While hedge fund performance certainly dropped in 2008, this reflected the liquidity trap and the ensuing effects on their leveraged strategies, not, they say, on the decisions necessarily of the fund managers.
"The average hedge fund lost 10-20 per cent during the GFC, however, many were able to perform positively," Man Investments director Hersh Gandhi says.
"I am not naive enough to say they [hedge fund managers] were flawless."
The other point they wish to clear up is the confusion investors make between hedge funds and absolute return funds.
"There was a range [of funds] presenting themselves as hedge funds or absolute return funds who did okay in 2008 or 2009," Lanterne Strategic Investors chief executive Lindsay Jones says.
"[But] some were not hedge funds. They were very directional and a lot of those did poorly in 2008."
He says unfortunately investors tend to focus on the performance of these directional funds.
In this regard, to ask hedge fund managers if investors have indeed forgiven the sector for its GFC performance is irrelevant.
"Whilst hedge funds as a group attracted some adverse publicity, there's a lot that didn't. You just need to take a considered and nuanced view," Jones says.
Doing better than expected
The hedge fund industry is concentrating on the future and is encouraging financial advisers and their clients to ask more questions so they can be more informed and take a more diversified approach to investing in hedge funds.
"The mistake that has been made is to have one investment with one manager and in one strategy and to think they have the full spectrum," Alternative Investment Management Association (AIMA) Australian president Kim Ivey says.
Gandhi says definitely there was a period where people were questioning the value of hedge funds. Hedge funds that did the wrong things, such as locking up capital and investing in illiquid opportunities, were certainly punished by investors.
It then may come as a surprise to some to hear that the hedge fund sector is actually doing well. Some strategies have worked particularly well in the prevailing market conditions and inflows continue to grow.
"Inflows into hedge funds are fairly strong globally and in Australia. With $2 trillion in assets globally, the industry is at or around the biggest it has ever been," Gandhi says.
He says the industry has recovered its outflows since 2008. "Man has just had a record quarter globally. We are very optimistic," he says.
Hedge funds using managed futures, global macro and emerging market strategies performed well last calendar year. However, this is likely to change as the economic situations in Greece and other parts of Europe, and Japan should dampen 2011 results.
According to AIMA, there is an estimated $70 billion invested in retail and wholesale funds in Australia. Morningstar says there are about 150 'alternative' strategies on offer.
While Morningstar reports that the Australian retail/wholesale alternatives sector has seen net outflows for the past three calendar years, it also says the rate of attrition from hedge funds has now slowed.
However, it is more conservative than some hedge fund managers as to how much money the sector is currently attracting.
"At the moment there are no huge inflows. Whether this changes depends on the attractiveness of the sector," Morningstar senior research analyst Julian Robertson says.
In Australia, the environment for hedge funds for raising money remains challenging. Jones says the immaturity of the industry going into the GFC did not help the sector as it meant investors were not clear about the distinctions between hedge funds and the strategies employed.
As a result, they tended to fall into the trap of lumping all hedge funds into one fallen category.
Retail market is tough
Reconciling the post-GFC experience with a desire to make greater inroads into the retail sector has been tough for hedge fund managers. Thankfully, hedge fund managers report that the institutional sector and offshore are interested in what they have to say.
"We have set up an investor adviser committee made up of some of the largest superannuation funds. They are indicating they are much more comfortable investing in the sector. They are more comfortable with the governance," Ivey says.
Jones agrees: "Most clients and prospects are offshore. It [the hedge fund industry] has had limited success in attracting funds domestically."
However, he says it is not all smooth sailing in the institutional space. As he sees it, there are still three main barriers to this market - concern about performance in 2008/09, general understanding of hedge funds and the size of investment mandates. "One of the struggles we have is we would love to get super funds, but we need to tick a few boxes in terms of size and familiarity," he says.
In the retail space, Ivey says the main challenge is to get a greater level of quality and objective research from the research houses on what hedge funds are on offer and how they differ.
If this can be provided, it will give financial planners more guidance on the different strategies used and how they can fit into client portfolios.
"Financial planners are being marketed to by a number of hedge funds and so the onus is on the research houses to increase their research of hedge funds," Ivey says.
AIMA Australia is currently working with ASIC to improve the coverage of information on hedge fund strategies.
Further, 18 months ago the AIMA together with Melbourne-based Zenith Investment Partners launched a hedge fund guide to help financial planners understand more about the different hedging strategies.
According to Robertson, one of the challenges in making the hedge fund industry more appealing to retail investors is its traditional fee-only fee structure.
As alternative and hedge fund strategies tend to be more expensive, fee structures can be an issue for retail investors. By introducing performance fees, investors feel as though managers are motivated to deliver the best return they can.
But perhaps a more environmental concern for hedge fund managers is investors' current appetite for more conservative or defensive investments.
"The general sentiment is risk averse. There is a lot of cash on the sidelines and not in active investments and inflows into hedge funds are affected by that," Gandhi says.
"In Australia, institutional [business] leads retail and there is strong interest at the moment. The retail space is a bit slower to recover. I think that's the result of some high-profile failures. And certainly fund of hedge funds are not as prominent as they used to be."
Areas of growth
New entrants and products in the hedge market remain few, but there are some.
Recently, IFA's sister publication, InvestorDaily, reported ASF Balmoral's plans to distribute United States-based manager Evolved Alpha's fund of hedge fund to Australian institutional investors, while in August, Advance Asset Management will launch its Advance Alternative Strategies Multi-Blend Fund in an attempt to recapture adviser interest in hedge funds.
More activity can be expected. According to Gandhi, Australia is an attractive market to hedge fund managers looking to raise funds.
"The fund-of-funds community has severely shrunk since 2008. But foreign institutions look at the size of the Australian asset pool and compulsory superannuation and Australia is a place asset managers want to be," he says.
New products have tended to be based on more liquid strategies such as managed futures. These appeal to investors who have concerns over liquidity and transparency.
Man Investments has seen similar trends. "If anything, in the sub-institutional environment we see people favouring liquid, transparent strategies offered by stable and well-regulated firms," Gandhi says.
"There is definitely a market in Australia for liquid and transparent investments run by well-regulated and stable companies."
One of the impediments to growth for smaller hedge fund managers has been their size.
However, Jones says in the Northern Hemisphere, hedge fund managers have been able to overcome this and in doing so are creating more opportunities for growth.
"Specialist hedge fund investors have allocated to smaller hedge funds until they get to a size where larger institutions invest," he says.
However, unfortunately this pipeline does not exist in Australia. Further, Jones says in the post-GFC environment it is more difficult to attract investors and service providers are less willing to take a punt.
This makes it difficult for small hedge fund managers who were really targeted by investors in the post-GFC redemption environment. Jones says even good hedge fund managers were affected by the hysteria created during the GFC.
"Smaller hedge funds with quite good performance and who didn't freeze their funds were removed from the sector because investors were so desperate to redeem some funds. As a result, a number of funds closed," he says.
Lanterne Strategic Investors is one of Australia's longest-standing hedge funds, having been established in 2001. While size can be an advantage for a manager, in Australia it remains a challenge for hedge fund managers.
"There is no shortage of studies by academics that show small funds outperform larger funds and new funds outperform old funds," Jones says.
But he understands it is difficult for larger institutional funds that may have $50 million to $100 million to invest. He suggests smaller hedge funds could run a separate account for a large institutional client so that they don't become a distorted shareholder of a fund.
Is there still a market for hedge funds?
The right hedge fund manager can add meaningfully to the medium to long-term performance of portfolios. Further, hedge funds try to deliver similar returns to the equity markets with less volatility.
"Our pitch is essentially that hedge funds shouldn't be the sole component of your investment portfolio, but when added they can limit the downside, introduce an element of diversification to dampen volatility and add a different source of return," Gandhi says.
"They are a valuable tool."
These characteristics would seem to make them attractive to investors and hedge fund managers say investors are listening.
"Investors want liquid investments that can diversify other parts of their portfolios offered by stable and transparent managers and if you can construct this, they [investors] will listen," Gandhi says.
But as mentioned earlier, such a sales pitch comes at a time when many investors are risk averse.
Robertson says with term deposits at 6.5 per cent, hedge funds offer investors the cash rate plus, but do have added risk and embedded fees.
"You can still build robust portfolios using fixed interest, equities, property and cash," he says.
To become more attractive to investors, hedge fund managers are going to have to do some work.
"Hedge funds managers are going to have to continue to improve their transparency, ensure decent degrees of liquidity, fees and be properly aligned to clients' investment objectives and to deliver returns over a period of time," Robertson says.
Post-GFC changes
Many of the issues behind international hedge fund managers' fall from grace, such as limited liquidity and excessive leverage, have been addressed through legislative change and changes to the practices and procedures of hedge funds.
Transparency is a key area of reform, designed to give investors greater comfort with the sector.
Jones says he is not so sure all the reforms were needed, with perhaps too much emphasis on making investors comfortable rather than being about risk management.
For example, he questions whether greater liquidity and transparency actually lead to better risk-adjusted returns.
Ivey says in Australia, the hedge fund market has not gone through a great deal of reform. That has mainly been the realm of Europe and North America where there have been quite fiery exchanges between the hedge fund industry and government.
In the US, calls for the registration of hedge fund managers and the periodic reporting by managers to supervisors has been supported by the AIMA, but not because it believes the industry increases financial stability risk.
"In fact, the diversity of our industry's activities serves to reduce pro-cyclicality in financial markets, and thereby supports financial stability," AIMA chairman Todd Groome says.
What the AIMA does oppose is the proposal to tax larger US hedge fund managers to finance the costs of new legislation.
"The inclusion of hedge funds in this financial tax suggests that our industry has been singled out for more onerous treatment," Groome says.
"If this tax is targeted at perceived wrongdoers or those who caused the crisis, hedge funds had nothing to do with the cause of the crisis, and there has been no finding before, during or since the crisis that hedge funds cause increased risk to financial stability."
Meanwhile, the Australian hedge fund industry has always been regulated by ASIC and AIMA continues to work with the corporate regulator to improve the disclosure of the industry.
As it stands, the hedge fund sector and in particular the different strategies used remain quite complicated. Even trying to find out exactly how many hedge fund managers or funds on offer there are is difficult because of the different definitions used to distinguish absolute return funds from hedge funds.
"You can't lump them in one bucket, especially around gearing, which introduces leverage and the need to understand this," Robertson says.
How planners use hedge funds
Hedge fund managers have a few messages they are keen to get out to planners on how to use hedge funds in their clients' portfolios.
According to Jones, some planners fall into the trap of thinking about the near term and try to allocate tactically.
"This will only end up in frustration," he says.
While Strategy First Financial Planning financial planner Patrick Anwandter agrees most investments should be held for the medium to long term, he has concerns over when to exit from a particular strategy.
"Without being able to fully understand the methodology, as an adviser or investor, it is difficult to fully understand the segments of the market cycle when these funds or strategies are likely to outperform, but more importantly, when they can be expected to significantly underperform," Anwandter says.
His other concerns over hedge funds include key person risk and the relatively infrequent redemption process. High fees are also unattractive.
For Ivey, the need to properly diversify across managers and strategies is a critical message for planners.
"It's the same problem managers have with retail investors that follow last year's returns," he says.
"It is not a homogeneous industry. It's extremely diverse. It's very important to have exposure to different strategies."
In many ways the questions and concerns advisers have about hedge funds are the same as the ones they had before the GFC - performance, understanding hedge fund strategies and how to best use them in clients' portfolios.
Gandhi says this is not a bad thing given the diversity of the sector and the amount of strategies employed by hedge funds. Performance is always a valid issue to ask questions about. «
