Hedging in a volatile climate -12th March 2005
John Collett - The Age
Boom times are ahead for hedge funds, but small investors still need to exercise caution, writes John Collett.
When hedge funds were rolled out to small investors in 2001 and 2002, they were billed as a panacea for those fed up with poorly performing global sharemarkets.
The promoters were hoping to achieve net returns of 10-15 per cent a year, regardless of the direction of share and bond markets.
Instead, the funds of hedge funds, where the local fund manager invests in more than 20 mostly US-based hedge fund managers, have average annual returns of 7 per cent over the three years to December 31, 2004.
David Smythe, co-founder of Zenith Investment Partners, says while funds of hedge funds have "underachieved on their return objectives", if there is a "pullback in the domestic equities market, that may well be when the defensive qualities of these funds shine".
However, it's evident at a glance just how tough the funds have found it. For the three years to December 31 last year, the Deutsche Strategic Value Fund has returned an average annualised 6.14 per cent. Over the same period, the BT Global Return Fund returned an average annualised 7.94 per cent.
Colonial First State's Wholesale Global Diversified Strategies Fund produced an average annualised return of 9.68 per cent, making it one of the better performers; but it's still short of the 12-14 per cent a year target given to the financial media at its 2001 launch.
But is this just the latest example of the confident hope of fund managers not living up to the hype?
Hedge funds are best described by what they are not. They do not invest with anything like the strict "mandates" of mainstream managers, and they will invest outside traditional asset classes.
Hedge funds are now everywhere, but most are small businesses based in the US, with most managing no more than $100 million.
At last count, there were up to 30 recognised hedge fund strategies. Some of the more popular bet that a stock's price will fall as well as rise (long-short); those that invest in companies the fund managers believe are about to be taken over (merger arbitrage), and "macro" strategies, where the manager looks for small pricing differences between markets.
David Smythe says while the funds of hedge funds have not delivered on performance, they have produced less volatility than Australian fixed-interest investments.
However, low volatility alone will not achieve long-term rewards for investors, says Peter Thornhill, the principal of investment educator Motivated Money. After all, investors can get returns of about 5.5 per cent with one of the online cash management accounts, practically risk free.
He says funds of hedge funds so far have been "long on marketing spin and short on results".
So why have the performances not generally been up to scratch? It may be that there is simply too much money chasing too few quality hedge fund managers or too few strategies, says Peter Thornhill.
But Richard Keary, the head of alternative investments at BT Financial Group, warns that "opportunistic participants" are going to be attracted to any fast-growing, profitable industry.
While there are many strategies, most hedge funds activities are sharemarket-related and do best in times of high volatility. While Australian investors have been enjoying a booming local stockmarket, global shares have still not recovered, in either local currency or $A terms, from the highs made just prior to the tech wreck of April/May 2000. Keary says hedge fund managers will stay in cash if they cannot fund suitable opportunities. Mainstream managers have no choice but to stay fully invested, regardless of market conditions.
However, another factor is undoubtedly the generally high fees paid by small investors to access hedge funds.
Most funds of hedge funds charge small investors "2 plus 20", says David Smythe. That is, 2 per cent a year as the base fee, and 20 per cent of any returns above zero. Smythe thinks that they should only be taking a performance fee on returns in excess of the cash rate only. "Why should managers be paid performance fees for parking the money in cash?" he says.
As to the outlook, Keary is optimistic, given the backdrop of rising short-term interest rates. Rising rates are negatives for bond and stockmarkets, and Keary says that should help to introduce some volatility and present opportunities for hedge funds.
That may prove correct. But the funds of hedge fund managers say exposure should be no more than 5-10 per cent of an investor's portfolio. Take also the fact that hedge funds cannot be accessed cheaply by small investors, and the real question for small investors may be: why bother with hedge funds at all?