Insights

Debunking the hedge fund myths

7 May 2013

The hedge fund industry is currently worth around $208 billion in Australia alone*. But while investors are familiar with the concept of traditional ‘managed funds', there is less awareness of how hedge funds operate... which is the root of many misconceptions.

Mark Burgess, Principal of Kardinia Capital and Portfolio Manager of the Bennelong Kardinia Absolute Return Fund, debunks the myths surrounding hedge funds. Mark has over 25 years of experience in the financial services industry in Australia, London and New York, and has been managing hedge funds for over eight years.

What are hedge funds?

The RBA says the term ‘hedge fund' is typically applied to "managed funds that use a wider range of financial instruments and investment strategies than traditional managed funds, including the use of short selling and derivatives to create leverage, with the aim of generating positive returns regardless of overall market performance"**.

In other words, hedge funds aim to ‘hedge' or manage the risks of a volatile market by using a variety of different and often innovative investment strategies.

Myth no.1 - hedge funds are only for the very wealthy

This may have been true in the past, when hedge funds were commonly set up as private investment partnerships open to a limited number of investors and requiring a substantial initial investment. But this is no longer the case, as an increasing number of retail hedge funds are now available.

Until recently, the Bennelong Kardinia Absolute Return Fund was only accessible to wholesale investors with a minimum of half a million dollars. But today, investors can access the fund via a PDS with as little as $20,000. We see this market as a real growth avenue - there is a lot of interest in the absolute return space. Some investors are quite disillusioned with the returns they've achieved from more traditional Australian equity managers over the last five years, and are looking for strategies that can give them a positive return in any market environment.

We have quite a diverse investor base made up of high net worth individuals and family offices, but also fund-of-funds, charitable organisations, financial planners, dealer groups and, increasingly, self-managed super funds.

Myth no. 2 - hedge funds are risky

Most hedge funds are active managers of investment risk with defensive strategies in place.

An index fund, perceived by some as a ‘safe' option, is at the mercy of the volatility of the market it tracks; susceptible to fluctuations which aren't actively managed. However, a market neutral hedge fund targets a positive rate of return regardless of the return of the market, which means the risk is actively monitored, positions are hedged and exposure to the market limited as required.

Some hedge funds are purely focused on preserving capital (ie. your original investment), so making strong returns over the short term is not their primary focus. While others only trade when opportunities arise and have clear investment guidelines which act as a framework for their investment decisions - such as exposure limits, risk management frameworks, stop loss levels, etc.

While hedge funds do aim to generate returns from exploiting market anomalies such as mispricing between similar securities, this is done within a framework of managing risk. The Bennelong Kardinia Absolute Return Fund, for example, aims to achieve double-digit annual rates of return - but its objective is to do so without compromising on capital protection.

We are as focused on avoiding losing money as we are on making money. It comes down to the risk parameters around which you structure your funds. We have pretty conservative gross and net exposure limits and have never used financial leverage, which was clearly the area in 2008 where most of the problems occurred. We use stop losses in a dynamic sense at the individual stock level, and employ derivatives to hedge our physical exposures when necessary.

Risk management requires deep knowledge and market experience. Before you select a hedge fund, it's critical to undertake your due diligence... people and processes are critical.

Myth no. 3 - hedge funds have exorbitant fees

The typical hedge fund fee structure in Australia is 1.5% management fee and 20% performance fee. At first glance, this appears to be high when compared to long-only domestic managers. To see true value for money, however, you need to focus on returns not just fees. If you're paying very low fees but the fund is not performing, this is a false economy.

Performance fees are only payable when the fund outperforms its benchmark, meaning investors pay for the manager's skills and expertise when they're getting a good return on their investment.

Myth no. 4 - hedge funds are illiquid

In Australia, redemption restrictions and high withdrawal fees are rare.

Units in the Bennelong Kardinia Absolute Return Fund, for example, are priced daily and the redemption process is as straightforward as for a long-only equities fund. While the recommended investment period is for five or more years, investors can withdraw a minimum of $10,000 at any time, should the need arise. In addition, there are no withdrawal fees.

Myth no. 5 - hedge funds are unregulated and lack transparency

In Australia, hedge funds are as tightly regulated by ASIC as any other managed fund, if not more so. ASIC has recently introduced changes to reporting and increased investment process transparency, which will further improve the current status quo.

Our approach is to be as open and transparent as possible, not only with our existing investors but also potential investors. We have a six-year track record, with detailed data going back every month since inception, which includes portfolios and breaking down the attribution to every single basis point on each position. This data enables investors to undertake a thorough due diligence analysis. We also have research houses review our processes and fund, providing an impartial assessment.

Any reputable hedge fund manager will have compliance controls in place. One of the reasons we partnered with Bennelong Funds Management***, was their robust governance. They have invested considerable resources in their internal governance andcompliance framework, utilising the support of external specialists as needed. This back-office support allows the investment team to focus on what is most important: managing the fund and achieving strong returns for our investors.

Conclusion

Hedge funds play a unique role when teamed with a portfolio of more traditional investment products. They can reduce volatility and increase returns, as returns are correlated quite differently than those of a traditional long-only fund. Next time you're creating a personalised portfolio, consider adding a hedge fund to the mix.

*http://www.moneymanagement.com.au/news/investment/alternative-assets/australia-supports-strong-hedge-fund-industry
**http://www.rba.gov.au/publications/fsr/2004/sep/pdf/0904-2.pdf
***Kardinia Capital is a Bennelong Funds Management boutique.

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