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Should you invest in hedge funds?

John Wasiliev

While some advisers are attracted by certain managers and particular strategies in hedge funds or alternative investment managed funds, such investments have generally been given the thumbs down for most investors by research group Morningstar.

Reasons to be wary

Hedge funds should generally be avoided by moderate or conservative investors, and play only a limited role in the growth portfolios of less risk-averse investors for one very good reason, Morningstar says. Many of them may not be able to deliver what they promise, especially if there is further global market turmoil in the year ahead.

This conclusion by the country’s leading managed funds researcher is an unflattering assessment of a category of managed investments that stakes its reputations on delivering positive returns in both rising and falling markets.

When you analyse the performance of hedge or alternative investment strategy funds, says senior Morningstar analyst Julian Robertson, they have generally been disappointing. While some managed futures funds had a purple patch in 2008, with strongly positive performances during the post-financial crisis falling market, and a reasonable 2011, they have struggled for most of the five years to 2012.

Unable to cope

Robertson says managed futures (represented in the Morningstar study by promoters Winton and Aspect) have suffered thanks to computer-driven strategies not coping with the choppy markets: so they have posted negative returns, something that hedge funds with their unrestricted strategies claim to be able to avoid.

The funds, which have attracted solid support from investors and advisers based on their past performance, have failed to give investors the promised greater returns. They are also costly in terms of fees and charges, Robertson says. Most hedge funds charge investors performance fees.

Not reliant

The big consideration is their scope to provide diversification and performance returns that are not correlated with, or reliant on, the investment sectors on which they focus, Robertson says.

The Morningstar study suggests many hedge funds are too reliant on the underlying markets for their performance, rather than the strategies they claim allow them to deliver uncorrelated returns.

This suggests many managers have yet to prove their strategies can deliver positive or absolute returns, as they are often called.

It’s difficult to be comfortable about the long-term potential of their strategies. Many also run relatively new strategies that are often difficult to understand and not clearly explained.

Another challenge for investors is the range of strategies. As well as managed futures funds, the principal hedge fund categories include funds that run long-short portfolios, where the managers create a portfolio of the best shares to buy in a particular market as well as the best against which to take a short position. The aim is to provide a risk-adjusted return that is either lower or neutral compared with the market.

Impress

But some Australian long-short, market-neutral hedge fund managers do impress investment adviser Tom Murphy of Family Office Research.

Several have delivered double-digit returns over the past few years, although Robertson cautions investors that strategies need to prove themselves over time. While past performance isn’t everything, being able to identify a manager’s track record during different investment cycles and market conditions is always preferable.

Murphy says Australia has some of the world’s best long-short managers, naming the Bennelong Long Short Equity Fund run by manager Richard Fish, the Bennelong Kardinia Absolute Return Fund run by Mark Burgess, the Wavestone Australian Equity Long/Short Fund and the Regal Funds Management Long Short Fund as his picks. It’s a sector where there is a fair amount of expertise, he says. One reason, he suggests, is the history of shorting in funds management pioneered by respected Kerr Neilson of Platinum Asset Management.

Murphy says Neilson deserves much credit for this style of management, as he was among the first in the world to use it.

Creative

Long-short portfolio management, says Murphy, can be creative and it requires a fair bit of analysis to separate serious long-short managers from traditional portfolio managers who have tried to reinvent themselves as long-short managers.

Many of the latter tend to add most value on the long side, so like traditional equity managers they will do best when markets rally.

But genuine long-short managers seek to add equal value from short and long positions. They will also look to manage their fund size so it doesn’t get too large relative to the market they are focusing on.

A mature approach

Murphy describes this as a mature approach to specialist funds management, where the managers focus on delivering returns to their investors rather than building their own businesses.

By contrast, many overseas managers will look to raise twice the money their strategy works best at, on the understanding that returns, while still positive, will nevertheless be lower.

As far as investor expectations from hedge funds are concerned, Murphy says the major focus is not losing money.

Many high net-worth investors would rather embrace a well-managed long-short investment strategy than an index strategy, for instance, where you can go backwards.

You may also wish to read Can you do better than the fund managers?

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