Prickly hedges By Scott Francis

• 15% Australian bonds.
• 10% International bonds.
• 2% Cash and cash enhanced.
• 3% Alternative strategies - the hedge fund holding.

You can see that the hedge fund is not a big asset within the defensive portion of this fund, making up only 10% of this part of the assets. The question, however, is can a hedge fund really sit within the defensive asset classes of an investment portfolio?

This article looks at the increasing bastardisation of "defensive assets" - particularly the use of hedge funds as defensive assets. There was a time when defensive assets would only include cash and high credit quality fixed interest investments, such as term deposits, government bonds and highly rated corporate bonds. These were the reliable investments with known income repayments, and the repayment of capital at the end of a set term; they were the investments that let you sleep soundly at night. Now there are all sorts of things classed as "defensive assets" that, if fully understood, might keep you tossing and turning all night.

The argument that hedge funds should not be used as a defensive asset also has practical significance, as demonstrated in Careful how you hedge your bets, an article I co-wrote with Eureka Report editor James Kirby in 2007. It looked at superannuation funds holding the failed hedge funds of Basis Capital.

Should hedge funds be considered a defensive investment?

QIEU Super provides a superannuation option for many people employed in the education sector. The QIEU balanced growth fund consists of 72% growth assets (32% Australian shares, 26% international shares, 4% private equity and 12% direct property) and 28% defensive (10% fixed interest, 10% infrastructure, 4% cash and 4% absolute returns strategies - hedge funds).

Interestingly, on the page that precedes discussion of the asset allocation of its balanced growth fund, QIEU Super describes infrastructure and hedge funds as "growth assets". Yet within its balanced growth fund QIEU says there are 28% defensive assets, and the only way of arriving at that figure is to include infrastructure and hedge funds as defensive assets.

Australian Super, an industry fund running an aggressive advertising campaign, includes in its balanced fund a 9% allocation to the traditional defensive asset classes of cash and fixed interest investments. Other asset classes include private equity (3%), absolute returns (3%) and infrastructure (10%). Australian Super advertises on the basis of its investment performance. It is not surprising that it has outperformed "normal" balanced funds, which might include 25-40% cash and fixed interest investments - if it includes higher return/higher risk investments such as private equity, hedge funds and infrastructure where other funds include lower risk/lower returns investments such as cash and fixed interest investments.

Compare the asset allocation of QIEU and Australian Super balanced fund to the Q Super Balanced fund, which has 25% in cash and fixed interest investments.

There are two key arguments that I am aware of for the categorisation of hedge funds as defensive assets:

• Hedge fund returns are uncorrelated to traditional asset class returns.
• Hedge funds tend to have very low levels of volatility.

The first argument is not a strong one, in my opinion. Horse three, race six has a low correlation with traditional asset classes and that does not make it a great investment. That said, if hedge funds are genuinely uncorrelated with traditional asset classes then they will be able to moderate the volatility in a portfolio.

Current evidence does not seem to support this "lack of correlation" argument; the first sharp equity market downturn in five years has seen many hedge funds (Basis Capital, Macquarie Fortress Notes, Absolute Capital and hedge funds run by Bear Stearns, among others) really struggle. The uncorrelated asset class argument should see hedge funds shooting the lights out at the moment. There is little evidence of this.

On November 3, 2005, a group of financial economists issued a statement on hedge funds. The statement was signed by highly regarded academics such as Bill Sharpe (Nobel Prize winner), Jeremy Seigel, George Kaufman and Jay Ritter. The statement included the following comments about hedge funds:

• '... their investment strategies are often risky'
• '... not understood by all investors'
• '... can employ leverage, thereby amplifying the variability of outcomes'
• '... it restricts redemptions so the investment is largely illiquid' (we are seeing many examples of this at the current time)
• Expenses are high. As a practical example, the HFA Diversified Investments Fund - a retail hedge fund - has a fee of 3.59% for the retail fund and 3.34% for the wholesale fund. That is a fee of $3,590 for every $100,000 invested in the retail fund.
• The risk that the failure of one counterparty to a transaction will trigger failure of other counterparties. A practical example of this has been seen in the CDO (collatoralised debt obligations) based on mortgages. As the mortgages fail this filters through to the end investors, sometimes geared investors in hedge funds.
• Returns on many hedge funds are not normally distributed, but have a distribution characterised by 'fat tails'. (This means that there are a higher than expected number of hedge funds that have very poor returns, or collapse) ... tail risk is difficult to measure.
• Risk-adjusted returns tend to be overstated, because of survivorship bias. (This means that because so many hedge funds collapse, the returns of these collapsed funds are often excluded from performance data. For example, if in three years' time someone averages the return from all hedge funds, they will not include the Basis Capital fund that has collapsed. Therefore the average investor's return will be overstated because collapsed hedge funds are not included).

This warning, from two and a half years ago, is a great summary of many of the problems in hedge funds. Leverage, counterparty risk, illiquidity and the fat tail of returns has been demonstrated over recent times, when the supposedly "counter-cyclical" nature of hedge funds should see their returns going very strongly.

So should hedge funds be included in portfolios as defensive investments? My opinion is that they should not. Their risk/reward profile is massively different from a cash or fixed interest investment. If the nature of a fixed interest investment is to provide a reliable and known return, to provide liquidity and to dampen the overall volatility of a portfolio then a hedge fund does not have a place in this part of the portfolio.

Recent performance of retail hedge funds

One of the difficulties of assessing hedge funds in portfolios is that there is little long-term data available on the performance and volatility of the asset class because they are a relatively new addition to the investment landscape and, with the number of hedge funds that do collapse, data is skewed by "survivorship bias". Given the absence of this data, it is interesting to look at the actual returns from current hedge funds.

The most common hedge fund manager that I come into contact with (as a financial adviser) is HFA Asset Management fund. It is interesting to look at the return from the HFA funds, and to consider their performance in the light of the promises made about hedge fund returns.

HFA tends to use a "fund of funds" strategy, in which multiple investment managers are used. This is designed to address the risk of any one investment manager failing, but it does add another layer of costs for investors.

The data is taken from the most recent performance report for each fund. Some are to the end of February; others to the end of January.

The first column of each table lists the latest three-month returns. Given that Australian sharemarkets have provided negative returns over this period, it is interesting to consider how hedge funds have performed. Have they provided a positive return when markets are down? The simple answer is no, all six hedge funds had a negative return over the period, although their returns would have been "less negative" that the equity markets.

The last four columns compare the total return of the fund since it was started with the total return of the 90-day bank bill index over the same period, and then the volatility of both. While the various hedge funds had returned slightly higher returns than the bank bill rate - basically a cash rate of return - their volatility was much higher. At the end of the day investors earned a little more than the rate of cash for the risk of holding a hedge fund with increased volatility.

HFA Fund Returns - to the end of February, 2008
Fund Name	3 Month Return	Date of Fund Inception	Total Return Since Inception	90 Day Bank Bill Total Return Since Inception	Volatility Since Inception	90 Day Bank Bill Volatility Since Inception
International Shares Fund	-1.69%		59.72%	46.33%	4.96%	0.22%
Diversified Investments Fund	-.54%		69.10%	46.32%	3.55%	0.22%

HFA Fund Returns - to the end of January, 2008
Fund Name	3 Month Return	Date of Fund Inception	Total Return Since Inception	90 Day Bank Bill Total Return Since Inception	Volatility Since Inception	90 Day Bank Bill Volatility Since Inception
Octane Fund	-4.32%	8 Nov 2004	25.79%	21.76%	5.50%	0.16%
Octane Fund 2	-4.62%	30 June 2005	18.29%	17.33%	6.32%	0.16%
Octane Asia Fund	-9.98%		16.63%	10.88%	10.44%	0.12%
Partners Fund	-4.30	1 January 2007	9.16%	7.48%	12.56%	0.12%

Source: HFA Asset Management

Conclusion

Investing is a game of risk and reward. The danger of "balanced" funds using higher risk assets in the defensive component of portfolios is that investors will be lured in by their higher returns, only to find out down the track that the reason returns were higher was because the risks were greater.

Defensive investments within a portfolio are what should let an investor sleep at night. In that part of my portfolio I want cash and highly rated fixed interest investments. Hedge funds don't belong there.