Hedge funds: hedging against the future

Not all hedge funds proved to be the all-weather performers many had expected through the global financial crisis but, as Damon Taylor writes, that does not mean they should disappear from well-balanced asset allocations.

As Australian super funds make their way towards the end of the 2010-11 financial year, it seems likely their returns will reflect steady - if not stellar - growth.

Markets have settled to the point where the troubles of the global financial crisis (GFC) seem a distant memory, but the experience has not been forgotten.

Hedge funds, like a number of alternative assets, did not provide the downside protection expected - and according to Towers Watson director of investment services Graeme Miller, that fact is something investors remember well.

"The thing that disappointed hedge fund investors most through the GFC was that these funds had been marketed as being absolute return funds that would aim to deliver positive returns regardless of equity and credit market conditions," he said.

"And unfortunately, the great majority of hedge funds failed to deliver on that promise.

"Now as markets returned more to normality or as we saw stronger investment performance from markets from about March 2009 onwards, hedge funds - like all other forms of risky investments - delivered strong positive returns," Miller continued.

"But in saying that, I think the jury is still out as to whether those strong positive returns are simply reflections of strong market conditions across the board or whether they do, in fact, reflect learnings that hedge fund managers have derived from their financial crisis experience."

Crisis mode

Providing an another perspective, Alternative Investment Management Association president Kim Ivey said that for the vast majority of super funds he'd spoken to, hedge fund experiences had been positive during the GFC.

"The sense some people seem to have that all hedge fund investors were disappointed during the GFC, I think is a misnomer," he said.

"Yes, there were investors in hedge funds who may have gone into or invested in funds purely on the back of past performance or purely on the back of a brand or a name.

"But what's so important about investing in hedge funds is an understanding of what the strategy really is," Ivey continued.

"There's so much diversity, so much dispersion, even inside a recognised strategy from manager to manager, much more dispersion of returns than there is in the traditional world.

"So just going with one manager, believing that it's a brand name and really not digging down into the risks and what are all the sources for the performance is a critical mistake."

Ivey also pointed out that the chief reason Australian hedge fund investors may not have been disappointed was, in fact, their GFC performance.

"More than 50 per cent of Australian-based hedge funds actually outperformed the ASX200 during the calendar year 2008," he said.

"Many, particularly those in the managed futures and market neutral sectors, also exceeded cash returns during this period."

Yet according to Miller, the real test of hedge funds will not be during a period such as the one that we've just experienced where equity markets and credit markets themselves have delivered very strong returns.

"Rather, I think the real test will be during the next crisis we experience," he said.

"In a strange sort of way, even as I say this, it will be very interesting to see how hedge funds perform in light of a certain amount of weakness in markets following the Japanese tsunami.

"At the end of the day, hedge funds have done well in recent times - but so have all risky assets," Miller continued.

"The thing that most institutional investors are looking for from their hedge funds is to provide diversified returns relative to the other sources of returns in their portfolio.

"And realistically, the last 18 months haven't been a very good test of whether that objective is being met."

Ultimately, it is apparent that the question of whether hedge funds survived the GFC well or emerged battered and bruised is a matter perspective and investor expectations.

Yet irrespective of one's standpoint in that argument, Mercer principal Harry Liem said that in recent months the hedge fund performance story had been a positive one.

"So looking at the official numbers for hedge funds in 2010, based on the HFR [Hedge Funds Research] index, in US dollars the funds were up about 10.5 per cent," he said.

"So if you hedge that back to the Aussie dollar, you get a little bit more but given they do better when equities markets are a bit normal, rationalised or have recovered slightly, it was actually a pretty good year for hedge funds.

"The hedge fund industry is basically back on track in that before the GFC happened, the industry's assets were at about $1.9 trillion US dollars," Liem continued.

"That fell to as low as $1.4 trillion during the GFC, but they've actually got back to that $1.9 trillion mark now.

"On the surface, it seems like the industry has managed to recover and is now tracking well."

Looking at individual strategies, and specifically at those that had led hedge funds' overall recovery, Ivey said that there had been some wind in the sails of most recognised strategies this year.

"The one strategy which is logical given the strength of equity markets post-GFC, but that has found it difficult to make money, is on the short selling side," he said.

"But most recognised strategies have been positive over the past 12 months. Those that have done better than others have tended to be strategies like macro which look at the thematic issues in marketplaces and tend to invest in deep and liquid markets."

Multi-strategy funds

Adding further detail, JANA Investment Advisers principal for alternative investment solutions, Michael O'Dea, said that multi-strategy funds had also been popular with institutional investors implementing their own hedge fund programs.

"That is, multi-strategy funds with an event driven focus that typically invest in distressed securities, merger arbitrage and other corporate events," he said.

"These are managers who offer diversification benefits and the possibility of re-deploying assets within their universe of strategies depending on the relative attractiveness of each, though the drawbacks are that they tend to be less liquid and less transparent than many other single strategy hedge funds.

"Overall, we favour strategies which have a low net market exposure and are therefore less sensitive to swings in market sentiment," O'Dea continued.

"We think that strategies like global macro that take top-down views on markets are positioned well to profit from large macroeconomic events, and bottom-up stock pickers in long short equity can target companies priced cheaply relative to peers or other segments of the market.

"But ultimately, it's important to take advantage of a range of different opportunities and to diversify the portfolio as much as possible."

So with runs on the board during 2010 and with assets back to pre-GFC highs, it seems hedge funds should again tempt investors.

But the question, and one already posed by Miller, lies in what hedge fund managers and investors have learned from their GFC experience and, more importantly, how they intend to implement their new knowledge.

Ivey said that hedge fund managers and investors were both better placed simply because their understanding of what had occurred during the GFC was now much more complete.

"At the time of the GFC, no one really understood the reason why everyone was hitting bids all over the place because it just wasn't logical," he said.

"It didn't make investment sense for those sorts of prices to be transacted, but afterwards I think investors - and not just institutional investors here in Australia but investors all over the world - are now much more aware of the liquidity being forced out of markets.

"And the proof of that heightened understanding post-GFC lies in the fact that by far the biggest influx of money that's coming into the hedge fund industry over the past two years, again both here in Australia as well as globally, is coming from pension funds, insurance companies, banks, and large investors.

"It is not coming as much from high-net-worth investors and private banks - those investors which were really the backbone of the hedge fund industry when it started out in its first 20 years," Ivey continued.

"But in creating those inflows, these investors have started to place a lot more emphasis on what they see as the cardinal sins and the remedies to those sins are trying to find out what are the sources of risk, what are the sources of return and what sort of businesses are the investors placing their money in.

"In other words, they're looking at the operational risks behind the business of hedge funds and I think that's extremely prudent."

Sticking to basics

O'Dea said that the GFC had been a reminder not just to hedge fund investors but to all investors to adhere to some basic investment principles.

"The first of these is that liquidity is like oxygen; you only notice it when it's not there," he said. "Number two is ensuring there is a sufficient margin of safety."

O'Dea added that diversification was always important and pointed out that it was never a good idea to invest in complex models and strategies that weren't well understood.

"Another key learning has been that leverage doesn't make a bad investment good and excessive leverage can be catastrophic," he said. "And finally, there is no such thing as an investment guru.

"The other risks of limited transparency, high fees, etc can be mitigated by a well thought out and structured program," O'Dea continued. "There are many talented managers across the industry, and no segment of the market should be ignored just because of a label.

"But the bottom line is that there are no infallible strategies to make money; common sense and good judgement are what are important."

For Miller the biggest change had been investors being far more forensic in trying to understand the market exposures embedded in hedge fund strategies.

"So trying to really understand the equity beta and the credit beta that are in hedge fund portfolios is something that is absolutely essential," he said.

"And that's because the reason that the majority of investors invest in hedge funds is to access a skill premium rather than to access an equity risk premium or a credit risk premium.

"Most investors have got more than enough of those sorts of premiums already in their portfolios and so what they ideally want to do is strip out other sorts of market premiums but, at the very least, understand the extent to which that presence exists," Miller continued.

"And that is so (a), they can make adjustments to other places in their portfolio to reflect that and (b) this is the other key learning, make sure that the fees that are being paid are only being paid in respect of the scarce skill that a hedge fund manager might bring to the table.

"They really want to make sure that fees are not being paid for market exposures that can be very cheaply and easily obtained through other means other than hedge funds."

According to O'Dea, there are five big areas where gradual change is taking place in hedge funds investment.

"Firstly, there is greater recognition of the advantages of investing via managed accounts, especially in liquid hedge fund strategies, where the assets are held in the investor's (or a third party's) name rather than the manager holding these assets in their own vehicle," he said.

"This helps limit the risk of fraud, provides the investor with total transparency, and affords the investor much greater control over the investments.

"There is also a better understanding of the real drivers of returns of hedge funds and their risks," O'Dea added.

"Some investors are using selective hedge funds as a complement to existing market exposures rather than investing in all the different hedge fund strategies."

O'Dea's third area of change was in the benchmarking of hedge fund returns. He added that fairer and lower fee structures were also emerging.

"Many investors are much more careful about the types of structures they are prepared to invest in as well," he said.

"For example, does the manager have the right to suspend redemptions? Is there a liquidity mismatch in the portfolio?

"And lastly, a better knowledge of hedge funds is making investors turn the spotlight back on some of the portfolio construction practices of conventional balanced fund investing," O'Dea finished.

"So they're asking if there's too much of an emphasis on equities to generate returns.

"What's clear though is that with a carefully developed plan, a small allocation to hedge funds can play a very meaningful role in overall portfolio construction."

MySuper looms

Yet while hedge fund investment habits may have changed for super funds in the wake of GFC experiences, the reality is that they may have to change again within a MySuper environment.

Though little is known of the upcoming legislation's final form, it seems clear that fees will be a prime focus. So given the skill, and therefore fee, premium that exists, will hedge fund investment suffer?

For Miller, the danger lies in how much emphasis MySuper places on the reduction of the management expense ratio (MER).

"Naturally, we don't yet know what the final MySuper regulations are going to look like but in the event that MySuper forces or encourages funds to reduce their MER-type fees, then I think the danger for hedge funds is that they'll become less relevant just given the amount of fee budget that they gobble up," he said.

"I'm hopeful though that MySuper will provide scope for trustees to construct portfolios in a way that has regard not so much to the absolute level of fees but rather to the expected level of performance net of all fees.

"Personally, I think it would be a real shame if MySuper meant that funds abandoned what would otherwise have been compelling investment opportunities simply because the headline impact on fees was something that couldn't be accommodated within MySuper," Miller continued.

"So I'm a little bit fearful that it might happen, and if that does happen, then I think the consequences for hedge funds would be negative.

"But I'd like to think there'd be recognition that it's not the absolute level of fee that's important, but rather the value derived from every dollar of fee that's spent."

Bringing another option to the table, Liem said a number of Mercer clients had already made it clear that they wanted to get into hedge funds but didn't want to pay heavy fees.

"And for investors taking that view, there's a number of products out there that can actually give them that," he said.

"These products actually do the same thing as hedge funds but they do so on a mechanical basis and at much lower fees.

"These sorts of mechanical replicators could be quite attractive for many super fund investors and they'll be sufficient for those who are fee conscious," Liem continued.

"We've actually got enough supply now with managers to cover maybe 70 to 80 per cent of hedge fund strategies through replicators as a cheap core.

"So while there's a few out there, the fees can be something like 50 basis points plus say another 10 per cent performance fee and that's way down from a 2 per cent management fee plus 20 per cent performance."

But if hedge fund manager skill is wanted, Ivey said that the unavoidable reality was that hedge funds were extremely active portfolios.

"So the fees they charge are at a premium to not just index funds but to traditional portfolios as well," he said.

"But we hope that super funds look to whether hedge fund performance justifies their fees rather than at fees alone.

"There's always going to be that tension," Ivey continued.

"If you move into a MySuper product and you already have a consultant telling you that you've got to watch your MER and hedge funds, whether you're paying one in 20 or even two in 20 in your normal superannuation product, I guarantee that same conversation is going to happen in the MySuper products.

"So the message for superannuation funds and trustees is not to be penny-wise and pound-foolish when looking at the benefits; make sure you're looking at the diversification of benefits and not just the basis point increase on underlying fees at the portfolio level."

Looking ahead

It seems evident that the year ahead will be an interesting one for hedge fund investment. But the guiding light for Miller is ensuring that the market risks embedded hedge fund portfolios are well understood.

"I think the most successful hedge fund portfolios will be those that draw their risk and return from sources other than traditional equity and credit betas," he said.

"Understanding the liquidity profile and making sure that liquidity is there when you need it is critically important as well.

"But the final point is to make sure that the fees that you pay are a sensible reflection of the true underlying value that's going to be added via skill," Miller continued.

"The last thing you want is to be paying excessive fees for returns that could be generated through conventional market exposures."

Focusing more on the hedge fund investment outlook, O'Dea admitted that 2011 was already shaping up in interesting fashion but he pointed out every year was interesting in investment markets.

"The uncertainty created by the tension between supporting government policies with weakening political resolve will create an interesting backdrop to investing in 2011," he said.

"At the moment, a potential opportunity comes from the fact that global companies are sitting on large stock piles of cash and at some point company management will be faced with a decision to (1) use it on capital expenditure; (2) return it shareholders; or (3) acquire other businesses.

"Mergers and acquisitions could be poised for a flurry of activity and hedge fund managers in the merger arbitrage space are ready to take advantage if this unfolds," O'Dea continued.

"Overall though, we favour strategies which have a low net market exposure and are less sensitive to swings in market sentiment.

"We think that strategies like global macro who take top down views on markets are well positioned to profit from large macroeconomic events, and bottom-up stock pickers in long/short equity can target companies priced cheaply relative to peers or other segments of the market."

Seeing similar opportunities, Liem said that the events outlined by O'Dea and the market dysfunction that they caused could not help but be a positive for hedge funds.

"Bottom-up and top-down, the opportunities are out there and as long as markets remain slightly dysfunctional, astute hedge fund investors will be able to take advantage."