Risk is just around the corner:

You might recall that just four weeks ago in Hedge Clippings (22 February) we referred to the fact that volatility was at historically low levels, and that all too frequently this preceded market pullbacks. That article by our Research Manager Sean Webster ended with the advice: "Potential risk is always around the corner, or bubbling just beneath the surface. Ignore it at your peril."

If you needed further proof of this just ask Kevin Rudd, who until Wednesday seemed to be Australia's Prime Minister in waiting before one of his so called supporters, Simon Crean intervened, and Rudd's nemesis Julia Gillard put him on the spot. Again.

This week's political fun and games is local history now, but who would have predicted that Cyprus, a geographic and financial spec on the world map, would in just a few days take centre stage and throw risk back into the global investment equation?

Unlike Gillard's government it looks as if the Cypriot saga still has some way to run before the result is known. Meanwhile the reverberations of both Gillard, and Cyprus' banking crisis will probably continue for years to come.

The short term effect of Cyprus for Australian investors is probably a timely reminder that exuberant markets can readjust. Having said that, to date at least the damage is not too great and the hunt for yield will still continue. Investing in this environment remains testing for many fund managers, with only the best absolute return funds able to adjust effectively to both rising and falling markets.

Meanwhile something completely different for this week with this clip being submitted by one of our loyal readers. Something completely different - not the two Ronnies!

Meanwhile have a good week-end.

Regards,

Chris

CEO, AUSTRALIAN FUND MONITORS

Global Macro Survey Highlights:

• Investors are gradually extending risk, amidst an improved outlook for global markets, according to a survey of more than 350 global investors conducted by Barclays. 17% of investors said they were running greater than normal exposure to risk (vs. 10% in December) and 23% had light or very light positions, compared with 38% in December. US equity prospects are upbeat, supported by the perception that Fed policy will remain loose, and while risks from Europe preoccupy investors, most believe they will not lead to a global financial event.

• Market participants are significantly more constructive about the outlook for global equities. The majority of investors expect equities to offer the highest returns over the next quarter. This is the first time in two years that more than 50% of investors have favoured equities over other asset classes in the next quarter. Meanwhile, the fraction of respondents that favour commodities and high quality bonds over other asset classes fell further to 7% and 10%, respectively. Most investors also perceive equities to be the likely outperformer in emerging markets (EM) over the next three months.

• Equity investors seem to be more cautious after the strong rally in the major markets in Q1. As such, they are gradually paring back their near-term returns expectations. 52% of respondents expect returns of between -5% and 5% in the next three months (vs. 45% in December) and 37% expect returns between 5-10% (vs. 44% in December).  Most respondents continue to see the asset class as fairly priced. But the fraction that believe the asset class to be undervalued dropped from 39% in December to 28% in March.

• Investors are also cautious due to lingering macro risks, citing the euro area crisis and worsening growth prospects in the US and the euro area as major concerns. Close to 60% of respondents see the low volatility environment of the past several months as the calm before another storm. More than 40% of investors considered the euro area crisis to be the most important risk over the next 12 months and slower-than-expected growth in the US and Europe is seen as the biggest risk to equity markets.

Read the entire report here.

ATTACHED FILESBarclays Global Macro Survey Q1 2013 (pdf format)

Hedge fund assets will increase by 11% in 2013 to an all-time high of $2.5 trillion, according to the 11th annual Alternative Investment Survey from Deutsche Bank.

Almost 60% of institutional investors surveyed increased hedge fund allocations in 2012, including two-thirds of pension fund respondents. Sixty-two percent of all respondents expect to increase hedge fund assets this year.

The 11% anticipated increase this year is attributed to $123 billion in net inflows and $169 billion in performance.

Almost half of pension fund respondents are expected to increase hedge fund allocations by $100 million or more this year. Emerging markets, event-driven and global macro hedge funds are the most popular type of strategies pension funds are seeking this year.

Read the entire article from Pensions & Investments here.

Amongst the renewed optimism that has taken hold of Australian equity markets it is often overlooked that the ASX200 has only had one negative return in the last fourteen months. Most investors recognise that the current rally began last July, but forget the pessimism that permeated the market in the first half of 2012.

With this in mind it is worth reading AFM's reviews of the absolute return sector in Australia, one covering 2012, and the other taking in longer term over five and ten years. Most readers will be aware that in 2012 the equity market (as measured by the ASX200 Accumulation Index) outperformed both the average and the majority of funds, but over the longer term the picture is quite different.

The five and ten year review, entitled Volatility eats Returns, shows that over five years the average fund (net of fees) clearly outperformed the ASX200 Index with less volatility, while over ten years funds and the ASX200 Accumulation Index both returned 10%, but once again funds had half the volatility.

The devil of course is in the detail, and the use of averages. The best performing funds can, and do provide the "high return, low risk" returns the marketing likes to promote, while the worst provide the hedge fund headlines the media love to quote. And just to confuse the issue, different strategies and funds perform differently in differing macro economic conditions. Finding the elusive all weather performer is not easy.

Both reports are available here.

Enjoy your week-end.

Regards,

Chris.

Absolute Return and Hedge Fund Performance over 5 & 10 Years.

As we reflect on the performance of Absolute Return and Hedge Funds over the past five and ten years, and show in the following analysis, "Volatility eats Returns" .

In fact, if 2012 was a year of two halves, so too was the previous decade.  For the first five years, from 2003 to 2007, equity investors could do little wrong as they overcame, and then forgot the lessons of the dot-com bubble, just as they had forgotten the previous lessons from LTCM, the Asian Currency Crisis and October 1987 amongst others.

For five years from 2003 to 2007 the ASX200 accumulation index had no problem notching up returns of 20% per annum, supported by easy credit, and lax lending at both corporate and personal levels, and volatility fell accordingly.

Read the entire report from Chris Gosselin, Australian Fund Monitors here.

ATTACHED FILESAFM's Five and Ten year Performance review to 2012 (pdf format)

2012 Performance Review:  Australian Absolute Return Funds

To use a sporting term, 2012 was a year of two halves for equity markets in Australia.  "Risk on" dominated for much of the year as Europe and the Euro threatened to unravel courtesy of debt levels in Greece, Spain, Italy and Portugal.  For much of the year the jury was also out seeking clarity on the prospects of a hard or soft landing in China, with iron ore and coal prices suffering accordingly.

However as the second half proceeded risk averse investors were reassured by the ECB "whatever it takes" policy.  At the same time, with the Fed continuing to crank the monetary presses, the US economy showed tentative signs of life, and initial jobless claims continued to fall - albeit frustratingly slowly. In time (just) the Fiscal Cliff was averted, and by the end of the year it seemed that China was not only avoiding a hard landing, but resuming growth.

Australia's equity market also alternated between risk on and risk off, only partly in response to these global influences. What seems difficult to reconcile is that in this environment of fluctuating risk the ASX200 Accumulation Index only suffered one negative month in 2012. 

To read the entire report by Chris Gosselin, please click here.

ATTACHED FILES2012 Performance Review (pdf format)

Clearing the Volatility Hedge

Our CEO, Chris Gosselin writes for Alan Kohler's Eureka Report this week.

Read his article - Clearing the Volatility Hedge here.

BUFFETT PULLS AHEAD

Warren Buffett's $1 million bet in January 2008 that an equity Index fund would beat a suite of fund of hedge funds over 10 years has recently received significant press coverage.

The bet was between Buffett and Protégé Partners, a New York hedge fund of funds. Protégé selected five funds of hedge funds to compete against Buffett's selection of a Vanguard fund tracking the S&P 500 Index.  A charity chosen by the winner will receive the $1 million when the bet ends on December 31, 2017.

As on January 1, 2013, after five years and half way through the bet, Buffet's choice of index fund has finally moved ahead of the fund of funds for the first time, having returned 8.69% compared with the five fund-of-funds return of 0.13%.  At the end of the previous year the Index fund lagged by 0.38%.

The identity of the underlying funds has never been disclosed. However the results of the Dow Jones Credit Suisse Hedge Fund Index have been used as a proxy, as it has roughly tracked the hedge funds chosen, after adjusting for extra fees.

A number of points need to be raised with respect to the performance of the hedge fund of funds. Firstly fund selection can be like stock selection, choosing the best manager is critical to performance.

Secondly Fund of Funds traditionally underperform single funds.  They may provide great diversification, but that generally dampens returns even if it does provide much lower volatility.

The main point is that the Index fund had a very significant drawdown of almost -37% in 2008 while the hedge funds fell -24% and deep drawdowns significantly damage the value of compounding. For example, assuming an average return of 5.5% pa over 10 years, $100 accumulates to $170.81 over that time. However assuming a 40% market pullback in year 5 the value declines to $78.41.  Even if the 5.5% returns commence again at this point until the end of ten years the value only rises to $97.1 0.  Over the decade the investor loses 3%. 

Read the entire article from Sean Webster, AFM Research and Database Manager here.

ATTACHED FILESBuffet Pulls Ahead (pdf format)

In spite of a couple of negative days on European and US markets the ASX200 just doesn't want to take a breather, even after rising over 25% from the lows of last June. While most fund managers, and even some brokers are concerned the market might be getting ahead of itself, there seem to be plenty of investors who are determined not to miss out - even though they would go near equities just six months ago.

AFM's Research Manager, Sean Webster has taken a look at the curious behavior of the VIX, the so called Fear Index, and it reverse correlation to the market: Taking a lead from an article published by Adam Hamilton in the US, the logic seems curious - that if the market has had a strong rally, investors lose their caution and become complacent. However the reality is often that the market is overbought, and therefore has a higher probability of a correction.

The cost of insurance however, as measured by the VIX, falls simply because there's less demand for protection. The reverse applies when the market has fallen sharply, and therefore stocks may offer better value: All of a sudden the cost of protection (the VIX) skyrockets as investors try to buy insurance after the event.

Sean's article and associated charts can be seen here. It's a moot point of course whether the VIX leads the market, or the market leads the VIX. What it does show however is that potential risk is always around the corner and investors ignore risk at their peril.

Meanwhile there's plenty of media coverage about incidents (some actual, some alleged) of insider trading, both in Australia and overseas. Last Saturday's AFR contained an interview with Belinda Gibson from ASIC and covered the attempt by an offshore fund manager trying to gain early access to a local broker's research and information. Aspects of trading in Heinz in the US ahead of Warren Buffett's recent proposed purchase are being investigated, and a major US hedge fund is also in the SEC's sights.

However as we argue in this article, institutional investors, including hedge funds get access to information not generally available to ordinary investors, whether by their added research capacity, by investor briefings directly from the company itself, or through broker presentations. There may be no insider trading involved, but there is certainly no level playing field either.

This week's now for something completely different contains not one but two completely different clips. We hope you share our appreciation of The Two Ronnies, who still make me laugh even though the material is now well dated. Our second clip is far from amusing but well worth watching: Last Monday's "Australian Story" on the EasyBeats' lead singer Stevie Wright on ABC TV was a chilling reminder of the dangers of drugs. It's a long clip, so if you're short of time watch it from about 4 minutes onwards. The program is re-broadcast on the ABC at 12:30pm Saturday afternoon. Record it and play it to your children.

Otherwise enjoy the week-end.

Regards,

Chris.

Potential risk is always around the corner, or bubbling just beneath the surface. Ignore it at your peril.

A recent article (January 2013) by Adam Hamilton of Zeal LLC examines the role of the VIX as a leading indicator for the S&P 500. In the current bullish climate for equities and very low levels of volatility this might be a timely reminder that risk is often present when least expected.

We have reproduced the chart from the Zeal article and also added a chart of the ASX and a local volatility index. Meanwhile the full Zeal article can be found in this link.

Hamilton points out that the US market has had a strong rally with stocks at their best levels is 5 years and the S&P 500 (SPX) recording 8 new cyclical highs in 13 days. However the gains have been marked by very high levels of complacency by investors, and as contrarians would be aware, most investors become bullish only after major rallies.

The issue for investors is how best to measure the bullishness or complacency of the market. Over time a number of indicators have been developed with the best based on the option trading concept of implied volatility. Given that traders buy options to bet on future price moves investors can analyse how fast they expect markets to move in the near term. The most well known indicator here is the VIX. It is commonly known "the fear gauge" i.e., the higher the implied volatility the more fear is being reflected in the VIX and vice versa.

Hamilton's article notes that the author prefers to use VXO index as opposed to the VIX and details the rationale for this. In summary the VXO looks at near-term at the money S&P 100 options, as opposed to the VIX which amongst other differences uses the S&P 500.

Read the entire article from Sean Webster here.

ATTACHED FILESIs low volatility a sign of low risk, or investor complacency? (pdf format)