In a report commissioned by the Alternative Investment Management Association (AIMA),Assirtstated that in June 2002 the Australian hedge fund industry was managing nearly $5.4 billion in funds.
This was made up of $3.47 billion in fund of hedge funds assets, $1.62 billion in single manager strategies and approximately $300 million allocated to offshore hedge funds.
One of the main attractions of hedge funds is that they can conceivably make profits in falling as well as rising markets. The past 18 to 24 months have, among other things, put this to the test.
Performance
In the 12 months to June 30, 2002, some hedge funds earned positive returns while others did not. Table 1 shows the returns earned by the five best performing funds that have been operating for at least one year.
Table 1 does not include well performing funds such asBGIEquity Market Neutral Fund (23.7 per cent for the 12 months to June 30, 2002) or BluePeak Long Short Australia Fund (17.0 per cent) because they have been operating for less than 12 months.
On the other hand, Table 2 shows the five worst performing hedge funds for the same period.
Table 2 does not include funds that have been operating for less than 12 months.
The conclusion that can be drawn here is that although hedge funds have an opportunity to earn good returns in a poor investment environment, there is no guarantee they will.
A second conclusion that can be drawn, from an examination of the performance of a wider range of hedge funds, is that, on the whole, the performance of single strategy managers was better than their fund of hedge funds counterparts.
For example, the highest return earned by a fund of hedge funds manager in this period was 7.1 per cent earned by the Sagitta Rothschild Total Return Fund. Fund of hedge funds may be less risky because they diversify across a range of underlying managers, but they were also less profitable.
In light of what many hedge fund managers were telling prospective investors 12 to 18 months ago and their subsequent actual performance, it is difficult not to be cynical.
Initially, many hedge fund managers were publicising high target returns, as much as 30 per cent per annum.
Then, when performance was generally nowhere near targets, some hedge fund managers pointed to declining world sharemarkets — international shares were down 24.5 per cent for the 12 months to June 30, 2002 — and took satisfaction in saying that hedge funds performed better. This is little consolation to those who invested on the basis of high target returns and who were assured that hedge funds could make profits in falling markets.
Volatility and risk
The promoters of hedge funds generally stress that the returns from investing in hedge funds are less volatile, as measured by the standard deviation of monthly returns, than, for example, investing in the sharemarket. They then conclude that investing in hedge funds is less risky than investing in the sharemarket; that is, they equate volatility and risk.
However, when a return is earned that is significantly above the average return, it contributes as much to the size of the standard deviation as does a return that is significantly below the average return. Yet an investor would be happy if they earned a return significantly above the average return. Such a return should not result in a higher measure of risk, which is what happens if you equate standard deviation with risk.
By equating risk with standard deviation, many hedge fund managers ignore Post-Modern Portfolio Theory (PMPT), which recognises that standard deviation measures the variability or volatility associated with achieving the average return, rather than risk.
PMPT proposes that investment risk be related to the failure to achieve a minimum acceptable rate of return, which is established by investors themselves. According to this theory, any return below the minimum acceptable rate of return is risk, while any return above the minimum acceptable rate of return represents opportunity, which, although uncertain, is not risk.
There are also other concepts of risk to consider. One is the risk of total loss. For example, in the US in 1997, 33 per cent of hedge funds ceased to exist and in the following year, 42.3 per cent went out of business. This is a high attrition rate and, although investors did not lose all their money in all cases, it leads to the question of how likely is it that an investor will be wiped out?
Australian regulatory controls are tighter than in the US, but in the case of a highly leveraged hedge fund, there is a possibility of that happening.
Another measure of risk that needs to be taken into account is the percentage of months over a period of time that yield a positive return. When examining such information it should be considered in the context of the length of the period of time over which it is provided — the longer the better.
Recent developments
In recent months Absolute Capital’s three retail funds have been listed on theASX, as is intended with the Wallace Absolute Return Fund. This removes a major disadvantage of hedge funds, namely the time it takes to redeem units. However, trading has been thin and there is no guarantee that investors can sell units at the price they would like to.
Hedge funds have been in the news in the UK recently in connection with Brambles’ shares. The company’s share price has fallen amid speculation that its earnings are declining and hedge funds are believed to be behind a major short selling of its shares.
As a result, Brambles is in danger of falling out of the FTSE 100, which could create a new wave of selling as fund managers who track the index are forced to sell off the company’s shares. Consequently, hedge funds could buy back in at lower prices. If this is borne out, it is the sort of behaviour that leads some observers to call for stricter controls over hedge fund activities.
New hedge funds are frequently being launched. One such fund, Rubicon, which was established in May, is the first Australian-based hedge fund to specialise in merger arbitrage. Hitherto, hedge fund managers had considered the Australian sharemarket to be too small to support merger arbitrage activity. It remains to be seen whether Rubicon will be of sufficient size to affect share prices in takeovers and mergers in Australia.
Charles Beelaerts is author ofHedge Funds: Cutting Through the Hypepublished by Wrightbooks
