The bitter taste of the GFC, and a strong equities market, have meant Australian investors remain cautious about hedge funds, Malavika Santhebennur reports.
The thought of investing in hedge funds evoked fear in advisers and retail clients after the global financial crisis (GFC).
The collapse of a Basis Capital hedge fund in 2007 did little to abate apprehensions after the firm sourced large amounts of money from retail investors through platforms offered by financial planners.
Australian investors lost hundreds of millions of dollars when Basis Yield Alpha Fund went into liquidation.
The corporate regulator used Basis Capital to make its case to investors on the risks of hedge funds, and updated its disclosure requirements for hedge funds in 2013.
Some industry experts have labelled Australia as an anomaly in the world for not supporting hedge funds to the same extent, and for not being included in every investor's asset allocation.
Head of alternative investments at Ibbotson Associates, Craig Stanford, said hedge fund investments are one of the more "polarising" topics in the investment arena, adding people have strong opinions at either end of the spectrum with little middle ground.
Supporters tend to sing its praises without recognising the downside, while sceptics deride the investment strategy without acknowledging the benefits.
He said that while hedge funds had not fallen out of favour globally, Australia stood apart.
Most of the assets that hedge funds managed offshore came from sophisticated institutional investors like sovereign wealth funds, foundations, endowments, private and public pension plans, and insurance companies.
"Australia has never had that high degree of institutional support for hedge funds," Stanford said.
"You could point to a number of reasons: maybe equity markets have been quite strong and bond markets have been quite strong, and it's been an easy market to make money. You didn't really have the sub-prime problem that you had originating in the States."
The high fees charged by hedge funds have repelled investors from using them in Australia, to the extent that risk-adjusted returns after fees were not even factored in.
Stanford said global hedge funds visiting Australia probably spent two-thirds of the meeting discussing fees and the remaining portion discussing investment strategies.
"But whenever they speak to other investors in the world, 100 per cent of the meeting is about the investment strategy and fees don't really come up.
"I think, unfortunately, this insane focus on fees probably has a detrimental impact on returns," Stanford said.
If it ain't broken
A number of industry experts agreed with the analysis that investors did not need to resort to hedge fund investment at present due to a robust equities market in Australia.
Aurora Funds Management managing director, Simon Lindsay, suggested that most investors had an over-exposure to listed equities, especially the big four banks and Telstra.
This was particularly the case for self-directed, self-managed super fund portfolios.
"Ultimately, when everything is going rosy, people don't tend to worry about the risk to the downside, and I think this is probably the exact time when people should be considering hedge funds in a portfolio," Lindsay said.
Investors believed they would continue to receive the same level of dividends even in the event of a movement in the valuations of banks.
It has been 24 years since recession swept Australia, and those 30 years or younger would not even know what a recession looked like.
Property prices have not declined since the 1990s, and unemployment has not risen significantly.
"There are all of those factors that people tend to forget about because it hasn't happened for such a long period of time. But these things can and will happen again," Lindsay warned.
Institutional investors have been investing in hedge funds over a long period of time.
In October 2014, a State Street survey of 235 hedge fund executives around the world revealed 63 per cent expected institutional investors to increase their exposure to hedge funds, while 55 per cent foresaw pension funds increasing their exposure.
However, they were bracing themselves for more complex operations, amid increasing regulatory pressures, with 89 per cent of hedge funds expecting increased operational complexity over the next five years.
More than eight out of 10 hedge fund managers expected increased regulatory scrutiny of their industry over the next five years, and this could be an expensive exercise.
A 2013 hedge fund survey found a medium-sized hedge fund spent $6 million on compliance, while the largest hedge funds spent around $14 million.
But Blackrock Australia head of wealth advisory, James Langlands, said the investment management firm was gradually seeing a revival in interest around hedge funds and absolute return funds from bank-aligned advisory businesses and clients in the independent financial space.
He said adviser interest in hedge funds were at the highest levels it had been for a while, and this was driven by concerns over domestic equity markets, as investors' portfolios remained heavily weighted towards equities.
They sought diversification and the versatility of absolute return or hedge fund strategies, and the potential for sustainable performance irrespective of economic conditions.
"Obviously there are some headwinds for the Australian economy, particularly for the first time in a couple of decades at least," Langlands said.
But was this translating to increased inflows to the extent that investors invested in traditional classes?
"No, not at this point. I don't think we're seeing widespread use of alternatives across the board yet. Whether it was through the GFC or prior to that, some advisers may have not had great experiences with alternative products in the past and therefore are a bit reluctant to dip their toes back in the water," he said.
But with equity valuations looking reasonably full and Australia's underlying economy showing signs of weakness, advisers were exploring other areas and deliberating whether hedge funds could deliver absolute returns, regardless of an economic downturn.
Perils vs. performance
Australia faced many structural issues in hedge funds during the GFC, including investors using leverage to invest in them, which snowballed when they saw losses in portfolios.
Also, unlike the US, hedge funds can sell to retail investors in Australia if they have the appropriate product disclosure statements and meet certain criteria, and many retail investors invested in hedge funds pre-GFC.
The problem was their lack of understanding of what they were venturing into, and products being mis-sold based on the promise that they would generate money and would not fail.
Third-party marketer Brookvine chief executive, Steve Hall, pointed to the challenges of getting access to hedge funds in retail market portfolios, particularly through platforms.
Institutional investors did not face platform constraints, or liquidity and offshore cost structures.
"I've always felt on the retail market that hedge funds are somewhat under-represented in those portfolios," Hall said.
"It's been about the availability of top tier hedge fund choices, and the preference for funds that are priced on a daily basis. There's just a much smaller set of hedge fund opportunities that are being marketed in Australia than there are in other parts of the world."
Regardless, specialist hedge fund research firm, Australian Fund Monitors (AFM) chief executive, Chris Gosselin, was quick to point out that equities plummeted by 45-47 per cent during the GFC, while the average hedge fund was down 23.5 per cent.
"Certainly some hedge funds performed badly in 2008 just in the same way that some managed funds and some companies performed badly in 2008," he said.
"But on average they actually did quite well."
According to the AFM database, nearly 25 per cent, or one in four hedge funds in Australia produced a positive return in 2008, Gosselin added.
AFM Equity Hedge Funds' cumulative return stood at 150.56 per cent over 10 years to December 2014, while ASX200 Accumulation stood at 107 per cent (see chart below).
AFM Equity Hedge Funds vs. ASX200 Accumulation Cumulative Returns over 10 years
AFM equity based hedge funds returned 13.91 per cent over the past 12 months, while the ASX200 total return stood at 9.93 per cent.
It is difficult to generalise about the average return in the hedge fund sector due to varying results between strategies but returns ranged from negative 16 per cent to positive 115 per cent over the 12 months to May (see chart below).
Distribution of all returns
To 30 May 2015, the top 12-month performance for a hedge fund strategy was 27.73 per cent for managed futures, outperforming the market (see chart below).
Average hedge fund return by strategy
Morningstar data showed the median return of hedge funds over three years to 31 March stood at 8.66 per cent, compared to growth super funds, which stood at 12.03 per cent (see chart below).
Alternative vs. median super fund returns
Between December 1992 and December 2012, the median Australian growth super fund annual return was 7.2 per cent, while returns from a portfolio of hedge funds stood at 8.2 per cent, Morningstar Australian Superannuation Survey showed.
Being in the know
However, different investment strategies have different risk-return profiles in the hedge funds space, with different track records, and according to Lindsay, investors found hedge funds intimidating because they all functioned in different ways.
Industry experts across the board agreed that asset managers had to provide ongoing education to advisers around alternatives.
Gosselin believed there was a lack of information around hedge funds during the GFC, with regulators worldwide trying to ban short selling, which reduced liquidity even further.
Hall said understanding the underlying drivers of return with respect to a particular strategy requires a specialised skill set. He insisted a fund of a hedge fund manager is best placed to build a portfolio of underlying hedge fund strategies.
"If you think about returns going forward, a typical portfolio will be cash plus four to five per cent above the prevailing cash rate," Hall said.
Lindsay said advisers must invest time in researching how it truly worked, what was available, and how hedge funds could deliver returns, and how it had low levels of correlation with other parts of the portfolio.
"It's a big scary world for most people to start in because there are a lot of different conditions. It takes a lot of time and research to come to the conclusion that you're making the right decisions about which hedge funds to choose," Lindsay said.