August 10, 2007

	Warning bells ring louder for hedge funds By James Kirby and Scott Francis

• Basis Capital has warned of losses of up to 50% in one of its funds.

• Absolute Capital has temporarily closed its yield strategies fund to protect investors while 'the market for the assets (of Absolute Capital) has ceased to operate normally'. Perhaps investors might want to know why Absolute Capital invested in any market that had this potential to 'cease to operate normally' (whatever that might mean).

• Macquarie Bank - the standard bearer for Australian investment banks on the global stage - has also suffered a sharp reversal, though leavened by occasional bounce-backs. Macquarie Bank stock has plunged from almost $100 to about $72.80, The immediate source of the bank's dramatic lack of popularity is the Macquarie Fortress Australia Notes Trust (MFN), a six times geared investment fund, listed on the Australian Stock Exchange.

MFN's investment in debt and promises of a yield of more than 10% led to the stock price halving after a mere 4% drop in the value of its assets. Macquarie Bank's wider share selloff followed an announcement by the bank that it expected a drop of about 25% in the value of the assets underpinning the Macquarie Fortress notes.

• Similarly, rival investment banks on the ASX such as Babcock & Brown (down 5% on Friday) or MFS and to some extent the 'Big Four' banks - ANZ, CBA, NAB and Westpac - have also been hit though the links between these stocks and the US credit crisis is largely by association. Nevertheless, all these financial stocks are exposed to negative sentiments washing out of the US.

As the crisis deepens attempts by various senior bankers to explain the crisis constantly reveal just how risky credit practices have become.

Yesterday's decision by France's BNP Paribas, to freeze more than $2.5 billion of its funds and suspend the calculation of net tangible assets stunned global markets. The BNP statement to the market offered little reassurance: "The complete evaporation of liquidity in certain market segments of the US securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating."

This is pretty similar to the statements put out by other hedge funds in crisis, a desperate contention that 'the markets are wrong'.

Not surprisingly, Australian listed hedge funds such as Everest Babcock & Brown have also dropped, from $4.65 in February to about $3.24; while K2 Asset Management, a hedge fund set to list for $340 million on August 28, has chosen what could only be described as an ambitious timetable.


Who will be hit by the hedge fund crisis ?

Hedge funds are basically trading funds that have a wide scope to borrow, invest and take 'short' positions in derivatives that benefit investors in falling markets.

Hedge funds may be much more widely held in Australia than the US. Hedge fund products have been available to Australian retail investors for more than a decade. In contrast, many US hedge funds are only open to 'accredited investors', those that satisfy strict criteria set by the Securities and Exchange Commission, including that the investor have a net worth of more than $US1 million or an annual income above $US200,000.

In Australia, several hedge funds are listed on the stock exchange. In practice you can have a hedge fund investment for $500: the standard minimum 'block' of shares a broker will deal in. Separately, unlisted hedge funds are generally accessible for a minimum cost of about $5000.

Hundreds of thousands of Australian investors are exposed to hedge funds either through direct retail holdings or through their superannuation funds. One of the revelations of the Basis Capital crisis was the composition of the fund's share register, where hospital and school funds ranked alongside better-known fund managers as significant shareholders.

Of course it must be noted that huge number of investors have benefited from successful hedge funds. The Man group has launched 28 unlisted funds in Australia since 1997. The flagship OM IP 220 series of funds (which have a capital guarantee) have earned a compound annual return of 17% while attracting 140,000 investors.

There is no reason to believe the best hedge funds will now falter; in fact, if previous performance is anything to go by, the best funds should make money from the intense volatility of the market at this time.


What are the risks for hedge fund investors?

Some time ago - well before the current crisis - a meeting of pre eminent economists William (Bill) Sharpe (Nobel Prize Winner), Jeremy Siegel (author of the book Stocks for the Long Run) and George Kaufman (finance professor at Loyola University, Chicago), issued a statement about hedge funds, which now seems remarkably prescient.

In relation to hedge funds, the group voiced concerns over:

• The use of leverage that 'amplifies' the variability of returns. Both the Macquarie Fortress notes and Basis Capital used borrowed money.
• The management fees that are often 1-2%, plus a performance fee of up to 20%. The listed absolute return group HFA (Hedge Funds Australia) has managed to retain a stable share price over the last few weeks yet. HFA's Diversified Investments Fund charges a fee of 1.25%, plus 10% of any performance over 0%. (That's not a particularly demanding benchmark!)
• The economists found that the average life of a hedge fund is only three years, which makes it very hard to put together an overall picture of hedge fund returns.

Yet, perhaps the most important element of the collective warning from the group concerned what is known in the industry as the 'long tail'.

• The long tail of returns means that there are a number of funds that provide extremely poor returns for investors.

Consider for a moment a managed fund in Australian shares. In the past 12 months the Australian stockmarket produced a return of 29% for the year. Almost all managed funds will provide a return within 10% of this - between 19% and 39%. As an investor, your chance of making a big mistake (a big loss) with a conventional 'long only' shares-based managed fund that does not deal in derivatives is very slight.

Hedge funds are not the same, and have a longer 'tail' of poorly performing funds. For example, if the average hedge fund return last year was 9%, most would be in a similar range to this, however there would still be some funds that provided returns of -50% (Basis Capital) and perhaps even -100% (the closed Bear Sterns and Amarnath funds).

In other words, hedge funds in themselves are not a problem. Good hedge funds are a welcome and useful tool for retail investors, bad hedge funds are, unfortunately, really bad and here's why: When they fail, they fail spectacularly.

This is the characteristic of a hedge fund that makes them absolutely unsuitable for use as part of a 'defensive asset allocation', as discussed in a recent Eureka Report feature, Careful how you hedge your bets. The traditional fixed interest classes of cash and investment grade bonds simply do not carry this risk.

The Economists Roundtable described the long tail of returns as the reality that 'day by day there is a small probability of a large loss'.

This is almost prophetic given what we are seeing now: reasonably long surviving hedge funds succumbing to this small probability of a large loss.


Australia's hedge fund dangers

In the Australian market it is the misuse or misclassification of hedge funds that causes the greatest concern, as Alan Kohler noted in his column on dividend yields on Monday, Look for yield.

Sure, many investors have managed to profit from the sophisticated use of top-performing hedge funds. But many more investors have had second-rate hedge funds imposed upon them . this is the heart of the problem.

Hedge funds are commonly presented to financial planners as defensive investments, a status that does not properly reflect their risks.

'Fund of fund' hedge funds are often touted as the way to manage hedge funds risks, although any fund of fund structure adds a level of fees to a portfolio. But the 'fund of fund' approach is a tacit acknowledgement of the risks of a hedge fund, otherwise such an approach would not be needed.

So there remains an argument for using hedge funds in diversified investment portfolios but there are risks and those risks are being clarified in the latest crisis

If you are continuing with hedge fund investment - or your super fund is exposed to hedge funds - remember this:

• The risk of the 'long tail' - the ongoing small chance of a big loss.
• The high fees that eat into returns.
• The occasional lack of liquidity - as we are seeing with Basis Capital and Absolute Capital and BNP (where the European Central Bank has reacted by pumping liquidty volumes into the market).
• The problems of gearing that magnify losses, as we have seen with Basis Capital and the Macquarie Fortress Notes.

Disclosure: Eureka Report editor James Kirby has holdings in the Man group hedge funds.