Betting on hedges for outsize returns

Mr and Mrs F sold the dairy farm four years ago for what they thought then was a great price.No matter that just two years later the buyer resold for $500,000 more. What really hurt was buying into international shares at a high and not only seeing their capital go backwards but, to quote Mr F, "getting bugger-all income either".

Their certified financial planner suggests they switch half of their offending share funds into a new hedge fund which apparently achieved double-digit returns at the same time as their international share portfolio bombed.

Billions of dollars from super-rich investors are apparently pouring into this latest innovation. Their planner advises that a hedge fund is a managed fund that uses a variety of strategies to make a profit.

These can include trading commodities, options and futures, borrowing to invest and "selling short" in the hope of profiting from a fall in the market.

Mr and Mrs F wonder what all that means and whether they should take the plunge too.

The facts are that while some individual funds have produced excellent results, the jury is still out as to whether the hedge fund sector is worth buying into.

Cynics note too that it is difficult to get access to the best performers.

One commentator even remarked that "he wouldn't invest in any hedge fund that would take his money".

Returns locally have been disappointing this year and most funds have fee structures (2 per cent plus 20 per cent of profits) that conventional fund managers can only dream of.

Kiwis, however, have committed several hundred million dollars to hedge fund type vehicles over the years with the OMIP funds from UK-based manager Mann Group extremely popular after three to four years of stellar returns.

For investors and financial planners alike, hedge funds offer the chance to extend the outsized returns and fees of the late 90s global equity bull market.

In the year ended March 2005, however, the hedge fund performance juggernaut has slowed. Not many local investors in hedge funds will be boasting about their returns in the last year. Most funds weren't even able to beat Government bonds in the 12 months and none got anywhere near the 20 per cent return from the local sharemarket.

There is even some doubt about the long-term performance of the sector.

Dr Harry Kat, professor of risk management at the Cass Business School in London, in a speech to a hedge fund conference in October, reckoned that through various statistical problems historic hedge fund returns could be up to 8 per cent a year lower than reported by various indices.

The recent dip in performance could just be an isolated bad patch but the trend is downward and two independent reports on the sector also cast doubt on the industry's long-term fundamentals.

The first report, "Have Hedge Funds Eroded Market Opportunities?", was published in October by broker J.P. Morgan Securities of London.

In it, they argue the very success of hedge funds in attracting billions of dollars of assets under management is "eroding the market opportunities and mispricings they have relied on to create their superior returns".

The 7 per cent recorded by the CSFB Tremont Hedge Fund Index in the March year is well down on the historic average of 11 per cent a year in the past 10 years and it must be remembered that this figure is in ultra-weak US dollars which, in 2004, will have materially assisted hedge funds invested outside the US.

The J.P. Morgan report identifies a number of problem areas for hedge-fund traders where high returns could previously be had with low risk.

One strategy has been to buy shares that are likely to become part of a share index in the hope that institutional and index investors will be forced to buy these stocks at a later date and at higher prices once the changes have been formally announced.

Now that everyone is playing that game, the profitability of this trade has been eroded.

J.P. Morgan also highlights the fact that about one-third of the assets of the typical hedge fund are applied to the art of picking cheap shares versus expensive ones but shows that this strategy too has become much more difficult.

The report concludes "that it is probably too early to write off hedge funds" but warns that they need to continually innovate to survive.

Areas where opportunities remain to be exploited include the currency and junk bond markets. Given the speed at which hedge funds are changing, one wonders just how relevant historic measures of return and risk are.

Indeed, is it reasonable to promote hedge funds as having historic returns independent of shares and bonds when the way these returns are produced is constantly changing?

The second article, by US bond guru Bill Gross, argues that history will record hedge funds as another fad with tulips and the Nasdaq index: "Fantasies ungrounded in reality and common sense."

Gross is to the bond market what Warren Buffett is to equities and, as the 20-year veteran manager of the multi-billion-dollar, top-performing Pimco Bond fund, when Gross speaks the bond market listens.

Gross is not at all impressed by hedge fund managers. Indeed if any other fund manager were to criticise his/her own industry so forthrightly they would likely be asked to retire early or perhaps even man the New Zealand office.

Gross reckons first that intense competition and excessive fees will "reduce the product's average investment return to mediocrity" and, secondly, that anyone who wants to can start their own hedge fund without the fees. Furthermore, he argues that the high historic returns from hedge funds have little to do with buying or selling the right stocks at the right time and everything to do with borrowing.

Gross concludes: "So if you're thinking about a hedge fund to bolster your portfolio returns, give it a long think. They're risky and they're generally overpriced."

On the risk side, a number of commentators see hedge funds as a potential contributor to the volatility of markets, mainly on the basis of their high borrowings.

Some experts have attributed the poor performance of the hedge fund sector generally this year to a lack of "momentum" in markets.

What they suggest is that while many hedge fund managers have genuine star quality some just "follow the trend".

When the market is rising, they buy and hang on in there till the trend stops then vice-versa when the trend is downward. High volatility means strong trends to follow, throw in a heap of leverage and, hey presto, you're a guru.

Sounds straightforward enough ... now who has got $500 million to get me started?

* Brent Sheather is a Whakatane-based investment adviser.