RBA Article on Hedge Funds
The RBA's David Jacobs and Susan Black published an article in the November 2006 RBA Bulletin that provides a good assessment of the current status of the Australian hedge fund industry. This article follows comments by the Governor (see Reserve Bank of Australia's Stevens Flags Australian Hedge Funds Risk). The article was picked up in a story by Fiona Buffini of the Australian Financial Review on 17 November 2006 in which she highlighted the surge of retail investment in hedge funds as being of concern to the RBA.
Buffini's article is headed "RBA Warns on Hedge Funds", but in fact the Jacobs & Black article identifies some real positives for the industry in Australia. Most importantly, the Australian regulatory regime makes no distinction between hedge funds and other managed funds; the same registration, operational and disclosure requirements apply to a fund regardless of whether it is a hedge fund or not. This is a great positive for the hedge funds industry and the financial services industry generally. There is no logic whatsoever in seeking to make special rules for hedge funds given the lack of clarity in what actually defines such a fund and the importance of all investments being treated on a comparable basis so investors can make proper assessments of risk and return. One of the reasons for the public concern about hedge funds in the US is that hedge funds aren't required to be registered with the Securities and Exchange Commission and that as a result transparency is limited.
Also highlighted in the Jacobs & Black article was the growing importance of the hedge fund industry as an exporter of financial services, even though Australian managers have generally not been adopted by Australian institutional investors (see also Australia as a Centre for Hedge Funds?)
Finally, the article notes the powerful diversifying features of hedge funds that are the result of their lack of correlation with sharemarkets and other traditional asset classes eg over the past five years the Australian hedge fund industry has delivered a return in line with local sharemarkets - 12% - but with half the standard deviation, a generally accepted measure of risk. For Australian investors with high weights to Australian shares and property that have performed well in the last several years, investing in assets that are not correlated with Australian shares and property is likely to be VERY important for portfolio diversification.
Jacobs & Black offer hints of concerns about fees and about transparency, but both factors face considerable commercial pressure, particularly among institutional investors. The article also raises the spectre of leverage that is generally adopted by hedge funds (and private equity) and the potential systemic risk this brings to bear on the Australian financial system. This is a matter that does fall directly at the doorstep of the Bank and requires monitoring. However, current investments in hedge funds are currently very low in the total of Australian savings, and though these funds employ leverage, this is not yet a matter that should be of concern.
It would be helpful for policy makers and market participants to have better data on the amount of leverage employed by hedge funds. There are a number of data providers who are developing better information on Australian funds. The LCA Group which was referenced in the Jacobs & Black article have a quarterly publication with news stories and performance tables and Investment & Technology is working on performance reporting. Aggregate leverage and exposure data, as well as other directory information, is expected to be provided by a new industry survey to be published shortly. Leverage information on overseas funds invested in by Australians may be more difficult to determine, particularly given the limited information made available by fund of funds and the weaker requirements for transparency in other jurisdictions.
One important matter omitted from the Jacob & Black article was reference to the amount of retail hedge funds that carry capital guarantees where the risk of capital loss has been limited. In Australia, a large share of Australian retail investor hedge funds offer investments guaranteed at maturity. In these cases, the floor on returns makes them less risky than many naked sharemarket funds and property.
The Jacobs & Black article notes that the proportion of investments by retail investors in Australia is higher than in the US. This is partly the result of the slower uptake by institutional investors in Australia and partly that US hedge fund managers are limited by regulation to offering their products to accredited investors, such as those that have net worth in excess of US$1 million. In an environment where hedge fund managers were licensed, as they are in Australia, and investors are provided with suitable information about the fund and the manager responsible, then naturally one would expect a higher take-up by retail investors. The proportion of investors participating in hedge funds could be reduced in Australia by simply prohibiting such investments and limiting choice, but this is unlikely to be beneficial from a portfolio risk management perspective. In view of the volatility (risk) data provided by the authors removing an asset class with low correlation to traditional asset classes would likely raise the exposure of retail investors to the inevitable correction in share and property markets.
The comment that hedge funds are difficult to assess because they depend on manager skill is a glib one. Broad asset class returns are also difficult to predict, and as noted above, can exhibit far greater volatility (risk) than hedge funds. Buffini quotes financial adviser Rick Capel of Capel & Associates who noted that hedge funds have not been tested in a wholesale market meltdown (decline). The question for investors of course is whether they would be better served by being exposed to sharemarkets or hedge funds in a market meltdown. As Jacobs & Black pointed out, more than half of Australia's hedge funds (and this would be indicative globally) are long/short equity funds including market neutral; these are just the funds that would be expected to perform best in such an environment.
Nevertheless, a market meltdown would impact those hedge funds that carry a long bias to sharemarkets. Just as market returns have contributed to the return of such funds a market decline, unless the fund was particularly nimble, would detract from hedge fund returns and may even contribute to losses. Again, survey data on aggegrate fund market exposure and leverage would help determine whether there was significant market risk in hedge fund portfolios.
In fact it could be argued that the real risk for retail investors is not the complexity and risks associated with hedge funds, but the more traditional risk of constructing investment portfolios based on recent historical returns. Presently, Australian retail investors risk being seduced into raising and even leveraging Australian share exposure, following a period of strong returns over the past three years, and not taking the opportunity to introduce risk-reducing investments such as hedge funds.
With hedge funds, like any investment, investors need to diversify their approach. This appears to have been the case with high profile Amaranth (See Amaranth Losses - Lessons for Australia). Although the fund did lose substantial sums of investors' money, individual investors appear to have been well diversified and generally had other investments against which this loss could be matched.
In summary, the Jacobs & Black article is a good account of the current state of the Australian hedge fund industry. It highlights some important postives for this young and growing industry. Care should be taken not to tar the Australian hedge fund industry with the same brush as overseas funds where there have been a number of high profile collapses and concerns about transparency that can in part be attributed to the unregulated nature of hedge funds. In contrast, Australian hedge funds have the benefit of a regulator that requires the same degree of operational and disclosure requirements as other funds offered to Australian investors. And impending new data on the Australian hedge fund industry should help defray concerns that are simply not warranted at this stage of the industry's development.
By Rick Steele