Hedge funds make the move to mainstream

HEDGE funds, once the pre-serve of wealthy individuals and institutions, are now readily available to Australian retail investors.

Well-known investment man-agers like Colonial First State, Deutsche and Rothschild have launched new products this year.

The managers have what appears to be a compelling sales pitch – that they can achieve high returns, averaging 12 per cent to 15 per cent a year, even in depressed markets, and reduce risk in a balanced portfolio. Does the reality match this claim?

The preferred approach is the ‘fund of funds’ structure. Instead of investing in one hedge fund, money is spread across 10 or more different hedge funds.

Most Australian firms also team with an established ‘fund of funds’ manager to select the underlying funds. For in-stance, Colonial has partnered with Zurich-based Harcourt Investment Consulting and Rothschild has teamed with Chicago-based Grosvenor Capital Management.

Colonial’s Damien Hatfield says currently there are up to 8,000 hedge funds worldwide managing $US500 billion.

A defining feature of hedge funds is that they focus on absolute returns regardless of general market conditions. For instance, if the share market falls sharply, hedge funds still aim to achieve positive returns.

In order to achieve their targeted returns, hedge funds tend to be active traders rather than ‘buy and hold’ investors.

Beyond this generalisation, there is enormous variety in the industry. Mark Thomas of van Eyk Research describes the hedge fund industry as a “diverse and opaque world”.

More than 20 different investment strategies are employed by hedge funds. While some hedge funds resemble main-stream investment managers, others are much more aggressive, using short-selling, gearing and derivatives (see article below).

Mr Thomas says individual hedge funds could be risky, losing money or even collapsing in extreme cases.

However, by mixing a variety of hedge fund strategies, the risk tends to fall dramatically, he says. This reflects the extraordinarily low correlation between the risk and return profiles of different hedge fund strategies.

Investors also need to re-cognise the low correlation between hedge funds and traditional assets, such as shares and bonds. By diversifying into hedge funds, investors can actually reduce their portfolio risk.

A good example is Deutsche’s Strategic Value Fund, which returned 5.7 per cent over the past year. Over the same period, all major global share markets were in negative territory.

Investors in hedge funds need to recognise some key differences from traditional managed funds.

The redemption period (when people want to exit their investment) can be longer than normal, up to three months.

Fee structures are also different. As well as entry fees and management fees, some ‘fund of funds’ levy a performance fee of 10 per cent or 15 per cent on profits above a defined hurdle rate.

The Rothschild ‘fund of funds’ does not levy a performance fee. This is an exception in Australia, but is normal practice overseas, according to Rothschild’s Richard Keary.

Mr Keary says another issue is that investors in hedge funds may be taxed on an accruals basis.

This means that investors are taxed each year on either the increased value of their investment or a deemed rate of return. The tax liability applies regardless of whether or not the investor receives any distributions.

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