A recent article in The Economist provided an excellent overview of the challenges of establishing a hedge fund in the current environment, even if the article's title, "Launch Bad" left a little to desired, assuming it wasn't a simple typo. Actually the first sentence was somewhat off the mark also, claiming that "bar inheritance or winning the lottery, there are few swifter paths to immense riches".

It is estimated that there are over 20,000 absolute such funds globally, variously described as absolute return, alternative or hedge funds. There are no doubt some which have made their founders immensely wealthy, but in spite of their profile they are a significant minority, and almost none have done it swiftly. The Economist should know better.

However, back to the excellent article (excluding the title and the first sentence) which does paint an accurate picture of the challenges facing not only any aspiring fund manager, but the vast majority of the existing funds as well.

The article focuses on the increased level of due diligence and compliance which institutional investors in particular focus on, an area that is frequently difficult for new and emerging managers to tick the appropriate boxes. Bernie Madoff of course made things more difficult in this regard, but with the increased institutional investment, plus the risk averse post GFC world,  this was always going to be the trend.

Along with due diligence from prospective investors the current crop of new managers also face increasing regulatory hurdles, particularly in the USA and UK/Europe. Australia's regulations have remained reasonably constant and consistent, (short selling bans aside) but that may be because they were better to start with.

Fees remain under pressure, but that is probably consistent with margins in most other industries, and particularly in financial services. In addition, any industry that emerges into the mainstream is always going to face competitive pricing pressure.

The initial capital raising process is certainly more difficult than it was seven or eight years ago. Back then the big investment banks would toss anywhere from $50 to $500 million to a star trading team wanting to leave the desk and set up on their own, just to ensure they could feed on the fees from prime brokerage operations including leverage, brokerage and stock lending.

Now many start ups have little other than choice of the three F's (friends, family and fools) or a couple of seed investors with which to build the three year track record that most institutions, asset allocators and research houses demand. Umbrella groups or incubators in Australia such as Bennelong, Ascalon and Pengana generally prefer a decent track record prior to risking their capital and reputation by investing in an early stage or start up manager.

There are exceptions, mainly those former star portfolio manager with a prior high profile who gain the backing of an institution or distribution house, but they are certainly in the minority.  All this leads to the question, why bother?

For some it's the opportunity, some a necessity as the big banks close their proprietary trading desks as a result of the Volker Rule in the US. For others, the challenge, or wish to prove their own worth after ten or twenty years under the perceived security of a broad corporate roof.

But what of the investors who back them and take the risk of allocating to early stage manager? Reduced fees certainly don't make the difference, but all the research shows that early stage, smaller or boutique fund managers provide significantly better returns, better transparency and more personal investor relations.

It is open to debate if this improved performance is due to the alignment of interests, managing smaller pools of capital, or lower levels of bureaucracy, but it hasn't changed much over the past decade.   

So much so that the big end of town is trending back to funding start ups, but with the added incentive of sharing the revenue when they're successful.  As in the past however, and in spite of the impression given by The Economist, only a handful make it to the front pages, and almost all will take a decade at least to confirm their position. 

Hardly swift or overnight success, and only if they provide their investors their promised, or hoped for, returns.

Chris Gosselin
CEO, Australian Fund Monitors

In 2012, AFM hosted a series of lunch presentations  entitled "Understanding Hedge Funds" which provided investors with a more balanced view on the sector than is sometimes portrayed in the media.  Following feedback from a number of our guests we also organised briefings and presentations for a small group of investors to "meet the manager" and hear from individual fund managers in person.

Our "Meet the Manager" briefings will be held every month, over breakfast or lunch and will showcase AFM's Fund Manager clients, their available Funds and views of the current market and opportunities ahead.  

If you are interested in attending any of AFM's "Meet the Manager" briefings, please reply by email.

Fund Managers wishing to participate in the presentation series are invited to contact Chris Gosselin, CEO, to discuss the opportunity.

Alternatives category 'meaningless'

By Katarina Taurian, Investor Daily

Mon 22 Apr 2013

Pengana recommends 'uncorrelated' category

Placing investments into an alternatives category because they vary from standard categories is a "flawed logic", according to Pengana Capital. 

Some portfolio constructors have created an alternatives category to hold investments that differ from standard categories, resulting in that category becoming "meaningless", according to Russel Pillemer, chief executive officer at Pengana Capital.

"If you're using it as a category to throw in all orphan investment opportunities - everything that doesn't fit anywhere else - then you just end up with a collection of strategies where there's no logic for them to be together," Mr Pillemer told InvestorDaily.

ATTACHED FILESAlternatives category "meaningless" (pdf format)

Risk comes roaring back.

Over the past few weeks we have ignored market risk, focusing instead on the risk facing the retirement incomes of more Australians than the treasurer would have us believe.

This is a good lesson, as investors generally ignore risk at their peril. Looking back through March editions of 'Hedge Clippings' we were pointing to the historically low levels of the VIX 'fear index' and the tendency for markets to wobble when that occurs.

Of course low volatility might not cause markets to fall, but it does indicate that investors as a whole are optimistic enough to put risk to the back of their minds. Cyprus gave investors some cause to pause, and then it was back to the fray. However as the past week or so has shown, while it takes a while for investor confidence to build, it can evaporate very quickly.

March performance from Australia's absolute return sector reinforced its risk averse nature. With 80% of all returns to hand the average fund fell -0.15%, against the ASX200's fall of -2.7% or the ASX200 Accumulation's decline of -2.27%. Overall 91% of funds in the database outperformed the index, and 55% were in positive territory.

It is too early to call the ASX200 as negative in April, but if it turns out that way it will be two in a row, heading into 'sell in May and go away'. The real issue seems to be the exit from the resources sector, which will only create more focus on the yield and defensive areas, particularly while rates seem destined to stay low for some time to come.

Performance and News Updates on www.fundmonitors.com this week:

Insync's Global Titans Fund was up 1.17% in March, and 14.5% for the past 12 months as global markets were mixed with rises in the US and Japan offset by subdued returns in Europe thanks to Cyprus, China and Hong Kong.

Optimal's Australia Absolute Trust was broadly flat in March with small losses on long positions being offset by similar gains on their shorts. The manager continues to be confounded by the performance gap between defensive industrials and resources stocks, and finding difficulty finding value at current pricing

BlackRock's Australian Equity Market Neutral Fund was up 1.29% in March after being caught in the first half of January by the sharp rally in specific sectors such as building materials and diversified financials.

Platinum's Unhedged Fund returned +0.69% in March, taking 12 month performance to +8.33%, in line with annualised performance of 8.25% since inception in January 2005. As above, and in common with many other manager's comments, Platimum noted that complacency was creeping back into markets.

And now for something completely different, a short clip showcasing one of the greatest magicians in the world, the Great Flydini!

On that note, I hope you have a happy and healthy weekend!

Regards,

Chris

CEO, AUSTRALIAN FUND MONITORS