Walk into the office of Phillip Boustridge at Pengana Capital's Sydney office on Bond Street and you will notice immediately that this is no ordinary office.
The room is filled with computer screens. There are three desks in the office and among them they have a grand total of eight screens, four of them are Boustridge's. There is no doubt possible: he is a quantitative fund manager.
Quantitative fund managers make use of complex mathematical and statistical models, measurements and research in their analysis of companies.
By assigning a numerical value to variables, quantitative analysts try to replicate reality mathematically, and hopefully predict movements in share prices. To do this, they need computers, lots of computers.
It is also striking to see how extremely organised the office is. For example, the desks are spotless and virtually empty. They look as if the team moved in a few hours ago and have just got their feet under the table.
"We have a clear desk policy here. After all, loose documents are just unprocessed data," Boustridge says.
Yet he has been working for more than two years in this control room on a new hedge fund that he says has the potential to take the retail market by storm.
"People now know what risk actually means. Risk is a budget that you can spend and you have to look at the risk-adjusted returns," he says.
The new fund combines quantitative analysis with more traditional stock analysis, using information gathered by other Pengana fund managers, into what is called a market-neutral fund.
A market-neutral strategy is a specific type of long/short fund in which an equal amount of long positions are held as there are short positions.
"If the fund would hold the market you would have no return, but our skill in stock selection determines the return," Boustridge says.
This strategy makes it possible for the fund to create positive returns even in a market downturn. For example, they might buy BHP Billiton, and also take a short position on Rio Tinto, because their research has shown that BHP will outperform Rio Tinto.
If the entire stock market collapses, both stocks could go down along with the market, but as long as BHP does better than Rio Tinto the tactic will produce a net profit for investors.
Because the strategy cancels out market movements, it has almost no correlation to indices. Investors can clearly see what they are paying for because the fund manager has nowhere to hide. After all, if returns are bad, Boustridge cannot blame the market.
"You don't pay us a fee for getting 95 per cent index returns; you pay us for skill," Boustridge says.
Judging by the performance table, he certainly seems to have skill. On an annualised basis, the fund has achieved a gross performance of 10.3 per cent since September 2008. If not hindered by any form of knowledge you could genuinely ask: what crisis?
Demand for hedge funds is growing
Listen to Boustridge speak and the case for hedge funds is undoubtedly an attractive one. The prospect of building wealth in both upturns and downturns is appealing, and there certainly seems to be more demand for products that deliver reliable and steady returns.
The global financial crisis (GFC) has made it painfully clear that investors' horror at losing more than half of their wealth by far outstrips their enjoyment of seeing 20-25 per cent annual returns for a limited period of time.
"Equities are great, they have very good long-run return characteristics, but they are also very volatile," BT Investment Management head of macro strategies Joe Bracken says.
"So the man in the street wants another investment that is less volatile, less linked with equity market risk, to soften the blow.
"Particular advisers, they are less concerned with making their clients 25 per cent one year, lose them 12 the next and making them 10 the next, losing them 15 the next. That kind of volatility they don't want. They are far more interested in smoothing out those returns and really breaking down the risks as far as possible."
Bracken says there has been a significant change in the collective investing psyche since the GFC. Where three years ago it was all about returns, it is now much more about reducing downside risk and hedge funds are the beneficiaries.
"The tide has turned significantly and we are seeing, not just ours, but also other absolute return funds go on approved product lists. The tide is very much turning in favour of the absolute return funds," Bracken says.
This renewed interest is in part due to the fact that, despite some eye-catching failures, the Australian hedge fund sector has on average held up quite well during the GFC.
"If you stand back from it and look at what happened during 2008 and 2009 you will see that the vast majority of absolute return funds actually survived the GFC pretty well," Bracken says.
"They limited their drawdowns significantly and then when the markets came back they participated in the upside quite well. They actually did quite well throughout the GFC and beyond."
Australian Fund Monitors tracks the performance of global and domestic hedge funds (see graph). A comparison of the Australian hedge fund universe with the ASX 200 Index shows these funds were certainly not immune to the market downturn, but they did not decline anywhere near as much as the index. And when stripping out the fund of hedge funds, the sector's performance is even better.
According to Australian Fund Monitors data, $100,000 invested in the ASX 200 in September 2007, when the United States sub-prime crisis started to spread around the globe, was worth $65,495 by the end of June 2010, a decline of 34.5 per cent. The same amount invested in the hedge fund sector as a whole would give you a decline of 1.2 per cent, leaving you with $98,819 in your portfolio.
An investor who had put their $100,000 in single hedge fund managers (excluding fund-of-hedge-fund managers) would have booked a gain of 4 per cent and would now have $104,182 in their portfolio.
The reasons why fund of hedge funds have done worse than single managers are diverse, Australian Fund Monitors chief executive Chris Gosselin says.
"You have a second layer of fees, many were invested in offshore managers which have been hit harder than Australian funds, and then you have currency risk," Gosselin says.
"But the greatest problem in 2008 was that the bulk of retail money was in fund of hedge funds, which did not have the liquidity that retail investors were led to believe they had."
Reminders of the past
Investors might have become more attracted to hedge funds, but dealer groups have traditionally shied away from adding these funds to their approved product lists. Snowball is one group that admits it finds it hard to support these funds.
"They are hard to explain to clients and they are too illiquid," Snowball Group managing director Tony McDonald says.
McDonald also says many funds promised the skies, but failed to deliver at the time of reckoning.
"The promise was that they would not be much affected by a downturn in the market, but the GFC has showed differently," he says.
"They didn't deliver."
When done properly, hedge funds can go a long way in providing diversification and reducing risk in an investment portfolio. But when done poorly, bad things will happen, and the hedge fund industry certainly had more than its fair share of train wrecks.
The most spectacular hedge fund collapse in history was undoubtedly that of US arbitrage fund Long Term Capital Management.
The firm's founders had developed a model that was based on making small profits on thousands of trades in bond and equity futures.
Because of the large number of transactions involved, the firm was able to gear up to extraordinary heights, as the chances of everything failing at once was perceived to be tiny.
In fact, the founders estimated that the chance of losing 20 per cent of their assets would be one in a hundred, and so they geared up to the point that in late 1997 the fund was running more than US$120 billion in debt against just US$4.7 billion in capital. It was as if they had found a way to weed out risk.
But then reality caught up with them. In 1998 the Asian financial crisis hit, followed by a collapse in the Russian financial system. As a result of many markets failing simultaneously, Long Term Capital's model came crashing down.
Its arbitrage positions in Japanese and European bonds turned into catastrophic losses and led the firm to lose almost US$2 billion in a matter of months. The firm had to be bailed out in a US$3.6 billion rescue operation orchestrated by the Federal Reserve Bank of New York.
It is cases like these that have given hedge funds a shady image, and this was not helped by the demise of a number of Australian hedge funds in recent years. One notorious case is that of Basis Capital, whose high-yield fund invested heavily in collateralised debt obligations.
As these instruments plummeted in value, margin calls were made and assets were sold off into a falling market. The fund was ultimately placed into receivership and the units of what was left of the fund became virtually worthless.
The impact of the collapse continues to be felt and last month Basis Capital sued investment bank Goldman Sachs for $1 billion, claiming it was misled by the Wall Street giant when it bought a security, called Timberwolf, which consisted largely of sub-prime mortgages.
Fund of hedge fund HFA Capital nearly collapsed due to the large amount of redemptions it had to face as international hedge funds saw their funds under management evaporate.
And then there is the case of Astarra Asset Management, later renamed Trio Capital, which did not lose money because it miscalculated risk, but literally has lost it as in it has no idea what happened to it. Not even a private investigator could track all of the money that was invested in the firm's flagship fund, Astarra Strategic.
Poor image
These headline cases have given the sector a bad reputation and evoked the image of hedge funds being highly risky products managed by Italian sports car driving whiz kids without a sense of responsibility.
The very term hedge fund itself now evokes such negative connotations that most fund managers refrain from using it.
"We are a hedge fund, but my lawyer says we're not," one fund manager summarises.
Instead fund managers have adopted the names of the various hedge fund categories, such as market neutral and absolute return fund.
But the original idea behind a hedge fund strategy is to reduce risk, not to increase it. A hedge fund tries to reduce risk of its stock holdings by short selling other stocks.
The idea is that the short positions provide some return in case the companies held in the portfolio do not perform as expected. The first person to use this strategy was Alfred Winslow Jones. He was born in Melbourne in 1901, but moved as a young child to the US.
After a stint as a diplomat in Germany, he returned to the US and ended up working for Fortune magazine. The story goes that he became interested in managing money while he was writing an article about the latest investment trends in 1949.
And so he raised $100,000 to establish a partnership and became the father of the hedge fund.
Hedge fund managers like to refer back to the original principles of the funds when they explain they are in essence really quite conservative vehicles that provide a sure route to wealth creation. But the sector seems to continue to be shaken up by spectacular failures.
The reason for these collapses lay partly in how these funds are managed. Because they aim to be uncorrelated to the market, the funds performance rests almost completely on the skill of the manager.
This poses two problems. One is of a competitive nature. If a manager really does run a process that works, other people are likely to want to copy it.
Historically, managers have, therefore, operated under loosely regulated structures, which enabled them to conceal most of their processes.
Unfortunately, these 'black box' strategies provided a welcome excuse for the not-so-impressive managers to dress up simple strategies as rocket science and charge corresponding fees for them.
"A lot of absolute return funds cloak themselves in this air of mystic: 'oh, we are very complicated and we are doing this and we're doing that. It is so complicated that you could never understand it', which is somewhat hubris on their part," Bracken says.
"They like to pretend that they are incredibly sophisticated. At the end of the day an ordinary investor should be able to understand what you are doing. In our global macro fund, the strategies are fairly straightforward and I think fairly understandable to the average person."
The second problem in decoupling an investment from the market is that you rely completely on a manager's skill to deliver returns. What if they get it wrong? In the case of Long Term Capital, the founders genuinely believed they had a rock solid model, and the numbers stacked up in their favour, but still it collapsed. Often the problem is that overconfidence in the developed investment model leads to assuming too high levels of leverage, which makes firms vulnerable when major shifts in the market occur. Quant funds rely on a mathematical model of reality, not reality itself, and these models need constant monitoring and finetuning.
"We often encounter fund managers who claim to have found the perfect model. And so we ask them: 'What do you do the rest of the month?'" Boustridge says.
Fees
Hedge funds have also been chastised for charging what have been perceived as exuberant fees.
Hedge funds have a long history of charging performance fees, starting with Alfred Jones, who charged his clients 20 per cent of the fund's gains, apparently inspired by Phoenician sea captains who kept a fifth of the profits from successful voyages.
In the early days of hedge funds in Australia, some managers took advantage of the limited understanding people had about fee structures. As one fund manager recalls, performance fees were charged on anything above flat returns. "It basically meant they can put their clients' money in a term deposit and charge a performance fee over the interest generated without having to do anything at all," the fund manager says.
And there still are some funds that claim to be a hedge fund so they can charge hefty fees.
"A lot of fee structures are not right out there at the moment," Fitzpatricks chief investment officer Alex Hone says.
Some 130/30 long-short funds out there charge hedge fund-type fees, but have near index returns.
But at the same time, the debate about appropriate levels of fees has recently been somewhat one-sided, Hone says.
"If a manager makes 20 per cent returns after fees consistently, then I don't care how much fees I pay," he says.
Gosselin agrees: "Fees should be judged on the basis of after-fee returns."
There have been some efforts made to bring low-cost hedge fund strategies to the market. Suncorp has been working on a strategy, called Global Premia, that tries to replicate the strategies at minimal cost. It argues that there are a number of good strategies out there that are relatively easy to implement.
Bracken is unconcerned about the competition these strategies might form. In fact, he is rather taken by the idea.
"I actually think it is good that people are more sophisticated now that they can say: 'Now hang on, you said you were Mr Complicated, Mr Black Box, Mr Look-we-are-so-clever, but in actual fact I just replicated your returns using this very simple strategy'. I think that is a great idea," he says.
But Bracken argues that running a true hedge fund that produces as close to pure alpha (investment gains that cannot be earned from exposure to a market index) as it can is an expensive process, no matter how you look at it.
"At the end of the day, despite what you might read in various magazines, alpha is hard to find and it is expensive. The investor will typically get beta fairly cheap, but to get and capture alpha that is unrelated to the beta part, that is always going to demand a premium," he says.
Understanding the risks
Hedge funds can be a solid and conservative investment, but it is essential that investors understand the underlying process that is being applied to make sure they understand the risks they take on. And not everybody is equipped, or has the time, to immerse themselves in the intricacies of the hedge fund world.
Fitzpatricks is one of the few dealer groups to make use of hedge funds in their advice business. Hone - a former Magellan Asset Management portfolio manager, who joined Fitzpatricks just 15 months ago - runs a number of strategies, including a market-neutral fund.
He says the access to good hedge fund research is one of the prime reasons why these funds have not seen a more widespread use among planners.
"We have a team of four full-time investment staff, all with backgrounds at institutional investors. Even with a professional team like ours it is not always easy to understand the strategies out there," he says.
He believes it would be nearly impossible for an adviser to get a good understanding of all the strategies out there, as it forms only a small part of their overall advice services.
Hone gives the example of a hedge fund that lost 10 per cent in value when an arbitrage position on the 90-day bank bill rate in Europe did not work out.
"Many advisers would struggle to explain that to their clients," he says.
"The importance of understanding your absolute return fund is paramount, because you are buying manager risk."
Hedge funds are very different animals to traditional managed funds.
"It is like making a cake and putting rhubarb in it: it is not wrong, but when you bake the cake it could behave very differently than what you expect," Hone says.
Fitzpatricks has made the incorporation of hedge fund strategies work for it because the funds are run internally, through its investment arm, Atrium Investment Management. It bears full responsibility for the funds, while advisers have access to any research they need, Hone says.
Besides, the firm runs most of its investments through managed discretionary accounts, which means the firm has a fiduciary role towards its clients.
"We do everything internally from the ground up, so we are not [dependent] upon a research house," he says.
Research houses confirm the demand for reliable hedge fund analysis has increased.
"Investors are looking more for investments that are uncorrelated to traditional assets," Lonsec analyst Deanne Fuller says.
The single manager space has attracted the most activity, Fuller says.
"We haven't seen any money flowing into the fund-of-hedge-fund space. The picture is a bit different in the single manager space. We are seeing a bit of money flowing into where strategies have preformed well in the past. It's people chasing returns," she says.
Lonsec has expanded its coverage of the sector partly because of this higher demand, but also because more high-quality managers have entered the Australian market.
"We certainly have increased the coverage of single hedge fund managers,' Fuller says.
"We probably added five funds in the single manager space and this year we will add one more fund."
The case for hedge funds is attractive, especially from the perspective of an ageing population that needs steady investment gains without too much volatility.
But the process of investing in these vehicles still includes a number of significant pitfalls and advisers need all the support they can get if they are to navigate their way through this complex industry successfully.
The question is whether dealer groups are able and willing to put their resources into research and eduction, or whether they will throw them in the too-hard basket.
Source: www.fundmonitors.com
