The Hedge Fund Market Down Under

Alternatives in the Antipodes

Andrew Hutchings
Originally published in the August 2005 issue

Australia as a market presents hedge fund managers with both challenges and opportunities. In theory, Australia should be very prospective territory for managers of hedge funds. The local investment industry is highly sophisticated. The country is home to one of the world's largest pools of pension fund assets. More than in most countries, investment involves funds distribution and 'open architecture'. Well-established local managers have worked to promote hedge funds.

Kim Ivey, the head of the Australian chapter of the Alternative Investment Management Association (AIMA) is upbeat. "One of the important features of Australia's hedge fund industry is that there are many local managers who have not yet been discovered by investors in the rest of the world. For many of the investors, Australia is just too far away. The country cannot be reached in one hour's plane ride from London, New York or Geneva. A part of the opportunity is that Australian managers still have capacity."

This is a point which has not been lost on other observers of the Australian scene. Notes Ephraim Grunhard, a portfolio manager for PSS/CSS (the Canberra-based pension funds of Australia's federal public servants): "Offshore managers are increasingly beginning to look at Australian hedge funds. More and more money has been chasing hedge fund capacity. The time allowed for the hedge fund selection decision has been reduced. Some strategies are showing signs that they have had the life arbitraged out of them."

Adds Colin Taylor, Director-Sales & Marketing of Prime Services with UBS in Sydney, "2004 saw an increasing number of North American investors travelling to this region, with many willing to make an investment with local managers. However, because of the sizes of the allocations that these foreign investors were looking to make, they often had to work with several managers to satisfy their requirement.

"Several Australian managers tapped into this flow of capital. Many established managers who had been offering locally domiciled products to Australian investors looked at the possibility of running 'mirror' products that are domiciled offshore".

Prime brokers

One of the challenges for Australian managers is that there have effectively been barriers to entry to prime brokers in what is still only a small market place. Most observers agree that the total assets under Management of the Australian hedge fund community is about the same as Australian investors' holdings of hedge funds – at just A$20 billion (US$15 billion) or so.

UBS is generally reckoned to account for around 60% of the unleveraged hedge fund assets that are managed from Australia, and about 70% of the local managers. Its main competitors as prime brokers are Goldman Sachs and Morgan Stanley.

Colin Taylor argues that UBS' dominant position comes from a number of factors. Unlike its rivals, UBS had a presence on the ground in Australia and was well placed to use Australia's regulatory and tax requirements as a competitive advantage. UBS had a stronger local investment banking franchise than the other prime brokers. It was able to provide a wide range of services to local managers through a single platform, regardless of where the managers had domiciled their funds.

Even a brief discussion with a local fund-of-hedge funds manager about Australian-based investors' demand for hedge funds reveals a number of idiosyncrasies. For instance, David McKenzie, the Director of Institutional Investor Services with Russell Investment Group in Sydney, emphasises that demand for hedge funds tends to be concentrated in a limited number of pension funds and tends to focus on two kinds of products – funds of funds and long/short equities. (See Separate Q&A Section)

Nevertheless, the market for hedge funds does not end with institutional investors in Australia. Notes AIMA's Ivey: "One of the key trends has been retail investors' growing interest in hedge funds. The local regulatory regime means that fund promoters can reach retail investors provided that they have a locally domiciled product. Some of the master funds and other platform operators have looked for suitable single strategy products – and especially long/short equity funds."

"This has had implications for marketing of hedge funds. Local single-strategy managers have had the greatest opportunities with promoters of local retail products and with overseas-based investors. Conversely, it seems to us that those local pension funds who are actually using hedge funds have tended to seek large, offshore-domiciled, funds of funds."

Several observers suggest that retail investors' approach to hedge fund investing has been different to that of the pension funds and other institutions. One commentator, for instance, is Peter Coates, a Senior Investment Manager at HFA Asset Management, one of the leading local fund of funds managers. (See Separate Q&A Section) He suggests that retail investors were quicker, at least initially, than pension funds and other institutions to embrace the concept of absolute return investing.

Notes Dragana Timotevic, a Principal at Mercer Investment Consulting: "On balance, it is probably fair to say that retail investors led the way in terms of actually using hedge funds. Overall, though, the institutional investors have had more choice in terms of the variety of products that are available to them."

A plethora of alternative investment choices

One of the key aspects of the Australian hedge fund arena that sets it apart from those of other countries is that there is very widespread acceptance of the merits of non-traditional asset classes. The challenge is that non-traditional opportunities in Australia include direct and listed property, private equity, infrastructure funds, tax-advantaged forestry and agricultural investments, plus various other vehicles besides hedge funds and funds of hedge funds.

HFA's Coates and Russell's David McKenzie, representing leading fund-of-fund and multi-manager groups that are respectively focused mainly on retail and institutional investors, contend that the plethora of non-traditional, non-hedge fund vehicles that are available in Australia presents a challenge. Some pension funds and some consultants do not consider hedge funds separately from other non-traditional asset classes. Essentially, hedge fund promoters face meaningful competition for the investment dollar from a variety of quarters.

However, this view is not universal. PSS/CSS' Ephraim Grunhard, for instance, does not think that the usage of hedge funds is constrained by the availability of REITs, infrastructure funds and other proven non-traditional vehicles. Mercer's Timotevic suggests that investors recognise that many non-traditional vehicles provide superior income or greater stability of returns, especially when combined with other asset classes. "However, the other non-traditional vehicles usually offer different risk/return propositions to hedge funds – and this is widely understood," she says.

Long-only still delivers

Perhaps the greatest obstacle to the further development of hedge funds in Australia comes from the local stockmarket. In the world's largest hedge fund markets – the USA, Europe and Japan – interest in hedge funds was boosted by the poor performance of local stockmarkets. Investors could see a compelling reason to diversify away from local equities.

In Australia, on the other hand, the local stockmarket has consistently performed well. Australia largely missed out on the boom in technology, media and telecommunications shares in the late 1990s, but it also largely escaped the subsequent bust. Its world class natural resource companies have been seen as key beneficiaries of the rise in the price of energy and other raw materials. In part because many of the key industries are oligopolies, the earnings of listed companies have risen steadily at a time that domestic demand has been robust.

Equally importantly, local equities have been a core asset class for both retail and institutional investors. Retail investors have been attracted to the local stockmarket by the favourable tax treatment of dividends and by initial public offerings, some of which have resulted from the privatisation of state-owned enterprises.

Perhaps because defined contribution schemes are more common in Australia than in some other countries, the pension plans have seen local equities as an attractive offset to their long-term liabilities.

In the event that the Australian equities market disappoints local investors in a big way in the coming year or so, it is quite possible that there will be a new, and significant, shift towards non-traditional assets. However, hedge funds will not be the only beneficiaries.

Australia's hedge fund market at a glance

  • Total AUM of Australian-based hedge fund managers: cA$20 billion (US$15 billion).
  • Investors' holdings of hedge funds: c$A20 billion (US$billion) or around 3% of retirement assets.
  • Estimated number of pension funds that use hedge funds: 32% (according to Russell survey).
  • Australian investors' favourite strategies: funds of funds and long/short equity.
  • Locally domiciled retail products: significant and arguably led acceptance of absolute return investing in Australia.
  • Dominant prime broker: UBS, with apparently 60-70% market share.
  • Apparent constraints on development of Australian hedge fund industry: strong performance of local stockmarket; widespread availability of non-traditional vehicles other than hedge funds

Q&A with Peter Coates HFA Asset Management

What are the key features of HFA's approach to fund of hedge fund management that you would emphasise?

All of our fund of fund products focus, to varying degrees, on absolute returns, capital preservation and the diversification of traditional portfolios. Our flagship product – HFA Diversified – has a history of delivering consistent positive returns with low instance and depth of loss, together with excellent diversification away from equities, bonds, credit, commodities and property.

The HFA International Shares Fund makes allocations to around 15 equity stock pickers based around the world in their geographic market of expertise. This vehicle is an international equity alternative with the ability to produce non-market-directional returns, limit any loss caused by a market downturn and to diversify away from both the global stockmarket and from individual equity managers.

The HFA Australian Shares Fund has a similar mandate and objective to HFA International Shares Fund, but invests in domestic managers and strategies. This fund provides an alternative to the traditional allocation to Australian equities and typically has a net market exposure of around 15%.

How have Australian retail and institutional investors responded to the opportunities of investing in hedge funds?

We found that retail investors were initially much more accepting of the philosophy of absolute returns than were institutional investors. In essence, retail investors' objectives were closely aligned with our own – to make positive returns whenever possible, rather than to be beholden to a volatile index.

Trends of hedge fund usage by Australian pension funds and other institutions are changing. When the institutions first made allocations to hedge funds and absolute return funds, they typically began by using international/global funds of hedge funds. These funds of funds were usually domiciled outside Australia and generally managed in excess of US$10 billion. The institutions wanted a feeling of comfort and they found it in large funds.

Increasingly, the large funds are achieving returns that are becoming "commoditised". Accordingly, the Australian pension funds are more and more focusing on flexible and nimble boutique funds of hedge funds – which are usually managing less than US$5 billion – to meet their objectives.

Of course the pension funds were also keen to find alternatives to traditional long-only investment in Australian equities. Initially, they tended to use locally based single strategy managers who were offering quantitative equity market neutral products. This was a quite different approach to that which we, and other fund of hedge fund managers, were following: we were making allocations to niche, opportunistic Australian managers.

Now it seems that some Australian pension funds have realised that picking single-strategy hedge fund managers is harder than picking traditional long-only managers, in part because the dispersion of returns from the various managers and strategies is that much greater. However, we have not yet seen a trend for Australian pension funds to make allocations to opportunistic boutique single managers. Nor do they seem to have made allocations to local funds of hedge funds, who are increasingly filling their capacity offshore.

To what extent are hedge funds competing with other non-traditional investment opportunities in Australia?

Unfortunately, hedge funds are in competition with other non-traditional opportunities in this country. It seems to us that some investment consultants, and particularly those that are focusing mainly on retail products, have not progressed from the view that all "alternative investments" should be classified together. They include hedge funds, funds of hedge funds, infrastructure funds, forestry and agricultural investments, private equity, direct property and commodities in one, all-encompassing, investment category. This is in spite of the fact that each of these non-traditional asset classes have different risk-return qualities and do not respond in the same way to various trends in capital markets.

More progressive investors have recognised that these various non-traditional asset classes have different qualities and characteristics and have taken a suitably disciplined approach to building their portfolios. In many cases, these investors have been attracted to the consistently defensive qualities of a well-managed fund of hedge funds

Q&A with David McKenzie Russell Investment Group

What are the key features of Russell Investment Group's approach to fund of hedge fund management that you would emphasise?

We would stress that the philosophical justification for fund of hedge fund investment is clear and strong. In the first instance, hedge funds are a good place to find alpha. In the second, the fund of funds approach provides good diversification of risk – which is arguably more important with hedge funds than with conventional long only managers. We look for underlying managers that clearly have a competitive edge and a compelling story.

What do you see as the main additional risks that hedge funds carry relative to long-only managers?

Operational risk is something that we pay a lot of attention to. For instance, we consider the extent to which the hedge fund manager is dependent on the insights of one or two senior individuals. We also consider the possible implications of a hedge fund manager going out of business. Suppose a pension fund with a conventional long-only segregated portfolio learns one day that an underlying manager has gone out of business. The pension fund will be able to exert control over the portfolio very quickly, because it has the primary relationship with the custodian. There may well be transition management issues to be dealt with, but the potential fall out is limited.

Then suppose that the pension fund has allocated money to a hedge fund manager that has ceased operations. The pension fund will almost certainly have invested through a fund rather than a segregated portfolio. There will of course be a custodian, but its primary relationship will be with the hedge fund manager not the pension fund: it will be harder for the pension fund to re-exert control. To the extent that the hedge fund manager has been using leverage, it is conceivable that the possible losses will exceed the amount of money invested by the pension fund in the hedge fund.

How would you describe the Australian hedge fund industry?

We see the Australian hedge fund industry as one that is growing, but neither rapidly nor evenly. In our annual survey of local pension (superannuation) funds, which was completed earlier this year, we found that about 32% of all pension funds are using hedge funds. However, hedgefunds are much more important to some parts of the pension community than others. They are, for instance, very widely used among the industry funds (i.e. the not-for-profit pension funds associated with Australia's trade union movement and which account for roughly 10% of overall pension assets).

Conversely, hedge funds are not widely used by Australia's corporate pension funds. They are focusing on the new licensing requirements and the implications of the new choice-of-fund legislation. They may not be averse to the idea of using hedge funds, but they have other issues to deal with in the short term.

Most estimates suggest that the Australian pension funds hold around A$20 billion in hedge funds – or roughly 3% of total assets under management. However, we have found that those pension funds that actually use hedge funds typically have allocations that are twice this size at around 6%.

The other feature of the Australian hedge fund industry that we would emphasise is that it is highly concentrated. Our survey found that local pension funds overwhelmingly focused on two types of products. One, as might be expected, is multi-strategy funds of hedge funds. The other is funds that are following long/short equity strategies.

Did the comparatively disappointing performance of hedge funds in 2004 have an impact on the Australian industry?

In Australia, the issue has not been the performance of hedge funds – and, in particular, the fairly pedestrian returns that were garnered during 2004. The real problem is that the local stockmarket has performed so well, both in absolute and relative terms. Thanks to the boom in commodity prices, a fairly robust local economy and good corporate profit results, long-only investors have made good money from Australian equities – which represent an important asset class for the local pension funds. Even in a reasonably sophisticated financial services industry, it can be hard to make the case for diversification into alternatives when the traditional asset class(es) are delivering good returns.

Conversely, the typical pattern in other countries is that demand for hedge funds has picked up when local stockmarkets have performed poorly. In the USA, for instance, interest in hedge funds grew substantially in the wake of the bursting of the technology, media and telecommunications bubble in early 2000. One of the reasons why Japan is an important market for hedge funds is that the local stockmarket has performed in a disappointing fashion for much of the 6 years or so since the major indices peaked.

To what extent are hedge funds competing with other non-traditional investment opportunities in Australia?

Even if a pension fund is philosophically committed to allocating 6% – or even more – of its assets to non-traditional asset classes, it will almost certainly have to make a corresponding reduction to its existing portfolios of local equities, local fixed income, international equities and so on. The pension fund can consider real estate investment trusts (or listed property trusts, as they are generally known in Australia) which are well established. The country is also widely recognised as a leader in the development of infrastructure funds. Private equity funds are available as, of course, are hedge funds. The bottom line is that the hedge fund managers of the world probably face more competition from providers of a wide variety of non-traditional vehicles in Australia than they would in other countries.

What does all this mean for Australian hedge fund managers who are keen to promote their services?

There are undoubtedly opportunities for the Australian-based hedge fund managers. However, their marketing needs to be targeted carefully. Within Australia, the most prospective clients are the industry funds and some other pension funds. They should also be able to do good business with foreign-based funds of hedge funds.