Australia: Hedge Funds

Will hedge funds down under become a dominant force?

Originally published in the October 2007 issue

The Australian hedge fund community remains positive about the prospects for absolute return asset management in the country despite a number of well publicised fund struggles. Although the knock-on effects of the credit crunch hit some Australian funds harder than their Asian peers, the fundamentals of a market in which the overall investment pool continues to soar suggest that the rapid growth in number of funds and their total assets under management should be maintained despite the hiccups.

Indeed, some forecasters are prepared to make the case that Australia may be positionedto move out of 2007 into a growth cycle which will outperform many more developed absolute return markets.

The domestic investment management community was not as highly exposed to complex credit instruments as funds in the US and Europe, so may be better positioned to exploit the new investment environment. With a unique savings environment and a buoyant economy, total assets will continue to grow; meanwhile, the sophistication of asset allocation is already increasing, traditionally a good sign for hedge fund managers as consultants lose their aversion to alternative strategies.

There is also a growing level of cultural and investment familiarity with mainland Asia among Australian fund managers, combined with a domestic economy which has benefited enormously from the commodity boom on the back of Asian demand. If the next driver of world growth does come from Asia, these factors, together with beneficial geography, position Australia well to take advantage of the new opportunities.

The growth story

The Australian hedge fund industry has grown rapidly since 2000 having been a relatively late adopter. Government agency statistics indicate total assets across hedge funds have increased from little more than a rounding error at the turn of the century to over A$60 billion by the mid point of 2007.

Local observers ascribe the growth to two main factors. Most significant has been the phenomenal increase in assets under management created by Australia’s superannuation laws, which have enforced a mandatory employer contribution to a pension plan since 1992. Nationally, that contribution, currently set at 9% of gross salary, has pushed the total pension assets under management in Australia through the A$1trillion barrier at the end of 2006 – a figure which is also predicted to grow to nearly A$2trillion by 2015 (see Figure 2). Australia now has the largest pension asset pool in Asia, the highest per capita investment level in the world and is one of the top five asset management markets globally.

This cannot help but mean more money for hedge funds. “Alternative allocations in Australia have been growing – it’s really the fastest growing sector in the country,” says Kumar Palghat, Founder and Director at Sydney-based fixed income fund Kapstream Capital. “The money is coming out of fixed income, or from rebalancing the equity market that has done so well in recent years. Investors are interested in alternatives because their inflows are so great and they have to find a home for them.”

At the same time, there is evidence that pension funds and their investment consultants have been following the path taken elsewhere in becoming more comfortable with significant allocations to absolute return. A January 2006 survey of superannuation funds by University of New South Wales (UNSW) in association with Alternative Investment Management Association (AIMA)’s Australia chapter showed 71% of respondents already allocating to hedge funds, most usually in funds of funds with a global strategic bias. However, although respondents said they expected their allocations to grow over the next five years, the level at the time remained low, averaging just under 3%.

According to John Evans, Associate Professor at UNSW’s commerce and economics faculty and co-author of the survey, “The exposure to hedge funds is not universal, and restricted in most instances to the major superannuation funds; even then the exposure is small. Given the purported ability of hedge funds to enhance returns and reduce risk from combinations of traded securities and to produce returns that in many instances are lowly correlated with the existing superannuation fund asset classes, the lack of exposure by most superannuation does raise the issue of why the exposure is so low.”

One source, who until recently held a senior position in manager selection at a major investment consultancy in Sydney, explains the relatively low take-up to date as a function of the pension funds rather than the asset management world. “It would be wrong to think that Australia isn’t a sophisticated place as far as fund strategies goes – a lot of the local investment community cut its teeth offshore and in some ways the relative youth of the markets here make it easier to exploit opportunities. But alternative asset management isn’t an easy sell to a lot of the investors here – of course then horror stories come back here and it wouldn’t be too much of an exaggeration to say that the phrase ‘hedge fund’ is still one that you have to tiptoe around in a lot of cases.”

Clearly the consultants have a significant role to play in convincing investors to move a significant segment of the huge pool of domestic assets into alternatives; the UNSW/AIMA survey clearly indicates that advisors are seen as the key source of information on hedge funds by superannuation funds. There are signs that a soft landing for the investors may be possible, with Australia’s funds of funds market playing an especially significant role, managing just under half the country’s total hedge fund assets.

In addition, the Australian industry features more recognisable, institutional names than the boutique hedge fund model seen elsewhere in the world. The ten largest single manager hedge fund operations in the country include names familiar to local investors like Barclays Global Investors, AMP Capital, WestLB and Portfolio Partners while incubation businesses are run by other well-known firms including Challenger Investments and Macquarie Bank. Although the country’s four largest banks – the ‘four pillars’ – are yet to develop significant presences in alternatives, there is no reason for investors to be unfamiliar with fund manager names.

The credit crunch

The down side of the involvement of well-known names is that turbulence associated with hedge funds can also be associated with them. The three firms most publicly hit by the global credit crisis included Macquarie’s Fortress Funds – news which reached national prominence in Australia but did not dent the bank’s quarterly results. After acknowledging likely losses of over 30% of the Fortress Funds’ net asset value, Macquarie also insisted the investments were fundamentally sound and would continue to function as initially constructed – including continuing to pay interest at the launch level in the case of Fortress notes.

The fact that one of Macquarie’s struggling investment vehicles has a retail note structure gives a clue regarding the status of the hedge fund industry in Australia: something that is commonly referred to as a ‘hedge fund’ is not necessarily so. Speaking of the funds affected in the recent upheaval, Dominic McCormick, Chief Investment Officer of Select Asset Management in Sydney, says, “The media has branded all the problem funds ‘hedge funds’ even though many of were not. The fund suffering the most damage, the Basis Yield Fund, was actually a leveraged credit fund playing at the riskiest end of the debt spectrum – the equity tranche of collateralised debt obligations…. While the second affected Basis fund is clearly a hedge fund, the Absolute Capital and Macquarie Fortress products that have featured in the media are not hedge funds either.”

According to McCormick, “Rather than a question of how much and whether exposure to leveraged credit made sense, the lesson to take from the Basis situation is that one should never invest in, or recommend, anything one does not understand – particularly hedge funds. The problem is, taken to extremes, many investors and advisers would end up investing in very little.” He argues the answer for new investors is to develop familiarity through funds of hedge funds, as has been the case in other countries.

The problem is that if investors associate the problems of Basis, Absolute and Macquarie’s Fortress with hedge funds generically the burgeoning alternative asset management community in Australia could be set back significantly; it is certainly true that the losses were both significant and highly visible.

Basis Capital, the worst affected firm, was Australia’s seventh largest single manager hedge fund firm by mid 2006, according to LCA Group figures, with A$1billion under management. Following a fall in value estimated at 80% and a filing for bankruptcy relief in the US, Basis appointed Blackstone Group as financial adviser to its Yield Alpha and Pac-Rim Opportunity funds on 24 July this year, “to prevent adverse pricing and selling of assets, as well as add to the international experience of the Funds’ investment management and advisory teams”. By 21 September, fund redemptions remained suspended.

The situation at Absolute appeared somewhat less critical. A statement from the firm released in August said, “Since our last update of late July, we have seen some stabilisation as well as some opportunities emerge. The structured credit market, however, remains illiquid with few secondary transactions being completed and almost no primary issues being priced. What started as a subprime credit event has now spread and impacted just about all forms of credit investments…. The fund continues to receive interest payments from its debt investments and expects repayment of capital at maturity. This, in addition to the fund’s cash flow management arrangements, means that at this time we expect the fund will be in a position to pay a distribution for the September quarter.”

Opportunity set

Despite the short-term pain, market insiders are prepared to suggest that more money will find its way to Australian hedge funds in the coming years and that, when it does, those managers should be positioned to make the most of it. The ex-investment consultant says, “I have been convinced that what we have seen recently is not really a liquidity crisis but a ‘buyers’ strike’. The bottom line is that there is a lot of cash in the Australian system nowadays and that isn’t going to change any time soon. If you believe – as many people do – that long-run equity market gains aren’t going to be everything they have been before then it will be part of trustees’ fiduciary duties to widen the net in terms of getting return on all that cash. I would say that the hedge fund market has to grow over the next few years, almost regardless of what goes on in the financial markets as a whole.”

Local hedge fund managers are already strategically positioned to exploit international opportunities and offer diversification of returns that a conservative domestic portfolio cannot.

For instance, Kapstream’s Palghat explains his own investment philosophy by saying, “I don’t necessarily look specifically at AUD issuance; the way I see markets is that I look at bonds, but I look at bonds everywhere. You’ve got to take risk in any country hedged back into a base currency so you can compare apples to apples: a World Bank issue in dollars versus a World Bank issue in Aussie dollars versus one in UK, once it’s all swapped back into US dollars, where does it trade?

“It shouldn’t ever really be that one trades cheaper than another because the credit risk is identical and FX risk can be hedged. But in the market that’s not necessarily true because there are liquidity issues, market sophistications and swap issues so every now and again you might get a few issues that are mispriced. What you should say is ‘I’m going to own the cheapest bond wherever I can find it, then hedge it back into Aussie dollars.”

The international outlook of itself gives Australian fund managers a potential edge: in the wake of the sub-prime crisis, major fund of funds managers in the country – including the second and third largest, HFA Asset Management and Ernest, Babcock & Brown, with A$2.5billion and A$2.1billion under management respectively – queued up to make it known that they were net short of US sub-prime debt. Indeed, HFA’s Chief Investment Strategist, Jonathan Paine, takes a macroeconomic view which strongly favours Asian investment as a relative value trade over the US.

“The global economy can survive an American recession and I am still convinced that it is now the turn of the Asian consumer to go shopping and that it is time for the American ‘shop till you drop’ consumer to take a breather,” Paine argues. “What I see is a strong rise in Asian and European (ex-UK) equity markets, as we saw in 1999. What I also see is an extraordinary array of investment opportunities for nimble and disciplined investors and, similar to 1998, we have seen a period of capital market dislocation and contagion which has in turn created numerous anomalies across a broad spectrum of financial asset prices. Those investors who are not slaves to their benchmarks thrive in such an environment.”

For Paine, the recent credit crunch was a sign of no less than the rebalancing of the global economy away from its previously US-centric position to a more globally balanced future.

“I know people who have borrowed too much need to learn that they have been very reckless, but the world we live in today means that silly Mr Smith in Idaho who borrowed too much has hurt Mrs Smith in Gosford, Australia,” he says. “The Asian consumer wants to go shopping now and America needs to put its own economic house in order. There is a particular irony about much of this. In the nineties, America lectured Japan and Asia for ‘crony capitalism’ and told them to embrace the American way. Well, perhaps it is time for America to eat some of its own humble apple pie, and then let us hope that the Chinese, Japanese and everyone else with a lot of money comes to the rescue of the global economy.”

Fresh start

In addition to any shift in global economic paradigms, the relatively early stage in development of Australian hedge fund strategies gives the country a chance to emerge from the post credit crunch malaise ahead of the field. While under a third of US hedge fund assets are now devoted to long/short equity, the Australian industry is still reliant on that strategy (see Figure 3) – meaning it has largely avoided the complex credit investment practices which seem likely to keep the American business hamstrung for some time to come.

In addition, Australian hedge funds have traditionally used less leverage – frequently no more than four or five times, compared to the ten to 15 times common in the US – and are therefore more likely to survive adverse conditions. Finally, with Ernst & Young estimating that start-up and running costs for Australian hedge funds compare favourably with Singapore and are less than half the level experienced in Hong Kong or Tokyo, the possibility exists that Australia could become an Asian hedge fund capital.

Observers believe the recovery from the middle months of 2007 could be key, but the question is not whether Australia can build a vibrant hedge fund community but whether its industry can become the region’s dominant force instead of just a locally significant player.