Season of the hedge

After the bear market that followed the tech wreck earlier this decade, a number of fund managers decided to follow the lead of pioneers such as Platinum’s Kerr Neilson and switch from investing long-only in the equity market to long/short.

With hedge fund-style investing becoming very popular, some of the big names that moved in that direction included former Colonial First State head of Australia equities Greg Perry, who formed a long/short boutique QED with another ex-Colonial fund manager Barry Henderson. Former BT fund manager Paul Moore launched PM Capital as a long/short equity house.

Hedge funds have been proliferating in the Australian market. They’re even listing on the ASX: Everest Babcock & Brown Alternative Investment Trust (EBI), HFA Accelerator Plus (HAP), Wallace Absolute Return Ltd (WAB) and Cadence Capital Ltd (CDM).

There are many different types of hedge funds; one of the most popular is “long/short”, a strategy combining long holdings of stocks expected to increase in price with short sales of stocks calculated to decrease in price. Short sellers also borrow stock to sell in the expectation that they will be able to buy the stock back and close out their position at a profit when it has fallen.

The premium earned from short selling can be invested, giving long/short funds a leveraged exposure to the market. Managers express this by saying their fund is “120% long and 20% short” (meaning that they will hold short positions up to 20% of the value of funds invested), or “130% long and 30% short” and so on.

Theoretically, a long/short strategy creates opportunities for targeted returns to minimise portfolio risk and to capture returns during market conditions in which conventional investment strategies offer limited opportunities.

So, have there been any winners in the current market downturn that began on November 1?

Yes. In the United States, Wall Street hedge fund manager John Paulson saw the fall way before the rest of the pack. He started laying bets against the housing market, shorting stocks in the sector. His strategy worked: he made $US3 billion in 2007, equal to the average salary of more than 60,000 Americans.

Closer to home, some of the long-short funds had a very profitable 2007. Recent research from Mercer Investment Consulting shows that Australian long/short funds outperformed both long-only funds and the S&P/ASX 200 last year. The median return for long/short funds was 26.7%; long-only managers had a median return of 18.5%; and the S&P/ASX 200 returned 16.1% over that period.

Mercer’s figures show several funds earning in excess of 30% in the 12 months to December 31 (prior to the more severe market downturn in January this year), including the Barclays Global Investors (BGI) Equitised Long/Short Fund, Macquarie’s Australian Long/Short Equitised Fund and Tribeca’s Australian Equity Long/Short Trust.

Of the long/short hedges included in Mercer’s survey, only Suncorp’s Long/Short Fund underperformed the S&P/ASX 200, returning only 11.7% for 2007.

Still, the overall outcome for hedge fund investors has been mixed: results for listed funds have been mixed, with many also performing below the market last year: Everest Babcock & Brown Alternative Investment Trust (EBI), HFA Accelerator Plus (HAP), Wallace Absolute Return Ltd (WAB) and Cadence Capital Ltd (CDM).

One of the most highly rated long/short managers is K2 Asset Management (KAM), whose Australian Absolute Return Fund is the only Australian long/short fund with a Standard & Poor’s five-star rating.

K2’s returns have not been stellar but they have been consistent: the Australian Absolute Return Fund produced a return of 10.4% for the 12 months to the end of December, well down on the 16.1% return of the S&P/ASX 200 over the same period.

Since the fund’s launch in 1999, it has produced a cumulative return of 287.9%, compared to the cumulative return of 205% for the market.

The recently listed WAM Active Ltd (WAA) is bucking this trend, performing above the market since its debut on January 11 this year. It opened at 94¢ a share and is holding steady at 99¢.

But overall perhaps the biggest risk in hedge funds is picking which hedge fund to invest in; there were some spectacular hedge fund collapses last year.

Basis Capital was a heavily geared hedge fund specialising in collateralised debt obligations (CDOs), which lost their value in the sub-prime mortgage crisis. Assets had to be sold in an unfavourable market to meet margin call obligations and the fund was ultimately placed into receivership.

Absolute Capital’s downfall was the collapse of the market for collateralised loan obligations (CLOs). These are primarily backed by leveraged bank loans that have been referred to by some analysts as “toxic waste”. The company went into administration in December and is in the process of being wound up.

Goldlink came perilously close to failure after its exposure to market volatility from investing in forwards and options saw it lose more than $130 million. Unlike Basis and Absolute, Goldlink wasn’t too highly geared and implemented a risk mitigation strategy to protect its remaining reserves.

– with additional reporting by Rebecca Harrison.

John Kavanagh writes for The Sheet.