A dollar every way

By MARK FRYER

If investments were cars, hedge funds would be Ferraris - sleek and nimble, with a hint of danger.

And, at the moment, very much in fashion. Estimates vary, but there are believed to be 6000 to 8000 hedge funds in the world, and new ones are being launched every day.

What are they? In brief, they are funds that use a host of strategies to try to make money, rather than simply buying and holding investments (see "A little bit of this...", below).

Like most investment trends, the hedge fund fashion has filtered down to New Zealand. Three managers - Tower Managed Funds, OM Strategic and Macquarie - have offered hedge funds direct to ordinary investors, and others have targeted institutional investors such as superannuation funds.

This month Tower launched another hedge fund, aimed at investors with $5000 or more.

In the past, hedge funds tended to be only for wealthy investors. Some in the United States - home to the vast majority of such funds - require minimum investments as high as US$1 million.

The reasons why not-so-wealthy investors may also be interested are easy to see, given the gyrations international sharemarket have suffered, and widespread predictions that future returns will be modest. In that environment, any investment that claims to be able to earn a return whatever the markets do has an obvious attraction.

Investors in one of Tower's existing hedge funds - the GAM Multi-Trading Fund - shouldn't have too many complaints about earning 13 per cent a year for the past three years, according to figures from researcher Morningstar.

Tower's latest offering, the Advantage Hedge Fund, promises to seek "consistent positive returns with low to moderate volatility".

From an investor's point of view it works in much the same way as any other unit trust; the minimum initial investment is $5000, there's an up-front fee of zero to 3 per cent, depending on your relationship with your financial adviser, and a management fee of about 2.2 per cent a year.

Withdrawal terms are more restrictive than most managed investments, as investors must give at least a month's notice to get their money out of the fund.

Tower won't play the markets itself. The money will be managed by DB Absolute Return Strategies, an arm of the Deutsche Bank Group, which will select as many 25 hedge fund managers and monitor their performance.

That approach adds an extra layer of costs, since the individual managers will also be rewarded for their efforts; hedge fund managers typically get 20 per cent of any profits as a performance fee.

Tower is marketing the fund as a worthwhile addition to an investment portfolio, arguing that putting part of your money into a hedge fund can smooth out your overall returns.

But what's the record? Can hedge funds swim against the tide?

Some observers say yes. Van Hedge Fund Advisors International, a US-based adviser to hedge funds, says the average such fund earned 5.6 per cent last year, while the S&P 500 index - a broad measure of the US sharemarket - fell almost 12 per cent.

Van says the average US-based hedge fund made 17.4 per cent a year over the five years from 1997 to 2001, compared with 10.7 per cent a year for the S&P500 index. Its figures also showed hedge funds to be less risky than sharemarkets.

Not everyone is so convinced. An article in the US business magazine Forbes last August criticised hedge funds for producing "mediocre returns" while charging "outrageous fees". Forbes cited figures showing that, in the 10 years to May 2001, most hedge funds failed to match the US sharemarket, and criticised hedge fund managers' practice of taking 20 per cent of any profits as a success fee.

The US Securities and Exchange Commission has also sounded a cautious note about the growth in hedge funds.

The Director of the commission's investment management division, Paul Roye, said last year that funds often found it hard to keep performing as they got bigger, and that rapid growth in the industry meant many managers with little experience were setting up funds.

Barton Biggs, chairman of US company Morgan Stanley Asset Management, said last year that the "hedge fund mania now gripping the United States and Europe is rapidly assuming all the classic characteristics of a bubble ... where new money is being directed at [managers who are] relative newcomers".

Though there was a good argument for institutions or wealthy investors to put some of their money into hedge funds, he said, the business was growing too fast. Some researchers have cautioned against relying too much on the past performance of the "average" hedge fund, given that funds frequently close, and those that do so simply fall out of the figures, artificially inflating average returns.

Australian company van Eyk Research says that "hedge fund data can be seriously biased and performance statements may tell only part of the story. Even more than usual investors should seek sensible advice."

Closer to home, David van Schaardenburg, chairman of investment research company FundSource, is also cautious about hedge funds. "I think you need to be a very sophisticated investor to feel you can use them," he says.

In a typical managed investment, says van Schaardenburg, your main risk is "market risk" - if the overall market falls, so will the value of your investment.

With hedge funds it's "manager risk".

"You don't go up and down with all the other people in the market. Whether you go up or down is based on what that particular manager is doing.

"It doesn't mean they're bad, but they are very complex vehicles," he says. "They don't give out much information so therefore people are going in on the basis of simple faith.

"Some of the portfolios we advise on do use hedge funds but we use them extremely carefully and monitor them very closely because we know it's very easy for them to blow up," says van Schaardenburg.

A British study of hedge fund performance from 1990 to 2000 found that they did not offer superior returns, after adjusting for risk.

However, the same study found there was a very weak relationship between the return on hedge funds and the return on other investments, meaning that including hedge funds in a portfolio would have the desired effect of smoothing out overall returns.

* To contact Personal Finance Editor Mark Fryer write to: Weekend Business, PO Box 32, Auckland. Phone (09) 373 6400 ext 8833. Fax: (09) 373 6423. e-mail: mark_fryer@nzherald.co.nz