ALTERNATIVE INVESTMENTS – THEY ARE HERE TO STAY !

As the 1990’s market boom becomes a fond memory and economists forecast a decade of lacklustre share market returns, the challenge for investors now is to find where they will be able to extract the best returns for a designated level of risk. The group of alternative assets, which include hedge funds, venture capital, commodity funds and other innovative products, are increasingly being used in diversified, high growth portfolios to enhance portfolio returns while managing risk.

Hedge funds were created over 50 years ago by an Australian Alfred Winslow Jones in the U.S. specifically to protect capital from market downturns. Currently, it is estimated that there are over 8,000 hedge funds worldwide in a $400 billion industry, which attracts the best and brightest investment managers to it.

What are Hedge Funds?

Hedge funds are commonly used to describe any fund that isn’t a strictly conventional investment fund. In the U.S., the term "hedge fund" usually refers to a private investment limited partnership that is not regulated and only available to professional investors. These funds are sometimes domiciled in countries like Bermuda and Cayman Islands for their low or zero tax benefits.

The aim of the hedge fund is to achieve a positive return irrespective of market conditions. They attempt to do this by using strategies that go beyond the normal buying of shares and bonds that a traditional fund manager would undertake in a typical managed fund. Performance results depend primarily on the manager’s abilities rather than market movements. There are over 25 different strategies that can be utilised each with their own risk/return characteristics. They include, short selling, complex use of options and futures, leverage and other flexible investment strategies.

Hedge funds are very different to managed funds, as their key objective is not to lose money. The focus on preservation of capital means that returns are measured in absolute and not relative terms. Mainstream managers try to beat the index and their performance is measured relative to that index. So if the market fell 15% and the manager fell only 8%, that is considered a good result. The client however, may have a different view. A hedge fund manager’s focus is to avoid negative returns altogether and attempts to make money in market downturns.

Let’s take an example of a hedge fund. A Long/Short fund simply buys the stocks it likes and sells (shorts) the stocks it does not like. Being "long" a stock simply means that you own it or have bought it. By short selling, you plan to sell the share (which is borrowed from a fund manager or broker) and later buy it back at a lower price when it has fallen thereby profiting from the decline and not losing from it.

Some investors may remember the success of the fund manager BT during the 1987 October crash. The reason for this success? They took out hedging positions (selling index futures and buying put options) that saved the fund from the horrific falls and made BT the premier fund manager for many years after that. Kerr Neilson was responsible for the Australian share fund at the time and later Paul Moore until 1998. Each of these two have left BT and started their own investment companies in, you guessed it, hedge funds!

Demystifying Hedge Funds

Investors should not be scared of the term hedge funds as the investment reality is very different from client perceptions. Yes, there have been infamous examples that have caused some trepidation with clients such as the Long term Credit Management (LTCM), the winding down of the Soros’ Quantum funds and Robertson’s Tiger Asset Management. To liken all hedge funds to LTCM is like saying all Australian shares are like FAI and HIH.

Hedge funds should not be ignored. There are many well-known fund managers that have introduced or about to introduce hedge funds to the market. They include Deutsche, Macquarie, Colonial First State, Challenger, Rothschild and Merrill Lynch.

Some of the characteristics of hedge funds include:

The investment managers typically have a large part of their own wealth tied up in the fund with your money.

Operating with secrecy and lack of transparency is part of the investment set-up as the success of the fund is dependent on the market not knowing the actual positions taken

Use of short term strategies that may profit from both positive and negative market conditions They are opportunistic and have a free choice of investment styles and use of derivative instruments

Remuneration is also derived from performance fees. The manager is therefore more driven to provide good results for clients unlike some managed funds which are more concerned about growing the size of funds under management than performance.

Leverage (borrowing) can be an essential part of their strategy. This does not mean however that all hedge funds leverage. According to Van Hedge Fund Advisors, 80% of hedge funds use no or low levels of borrowing.

Size is a critical factor in the performance of hedge funds as it is important to be nimble and responsive to investment opportunities, which is difficult to achieve being a large fund. 60% of all hedge funds are between $3million and $500 million in size. Quality hedge funds as a result, are only open to investors for a limited time.

Returns for the periods ending 31/01/2002

	3 Months	6 Months	1 year	2 years	3 years
S&P/ASX All Ordinaries Acc Index	7.52	5.82	6.93	17.67	30.44
Australian Equity Trusts (Avge)	5.59	5.16	7.36	24.3	34.29
MSCI World Acc Index Gross Div (A$)	2.96	-8.39	-13.93	-5.89	7.2
International Equity Trusts (Avge)	4.22	-5.6	-15.2	-10.96	15.2
Australian Cash Funds	0.87	1.85	4.03	9.46	13.83
Hedge Funds
HFA Australian Blue Chip	7.85	4.86	3.92	13.36
P.M. Australian Opportunities fund	9.92	7.10	12.51	43.80
P.M. Absolute Performance Fund	16.71	5.36	-2.79	22.14	35.31
Platinum International fund	7.12	11.34	8.31	41.00	130.13

The main points to note in the above table within the period selected is that it has been a difficult period for equity markets, in particular overseas shares. In the downturn periods over the last 2 years, you will notice that the hedge funds hold their own. Hence, the diversification benefits. Please do not get carried away with the high returns of the hedge funds as they are historical returns, but altogether important to have when the next downturn in the market occurs.

Why invest in Hedge Funds?

Hedge funds provide the potential to improve portfolio returns while having the capacity to lower risk within the portfolio. The strong diversification benefits arise because they behave differently to traditional assets like shares and bonds. Most hedge funds seek to make consistency and stability of return their main priority, rather than simply the magnitude of the return.

Hedge funds can provide a viable alternative to investors concerned about the future volatility and overall returns from mainstream investments. Hedge funds are expected to outperform a share portfolio in a flat or falling market. They are a good complement to your portfolio and should be considered in the asset allocation process.