Financial planners have understandably been reluctant to include hedge funds and alternative return funds in client portfolios. Now the funds are looking to woo planners back. Simon Hoyle reports.
The face of the hedge funds industry has changed considerably over the past 18 months or two years, with managers striving to make their products more transparent, to simplify fee structures and to avoid the worst of the liquidity mismatches that were the cause of many previous failures.
Kim Ivey, the president of the Alternative Investment Management Association (AIMA) in Australia, says “the reluctance or the cynicism that financial planners have about hedge funds revolves around a couple of key areas”.
“I understand, and I think many managers understand, why there is that reluctance to look at hedge funds, and those areas really revolve around transparency, around fees and around where hedge funds actually can deliver the alpha that so many of them purport to be able to do,” Ivey says.
“Part of the problem with understanding the hedge fund industry is the lack of homogeneity; it’s not ‘they’ or ‘it’, it’s such a diverse industry in terms of strategies. There’s now nearly $2 trillion in hedge funds around the world, there’s nearly 10,000 hedge funds and many of them across the board are quite different.”
Research firm Standard & Poor’s issued a Sector Report on alternative investment strategies in late June. It concluded that “the multi-manager/fund of hedge fund (FoHF) space has undergone notable changes” since its last review, in December 2009.
“Following the challenging period of the GFC, where many FoHF products failed to deliver absolute returns or diversifying protection from equity market sell-offs, significant doubts arose in investors’ minds as to the core value premise of the format,” S&P says.
“The growing demand for transparency, increased liquidity, fee structure changes, and lower stockmarket beta products have increased competition in the sector. The classic FoHF model – offering investors ‘access’ to a diversifying set of alpha managers, albeit at a higher cost and with reduced liquidity – is being challenged, especially where performance has failed.”
Richard Keary, chief executive of Financial Risk Management (Australia), says uncertainty in global economies means there should be strong demand for investment products whose sources of return, and risks, aren’t correlated to mainstream asset classes or markets.
Keary says traditional managed funds that follow market indexes with low tracking error, and products like ETFs and index funds that follow markets closely, will produce flat returns when markets are trending sideways.
Such funds’ portfolios contain both winners and losers, and managers have no mechanism by which to differentiate between the two. An index fund has to own the stocks in the same proportion as in the index; a manager with a low tracking error fund might be able to underweight a particular stock, but not by much.
Keary says there’s enough uncertainty in global economies at the moment to believe that the equity market could well be “range bound”, and that therefore those managers that have the flexibility (and the ability) to pick winners and avoid losers should come out on top.
“If you buy into this idea that the index can be range bound, then the first step is that you want a genuine active manager, who is benchmark unaware,” Keary says.
“A logical extension of that active management story is hedge funds. But at this stage, [it’s a case of ] suspend your disbelief, because a lot of people go, ‘Here we go again…’
“[But] if you are a Martian that turned up at earth and someone showed you two time series, fund- of-hedge-fund [returns] versus the equity index, and allowed you to invest in one of them after the event, and you asked the Martian which would you pick, the Martian would pick the hedge funds. They produced more return at lower volatility.”
Keary says a lot of the bitter taste left in investors’ and planners’ mouths was because products failed for non-investment reasons. The product manufacturer might have got spooked, and closed a loss-making fund for business reasons, crystallising investors’ losses in the process.
Or a manager might have tried to offer a daily redemption facility in a fund based on underlying assets that were relatively illiquid – so when a wave of redemptions rolled in, the fund had to either freeze or place a significant restriction on investors’ access to their own money.
Sometimes product manufac- turers were responding to a perceived distortion in the marketplace caused by investment platforms, such as wraps. A managed fund or investment product that prices its units, say, once a month cannot always be easily accommodated on such a platform.
Keary says that platforms play a critical part in making the financial planning business efficient – as well as channelling money from investors to fund managers – but both parties could be smarter in how they deal with the other.
On one hand, planners could investigate ways of incorporating less liquid products into client portfolios; on the other hand, alternative invest- ment managers could ensure that their products do not expose planners and clients to a liquidity mismatch.
“The platforms are a facilitator for user demand, and so they are definitely quite restrictive in looking at the operations of a particular product, saying, ‘Look this is monthly [redemptions] with 30 days’ notice; we can’t administer this’.
