Alex writes his perspective from the position of a multi-asset investment firm that has incorporated some hedge funds and other alternative investments into its diversified portfolio construction since inception in 2002.

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There have been attempts over many years to classify alternative investments and hedge funds into defensive and growth categories. Why? Expediency is one reason – the primary purpose was to mirror existing industry terminology used to classify mainstream asset classes like shares and fixed interest.

Additionally some allocators placed hedge fund strategies into specific asset classes based on their return characteristics.  Low risk (or more accurately “standard deviation”) funds were included as “fixed income” and higher standard deviation managers as “equity” irrespective of whether they invested in those asset classes!  This made portfolio construction easier but failed to analyse the true characteristics of these investments – allowing the crazy situation of derivatives funds classified as fixed income.  The problem was that these low or higher standard deviation hedge funds did not exhibit the same characteristics as equity or fixed income in many other ways and they shouldn’t have been sold (or bought) on that basis. It is not unreasonable however, where the advisor is more sophisticated, that long/short equity funds that are exposed to the market can be included in equity allocations as they exhibit the same characteristics based on many measures.

Unsurprisingly confusion remains. Which is why many expert investors and their consultants deal with the categorisation issue through the creation of a separate ‘alternatives’ allocation within a diversified portfolio – mostly made up of hedge funds. The existing asset classes within the portfolio are then proportionately reduced to take into account the inclusion of alternatives.

As discussed in previous articles, accessing alternatives requires specialist expertise. The skills required to realise the full benefits of alternative investments should always include:

• The ability to assess which opportunities are worth exploring further;
• The ability to perform the required due diligence;
• Experience and industry networks;
• The ability to discern which investments are appropriate for clients;
• The ability to access certain structures and offshore domiciled funds.

Alternative investments increase portfolio diversification.  A diversified portfolio which includes assets with different risk and return profiles is difficult to build.  A diversified portfolio helps reduce overall risk without necessarily impacting expected returns. A single manager fund exposes an investor to idiosyncratic risks associated with a single manager, for example key man risk of investing with a ‘name’ portfolio manager.

Alternative investments provide access to specialist investment opportunities.  Some of the best opportunities are normally only available to sophisticated investors including large pension schemes or endowment managers. In turn most of these single managers are only available to wholesale investors.  A diversified portfolio can provide access to these “best of generation” investment managers with high alpha potential.

Using a diversified portfolio materially reduces single manager investment risk. This is essential given the complexities that are involved in understanding and accessing some alternative investments.

Provided an adviser and the client have agreed on the diversification benefits of utilising alternatives, the most important question is sizing; how much should be allocated to alternatives?

Investment views on allocation weightings vary. Typically, a diversified portfolio can hold between 10 per cent and 35 per cent in alternative investments at any one time of which the largest part is likely to be hedge funds.

Hedge Fund Behaviour

Equity Funds

The term “hedge funds” comprises many different types of investment styles.  As hedge funds invest differently (for example some invest in equities others in options) it’s not easy to group their returns as one.   There is significant risk in looking backwards at how alternatives have performed in the past.  Having said that, it is worth noting that during the GFC many hedge funds dropped in value as they were positioned to capture market upside or they were “net long the market”, however prior to the GFC these funds had performed very well.

Many lessons have been learnt from the GFC, in particular improvements in transparency and liquidity – meaning investors can “see through” into certain investments to ensure an understanding of the market risk or “beta” that they are exposed to.  Additionally, the evolution of liquidity means many high quality equity hedge funds can be accessed on a daily basis – particularly those that are regulated in the US or Europe.

As stated above many investors classify long/short equity funds as “equity”, which really means “market risk” or beta.  This allows investors to seek out outperforming funds “alpha” and the pay the premium for this skill.  These are often mult-strategy funds that can invest across the spectrum.

The primary driver of these improvements is founded on allowing investors a clean exit in the event that the underlying investments fail to perform.  For our firm, this means access to these strategies with the additional benefit of low fees.  If equity markets perform poorly and these funds are net long these funds are likely to underperform historic NAV highs – but potentially outperform the index.  In such an instance the enhanced structural aspects mean investors can go to cash quickly.

Market Neutral

Strategies such as market neutral (where the manager is long and short often in equal measures) should also outperform equities. These funds take advantage of small mispricing between similar or related securities and tend to use leverage to exploit small pricing inefficiencies.

Systematic Funds/ CTAs

Other hedge fund strategies such as systematic funds performed well in 2008; during this time our firm had exposure to systematic funds or “CTAs” that performed well.  Many believe these strategies responded well to the volatility in the market.  Evidence this year indicates that CTAs fail to perform in periods where equity markets are range bound and bonds underperform.  Many had not expected that both bonds and equities would underperform at the same time and as such both CTAs and equities tended to underperform.

This adds complexity in considering the role of CTAs in a portfolio with many international investors remaining cautious that CTAs can provide portfolio protection in all circumstances where equity markets are flat or even falling.

Tail Risk Funds

Tail risk is the risk of outsized losses outside of the normal distribution of returns, some funds are structured to take profits from these outsize events (“tail risk funds”).  During the GFC some strategies performed extremely well, for example tail risk funds which profited from volatility in markets.  However, these funds tend to perform relatively poorly in a rising market; one of the tail risk funds held by our firm in 2008 made a triple digit return whilst equity markets collapsed.  Many of these funds are also described as long volatility.  Generally in a falling equities market, long volatility and tail risk strategies perform well.

Diversified Alternatives

As discussed above a diversified portfolio of alternatives reduces reliance on one particular asset class.  It is rare to find an asset that outperforms in any scenario! Some managers can exhibit these characteristics and charge high fees to compensate for this rare skill.  By investing in a diversified portfolio – in theory the fund should perform well versus a cash benchmark (or absolute return investing) – as opposed to benchmarking against the market. The range of hedge fund strategies is balanced with the objective of providing “all-weather” protection for investors.  The allocations can also be rebalanced during the cycle to adjust the allocations to alpha and beta.

There is no guarantee cast iron or otherwise that investments will perform as expected.  We all know that that past performance is not indicative of future returns.  The alternative to looking backwards is looking forwards. Performance based on an expected set of worked events can of course be modelled although this is more of an art than a science as prescience has not been a widely bestowed gift since the days of the Hebrew prophets.

Summary

On the whole alternative investments can bring lower correlation with traditional asset classes. This means that when blended with mainstream investments they can help to smooth out an investor’s portfolio returns over time (particularly taking into account times of market dislocation).

Investing in a single hedge fund requires deep analysis on the investment strategy and how it can perform across a range of market scenarios. Where advisors choose one or two hedge funds there is a risk that those strategies can respond poorly at times when protection is needed. It’s also a big mistake to classify funds as equity or fixed income solely based on their standard deviation as an indicator of risk.  A CTA for example has a considerable departure form traditional asset class thinking and is a million miles from fixed income in many respects.

Many institutional investors deal with this problem by building a diversified portfolio of alternatives assets with a target weighting often in excess of 10 per cent.  They also use specialists to help build the portfolio.

Building a portfolio of alternative investment requires expertise in understanding complex investment strategies and the ability to undertake due diligence including business risk due diligence.

Select Alternatives Portfolio

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Hedge funds attractive to Australian investors.

Hedge funds have earned their place as valuable components in Australian retail investor portfolios, according to Jarrod Brown, Bennelong Funds Management Chief Executive Officer.

Jarrod said that hedge funds, which are commonly used by institutional investors as diversification and risk management tools, can provide similar benefits to retail investors, when selected carefully.

“According to independent data from research firm Australian Fund Monitors (AFM), which tracks over 208 Australian-offered hedge and absolute return funds via their Equity Fund Index, hedge funds actually outperformed the S&P/ASX 200 Accumulation Index over a 10 year period,” he said. “In fact, from January 2003 to June 2013, the AFM Equity Fund Index returned 11.53% compared with 9.22% from S&P/ASX 200.”

Jarrod said that even more importantly, the equity based funds outperformed with less risk, which is something that many investors may not have expected.

“When the usual measure of risk, standard deviation was calculated for the two indices, the AFM Equity Fund Index came in at 7.88% p.a, whereas the S&P/ASX 200 was 13.41% p.a. – significantly higher,” he explained.

As measured by Sharpe Ratio, investors received more than twice as much reward for each unit of risk if investing in the AFM Equity Fund Index as opposed to the S&P/ASX 200 Accumulation Index.

Jarrod said that while it is true that the Australian hedge fund sector as a whole outperformed, retail investors still need to consider how the underlying strategies and risk exposure of specific funds meet their individual needs.

Not all hedge funds are inherently risky, but investors do need to understand the risk/return profile of the specific fund they are considering. The Bennelong Long Short Equity Fund, for instance, which adopts a relatively low-risk ‘neutral pairs’ trading strategy, has achieved 21.81% in the last 12 months (as at 30 September). Since inception, the Fund has earned positive returns every year, including an 11.95% return in calendar year 2008 and 20.6% in calendar year 2011, both of which were negative years for the S&P/ASX 200.

Similarly, Kardinia Capital manages Bennelong’s second hedge fund, The Bennelong Kardinia Absolute Return Fund has delivered investors 14% per annum over seven years. This ‘variable beta’ (which means the manager has the flexibility to adjust the Fund’s exposure to the underlying market) strategy has ensured a positive return in every calendar year since inception in 2006. This obviously includes the heart of the Global Financial Crisis in 2008 when the Fund returned positive 0.30% whilst the market fell close to 40%.

“Clearly, some hedge funds can both generate and protect wealth,” Jarrod said.

Nonetheless, and despite these dual benefits, some Australian retail investors are still averse to investing in hedge funds, with concerns focused on the structure of the funds, and in particular fees and liquidity.

Jarrod said that when it comes to fees, transparency is a regulatory requirement in Australia – there are no hidden surprises; investors know exactly what they will be paying.

“The good news is that the AFM data shows that Australian hedge funds are generally cheaper than offshore-based funds,” he explained. “The average fee charged on funds in the AFM database was 1.3% p.a for management, whereas the typical formula for overseas funds is ‘2 plus 20’, which means a 2% management fee and a 20% performance fee if performance hurdles are met.”

With respect to performance fees in Australia, the average was 13%, much lower than the 20% typically charged overseas.

“And it’s important to remember that performance fees are only charged when specific performance hurdles are met or exceeded,” Jarrod explained.

When it comes to liquidity, this does vary from fund to fund. While the Australian market is more heavily regulated than the US market, investors do need to do their homework. While some funds will have a minimum investment of $500,000 and monthly unit prices, the Bennelong Kardinia Absolute Return Fund, for example, has an initial investment of $20,000, a minimum withdrawal of $10,000 and daily unit prices.

Jarrod concluded by saying that a growing number of research houses, financial planning groups and investment platforms have expressed confidence in hedge funds for Australian retail investors, which in turn has increased interest and access to the funds.

For example, the Bennelong Kardinia Absolute Return Fund has been rated by a number of researchers and made available via several platforms including Macquarie Super Wrap, BT Wrap, Asgard, Netwealth and Wealthtrac, as well as being added to the manager line-up of Colonial’s fund-of-fund offering, FirstChoice Lower Volatility Australian Share Fund.

“Hedge funds might not be suitable for everyone – and their structures, strategies and risks certainly require additional research and understanding on the part of advisers and clients alike,” he said. “But the reality is that the best hedge funds can provide outstanding performance with significantly lower volatility than traditional managed funds.”

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Hedge fund definitions refined to assist investors.

ASIC has today refined the definition of a hedge fund to ensure our disclosure requirements are appropriately targeted at those funds that pose more complex risks to investors.

Following extensive consultation with industry, Class Order [CO 13/1128] Amendment of Class Order [CO 12/749] and an updated Regulatory Guide 240 Hedge funds: Improving disclosure (RG 240), make changes to the characteristics that prompt a registered managed investment scheme to be classified as a hedge fund.

‘Our changes will benefit the industry by relieving some lower-risk funds from the more extensive disclosure obligations imposed on a hedge fund under RG 240.

‘This will also benefit investors by more clearly differentiating hedge funds from other types of managed investment schemes so that they can better understand and assess these products,’ ASIC Commissioner Greg Tanzer said.

ASIC’s disclosure requirements for hedge funds commence from 1 February 2014.

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Looking beyond the Hedge.

Advisers and their retail clients cast a wary eye whenever the expression ‘hedge fund’ is raised.

Why so? Institutional investors have embraced alternative investing with great vigour, while the regulator, ASIC, has recently allayed fears concerning the underlying liquidity and gearing levels of Australian hedge funds. Alex Wise gives an insider’s view on the journey for hedging from lowbrow blunt instrument to today’s legitimate tool in the investor portfolio kit bag.

The alternative investment industry has grown substantially in size since the lows of the GFC (from a low of around USD 1 trillion to over USD 2.3 trillion today[1]).  Institutional investors particularly endowment funds, pensions, sovereign wealth funds (e.g. the Future Fund) have markedly increased their use of alternatives in their portfolios. Alternative strategies (such as hedge funds and managed futures) and alternative assets (such as commodities, private equity, infrastructure and gold/precious metals) have formed an important part of that strategy.

Yet for retail investors the hedge fund has struggled to overcome negative perceptions – understandable given that hedge funds often take conflicting positions to other investors by going short on equity that they believed to be over-valued. Closer to home, a recent ASIC report[2] notes that Australian hedge funds do not pose a systemic risk to the financial system, because they have low levels of gearing and adequate liquidity.

At Select we have been investing in alternative managers since 2002 and in 2004 we launched a fund tailored to alternative investments. During this time we have learnt a lot about the asset class.

What are alternatives and what are hedge funds?

In summary, both terms are somewhat ambiguous. Alternative investments In Regulatory Guide RG240 ASIC sought to define a hedge fund but ended up categorising a large proportion of the investment industry as hedge funds!

We define a hedge fund or an alternative fund by its investment strategy – therefore avoiding broad “catch all” definitions. Typically hedge funds exhibit an alternative investment strategy. This means the main portfolio objective is to do something other than purchasing (long) equities or bonds (traditional investing).  Some examples of what we consider hedge funds are set out below.  Often the descriptions of strategies can be quite technical, so I have sought to apply how Select defines some of those strategies below.

Portfolio Construction: What are the key trends in alternatives investing?

It is now a widely held belief that investors should have some alternatives exposure either directly into a portfolio of funds or into a diversified alternatives portfolio (also known as a fund of funds).   In a recent survey McKinsey noted the growth in alternatives particularly amongst retail investors in the United States:

What should I consider before investing in alternatives?

First of all – we all know that past performance is not indicative of future returns so after a cursory glance at long term and recent performance be prepared to consider a wide range of additional due diligence issues. Advisers should consider capacity, transparency and liquidity when evaluating the appropriateness of a particular alternative strategy/asset for a client.

Capacity

Capacity is important to ensure that the manager can deliver its strategy as its assets grow.  Many strategies are niche and too many assets may indicate a successful marketing machine but not necessarily a good long term performance engine.

LESSON #1 – Objective due diligence

Previously investors has sought to chase returns or chase perceived quality.  Following the herd into an investment has proven ill-advised on many occasions.   Just because a fund is large or “exclusive”, that doesn’t make it a good investment.  Wealthy Swiss investors found this out the hard way with Bernie Madoff!

KEY CHECKS – how much have fund assets grown?  Track performance over the same period along with performance of an appropriate index… Note significant asset raising versus average performance relative to the index.

Transparency

Avoiding funds that are not open about their investment strategy is vitally important.  Many funds harbour secretive strategies behind such terms as “proprietary trading systems”. These funds are unlikely to be engaged in nefarious activity however investors should place high value on clarity of what the fund invests into. This is one easy way investors could have avoided Bernie Madoff’s fund, the biggest managed fund fraud in history, exposed in 2008.   An increasing number of fund of funds are able to look through into the holdings of the underlying managers ensuring that the additional layers do not obscure the ultimate underlying investment.

LESSON # 2 – Transparency

When I first joined the hedge fund industry in 2002 the London based firm I was working for had an investment with a US fund called Beacon Hill.  Whilst our investment team liked the principals and felt the strategy was solid, transparency within the portfolio and governance process was questionable.  We learned the hard way when the fund lost 50% of its value by doubling down losing bets and conjuring up a false unit price.  After this we invested a lot in transparency and operational due diligence to check the portfolio and the unit pricing process.

KEY CHECKS – what reports are available to an investor?  Do you get a breakdown of the entire underlying portfolio? Also ask for the Fund’s audit report.  Does the report show the underlying assets – if not ask why!

Liquidity

Despite the rapid recovery of the industry, the growth of alternatives has actually been held back by many funds lacking the ability to provide desired investor liquidity.  In a recent report “Rise of Liquid Alternatives Survey” Citigroup sees global demand for liquid alternatives from the retail audience reaching $US939Bllion by 2017 and $US1.3Trillion including institutions seeking greater liquidity. They note that this would make the liquid alternatives market nearly as big as the entire hedge fund industry at the end of 2008.

LESSON # 3 – Underlying Liquidity

Many hedge funds began investing in private equity assets in 2006 and 2007.  When liquidity dried up in the markets (there were no buyers), these assets became impossible to sell.  Some pension funds still have these assets on their books.

KEY CHECKS – Does a multi-manager have significant look through to the underlying assets? What liquidity does the fund offer?  Can an independent risk manager prevent the sale of illiquid assets?

What about Fees?

Trends from the United States indicate that fee levels in alternative strategies are reducing – or improving for investors. However investors should carefully review all fees – particularly performance fee structures – that may contain surprises for the unwary. However it is our experience that many hedge funds targeted at US retail investors are now offering structures with no performance fees at all.

For retail investors, unless they are investing through a fund of funds, the choice of alternatives will be limited to those that can offer their products in Australia. This limits the investment universe for retail investors, with many preferring the fund of funds route to gain access to institutional quality managers offshore. The Australian alternatives markets can limit the strategies available particularly in an increasingly global world.

KEY CHECKS – how does the performance fee work? Does it apply to unit holders as a whole or each individual investor?  If the fees seem low – ask why.  Are they being hidden by a swap or similar arrangement?

Summary

The alternative investment industry has evolved substantially since the lows of the GFC and many believe they offer substantial benefits to a diversified portfolio.  The industry must however be able to deliver capacity, transparency and liquidity along with cheaper fees to match the goals of retail investors in Australia.  At Select we believe that change is happening.  Global investors (including the bellwether of US retail investors) are steadily increasing the use of alternatives in their portfolios, as they also believe better conditions prevail to ensure lessons have been learnt since 2008.

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes. 

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Australian hedge funds: no systemic risk to the Australian financial system: ASIC.

Australian hedge funds do not currently pose a systemic risk to the Australian financial system, an ASIC report released today has found.

Key points:

• Hedge funds ASIC identified manage only a small share of Australia’s $2.1 trillion managed funds industry with more than half of these holding less than $50 million each
• The survey indicates Australian hedge funds do not currently appear to pose a systemic risk to the Australian financial system
• Listed equities represent surveyed hedge fund managers’ greatest asset exposure, with 32% of this being in Australian-listed shares
• Surveyed qualifying hedge funds also use low leverage and appear to have adequate liquidity to meet obligations

The survey was representative of the state of the Australian hedge fund industry as a whole, with the assets of the 12 surveyed qualifying hedge funds representing approximately 42% of the assets held by single-strategy hedge funds in Australia.

Australian wholesale investors are the main investors in the surveyed funds. Their hedge-fund investment relative to their total investments is minimal, which tends to reduce systemic impact of any problems in the sector.

By asset class, listed equities (over US$19 billion) are the surveyed fund managers’ greatest gross exposures, with almost one-third of this being Australian equities. Equity derivatives and G10 sovereign bonds are the next two most significant asset classes, with exposures of US$8.2 billion and US$6.9 billion respectively.

Hedge fund redemptions exceeded applications in 2012, compared with the substantial inflows in 2010. However, the 2012 redemptions are unlikely to result in liquidity pressures because the average redemption size is relatively small as a percentage of funds’ net asset value.

The average time in which surveyed funds can liquidate 92% of their portfolio is less than 30 days. However, creditors can demand 99% of fund liabilities in less than 30 days. If the Australian market were subject to significant stress, the sector may struggle to meet redemption requests. However, this risk is offset by all the surveyed funds being able to suspend redemptions, if required.

Surveyed funds use relatively low levels of leverage, with synthetic leverage being the largest source in 2012. Average leverage, by gross market value as a multiple of net asset value, increased from 1.25 times assets in 2010 to 1.51 times assets in 2012.

Background

Hedge funds’ investments have in the past adversely affected the financial system by disrupting liquidity and pricing in markets (market channel risk) or by causing creditors to lose money (credit channel risk). The potential for systemic risk depends on the size, significance and interconnectedness of hedge funds.

In 2010 and 2012, the International Organization of Securities Commissions (IOSCO) called on members to survey their jurisdictions’ largest hedge fund managers to better understand the systemic risk these funds posed. In late 2012, ASIC surveyed hedge fund managers operating in Australia with more than US$500 million under management.

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So why is this important and why is the market selling off?

Over the past few years Hedge Funds and others have been able to make certain investments on expectation that the trends will continue. That is that QE will keep bonds yields low and that this will mean other yield orientated investments will also be attractive. These investors are now starting to unravel some of their positions which are causing an adjustment for the markets.

Implications

The implications for our market are as follows:

1. It places downward pressure on our currency as A$ bonds and high yield stocks were one of those investments that have benefited from QE. In the short term as offshore investors sell out of the Australian positions it creates some negative volatility.
2. Ultimately a pullback in the currency has positive implications for profits of the Australian market and will improve the competitive position of many companies. We estimate that at a 90 cent A$ there is a 9% positive impact to profits.
3. From a valuation perspective the Australian market has pulled back 10% so when combined with the impact of a lower currency the Australian market is nearly 20% cheaper than it was two months ago.

In addition to the QE easing the Australian market is adjusting to life after the resource boom. Some of those sectors of the economy which have done well in the past few years are likely to struggle and the RBA will be looking for other segments such as housing and non-residential construction to breathe life into the economy. A lower currency and lower interest rates will help in this regard as will an election to remove current uncertainty.

From a positioning perspective we continue to like those companies exposed to offshore earnings such as Brambles, QBE and Ansell and those companies which can benefit as money flows out of bond markets (such as QBE and Macquarie Bank). We will also be looking at opportunities that emerge from the current volatility.

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Class Order [CO 12/1592] extends the relief in Class Order [CO 12/749] Relief from the Shorter PDS regime for a further 12 months, to 22 June 2014. The relief was due to expire on 22 June 2013.

ASIC has extended the relief pending a future Government decision on the application of the shorter PDS regime to superannuation platforms, multi-funds and hedge funds.

A number of hedge funds had issued shorter PDSs when ASIC excluded hedge funds from the shorter PDS regime. [CO 12/749] provides that a hedge fund that has issued a shorter PDS before 18 June 2012 may continue to use that shorter PDS until 31 January 2013.

ASIC has:

• extended this transitional relief to 22 June 2013; and
• provided hedge funds who have prepared and given a shorter PDS between 18 June 2012 and 22 June 2012 with the benefit of the transitional period from the commencement of this class order.

From 22 June 2013 hedge funds must prepare and give a full PDS.

Extending the transitional period for hedge funds will align with the commencement of new disclosure obligations for hedge funds under ASIC Regulatory Guide 240 Hedge funds: Improving disclosure (RG 240).

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ASIC’s guide, Regulatory Guide 240 Hedge funds: Improving disclosure (RG 240), follows industry consultation earlier this year (refer: 12-30MR) and the Parliamentary Joint Committee on Corporations and Financial Services (PJC) report into the Trio collapse, and is part of ASIC’s forward plan of work to improve the conduct of gatekeepers for managed investment schemes and strengthen the regulatory requirements applying to hedge funds.

In the final version of the regulatory guide, there are a number of changes made as a result of submissions received during the consultation, including:

• defining ‘hedge funds’ as managed investment schemes which exhibit at least two out of five characteristics: complex investment strategy or structure; use of leverage; use of derivatives; use of short selling; charging a performance fee
• removal of an independent custody benchmark
• simpler fee disclosure more in line with prevailing industry practice, and
• where a hedge fund has invested 35% or more of its assets in an underlying hedge fund or similar investment vehicle, the disclosure principles and benchmarks should be taken to apply to each such ‘significant underlying fund’.

‘Hedge funds, because of their diverse investment strategies and use of leverage and offshore investments, can pose more diverse and complex risks for investors than traditional managed investment schemes,’ ASIC Commissioner Greg Tanzer said.

‘Given the risks for retail investors associated with investing in hedge funds, disclosure needs to provide retail investors with all the information they require to make an informed investment decision. In some cases, this may include a decision not to invest in these products.’

Responsible entities of hedge funds should disclose against the benchmarks and apply the disclosure principles in any PDS dated on or after 22 June 2013.

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Highlights

• 165 hedge and boutique investment management firms control $208.4 billion, equivalent to 17% of the $1.19 trillion managed by all investment managers in Australia.
• The directory identifies 102 independently-owned boutiques (predominantly long-only, benchmark-unaware strategies) with $165.6 billion in assets under management (AUM), and 63 hedge fund firms with $42.8 billion in AUM.
• The industry eclipses Hong Kong’s $37 billion in hedge fund & long-only absolute return assets, and Singapore’s $20 billion sector.
• More than $60 billion (roughly 30% of sector AUM) is deployed by Australian managers into global markets such as global and Asian equities, global fixed income and global macro.
• NSW based managers have combined AUM of $142.2 billion, while Victoria and Queensland based managers have $38 billion and $24.2 billion respectively.  South Australian and West Australian managers have $3.5 billion and $0.4 billion respectively.

The report’s author and publisher, David Chin, Managing Director of Basis Point Consulting, commented, ‘The Australian hedge and boutique universe is much larger than expected and reflects the diverse investor support for the sector.’

‘Investors in hedge funds are evenly split between four categories: direct high-net-worth investors/principals own funds; offshore investors, Australian institutional investors; and Australian wholesale (dealer groups/planners) investors.  For boutiques, Australian institutions and wholesale investors account for 61% and 29% of assets respectively, reflecting the focus by many boutiques on Australian investment markets.’

Now that the size of the sector has been comprehensively reviewed for the first time, David Chin said, ‘Global investors will be more willing to send due-diligence teams to Australia.  Previously, major European and US investors would visit Asia but did not take the additional trip to Australia in the erroneous belief that the local sector was too small.’

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Senior Investment Analyst Deanne Fuller commented, “We reviewed over 40 managers in the lead up to the 2011 review, conducting on-site due diligence on managers located across the major hedge fund centres of Zurich, London, New York, Princeton, Greenwich and San Francisco, as well as Melbourne and Sydney.”

“As well as meeting with incumbent managers, it’s important for us to meet with ‘prospect managers’ and identify any potential managers that would enhance Lonsec’s recommended list. Not all managers we meet with are rated.”

Sector themes and observations

Sector flows
After the significant outflows experienced by the hedge fund industry during the GFC, 2010-2011 saw assets under management in the sector return close to 2007 levels according to BarclayHedge, a provider of alternative investment databases; total hedge fund assets were estimated at US$1.77 trillion at 30 March 2011.

“The managed futures, global macro and event driven sectors received the largest inflows,” observed Fuller.

“As many investors still have the effects of the GFC fresh in their mind, larger funds with longer track records attracted the majority of inflows due to their lower perceived risk.”

“Most flows came from pension funds and institutional investors driven by a desire to find attractive risk adjusted returns uncorrelated to the stock and bond markets,” continued Fuller.

One of the trends noted by Lonsec is the rapid growth in the managed futures space since the end of 2009. Assets under management in this sector globally have grown 36% to US$291 billion at 30 March 2011, making managed futures the largest hedge fund strategy in the market.

“The weight of money and high correlation among managers in this strategy leads Lonsec to believe that risks have generally increased, specifically the potential for signal decay and the inefficiencies and negative performance impact that can be attributed to the unwinding of crowded trades,” said Fuller.

“While we do not see this as an immediate concern, should growth continue at this pace, Lonsec believes there may be cause for a re-rating of funds across the sector.”

Active versus passive
“The active versus passive debate has now entered the alternatives arena,” said Fuller.

“While investors have been attracted to the low correlation with traditional asset classes, higher fees have made the sector less attractive.”
In an effort to reduce hedge fund fees, reduce trading costs, lower financing costs and increase transparency, a number of approaches have been put forward by managers, including investible hedge fund indices, hedge index tracker funds, hedge fund replication strategies and hedge fund beta strategies.

“Lonsec regards the hedge fund beta concept as being superior to hedge fund replication and investing in hedge fund indices,” commented Fuller.

“Essentially hedge fund beta examines a number of hedge fund strategies and identifies and implements the ‘bread and butter’ trades that underpin each strategy.”

“While the underlying strategies are less likely to perform as well as a dedicated manager specialising in a particular strategy, the trade-off to investors is that this strategy is substantially cheaper.”

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