Clipping the hedge fund investing myths

Among the many common misconceptions about hedge funds is that they are not available, or suitable, for retail investors.

As with many inaccuracies about hedge funds, these misconceptions arise partly out of the history of the hedge fund sector, partly out of overseas experience and partly out of a lack of knowledge or education by the industry in Australia.

The main focus of these misconceptions generally sits with the minimum investment required for absolute return or alternative managed funds, with it frequently being reported that they are only open to sophisticated investors or institutions. This is, and has been, the case in the United States where the industry first evolved, and is also often the case in Europe, although this has changed with the introduction of what are known as “UCITS” funds (Undertakings for Collective Investment in Transferable Securities).

Added to the perception that absolute return and hedge funds strategies are only open to sophisticated investors is that they have limited liquidity and frequent “lock-ups”, where the initial investment cannot be redeemed for periods of 12 months or more without penalty. Once again this has often been the case in the United States, and particularly with those funds which invest in more illiquid assets or that use strategies requiring time before the investment’s pay-off could emerge.

Ready access for investors

In Australia, however, the simple facts are that there are a wide array of absolute return and hedge funds available to individual investors with minimum investment amounts ranging from as little as $2,000. Furthermore, the liquidity of the majority of funds in Australia with minimum investment amounts of $50,000 or less is daily or weekly. In addition, there are a wide range of strategies open to investments of less than $50,000, even though the majority are equity-based.

So firstly, let’s look at the total universe of 214 funds in our database that are currently open to investment. Of these, 120 (over 50%) have a minimum investment amount of $50,000 or less.

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Breaking down the data for those funds open to investment of less than $50,000, we can see that 75% of them have minimum investments below $25,000. Clearly size is not a barrier to investment in absolute return and hedge funds by smaller or retail investors.

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Turning to the variety of funds also shows that there is an wide choice between asset classes and their investment strategies, which is on a par with the choice available to large investors and institutions. For this purpose I have divided asset classes between those funds investing in equities, whether local or global, from those investing in alternative assets such as commodities currencies or fixed income.

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Picking a hedge fund strategy

Inevitably the majority of funds invest in equities, even though the variety of strategies available within each of the two broad asset classes is considerable. Therein lies part of the challenge for retail investors and their advisers: the variety of investment strategies employed by the various funds makes both understanding, analysing and selecting suitable funds far more of a challenge for the smaller investor than actually finding funds which are open to their investment.

Some investors may question the inclusion of “equity long” strategies in these tables, but the definition I use when filtering strategies with equity long funds is that they can be highly concentrated or, in the event of concerns about market direction, can move to cash to avoid market risk. In addition, some equity long funds use broad derivative exposures to hedge against market risk.

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Turning to the criticism that absolute return and hedge funds are illiquid, with lock-ups and redemption periods that are unattractive to retail investors. Once again the facts clearly disprove this, not only for funds with lower minimum investment amounts, but also for all funds in the database. This is an area where Australian funds differ significantly from their North American counterparts, which do frequently have longer lock-ups, generally a minimum of one month, but frequently three months or more.

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Availability vs suitability?

Finally, of course, there is the issue that even if funds are available to investors with less than $50,000, are they suitable for retail or unsophisticated investors?  This is much more to the point and I would suggest that the research industry in Australia, which frequently struggles to overcome basic conflicts of interest, has not in the past always provided retail investors or their advisers with a reliable source of accurate or reliable information on which to base their decision.

Frequently absolute return and hedge funds are criticised for poor performance, and as I have always acknowledged, there are funds where performance has been substandard, or which I would have thought were not suitable for unsophisticated or risk averse investors.  For this, some research houses, overly enthusiastic marketers, and ill-informed advisers should shoulder the blame.

However, the reality is that there are funds open to investments of less than $50,000 and available to retail investors which have provided excellent risk-adjusted returns, as can be seen in the following tables showing the distribution of returns over the past one, three, and five years.

What is apparent when looking at each of the three time periods is the significant difference in performance between the best and worst funds, and this in part explains why it is so difficult for retail investors (or any investor for that matter) to select between the various funds available. Added to this difficulty is the fact that funds, which might perform well in one particular environment, may struggle under different market conditions.

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I am a supporter of the absolute return and hedge fund sector. However, I am not a blind follower and am well aware of the risks and dangers of funds that have been, in my opinion, incorrectly marketed to retail investors. I believe that the structure of fund research, and the distribution process for retail investors, has the potential for significant improvement.

There is no doubt that the more complex investment strategies involved with hedge funds demand significantly greater understanding by investors, and therefore research and investigation. However the clear fact is that the best funds (not always in the majority) do provide investors with the benefit of significantly better risk-adjusted performance.

Chris Gosselin is chief executive officer of Australian Fund Monitors Pty Ltd. www.fundmonitors.com