Hedge Funds - Shooting the Messenger

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?

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

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

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?

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

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

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

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?

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

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

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

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?

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

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

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

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

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

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

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

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

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

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

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.