While Australian superannuation funds and institutional investors have discovered hedge funds, their participation is not to the extent of most of their developed market peers.
But the current market downturn may change that behaviour, because the juicy returns they had become used to from the traditional asset classes have disappeared for the moment.
"The industry super funds were early adopters of hedge funds, but for most other dealer groups and institutions, they didn't have the imperative in 2003-2007 to look fully into alternative assets, because traditional ones were motoring along so well," Lonsec head of investment consulting Amanda Gillespie says.
"When you've got investors and advisers looking at the phenomenal returns we've seen in traditional markets - up until the last 12 months - it's been a really hard sell to talk them into making really big allocations to alternatives in that environment. But I think that more of them are ready to look at alternative investment categories now."
Boutique hedge fund research and advisory firm Hatfield Liptak partner Daniel Liptak says that in 2000, the local hedge fund industry was $2 billion in size.
"At the end of 2005, that had grown to about $45 billion; two years later, that was about $87.5 billion. We project that Australian investments in hedge funds will grow to $225 billion-$250 billion, on a very conservative growth path, by 2015."
Liptak says the Australian investment into hedge funds has followed a very different growth pattern than that seen in Europe and the United States.
"Back in 2000, the industry was $2 billion in size, with most of that having come from high net worth and retail investors," he says.
"Then some of the industry superannuation funds started coming in, which really was the first institutional money to come into the sector."
According to Axiss Australia, the 10 largest superannuation fund allocations to hedge funds and funds of hedge funds are (in order) ARIA, REST, UniSuper, AustralianSuper, Health Super, Telstra Super Scheme, QLGSS, Qantas Super Plan, HESTA and Hostplus.
The fact industry funds are more likely to invest in alternative assets, such as hedge and absolute return funds, private equity and infrastructure - which tend not to be highly correlated to the traditional asset classes of shares, bonds and property - is a large contributor to the performance gap they enjoy over retail funds, which is usually considered to be in the order of 2 per cent a year.
Of course, having lower fees also helps.
Institutional interest picked up in 2005, Liptak says.
"That was when we saw things move really quickly on the institutional front, but it was still coming off a low base. Of the $45 billion at the end of 2007, 65 per cent of that was still retail money - of which more than half of that was in long-short equity - and the balance was split between offshore investors and domestic institutions, half and half," he says.
"At the end of 2007, 35 per cent of that $87.5 billion has come from domestic institutions."
He says most institutional investors in hedge funds have used funds of hedge funds to gain familiarity with the investment class in a diversified portfolio. This is a more risk-averse way to enter the hedge fund market, because the investor gains the benefit of a broad range of managers and strategies, while using a manager to monitor the underlying managers and manage the underlying single-manager risk associated with the portfolio, he says.
"The growth in the last couple of years has been from the institutions, mostly allocating to fund of funds, although that rate has slowed down somewhat," he says.
"We've seen a lot of them getting comfortable in this way using hedge funds, and they've subsequently chosen a particular manager or strategy."
Vertex Capital Management managing director and chairman of the Alternative Investment Managers Association of Australia (AIMA) Kim Ivey says the $1.2 trillion superannuation industry is fertile ground for the hedge fund industry.
"Our latest survey of super funds, which we did in April 2008 with the University of New South Wales, showed that 70 per cent of the very large funds, those with assets of more than $100 billion, had existing investments in hedge funds," Ivey says.
"Allocations were on average 2.5 per cent, ranging from zero to more than 5 per cent. The major investment structure used was funds of funds, and we don't expect that to change. The average allocation is expected to rise only marginally over the next few years."
He says the problem is the sustained run of traditional asset classes at above-average returns in recent years. "Growth in hedge fund investments has been quite static, because hedge fund performances haven't been doing 20 per cent," he says.
"The super funds are still putting money into hedge funds, but they're not putting it in at the same rate that their equities or property portfolios were growing up until the end of last year. But as the traditional asset classes weaken in performance, we're starting to see more interest from super funds that have never made an investment into hedge funds now saying that they're ready to make that investment."
Mercer Investment Consulting principal Harry Liem says the bear market in stocks is a good opportunity for hedge fund to show their worth. "In bull markets, people always say, 'hedge funds don't make as much money as stocks'," Liem says.
"That's usually true, but when markets go down, they say 'how come hedge funds aren't earning as much as cash rates?' The fact is that when traditional asset classes go down, hedge funds offer some protection.
"On a year-to-date basis, a lot of the hedge fund strategies may have lost some money, but over longer time periods it's been proven that they have low correlations, which is their major attraction in institutional portfolios."
He says institutional investors have come to understand that hedge funds will not deliver them pure alpha. "In the past some people might have assumed that hedge funds hedge, but they don't," he says.
"There is a lot of beta in hedge funds, and if markets go down, hedge funds go down. But I think the institutions buying into them understand that in most cases, they're buying some beta."
He points out that the main hedge fund index, the Credit Suisse Tremont Hedge Fund Index, gained about 4.9 per cent in US dollar terms over the year to May.
"It's still positive, even though the S&P500 was down 7 per cent and the S&P/ASX 200 was down 10.4 per cent," he says.
"Most people investing in hedge funds are Australian dollar hedged, so that is probably going to come out to 5-6 per cent gain."
But Australian institutional investors have also come to understand that it is very far from being a homogenous asset class, he says.
"There are a lot of different hedge fund strategies, and some of them make money, some of them don't," he says.
"In general, we've found that in terms of market declines, the only ones that have made money are the dedicated shorts - short equities or short credit or managed futures/commodity trading advisers (CTA)."
As volatility expands, CTAs make money, and rising volatility is usually the case in bear markets.
Over the year to May, managed futures/CTAs are up 11.4 per cent - they are picking up on that volatility.
Some of the global macro funds are up 17.8 per cent: they are picking up on directional moves in commodities and making full use of the fact they can go short on stock markets. But in strategies such as fixed interest arbitrage and distressed debt, the managers are doing it tough.
"By the same token, you can't compare fund-of-fund data with single-index data, because there are different constraints that apply to managers," Liem says.
"They are apples and pears. There are different beta exposures - you're paying for very different stuff."
Gillespie says understanding the varied nature of hedge funds is critical to deciding on the allocation to them. She says Lonsec splits alternative investments into two buckets - conservative and aggressive alternatives.
"Our house view is that a 10 per cent allocation to alternatives is appropriate," she says.
"But we recognise that some of our dealer group subscribers are not comfortable with the concept of alternatives and don't want to use them. For those that do, we have a conservative bucket, allocated to diversified fund of hedge funds, or typically those kinds of hedge funds that are targeting bond-like volatility. We see that as sitting appropriately in the conservative part of an investor's portfolio.
"In the aggressive alternatives bucket we would see single-strategy hedge funds, such as global macro, and managed futures/CTAs. Because it's not a homogenous asset class, you've got to be careful that you're not lumping everything together. A lot of investors think from their reputation that hedge funds are all aggressive. The high-profile aggressive ones get the attention, which encourages that perception, but certainly there are quite a lot of products that we consider to be far more conservative in nature, like some of the fund of funds."
Liptak says most of the domestic institutions that have invested in hedge funds have allocated the money to an alternatives bucket, where they might have placed between 5-10 per cent, typically through fund of hedge funds.
"That's been the case over the last couple of years, but I think we're seeing a change, where they're starting to allocate large amounts to long-short equity - but they're putting that into their traditional equity buckets, whether international or Australian," he says.
"That's great, because it means they're making more room for alternatives, by taking some of that allocation and putting it in the equity bucket. They still have their 5-10 per cent allocation to alternatives, which would be going to fund of hedge funds and private equity, but they are increasing their allocations by virtue of the fact that they are using long-short equity.
"They're doing this because one, they're looking to increase performance, and hedge funds can do that; two, they're looking for diversification benefits and hedge funds do that; also, they're looking to generate alpha over the index. Look at international equities in the 2000s: it's been an absolute failure as far as performance goes. If you're an institution, that's only getting MSCI World Index performance, and it's just not done anything, you've got to look at something else, and they are starting to do just that."
Fund of funds appeal because most asset consultants are not going to review the thousands of hedge funds that are out there in the world, Macquarie Funds Group division director of hedge funds Jonathan Hall says.
"The fund-of-fund managers have already done that job, which is why funds of funds will remain by far the most important institutional conduit into hedge funds," Hall says.
"About 70 per cent of the money that goes into single-strategy hedge around the world comes from funds of hedge funds. If you think about who the clients of those funds of hedge funds are, they're the pension funds and institutions and endowment funds and foundations, and private wealth. All of those segments are simply not well enough resourced to go and pick hedge fund managers."
Liem says fund of hedge funds have been popular because of lower operational risk - and this attraction will increase as the attrition rate in hedge funds increases.
"There are too many people who want to run hedge funds these days, and they can't all do it successfully. The sheer explosion in hedge fund numbers is a big problem for investors, because a lot of them will blow up," he says.
According to the 2008 Hedge Funds report released in July by research house International Financial Services London (IFSL), worldwide hedge fund assets grew by 30 per cent in 2007, to reach US$2.25 trillion at the end of the year.
That represents a rise of more than 200 per cent in the last five years.
IFSL says the total number of hedge funds now tops 11,000, with single-manager funds accounting for about 75 per cent. The rest are funds of hedge funds.
"Investors might not understand that there is always, every year, a high attrition rate among hedge funds - about 20 per cent a year," the report said.
"If long-only managers were going out of business at that rate, institutions would be freaking out. It makes using fund of funds look pretty attractive."
But Watson Wyatt Australia head of investment consulting Graeme Miller says the fund-of-funds space has become more crowded, and many of the advantages of using the fund-of-funds approach have been diluted. Many of the better fund of funds are closed, Miller says.
He says an alternative to fund of funds is multi-strategy single-manager funds, which may have anywhere between four to eight teams running internal hedge-fund investment processes, or funds 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. But he says it still suits smaller super funds - those with less than $2 billion in assets - to use fund of funds to gain access to this investment class.
