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

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

In last week's Hedge Clippings on the latest changes to Australia's superannuation system I remarked that "few comments seen so far have been negative". What has transpired of course is that on closer inspection the numbers and assumptions provided by Treasurer Swan were to put it politely, a touch rubbery.

Swan proudly claimed that the new 15% tax on superannuation pension incomes over $100,000 would only affect those with fund balances of $2 million. His assumption was based on a fund returning 5% per annum, which coincidentally is the annualised return from the ASX 200 over the past 10 years. What most investors would recognise is that this return is not only unattractive, but that for the first five years the return of the ASX 200 averaged closer to 20%. The following three years are seared into most investor's memory, and the return in the past 12 months has yet again hit 20%.

So in six years in the last decade a relatively modest retirement balance of $500,000 could have triggered the new 15% tax, assuming an allocation of 100% to equities and that the market's gains were realised. Swan also claimed, or tried to have everyone believe, that all this was fair and reasonable based on taxing the rich who were ripping the system off. He was also aghast at any comparisons between his initiatives (although many believe they will be unlikely to come into force prior to the election in September) and the haircut that investors in Cypriot banks have just taken.

It is worth remembering that funds allocated to superannuation during the 40 year accumulation phase are locked in. People commit, willingly or otherwise, to superannuation over a long period of time and should be able to expect that the basis for doing so remains intact without politicians of the day, who have been unable to make their books balance, raiding it. Retrospective tax changes, which in effect is what Swan is proposing, are not as far away from Cyprus as he would have us believe.

Meanwhile on to fund performance in March. Against a backdrop of the ASX 200 accumulation index which lost 2.27%, and with just over 40% of fund returns to hand, the average return was minus 0.25% with 54% of funds providing positive returns, and 85% outperformed the index. View full details here.

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

Platinum Asset Management's International Fund's overweight position in Japanese equities continued to contribute to the Fund's recent six-month performance of 12.17%, much in line with their annualised performance since inception in April 1995 of 12.08%.

Morphic Asset Management's Global Opportunities Fund, which was launched in August 2012 and is headed by industry veteran Jack Lowenstein (ex Hunter Hall deputy CIO) returned 0.99% in March, taking six month performance to 9.34%. The new fund invests in globally listed shares with a macro overlay.

The Aurora Fortitude Absolute Return Fund returned 0.42% in March. The Fund has the distinction of providing positive returns every year since inception in 2005, and in every month during the GFC in 2008.

SEI Knowledge Partnership release their sixth annual survey of 107 global institutional hedge fund investors ranging in size from less than $500 m to more than $20 billion in assets. The survey concludes that "while it is clear that the hedge fund industry is here to stay, there is no doubt that the industry's value proposition is being seriously questioned, and not only by investors".

Bennelong Kardinia's Absolute Return Fund continued its consistent long term performance track record. The fund's March return was +1.42%, taking 12 month performance to 14.4% and their annualised return since inception in May 2006 to 14.44%.

Meanwhile Bennelong stablemate, the market neutral Bennelong Long Short Equity Fund (BLSEF) returned 0.69% in March taking 12 month performance to 15.46% and an annualised return since inception in January 2003 of 20.33%. The BLSEF remains closed to new investors.

And now for something completely different, while on the subject of Cyprus and just in case you thought the "best of" anything awards really mean that.

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

Regards,

Chris

CEO, AUSTRALIAN FUND MONITORS

Superannuation Update

Treasurer Swan and Superannuation Minister Shorten must have been well aware of the potential electoral backlash from major changes to superannuation judging by their announcement today, a month out from the budget. Although the changes will affect those on the top tax bracket, they are not nearly as ferocious as many, yours truly included, were expecting.

Few comments seen so far have been negative. A 15% tax rate on retirement incomes over $100,000 remains attractive, even if not as generous as zero % on everything. Generally speaking the changes seem to pass the "fair and reasonable" test, although they won't do much to fill Swan's budget problems, nor the government's electoral chances if it comes to that. Maybe it was the realisation that if they tinkered too much with everyone else's retirement incomes it might put too much focus on their own overly generous pension arrangements.

And so back to markets and fund performance. March was only the second negative month for the ASX200 since December 2011, ending a significant rally since last July of almost 25% during which risk averse absolute return funds underperformed, and the more concentrated long biased funds made up some of the ground lost in the previous three or four years. Early indications from funds that have reported March results indicate they have performed well, with positive returns confirming their value in negative markets.

Meanwhile the Japanese market continues to rally, now at a four and a half year high and 57% above the low hit in late July, while the Yen continues to weaken, as intended by their version of QE1, 2 and 3. Other Asian economies and markets may not be so happy about that, but may have to grin and bear it.

On that happy note, I wish you a happy, healthy and carefree week end.

Regards,

Chris

CEO, AUSTRALIAN FUND MONITORS

Meet the Manager

Due to an overwhelming response, our Wednesday 10 April Meet the Manager briefing with Insync Fund Managers is fully booked. We will be holding a second briefing for Insync and will release our next Fund Manager lunch briefing soon. Stay tuned for updates. 

Is Self Managed Super at risk of its own success?

With the countdown to the Federal budget (and by all accounts likely to be Wayne Swan's last, at least for a while) replacing the recent leadership shambles as the focus of attention for Canberra watchers, there's a strong feeling that Australia's much vaunted superannuation system is in the current treasurer's sights.

Originally introduced twenty years ago in 1992 by Labor's then Prime Minister Paul Keating as a 3% levy on employers, superannuation was intended to ensure that Australian's future retirement incomes were properly funded, and retirees were not, or at least less, dependent on a government pension. Since then the levy has risen to 9%, is scheduled to rise to 12%, and according to Keating should be 15%.

In most respects "Super" been a phenomenal success, as the funds management industry (which is now estimated to manage around $1.4 trillion of Super) will no doubt attest. So successful that successive treasurers haven't been able to keep their hands out of the cookie jar, although to be fair Peter Costello's lump sum contribution concessions greatly added to it. Which brings us to the looming budget, and the strong potential for more changes to the regulations in an attempt to increase the take on Super's concessional tax rates.

The Treasurer will of course want to keep the faith with his party's few remaining faithful and target the top end of the Super chain. This will put the Self Managed Super Fund sector firmly in his sights. SMSF now accounts for an estimated 35% of the total Superannuation pool with approaching 500,000 individual funds. This is likely to grow as the compounding effect of 20 years of contributions take effect.

Originally the administrative and compliance cost of operating a SMSF made it prohibitive for all but those with the largest balances to manage their own retirement nest egg. The combination of technology and scale has reduced this barrier, which coupled with rising contributions and balances will only increase the SMSF sector further.

What's this got to do with absolute return funds? According to Wikipedia, Australians now have more money invested in managed funds per capita than any other economy. While absolute return and alternative funds are not supported in Australia by institutions and pension funds to the same extent as they are overseas, SMSF investors seem to understand the benefits of active and discretionary management of their savings.

So come early May when Mr. Swan rises to announce his final budget with an expected attack on the industry's tax arrangements, SMSF beneficiaries are likely to be hardest hit. What started as a great idea for reducing the government's obligation to provide an aging population their pensions will have turned the full circle to be a source of filling the expanding hole of the budget deficit.

On that happy note, I wish you a happy, healthy and carefree long week end.

And for something completely different - "Ou est le papier?"

Regards,

Chris

CEO, AUSTRALIAN FUND MONITORS

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.