreign exchange contracts would be permissible provided they were in respect of overseas assets and management fees would be taxable at the company tax rate.

To tackle the additional risk of avoidance by residents, the exemption could be set to only apply to those non-residents of tax treaty countries including on a “look through” to the ultimate holder of a trust.

Australian non-resident withholding tax is a material impediment to potential growth of the hedge fund (and financial services) industry in Australia. In view of the other advantages Australia carries in financial services, exempting non-residents from withholding tax (with some reasonable caveats) would take Australia to a position of regional leadership in hedge funds.

Participants in the Australian Hedge Fund Industry

2006-08-18T09:37:00.000+10:00

The Australian hedge fund industry is young, but growing quickly. There are a number of hedge fund managers delivering single and multi-strategy products as well as aggregators offering fund of fund products. However, the available information on the make-up of the participants is sketchy.

The attached table examines the membership of the Australian Chapter of AIMA and dissects members according to some key criteria.

There are in excess of 1,000 members of AIMA globally and 61 (6%) members in the Australian Chapter. This is higher than Australia's weight in global sharemarkets for example. While there will be hedge fund managers who are not members of
AIMA, using this membership as a proxy for the industry as a whole in Australia shows some interesting results.

The first split shown is between fund managers (74%) and service providers (26%) such as lawyers, custodians, brokers and exchanges. Of the fund managers, 78% had their primary domicile in Australia and the balance overseas. Among the Australian domiciled managers, 83% were special purpose hedge fund managers and the others part of a diversified financial services business. Finally, 80% of hedge fund managers manufactured funds while the balance aggregated fund of funds.

In summary, of the 61 members of the AIMA's Australian Chapter, 23 (38%) are hedge fund manufacturers. These managers provide product for Australian retail and institutional investors, and in some cases overseas investors by way of special purpose vehicles or mandates.

Australian Superannuation Funds Use of Hedge Funds

2006-08-17T14:00:00.000+10:00

The assets of Australian Super funds total around $1 trillion and, despite the value of hedge funds in portfolio construction, have less than 3% invested in this asset class.

The University of NSW and the Australian chapter of AIMA conducted a survey in Jan 2006 aimed at examining the attitude of Super funds to hedge fund investing. The respondents to the survey carried funds under management of more than A$145 billion.

The key findings of the study were:

current allocation of under 3% is expected to rise to over 4% over the next 2-5 years
the current focus on global strategies is expected to remain - surprisingly only 14% were Australian-based strategies
funds of funds represented 49% of investments, although this is expected to decline in favour of individual funds and multi strategy funds in future
the most popular strategy is long/short equity
operational and governance issues were most important to those considering investment

Australia's ASIC Studies Hedge Funds

2006-08-15T09:14:00.000+10:00

Australia's financial services regulator, ASIC, is researching hedge funds in Australia to better understand the potential risks to investors. The study, based on publically available information, will not be published and will be used for internal purposes only.

In Australia, hedge funds may be offered to retail investors under a registered Product Disclosure Statement. Around half the A$20 billion Australian hedge fund industry is made up of registered funds.

A key observation of the study is that the funds offered are more benign then ASIC had expected in a number of respects; gearing, fees and profitability.

Also, there does not appear to be any disruptive influence by foreign-operated hedge funds on the efficient and proper functionaing of Australian markets.

As with all funds offered to Australian investors, ASIC is concerned that product documentation needs to be "clear, concise and effective". Hedge funds are not likely to be singled out in particular compared with other retail/mutual funds.

What is a hedge fund?

2006-08-14T16:15:00.000+10:00

The two defining features of a hedge fund are leverage and short selling. While traditional funds managers may also leverage and short sell they are generally conducted more extensively by hedge funds. There are other differences like fees, transparency of process and regulation which I will address in later posts.