Danger of hedging your bets

Hedge funds were sold to small investors as a way to get a slice of the action that had been available only to wealthy individual investors or institutional investors.

But many hedge funds have proved a disappointment. The money in some, such as Astarra, went missing. Others, notably Bernard Madoff's hedge fund in the US, were no more than Ponzi schemes where new money was used to pay existing investors high returns.

Most hedge funds have produced poor returns and many have closed, or are in the process of closing, and are returning money to investors. Some other managers have frozen or restricted redemptions from their funds.

Before their reputations were shredded by the financial crisis, hedge fund managers operating in tax havens in the Caribbean or in the US and Europe were regarded as among the best and brightest of the funds management industry. They rewarded themselves handsomely. The funds tend to have hefty performance fees and, in the good times, hedge fund managers made a fortune for themselves.

They promised the low risk of fixed interest with the high returns of shares. These two things - high returns and low risk - have long been regarded as incompatible in the same investment. They also promised returns that were not correlated to the performance of the sharemarket.

In 2001, just after the launch of several hedge funds aimed at small investors, a leading financial planner, Robert Keavney, said there was "nothing on this planet that is more or less guaranteed to give double-digit returns every year". He said investors had other options available to them in volatile periods, such as fixed interest, property and cash, which are not correlated to the sharemarket.

The hedge fund promoters promised returns of between 10 per cent and 15 per cent a year after management fees, over at least three years, regardless of the direction of share and bond markets. For small investors, hedge funds were bundled up into one offering by the big fund managers. Investing in several hedge funds through "fund of hedge funds" was considered more prudent for small investors because individual hedge fund managers were considered too risky. Hedge funds are mostly small businesses and usually not subject to regulation, though there are moves by governments overseas to bring them into the regulatory net.

The funds of hedge funds invested in up to 30 underlying hedge funds across a variety of impressive-sounding hedge fund strategies. Some of the more popular strategies include "long short", which is where the manager bets the price of some stocks will fall and others will rise, and "macro" strategies, where the manager looks for small pricing differences between markets.

From their launch in the early 2000s until the crisis in 2008, most were producing average annualised returns of 8 per cent or 9 per cent - just below the promised 10 per cent to 15 per cent.

It took the crisis to disprove one of the key claims of the funds of hedge funds: that their returns were mostly not correlated to sharemarkets. When sharemarkets around the world dropped by about 25 per cent in Australian dollar terms during 2008, the returns of most of the funds of hedge funds dropped by about as much.

One factor hampering their performance was the hefty investment management fees. Most hedge funds charge their small investors an annual fee of 1 per cent to 2 per cent of the money invested and a performance fee of 20 per cent of any returns above zero or the cash rate. By comparison, most share funds charge fees of less than 0.5 per cent a year.

The head of research at Morningstar, Tim Murphy, says part of the reason for the poor performances of hedge funds during the crisis was because many were highly leveraged. He says many of the trading strategies produced fairly small returns and they borrowed to magnify these returns. But when credit markets dried up in 2008, many funds had trouble borrowing.

Another problem with hedge funds was illiquidity. Investors wanted their money back and so did lenders to the hedge funds, forcing them to sell their assets at the worst possible time at poor prices with their returns being savaged as a result.

The average annual returns over the past five years of the funds of hedge funds, given in the table, range from minus 12 per cent to 2.27 per cent. Murphy says it is "hard to argue" that small investors have been served well by their investments in hedge funds.

UNDERACHIEVEMENT

Hedge fund promoters have failed to deliver on their promises.

Hefty fees leave even less for small investors.

As a result of the financial crisis, many had to freeze redemptions.

Others are slowly handing back money.