There is no doubting the fact Australian investors have discovered hedge funds. According to research house Rainmaker Information, the amount invested by Australians in hedge funds grew by 39 per cent in 2006, to reach $22.74 billion, surging at a rate of growth more than twice that of the Australian investment management market. In 2003, Australians had just $3.78 billion invested in hedge funds.
As was the case with the growth of hedge funds in the United States, this wave of investment has been led by high net worth and retail investor money. According to hedge fund research house LCA Group, 65 per cent of the assets of the Australian hedge fund industry at June 30, 2006, were invested by high net worth and retail investor money, with pension fund money accounting for 20 per cent and 15 per cent from offshore institutional investors.
But Australian institutional investors are making up for lost time. Figures from Russell Investment Group show the proportion of Australian institutional investors allocating money to hedge funds swelled from 3 per cent in 2001 to 32 per cent in 2005.
The preferred institutional vehicle has been diversified funds of hedge funds. According to Axiss Australia, at June 30, 2006, the 10 largest superannuation fund allocations to hedge funds and funds of hedge funds accounted for almost $7 billion, led by (in order) ARIA, REST, UniSuper, AustralianSuper, Health Super, Telstra Super Scheme, QLGSS, Qantas Super Plan, HESTA and Hostplus.
"It stands to reason that institutions dip their toe into this investment class by using a diversified portfolio and, as they become more confident, they then decide what individual strategies they like," Watson Wyatt Australia head of investment consulting Graeme Miller says.
"There's also an element that, as the fund-of-funds space has become more crowded, many of the advantages of using the fund-of-funds approach have been diluted. One of the advantages was that you could get access to a large number of high-quality managers in a very cost-effective way, but that's becoming more difficult given the large number of fund of funds at the moment. The fact is that the better managers close their funds."
Miller expects to see a trend away from mainstream fund of funds towards more specialised, more sophisticated hedge funds. "I think that the evolution of the investment class will move from the funds of funds towards specialised fund of funds and multi-strategy single-manager funds, which are fishing in several different ponds to generate alpha.
Only once super funds have been through that particular evolution will they move progressively into sector-specialist hedge funds, and indeed, single direct funds," he says.
"Typically the multi-strategy single-manager funds are more concentrated than the traditional fund of funds, so you'll typically have fewer internal strategies than you would have external funds in a fund-of-funds approach." Multi-strategy hedge fund managers differ from fund of funds in that, using only their internal capability, they might have anywhere between four to eight teams that run internal hedge fund investment processes and aggregate all of those approaches into a multi-strategy.
Another variation on the multi-strategy approach is where a single manager employs different styles to try to add value. For example, such a manager could run event arbitrage, a long-short fund and another equity-type strategy, and combine those into the one product. In some cases, managers combine equity and debt strategies within the same organisation. But it is commonly accepted investors do not get the same degree of diversification following these approaches that they do in a fund of hedge fund.
Miller says it still suits smaller super funds to use fund of funds to gain access to this investment class. "It's a function more of the governance of the fund more than the assets that it has, but having said that, any fund with less than $2 billion of assets would find it very challenging to invest in hedge funds in any way other than fund of funds," he says.
Ray King, managing director of specialist alternative investments consultant Sovereign Investment Research, says there are three common misconceptions about hedge funds, even among institutional investors.
"The first is that they are all ultra-aggressive investors. They vary a lot, the strategies, the degrees of leverage are very different. It's such a heterogenous group of funds; it's dangerous to generalise when you talk about hedge funds," King says.
"The second is that they're a source of higher returns. We see them much more as a portfolio diversifier, suiting investors that want to diversify risk or add a little bit of return. The most common category of hedge fund is the broadly-diversified fund of funds, which might have somewhere between 40 to 80 managers spread across a number of styles, typically having a relatively low to moderate risk by being widely diversified and having strong risk management, and with a target return of high single digits to low double digits.
"If we do have a client that wants to use hedge funds to get very significant improvements in returns, we point them to a much more concentrated fund of funds, something that might have somewhere between five to 15 funds. That's really a best-of-breed approach, where people are going for managers likely to deliver higher returns. That arcs up the risk, but you get a better information ratio for your dollar." The third misconception is that hedge funds deliver pure alpha. "This is a very common mistake that investors make, but in fact, it is very rare to find a hedge fund that doesn't have a beta component," King says.
"Saying that you're 'absolute return' implies that you're all alpha. In fact, they're a combination of beta and alpha. Some funds present themselves as absolute return but they shouldn't. An equity long-short fund will tend to have a beta of about 0.5 to equity markets.
"People have to understand that what they're paying for is to get above-benchmark returns - they're not paying to get the benchmark. In a lot of cases they pay significant dollars to get the benchmark."
Investors simply have to understand this beta component, he says. "You don't need a zero correlation between a hedge fund and equities or debt to get a signal that you should have an allocation to hedge funds. It gets back to understanding that their role in the portfolio is a mix of return enhancement and diversification," he says.
"It's not a necessary pre-condition that they have a relatively low beta - the major concern that we have is that you don't pay too much for the beta, and not be getting genuine alpha. Our research finds a role for hedge funds even though they can have betas of anywhere up to 0.6."
Miller agrees. "Super funds are waking up to the fact that when they go into hedge funds, there can be an awful lot of beta in what they're getting. This ties in to the fee debate: fees are very high in the hedge fund sector, we think they're too high, and going forward, investors will need to think very carefully about the way in which they go into hedge funds, because a large part of the value that funds are potentially able to generate will be eaten away by fees," he says.
"That's true in both the fund-of-funds space and in direct funds. It really underscores the need to choose quality managers, because chasing alpha is a zero-sum game before fees, and when you take fees into account it becomes a negative-sum game. A hedge fund is supposed to be relying on skill, and in theory does not have a market beta to fall back on. In practice, many observers have seen that fund of funds in particular often have a fairly material beta exposure that investors are not always aware of." Mercer head of alternative research Dragana Timotijevic says the major problem for investors going in through fund of funds is the extra layer of fees - particularly given that returns have not really been satisfactory.
"In the fund-of-funds structure you have that double layer of fees: you're paying 2 per cent to the manager, plus 20 per cent performance fee, and the fund-of-fund fee of 1 per cent, and another performance fee that can kick in at zero. Some of the funds are pushing 4 per cent in fees - which is a very high fee to pay when you are getting a mixed bag of alpha and beta, instead of pure alpha, which is what some investors might think they're getting," Timotijevic says.
While equity markets have been giving investors double-digit returns, she says funds of hedge funds have been more in the high-single-digit or low double-digit return range. "The hedge funds that are more in the pure alpha space have been doing 8-9 per cent, because cash rates have gone up. The issue is that there's so much beta around, it's hard to identify the alpha," she says.
"The funds of hedge funds have a lot of beta in them, and investors now know that there is beta in there. Quite simply, they want more for what they are paying."
Timotijevic says more sophisticated super funds will look at more sophisticated strategies. "Super funds are extending their strategies into long-short funds, especially those that are going 130:30, where they short 30 per cent and to fund that they increase exposure on the long side. The market exposure remains 100 per cent, the beta remains one, so they're fully exposed to the market, but they have a higher gross exposure and if the manager is good, they can benefit from the value-add on the short side or the reduced volatility," she says.
"Or they might look at equitised long-short strategies, which is essentially using a market-neutral strategy: managers like BGO or GMO go 100 per cent long and 100 per cent short, so the market exposure is almost zero. Usually the benchmark for those funds is cash-plus, but instead of that cash, they invest the cash in the futures index, so they're getting the underlying equity market plus the alpha from both long and short. This is equitised long-short, because you take the cash that is sitting and earning interest and you invest it in the market futures, and you have a full exposure to the market."
Large funds are looking to do this because of risk budgeting, she says. "They want to know what their beta is, or at least the range that it will be in. In a big fund of funds they will have a lot of equity managers, and they won't actually be able to control their beta. They want definition of exposure," she says. What is a hedge fund?
The first thing to understand about hedge funds is there is no formal definition that makes an investment vehicle a hedge fund.
A hedge fund is an investment vehicle pursuing absolute returns - positive returns irrespective of the return of the benchmark index for a particular asset class. Hedge funds use a wide variety of non-traditional investment styles to deliver a risk/return outcome different to that of the traditional asset classes of cash, stocks, bonds and property.
While all hedge funds are absolute return funds, not all absolute return funds are hedge funds. What characterises all of the strategies undertaken by hedge funds is they are trying to capture that elusive commodity known as alpha: defined by State Street as the value added by the skill of the manager, over and above the beta, the passive return earned by the benchmark index for that asset class.
There are at least 14 distinct hedge fund strategies, but the basic strategies include:
. Long/short: going long in undervalued securities and short in overvalued securities, particularly shares.
. Global macro/tactical asset allocation (TAA): researching and identifying economic trends or anomalies evolving across the world, and exploiting them by investing in different stocks, fixed-interest securities and currencies, often with leverage, using derivatives. Global macro/TAA funds have the broadest mandate of any of the major hedge fund strategies.
. Event-driven: taking advantage of market reactions (specifically, overreactions) to specific situations, for example takeovers, debt defaults, credit downgrades (even natural disasters).
. Arbitrage, buying and selling on different markets. For example, BHP shares are listed in Australia, London and New York, in three different currencies: some hedge funds will arbitrage between the three looking for minute mis-pricing to buy one and sell the other to make a profit. A variation of this strategy is convertible arbitrage: where a company has multiple classes of shares (for example, preference shares), some of which may be trading at different prices mathematically to where they should be based on conversion terms.
. The fund-of-funds approach combines these strategies: a single fund invests in multiple hedge fund managers, diversified across strategies, asset classes and geographic regions, with the fund manager managing the managers - choosing the managers and sacking them if performance slips.
