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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The new role has been created to grow the Group’s retail footprint throughout Queensland and provide a robust platform to support growth in BFM’s funds under management, currently at just under $5 billion.

BFM CEO Jarrod Brown said the Group was pleased to announce a permanent presence in the Queensland region. “Our existing sales team has built strong relationships with advisers and investors in this state. The introduction of the new role will enable us to better service these groups and grow our presence.”

Jodie has over 16 years’ experience within financial services, joining BFM from AIW Dealer Services where she was Practice Development Manager responsible for the group’s national network of advisory practices. Previously, Jodie worked as a Business Development Manager with Challenger Financial Services Group.

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Performance fees, charged to investors when investment professionals exceed specific performance hurdles, are growing in presence among Australian fund managers. Although far from new, charging for outperformance has received considerable focus recently due to weaker equity markets, the resulting flight to lower-risk and passive investments, and regulators’ ongoing discussions about performance fee standards in the context of FOFA and MySuper reforms. The knock-on effect is investors – those actually paying the fees – are questioning the price for alpha/outperformance. Not surprisingly, they may be losing sight of the relationship between price and the generation of value. But at what cost?

Aligning interests
Performance fees aim to align investor and fund manager interests. According to Lonsec, “performance fees change the incentive structure for a fund manager to make it congruent with the interests of investors by aligning the fund manager’s fee-earning potential with the performance outcomes for investors.”  Moreover, having a performance fee structure in place can also reduce a manager’s motivation to gather assets to maximise revenue at the possible expense of alpha.

In theory, this is a mutually beneficial scenario. However, with no industry standards on how performance fee structures are displayed and with high watermarks, hurdles and benchmarks often mentioned in financial media, it’s little wonder investors can find it difficult to compare the fees of actively managed products, let alone understand just what it is they’re paying for. With price an important factor when making purchase decisions, performance fees, despite their intended purpose, may sometimes deter investors from potentially alpha-generating opportunities.

Cheaper beta
Beta-driven products such as index and exchange-traded funds are generally cheaper than their actively managed counterparts. This pricing differential can sometimes cloud investors’ judgment when considering paying for active investment management. So, is this a case of investors not being able to see the wood for the trees?

When weighing-up paying for active management, it’s important investors consider the relationship between fees and the potential for superior investment outcomes. With exceptional investment management talent in short supply, it’s in the long-term financial interests of investors for fund managers to attract, retain and develop that talent. Naturally, this comes at a cost.

Similarly, managing a constrained pool of money rather than accumulating assets to the potential detriment of generating alpha, also has a price. Beyond these fundamentals, investors should also consider the robustness of the business, the manager’s investment philosophy and strategy, as well as the history of the fund and its managers, before investing their money.

Focusing purely on price does not allow for a balanced or comprehensive analysis. What investors must acknowledge is that accessing quality investment teams that have the potential to produce superior investment outcomes and whose practices foster sustainable alpha, costs more than buying passively managed alternatives that offer, at best, market returns.

Getting what you pay for
As management fees compress within the industry, we’re seeing an increasing number of fund managers charging performance fees as alignment between investors’ and managers’ interests grows. I believe this trend is likely to continue. Providing an appropriate connection between interests, performance fees not only promote mutually beneficial practices but encourage enduring partnerships that aim to control costs and deliver sustainable alpha.

At Bennelong, we aim to deliver superior investment outcomes by preserving capacity and working with the best industry talent. By protecting our portfolio sizes, we believe we can add greater value. By attracting, retaining and developing our investment managers, we believe we offer greater opportunity for quality investment returns. These practices and capabilities, however, cost money. As we’re not relying on luck to generate outperformance nor accumulating assets just to increase revenue, the processes involved to deliver alpha are multi-faceted and unique. So, as price can often denote quality, in the case of investment management, ultimately I believe investors get what they pay for.

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