The thin end of the hedge wedge

Equity markets have rallied, but most hedge funds have underperformed.

Summary: In the year to the end of April, Australian hedge funds on average delivered around half the return of the broad sharemarket. While charging investors high fees to deliver superior returns, most funds have chronically underperformed.
Key take-out: Eight of the 10 absolute return funds listed on the ASX have shown significant price falls during the past five years.
Key beneficiaries: General investors. Category: Portfolio management.

What’s in a name?  Not a great deal, if you consider the performance of hedge funds in recent years.

While the latest figures suggest an improvement during the first few months of 2013, the vast majority of hedge funds have lagged well behind global equity markets after a horror 2012 and a less-than-spectacular 2011.

By definition, a hedge fund is a risk-management tool, a product designed to smooth out the highs and lows, to reduce volatility and stabilise earnings, conjuring a vision of conservatism when it comes to managing money.

For the past few decades, however, they have been marketed as something altogether different, as a vehicle for superior returns with a daunting fee structure to match.

While the evidence suggests that, collectively, they have smoothed out the peaks and valleys of various cycles, by and large they have at best managed to simply keep pace with equity market indices in the longer term. This raises questions as to whether it would be simpler and cheaper to merely purchase an index fund.

Many have chronically underperformed during both rises and falls.

Unlike previous cycles in the 1970s and 1990s, and in the early part of this century, when hedge funds flourished during equity market bull runs, this time around they largely have left investors disappointed and out of pocket.

For the past five years, American hedge funds have underperformed the S&P 500, and a recent study by Goldman Sachs unearthed some sobering facts. In the year-to-date through to May 10, the average hedge fund returned just 5.4% compared with Wall Street’s 15.4%. Even mutual funds managed to deliver 14.8%.

Some attribute the poor performance directly to the US Federal Reserve and other central banks that have been flooding the world with cash, sending bond rates ever lower and deliberately pushing equity markets to record levels.

That has made short selling – a key strategy for many equity-based hedge funds – a dangerous occupation. In fact, hedge fund critics claim the best way to make money right now is to take long positions on the most heavily shorted stocks. As the hedge funds regularly abandon such positions, the upswings can be enormous.

The situation here is no different.  In the 12 months to the end of April, the Australian Securities Exchange delivered investors a return of 18.07%. Australian hedge funds, by contrast, managed around half that with 9.28%. Even pure equity-based funds underperformed, returning 11.96%.

In March, a difficult month on the ASX when the main index dropped 2.7%, hedge funds managed to “outperform”, shedding a more modest 0.09%.  Equity-based hedge funds, however, dropped 0.22%.

The Hedge Factor

Fund Type

March

April

YTD

12 Month

All

-0.09%

1.61%

5.56%

9.28%

Equity-based

-0.22%

2.01%

7.20%

11.96%

Non-equity

0.22%

0.56%

1.93%

3.47%

Fund of Funds

0.64%

0.83%

3.22%

5.79%

Single Funds

-0.23%

1.71%

5.94%

9.91%

ASX

-2.7%

4.52%

11.66%

18.07%

Source:  Australian Fund Monitors

According to statistics compiled by Australian Fund Monitors, which tracks the performance of more than 300 funds, more than 90% of funds “outperformed” during the falls in March. This means that most didn’t lose as much as the market.

But in April, when the rally resumed, a mere 15% of Australian hedge funds managed to beat the market.

This would appear to be at odds with an industry that long has promoted itself as delivering superior returns over the long haul. Much of that argument is based upon the notion that reduced volatility improves returns through compounding.

While a perfectly legitimate argument, it doesn’t address the deterioration in returns accompanied with the high-scale fee structures adopted by many funds.

There is a vast array of Australian hedge funds, encompassing a myriad of niche investment vehicles, with wildly different strategies: equities, resources, long-only, long-short, events-driven (takeovers), to name just a few. Add to that the funds that invest in everything other than the stockmarket, such as bonds and property.

For individual investors, BlackRock and Pengana are among the most visible and successful operators with minimum investments ranging from $20,000 to as much as $100,000. Some fund of fund operators allow investments of as little as $1,000.

When it comes to fees, hedge funds know how to charge, with many referring to the “Two and Twenty” principle. That’s a 2% management fee and a 20% performance fee. But that’s just a general rule of thumb.

BlackRock’s Australian Equity Absolute Return Fund, for example, charges just 0.3% as a management fee but carries a 30% performance fee. Pengana’s Australian Equities Fund, by contrast, charges 1.225% of the fund’s net asset value, with a performance fee of 10.25% on any increase in the net asset value.

Every Product Disclosure Statement issued by a hedge fund carries a stark warning from the corporate regulator that small differences in fees, both performance and management, can have a substantial impact on long-term returns.  A 1% difference in fees can result in a 20% difference in returns over a 30-year period.

It’s also worth noting that the glossy brochures with performance charts are often before fees are deducted. Others show changes in net tangible assets – rather than unit prices – against global share indices.

For those looking for a cheaper entry into the world of hedge funds, around 10 absolute return funds are listed on the ASX.

Again, according to performance rankings by Morningstar, there are starkly divergent performances.

Of the 10, eight show significant price falls during the past five years. The Hastings High Yield Fund is down 63% during the five-year period to the end of April, although that partly reflects the fact that it is in wind-up mode and has delivered a historic distribution yield of 153%.

Units in the Alternative Investment Trust, on the other hand, have dropped 43% in the past five years and delivered a yield of zero. That’s a less-than-stellar performance on any measure, although it has increased 45% over the past three years – a volatile performance history.

Of the two profitable and most stable performers, Trojan Equity comes out on top with 32% growth over five years and a 26% yield, while Wilson Asset Management’s WAM Active has delivered 26% growth and an 8% yield.

They say history is no indication of future performance. But if history is any guide, many of our big hedge funds either need to return to hedging or consider renaming themselves as Highly Volatile, Big Fee Charging Speculative Funds.