29 October 2013
To many Australian investors, the term ‘hedge fund’ still conjures up images of high-risk, high-return funds run by secretive geniuses, speculating in all sorts of global markets, taking big bets – which occasionally blow-up, taking investors’ money with them.
It is an image that needs to change, says Mark Burgess, co-portfolio manager of the Bennelong Kardinia Absolute Return Fund (the Fund).
Transparency is non-negotiable
Mark says the reality of equity-based absolute-return funds is less glamorous but far more dependable – particularly in the Australian market, where transparency of a fund’s investment process, internal governance and compliance record is critical to gaining acceptance from the gate-keepers of the Australian funds management industry.
“In this market there are asset consultants, research houses, investment committees, trustee boards, dealer groups’ Approved Product Lists…and you have to satisfy all of them that you have a process that won’t deliver any nasty surprises,” says Mark. “Transparency is non-negotiable – particularly if you want to get retail money.”
In fact, Mark and his co-portfolio manager, Kristiaan Rehder, take this openness to extremes that would shock many of their northern hemisphere counterparts: they provide any investor – or potential investor – all the data pertaining to their portfolio, even the performance attribution of every position, down to the last basis point, going back to the fund’s inception in May 2006. “Investors are going to do due diligence on us, so we provide them with everything they will need,” says Mark. “Then it is up to them to analyse it and decide whether or not they want to invest with us.”
Outperformance… with less risk
It is a fair bet that most would like what they see. At 31 August 2013, the Fund had, since inception, earned an annualised return of 14.1% a year, compared to 4.87% for its benchmark comparison, the Reserve Bank of Australia (RBA) cash rate.
Mark says the Australian equity-based hedge funds as a sector have “done exceptionally well” against the sharemarket’s return.
According to independent data from research firm Australian Fund Monitors (AFM), which covers more than 250 absolute-return and hedge funds managed in Australia, its AFM Equity Fund Index (which tracks 208 Australian-offered funds) outperformed the S&P/ASX 200 Accumulation Index over the period of January 2003 to June 2013, with a return of 11.53% a year, compared to 9.22% a year for the market benchmark.
The universe of funds covered by the AFM Equity Fund Index covers a range of strategies, including market-neutral, long-only, income, long/short, buy/write, event-driven and 130/30.
Importantly, the equity-based funds have outperformed the market with less risk. The standard deviation for the AFM Equity Fund Index was 7.88% a year, versus 13.41% a year for the S&P/ASX 200 Accumulation Index. In terms of largest drawdown, the peak slump for the AFM Equity Fund Index, at -25.22%, was significantly less than the largest drawdown for the S&P/ASX 200 Accumulation Index, which came in at -47.19%.
As measured by Sharpe Ratio, investors received more than twice as much reward for each unit of risk if investing in the AFM Equity Fund Index as opposed to the S&P/ASX 200 Accumulation Index: the Sharpe Ratio for the former was 0.81, compared to 0.37 for the latter.
A particular case in point is the period of January 2008 to June 2013 – which isolates the impact of the GFC – the performance of the AFM Equity Fund Index return again exceeded that of the S&P/ASX 200 Accumulation Index, with a return of 4.04% a year, compared to -0.53% a year.
The risk comparison again favoured the absolute-return funds. The standard deviation for the AFM Equity Fund Index was 8.90% a year, versus 16.09% a year for the S&P/ASX 200 Accumulation Index; while the largest drawdown is 23.97% as compared to 44.13% respectively. Finally the Sharpe ratio was 0.01 for the absolute-return index, against -0.22 for the S&P/ASX 200 Accumulation Index.
“The sector has effectively lived up to its value proposition to investors,” says Mark. “Absolute-return equity funds play a role in a diversified portfolio of both achieving returns that are less correlated with those of traditional long-only funds, and they have also demonstrated an ability to reduce the portfolio volatility. Speaking for our own fund, our correlation with the Australian market is about 65%, and we’ve had half the volatility of the market.”
The track record should “debunk the myth that hedge funds are inherently risky”, he says.
Getting value for money
Nor are they expensive, he adds. “That is another misconception. The typical absolute-return fund fee structure in Australia is a 1.5% annual management fee and 20% performance fee, which is triggered when the performance exceeds a certain level. For the Kardinia fund, that level is the RBA cash rate.
“We are a long-short equity fund, with a flexible mandate, we’re saying that potentially we can make you money in any market conditions, so we want an absolute benchmark. It’s fine for a long-only equity fund to benchmark itself against the equity market index, but we're saying to investors: we know you're taking some risk, so unless we can do better than what you can get putting your money in the bank, you shouldn’t be paying us a performance fee ,” he says.
In any case, an investor has to consider returns net of fees, he says. If they are not getting value for money, says Mark, they should look for another fund.
Understanding the fund’s proposition
Not all of the funds are the same, he says, which means investors should take the time to understand what they are getting. “To assess whether the fund is ‘true to label’, you have to understand what the fund claims to do. Our fund, for example, aims to achieve double-digit annual rates of return through an investment cycle, with an over-arching philosophy of capital protection.
“To do that, we’re going to pick stocks to hold, and pick stocks to sell short. It’s a ‘variable exposure’ or ‘variable beta’ fund – where we can adjust our exposure from having no net exposure to the market to 75% net exposure – but we will have some short positions at all times. We like the discipline of always having shorts in place and always having some protection and hedging in place, for the next event that comes along that no-one can foresee.”
Mark describes his and Kristiaan’s approach as ‘style-agnostic’. Being both Chartered Financial Analysts (CFAs) by training, they analyse the macro-economic situation to identify key thematic influences and trends before drilling down to individual companies and their operating environment.
“Management quality is important to us. We don't want to do detailed modeling – we let ‘the street’ (that is, analysts) do that for us. We have access to their research and models, and we’ll input our own assumptions into those, to ‘stress-test’ what might happen to earnings if you adjust interest rates, currencies, etc. The final step is the valuation, supported by some technical analysis.”
The portfolio is “high-conviction” – there will be somewhere between 20 to 50 stocks in the portfolio at any time, either long or short. Usually about 10 are short positions, limited to 1% of the fund’s net asset value (NAV) each. Mark and Kristiaan treat their short book as a profit centre – they go short to make money, not to hedge long exposure.
Although the pair likes to buy stocks that look cheap, Mark says looking cheap is not enough. “We need to identify a catalyst that is going to see that value recognised by the market, because otherwise it could be a value trap – low price/earnings (P/E), high dividend yield – but it can sit there and look cheap for five or 10 years, and never deliver, because it’s not actually a good business. We see this all the time.”
When the pair forms a fundamental core view on a stock, normally they look to hold it for at least 12 months, unless something goes wrong to change that thesis. Mark and Kristiaan are quite prepared to trade around specific events – for example, results announcements, index inclusions/exclusions, entitlement offers, ‘creep provision’ buying – and of course, they will go short.
The pair has worked together for seven years. “We sit next to each other and throw ideas at each other all day, every day, so we don’t need to have an investment committee meeting once a week,” says Mark. “We are very dynamic, very reactive and I guess, nimble and flexible. And we enjoy our work – which is the most important thing, in a lot of ways.”
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