The participants in the discussion were HFA Asset Management joint managing director Oscar Martinis, Select Asset Management head of portfolio management Robert Graham-Smith, Mercer Investment Consulting principal Harry Liem, Ashton Advisors executive director Nick Raphaely and Alternative Investment Management Association Australia chairman Kim Ivey. They spoke to InvestorDaily about how investors blamed hedge funds for causing the financial crisis, the effects of the short-selling ban and the future of the sector.
ID: What are your thoughts on investors' perception that hedge funds caused the global financial crisis (GFC)?
MARTINIS: We also shot JFK, caused global warming and did all those other nasty things. Clearly hedge funds had a part in it, in part of the deleveraging. But I think what a lot of people forget is we had the prop desks, all the major global investment banks and the global managed fund industry itself deleveraging. I mean in the September quarter of 2008 we saw $31 billion worth of redemptions come out of hedge funds. We saw $12 billion coming out of US-owned managed funds. So if you look at that sort of weight of money that was moving the markets around, yes we were part of it. But we were not the cause of it in the first instance. Clearly that was an issue for the banks, regulators, a whole host of people, but in terms of continuing to push markets further down, I think a lot of people blame the hedge funds and the whole short-selling concept where in reality I don't think there was a case.
GRAHAM-SMITH: I generally concur with that. I think part of it is related to perception. If you look at an average hedge fund manager, they might have some leverage, say, two to four times higher in some cases and some specific strategies, but when you compare that to the leverage that has been carried in some of the investment banks globally, 25 to 50 times in comparison to those in the hedge fund industry globally. I just don't think it's possible that hedge funds could be the cause of what we've seen. And I think to a larger extent they were participants in it and in some cases unwilling as banks withdrew leverage and borrowing from them and they were forced to sell into the falling market. So I think like everyone the hedge fund industry suffered from that deleveraging and the end of the credit cycle that we've seen built up over the last few years.
LIEM: I would probably say that hedge funds are as much victims as perpetrators. It is true that they probably magnified the financial crisis. I remember a discussion in 1999 during the tech bubble ... where there was evidence that showed hedge funds leveraged trends up and trends down.
RAPHAELY: The credit crisis as people like to call it was really caused by very loose lending practices and the proliferation of credit at the housing level and the corporate level over a long period of time. So it was that combined with relatively low and lax levels of regulation which really led to reckless lending and the thing sort of fed on itself you know, like lending, not lending, people borrowing more to keep up with competitors. Before you knew it, it was really on a spiral which was just getting out of control. Now if you look at where hedge funds fit in the picture ... they are much more the victims than perpetrators and certainly if you look at the impact that the blood, if you like, that certain hedge funds have had more broadly, you'd have to say it's relatively self-contained and that the primary victims have been ultimately both the managers of the hedge funds and investors.
Were there material spill-on effects to major banks around the world and to corporates? No. Investors got their money. And I think lessons were learnt, probably valuable lessons with relatively little pain. So I think to summarise, it's really highly inappropriate to lay blame on hedge funds.
IVEY: If you look at history, hedge funds did not go to the government for any bailout money. It didn't require citizens providing tax money to help them and didn't [need] government guarantees. The one point I'd like to emphasise is that hedge funds in many cases were the early warning mechanism. I think they were saying things early on in the piece before the crisis but no-one would listen to them. And yes there were managers that made money for their investors out of this and sometimes it's a buyer's reward, but you don't really want to see . schadenfreude; that you're making money from other people's demise. But at the same time we don't want to be duplicitous because investors give money to hedge fund managers with an express mandate to provide positive returns exactly in times like this. So I think hedge fund managers have probably learnt a lesson out of this, but we were no way the cause of the GFC.
ID: What are your views on global regulators' measures to curb short-selling of financial securities and ASIC's earlier move to temporarily ban short-selling of all stocks?
IVEY: They banned financial short-selling in the UK, they banned [short-selling] financials in the US, but ASIC decided to ban everything and I think that was one of the greatest steps backwards for the industry in having that unilateral decision being made.
We immediately started talking with ASIC, with APRA [Australian Prudential Regulation Authority], with the RBA [Reserve Bank of Australia] about the unintended consequences of this and certainly price discovery, liquidity, volatility, we came out and told them that all those things were going to get worse. They were not going to get any better. And unfortunately they did get worse. Markets kept on falling and we wanted them to reinstate the ability for more participants to come into the market as soon as possible. But there were other things that needed to be done first.
The short-selling bill had to be passed so that we could rule out naked short-selling completely and that was a big step forward. But until that time the ban remained and I think Australia was penalised in the eyes of investors and also the other regulators in looking at Australia as a sophisticated market. It was not a sophisticated decision.
MARTINIS: Absolutely [agree]. There were unintended consequences. Did it impact us at HFA specifically? No, not really, because we do the bulk of our investing offshore via Lighthouse Partners, so they run multi-strategy portfolios and there was only a small portion of our portfolio impacted clearly by US financials. But you know, the unintended consequences were there, the banks struggled to raise capital because a lot of places where they go to raise capital is the prop desks, is the hedge funds. They'd put out coverts, prefs or even common stock and the hedge fund would short the stock on the other end to try and mitigate risk and they weren't able to do that. So it created all sorts of problems for the whole world.
GRAHAM-SMITH: Most of the managers that we have money with in this space handled this situation very well. It wasn't the case of them haemorrhaging money, but for a while it was like they were fighting with one arm tied behind their back. So obviously that's difficult. I think anecdotally, you know, from various discussions we've had since then it looks like capital flogging from offshore has stopped in a number of circumstances because offshore fund of funds perceive it to be a risk in the future for the Australian market. So it's a potential impediment for local hedge funds to raise money essentially because of this perception of what happened.
ID: How have financial advisers and clients reacted to explanations about why fund of hedge funds have frozen redemptions?
MARTINIS: We've had tremendous support from financial advisers post-freeze. I think they recognised the logic behind why the funds have frozen and in a lot of cases, and ours in particular, it was a consequence of the Corporations Act.
We've just run through a unit-holder meeting. We had 99.64 per cent of investors vote in favour of continuing the fund with liquidity windows and 99.16 per cent vote against the wind up. So clearly the support in funds remains. We obviously had a lot of discussions with financial advisers leading up to the unit-holder meeting and they overwhelmingly continue to support the fund. They clearly understand that the model still works. The model had a tough period. Lighthouse has been doing this for almost 15 years and we've had three months where the model hasn't worked. And that was the last three months of 2008. And since then, with liquidity returning to the market and some sense of normality coming back in the model, the funds are performing in line with expectations. So we continue to have support of the financial adviser community.
GRAHAM-SMITH: I think reaction has generally been mixed. Obviously to a degree some advisers are disappointed by that sort of mixed expectation of absolute returns last year, which in general wasn't led particularly by fund of hedge funds. Given the context, the performance versus a lot of other traditional asset classes, particularly equity markets, wasn't actually that bad. But obviously on top of that there were the liquidity issues that went along with that. So I think some people have been disappointed and pretty annoyed, but, as Oscar indicated, this year we've seen a good bounce in performance in this space. The industry has had a flying start to 2009 and recovered some of those losses. But going forward clearly there is a push for better transparency and liquidity is probably the key as well.
MARTINIS: We've spent a lot of time discussing with advisers the difference between when markets fall and when markets failed. And clearly when markets fail there's nowhere to hide. And even in the hedge fund strategies there was nowhere to hide through that period. So we were carted away with the rest of the market. But if you look at the fund of hedge funds and most hedge funds leading up to say even August of last year when the market was falling, they were doing very well in preserving capital and it really was just that last quarter of 2008 which caused everybody in the world headaches which we couldn't avoid.
GRAHAM-SMITH: I think it's also important to differentiate between different types of hedge funds as well. I think that if you look at the equity space, a lot of long/short equity managers, some of the local managers did exceptionally well and not just on a relative basis but on an absolute basis. Some managers were up last year despite the short-selling ban and despite everything else that went on they had good results. So I think some people are exceptionally happy with that. Obviously there were disappointments, but there are other strategies that did well. Managed futures, managers that were short credit and managers that were long volatility did very well and were some of the best-performing investments last year. So it's important to segregate between the different underlying strategies and how they did as well and not just lump everyone in one basket.
MARTINIS: That's a really important point because too many people just think a hedge fund is a hedge fund is a hedge fund, whereas clearly they're not. It's just like a managed fund is not a managed fund. When you compare a small cap Aussie equity fund to an international fixed interest fund, they're completely different animals. And the same thing with hedge funds.
ID: Do you agree with industry commentators that hedge funds must boost transparency and charge fewer fees to survive in the future?
LIEM: It all depends on how big you are and of course how well you can negotiate. But definitely there's a trend. Now I see many, many good managers that have come now and they obviously said 'look, we're actually open again for business after so many years'.
GRAHAM-SMITH: One of the trends I've noticed in this industry is the whole notion of clawback performance fees. The whole notion of performance fees that managers' interests are aligned with investors is great while everyone is making money, but the problem is if they make 20 per cent per annum and then lose 40 per cent of your money, they don't have to give back the performance fees that they've earned in previous years. And I think that's becoming a little bit more prominent feature of the industry now where investors are demanding that if there is a drawdown, performance fees that are earned by the manager are kept as escrow for a couple of years and there is a drawdown for that to give some of that back to investors. And personally I think that's fair and a positive thing for investors.
MARTINIS: We've clearly come across good fee discounts at the underlying manager level where we go in there and negotiate fees at the underlying manager level. We're getting a lot more transparency these days. We've migrated one of our open-ended funds 100 per cent to managed accounts, which gives a completely look-through security level for us and we can provide that to investors if they so desire.
Our multi-manager, multi-strategy fund is a lot more difficult to migrate to managed accounts. We're probably 40 per cent along the way there. Will it ever get to 100 per cent managed accounts? Probably not. But we are working on a substitute diversified-type multi-manager, multi-strategy fund that will be one 100 per cent managed accounts.
And I think that's a big way that the whole hedge fund world is going. So whereas 12 or 18 months ago managers would say, 'no way, not the way you manage an account, you have to invest in our pools', today a lot more managers would say, 'absolutely we'll provide you with a managed account'. And that's terrific because you don't have that situation where you're invested in a pool. A manager has 50 other co-investors and, you know, some of them have to redeem for whatever reasons, the manager has to throw up their gates and then you're stuck there. Whereas you run a managed account, we as a fund of fund will own the assets so you get rid of that whole layer of risk.
ID: Should fund of hedge funds only be made up of liquid strategies, including global macro and long/short?
MARTINIS: No, not at all. If you're running a multi-manager, multi-strategy diversified-type fund you should have exposure across all the strategies. What perhaps needs to be communicated better to the underlying investors or advisers is an understanding of the liquidity limitations of those funds. I mean, it has been a liquidity mismatch leading up to this point of time and I think that needs to be better managed.
LIEM: I think it's a bit like a cake, so macro is [like] strawberry and if you can just taste the strawberry it's nice for a while, but you need more flavour.
RAPHAELY: I think Rob made a good point about different strategies being more popular at different points of the cycle and CTA [commodity trading advisers] ... has done particularly well last year. And I think the challenge for multi-managers and fund-of-fund managers is to be able to identify those cycles and add capital across strategies consistent with where those opportunities are. Because that's what investors are paying you for, aren't they? They expect you to have some sort of reading of what the macro environment is and what strategies do well at different times.
GRAHAM-SMITH: I think that the whole notion of permanent capital that people have had in terms of listed vehicles has proved a fallacy because in a number of cases investors have become impatient, aggressive and activist. Managers have come in and changed the status quo. And I think that sort of complacency that the capital is there forever and can't disappear is incorrect and in a number of cases has been proved that way too. I think there are swings and roundabouts and obviously if you're doing a good job of managing a fund, particularly the listed funds I'm talking about, and the discount to which the asset backing that fund is trading, your investors should be pretty happy. But obviously if you don't care about that sort of thing, then they have every right to get upset about things.
ID: Where do you see the Australian hedge fund industry in the next five to 10 years?
MARTINIS: I think there's a lot more opportunity set in the hedge fund universe now than there has been in the last four or five years. Clearly, a lot of managers have left the industry. The prop desks have reduced their trading capital by anywhere between 70-80 per cent. So there is a lot less money in chasing the same opportunities. And in a lot of cases because of the dislocation in the market that opportunity set is actually much greater than it once was. So I actually see the next three to five years being a bit of a boom time for the hedge fund industry. I think managers will be able to make money with a lot less volatility, lot less risk on the table, lot less leverage definitely on the table, than they once used to have to deploy in order to achieve the same results. So I think the next three to five years will be pretty strong.
GRAHAM-SMITH: Globally I think the sort of washout that we've seen in the industry generally is a good thing. I agree with Oscar's comments on liquidity and less competition for trades and arbitrage opportunities that haven't been there for a few years will probably come back. I think the industry is likely to see some consolidation. Some of the larger players are likely to get bigger and acquire some really good talent that's on the street now. I think over time you'll see smaller players come back. The industry is all about the innovation and talent and you know that will happen. I think in Australia probably one thing that we do suffer from is geographic distance. I think partly that might be solved by superannuation funds doing more work themselves and investing locally in managers. But I think it's always a challenge. It's a bridge too far in many cases for international investors to get on a plane from Hong Kong, Singapore, Tokyo to come down to Sydney or Melbourne. That's a challenge. Maybe local managers have to do more travel themselves. I don't know what the answer is.
RAPHAELY: I think that the washout we've had last year will probably be good for the industry longer term. I think the survivors will benefit from it. And as for the whole concept of mystique around hedge funds, I think there will always be a handful of people in the world that can generate excess returns and there will be people who want to invest with those people. So if you strip everything else away, are there investors who want absolute returns? They will be there. And the hedge fund industry is made up of the marriage of those two.
MARTINIS: I think if you ask the average mum and dad investor are they seeking relative returns or are they seeking absolute returns - well, you can ask everyone around this table - everyone seeks absolute returns. And there's a fundamental mismatch between how traditional money managers manage money and how the ultimate investor wants their money to be managed. And while that mismatch exists there'll always be a place for hedge funds or absolute return funds. Whilst they may not get it right every single time their objective is to make positive returns through all market conditions. So I think they will always have a place, absolutely.
IVEY: I think if we look at the next 12 months we are going to have more of an alignment in terms of liquidity risk. I think managers have their lesson about this complacency in offering liquidity in terms that are completely different in the underlying liquidity in strategies.
And I also think investors will learn that illiquidity of itself is not a bad thing for the appropriate strategy. Demanding daily or weekly liquidity is actually behind the eight ball in some respects because that is not going to be able to be met.
I think regulation over the next 12 months will actually start to come off. In terms of new regulations or new developments, I think the regulators are now at a stage where they want to solidify their sort of supervision. We don't need any more regulation here in Australia. There may be some new regulation in the US, new ones in Europe.
