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 Careful How You Hedge Your Bets - Eureka Report Article 

    July 20, 2007
Careful how you hedge your bets
By James Kirby and Scott Francis

PORTFOLIO POINT: Balanced clearly means different things to different investment managers, and further information should be sought by the prudent investor.



As Australian hedge fund managers stare down the barrel at their first major league disaster, the crisis this week at the $1 billion hedge fund group, Basis Capital, is set to spark a fresh examination of hedge fund exposure.

Hedge fund investments are increasingly important across the managed funds sector, especially in superannuation, education and hospital funds. An investigation by Eureka Report has revealed that some of the country's top-performing funds are using hedge funds, including CDO funds (the category that has sparked the crisis at Basis Capital) to propel their returns.

Moreover, leading Australian superannuation funds - including two funds that came in the top five balanced funds in the year to June - are defining their hedge fund holdings as defensive, a move that allows the funds to top up risk in 'aggressive equity' holdings with further risk assets in hedge funds.

Catholic Super, the best-performing fund manager last year, splits its flagship Catholic Super Balanced Fund into 70% growth assets and 30% self-described 'income' assets'. On closer inspection the income assets are held two-thirds in alternative assets, including hedge funds and property. In effect, the group only has 10% of its assets in traditional defensive allocations of cash (5%) and fixed income (5%).

Westscheme - another top-five fund last year - has even less in traditional defensive assets with just 5% in cash or fixed interest while its hedge fund holdings also include a direct exposure to CDO (Collateralised Debt Obligation) funds. Westcheme's Target Portfolio Fund has 4.6% of its assets in CDOs. (For everything you want to know about CDOs, see today's Big Question).

On Thursday, the Sydney hedge fund group Basis Capital announced that its Basis Yield Fund was in default, and investors were looking at getting back less than 50c in the dollar. Basis Capital executives have gone to ground offering no explanation for the drama and industry regulators are yet to comment directly on the crisis. Basis Capital was voted one of Standard and Poor's 'Hedge Fund Managers of the Year' this year. But this week, senior market executives such as Macquarie Bank's Alan Moss are urgently trying to distance themselves from the Basis Yield crisis.

Private investors with money in managed funds - or DIY funds with interests in managed funds - are asking hard questions, including what is the specific role of assets consultants and rating agencies who mediate between the global hedge fund market and institutional investors.

Investors may be surprised to learn school and hospital funds have aped the superannuation sector in categorising speculative hedge funds investments as defensive.

QIEC, a Queensland-based education fund with $420 million under management, explains in its product disclosure statement that the asset allocation of its balanced fund is 72% growth and 28% defensive. The defensive investments, however, are only 16% exposed to the traditional cash and fixed-interest investments, with the remaining 12% invested in hedge funds and Australian infrastructure (roads, ports and so on).

In Melbourne, the Combined Fund, a $430 million Victorian-based private schools fund - is also a top shareholder in the troubled Basis Yield hedge fund along with WA Local Government Superannuation Fund, the Van Eyk Blueprint Fund and the Rubicon Australian Leaders Fund. The Combined Fund has $21 million in the Basis Yield fund - about 5% of its total funds.

In Perth, the Princess Margaret Hospital Foundation - the investment unit of a children's hospital - has turned up as another loser in the Basis Capital crisis. The fund is listed as a top-20 shareholder of the Basis Yield fund. The hospital appears to have $3 million of its total of $17 million in funds invested in Basis Yield.

Vern Reid, the chief executive of the Princess Margaret Hospital Foundation, said: "We're reviewing the situation, specifically we are reviewing that our investments were within our guidelines, which require us to seek blue-chip conservative investments."

With $3 million in a hedge fund with CDO exposure, the debate between the hospital and its investment adviser, the Counterpoint Group, will be crucial to the future investment strategy of the hospital - and thousands of similar funds around Australia will be examining the nature of their non-traditional defensive investments with a new intensity after a string of hedge fund collapses overseas.

Over the past two months, two Bear Stearns hedge funds have had to be supported by the injection of more than $3 billion after revealing big trading losses. Separately, towards the end of 2006, Amaranth Advisors, a US-based hedge fund, collapsed after losing around $3.5 billion trading in natural gas futures.
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What's happening to traditional 'defensive' assets?

Traditional defensive assets in portfolios include cash and high-quality, fixed-interest investments such as government bonds, bank bonds and highly rated corporate bonds.

The returns from these asset classes are not exciting - say 6% to 7.5% at the moment. However, they are safe and reliable investments, the sort or investments that let you sleep easily at night.

For example, there has never been a default on a government bond in Australia. So, if your superannuation fund holds such bonds as part of its defensive portfolio, you know that while they will only provide a modest return, this is coupled by a very low level of investment risk.

Defensive assets should provide this safe return, and moderate the overall volatility of a portfolio.

But, increasingly, fund managers are putting investments into hedge funds or absolute return funds.
The ASIC consumer affairs site FIDO (www.fido.gov.au) puts hedge funds in its 'complex investments' category.

ASIC would not discuss hedge fund regulation for this article, referring the matter to APRA, which referred readers to work carried out in 2003, which offered the opinion that superannuation trustees had, broadly speaking, "adopted a relatively measured approach to hedge fund investments".

But ASIC also has opinions on hedge funds and its own website says: "Hedge funds aim to make money for investors in both rising and falling markets by relying heavily on the skill of the investment managers to buy and sell the right investments at the right time. Hedge funds may invest in all sorts of securities and non-mainstream asset classes, may use a wider variety of complex investment techniques than traditional funds and may borrow money to pay for the fund's investments. The skill of the investment managers and the reliability of their systems for managing risk can be critical."

This is a working definition of a hedge fund - a trading fund with a wide scope of potential investments, access to leverage, and reliant of the skill of the manager for investment results.

There are three key arguments for the use of hedge funds in the defensive parts of portfolios:

    The ability to make money in risking and falling investment markets. As attractive as this sounds, the ability to achieve this is now in the hands of an investment manager's skill. This itself is risky - you have 'uncoupled' yourself from traditional investment returns and put yourself in the hands of an investment manager who has a generally broad trading scope.

    Risk can be managed through ?fund of fund' hedge funds. In the investment industry, the joke runs: 'fund of funds' otherwise known as 'fees of fees'. 'Fund of fund' structures are expensive - they must add another layer of fees. Indeed, the requirement for a ?fund of fund' structure shows how risky hedge funds are. If you need to have diversified exposure to hedge fund managers to manage risk, then that itself highlights some of the risks of the asset class.

    Hedge funds are uncorrelated to traditional assets, and therefore lower the overall volatility of a portfolio. Taking a punt on the 2.30 at Randwick is also uncorrelated to the returns from traditional investment classes. It does not make it a good investment. However, if you still want to stick to the overall story of using hedge funds in a portfolio to try to reduce risk, then that may be reasonable. However, it should not be categorised as a 'defensive' asset - use it as part of the growth portfolio for the fund.



A reminder of risk and return .

Risk and reward is a profound relationship in investment markets. Catholic Super and Westscheme have been strong performers on the 'SuperRatings' balanced super fund table over the past 12 months. However, however a strong driver of this may well be the extra investment risk that they are taking in the defensive sector of their portfolios.

Every investor has to be aware of the risks that they are taking on within their portfolio - whether it is one they manage themselves or using an investment manager. The use of the term 'balanced' clearly means different things to different investment managers, and further information needs to be sought by the prudent investor.

Keep in mind Eureka Report is not arguing against the use of hedge funds in portfolios - just that it is stretching them to include them in the low-risk, defensive part of a portfolio next to cash and high-quality, fixed-interest investments.

Scott Francis' articles in the Eureka Report 

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