What are hedge funds?

The RBA says the term ‘hedge fund’ is typically applied to “managed funds that use a wider range of financial instruments and investment strategies than traditional managed funds, including the use of short selling and derivatives to create leverage, with the aim of generating positive returns regardless of overall market performance(2).

In other words, hedge funds aim to ‘hedge’ or manage the risks of a volatile market by using a variety of investment strategies.

Myth no.1 – hedge funds are only for the very wealthy

This may have been true in the past, but these days, investors can access hedge funds with as little as $20,000.

Myth no. 2 – hedge funds are risky

Most hedge funds are active managers of investment risk with defensive strategies in place.

An index fund, perceived by some as a ‘safe’ option, is at the mercy of the volatility of the market it tracks; susceptible to fluctuations which aren’t actively managed. However, a market neutral hedge fund targets a positive rate of return regardless of the return the market, which means the risk is actively monitored, positions are hedged and exposure to the market limited as required.

Some hedge funds are purely focused on preserving capital (ie. your original investment), so making strong returns over the short term is not their primary focus. Other hedge funds only trade when opportunities arise and have clear investment guidelines which act as a framework for their investment decisions – such as exposure limits, risk management frameworks, stop loss levels, etc.

Before you select a hedge fund, undertake your due diligence – people and processes are critical, as is a robust framework for managing risk.

Myth no. 3 – hedge funds have exorbitant fees

The typical hedge fund fee structure in Australia is 1.5% management fee and 20% performance fee. At fi rst glance, this appears to be high when compared to long-only domestic managers. To see true value for money, however, you need to focus on returns not just fees. If you’re paying very low fees but the fund is not performing, this is a false economy.

Performance fees are only payable when the fund outperforms the benchmark, meaning investors pay for the manager’s skills and expertise when they’re getting a good return on their investment.

Myth no. 4 – hedge funds are illiquid

In Australia, redemption restrictions and high withdrawal fees are rare. There are a number of retail hedge fund managers in Australia who price their fund daily and most have a straightforward redemption process with relatively low withdrawal minimums ($10,000).

Myth no. 5 – hedge funds are unregulated and lack transparency

In Australia, hedge funds are as tightly regulated by ASIC who have recently introduced changes to reporting and increased investment process transparency, which will further improve the current status quo.
Transparency and openness around investment processes, internal governance and compliance controls is critical when assessing hedge fund managers.

Conclusion

Hedge funds play a unique role when teamed with a portfolio of more traditional investment products. They can reduce volatility and increase returns. Next time you’re creating a personalised portfolio, consider adding a hedge fund to the mix. Speak to our friendly Financial Planning Team today.

1 http://www.basispoint.com.au/hedge-fund-directory/
2 http://www.rba.gov.au/publications/fsr/2004/sep/pdf/0904-2.pdf
Source: Bennelong Funds Management, August 2013

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China’s growth is expected to slow to 7.5% this year; the offi cial government target in its 2011-2015 fi ve-year plan is for an average growth rate of 7.0% per annum. Growth is slowing partly because Europe’s recession has crimped exports but also because China’s central bank is deliberately seeking to tighten credit conditions to stop speculative investment into property and other assets.

China launched a credit-fueled investment boom in 2008/09 in response to the Global Financial Crisis (GFC), which saw total debt rise from 160% of GDP to 210% of GDP according to official figures. While these debt levels are manageable, there is a lingering concern that more debt has been accumulated in the ‘shadow banking system’ and that property speculation is continuing. Accordingly, the central bank recently moved to tighten credit conditions more aggressively with a particular focus on non-bank fi nancial intermediaries.

Even if growth slows to 7.0%, this is still a significant growth rate considering China’s annual GDP is now over US$8.2 trillion, ranking it as the second largest economy in the world (after the US at nearly US$16 trillion and excluding Europe as a region rather than a country).

However, China’s growth is likely to be less investment-intensive in the future given investment has grown to over 50% of the economy and China’s new leaders aim to rebalance the economy towards consumption.

A slowdown in investment will obviously reduce demand for steel and other building materials, which will impact many commodities like iron ore, coal, copper and alumina – all of which are key exports of Australia. At the same time that China’s demand for commodities is slowing, global supply is set to increase, so it is likely that commodity prices will continue to weaken and that Australia’s export income will be under pressure.

The rebalancing of China’s economy is important for its long term stability and it will remain an important market for Australia; however it is likely that we have seen the end of the global mining boom. We see a long period of lower commodity prices and reduced mining activity ahead.

A slowdown in mining will obviously be a drag on Australian growth, particularly in the mining states of Western Australia and Queensland, but surely lower interest rates and a falling AUD will offset the mining slowdown?

In the past, the answer would be a resounding yes, but this time other sectors of the economy – such as retail, housing construction and business investment – are only showing modest signs of recovery. Lonsec believes there are a number of reasons for this including:

1 Attitudes to debt have changed post GFC, with companies, households and government all seeking to increase savings and reduce debt levels.

2 Low business confi dence on poor profi t growth and burdensome government policy has led to a focus on productivity measures rather than investment.

3 Job insecurity stemming from business and government reducing employees, in a number of sectors, has led to cautious consumer behavior.

These factors are not going to change overnight but falling interest rates, a falling currency and a clear Federal election result should eventually see the broader economy rebound. Accordingly, we expect the Australian share market to retain an upward trend but recommend investors tilt their portfolios towards financials and industrials.

William Keenan – General Manager Equities Research – Lonsec

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