Hedge fund clouds gather

By BRENT SHEATHER

About two years ago, Weekend Money noted that hedge funds had started to gain prominence in the local financial planning industry, as a successor to the disgraced old favourite - international shares.

Overseas shares were out of fashion, thanks to weak stockmarkets and a stronger New Zealand dollar. Many Mums and Dads were left wondering why they held these "growth assets" if they didn't produce any growth, and no income either. The answer was simple: switch to hedge funds.

According to their promoters, hedge funds offered something close to financial nirvana: high returns, low risk and lots of fees payable to all concerned.

A big part of hedge funds' appeal was that they provided a ray of hope to investors who expected a continuation of the high returns enjoyed in the 1980s and '90s, and who were loath to accept that they had entered an era of low returns.

Financial planners and fund managers probably regarded the timely manifestation of the hedge fund phenomenon as something of a miracle. It arrived at a time when fees on other products were under pressure and many retail investors were losing faith, not to mention money, in international shares.

So how have things worked out for investors who switched from international shares to hedge funds? And are those who stuck with more traditional ways of protecting their portfolios (such as bonds and property) missing out?

After all, the hedge fund advertising tells us that many of these products are "focusing" on returns of 15 per cent or more.

Internationally, the hedge fund business is booming. Worldwide, they now have assets approaching US$800 billion ($1.27 billion) and that is forecast to double again to US$1.6 trillion in the next four years.

And it's not just Mum and Dad who have caught the mania - big institutions are getting involved too. The General Motors Pension Fund in the US and the British Telecom Pension Fund are among the large investors reported to be committing hundreds of millions of dollars to hedge funds.

Consistent performance data on locally marketed hedge funds is rather hard to come by, despite their apparent popularity. The table shows how many of the locally available funds have performed over the past five years, either in New Zealand or Australian dollars, depending on how each fund is set up.

What do the numbers tell us? First, that investors who bought into the OM-IP funds five years ago have done well compared to most other competing investments.

Investors in Tower's funds have also done well - a bit better than local bonds in the short term, and about as well as local shares over five years.

Unfortunately, these numbers tell us nothing about the future because past performance is no indicator of future returns. Nevertheless, the 18.3 per cent annual gain that the OM-IP 220 fund earned over the past five years will turn a few heads, especially since it was achieved at a time when international shares remained stagnant.

How did they do it? The OM-IP marketing material isn't particularly helpful. However, many hedge funds invest in commodities futures, which might explain a little as commodities have been in a bull market.

So if the commodity bull market stops, will the party be over for hedge fund investors? Prospective investors also need to know whether OM-IP's great results reflect the industry as a whole.

One answer to the second question comes from looking at the CSFB-Tremont Index, which measures the performance of the world's largest hedge funds. Over the longer term, the OM-IP funds have done much better than the index.

So, someone buying into hedge funds today should, if all goes to plan, more realistically expect returns like the theory suggests they should be - midway between bonds and equities.

As for OM-IP's future, who knows? The money flowing its way may dilute its performance, its strategies might stop working or its run of luck may end - or it may just keep on returning 20 per cent a year.

Despite these impressive figures, there are some dark clouds on the horizon for those who care to look.

Potentially inclement weather comes in the form of multiple layers of fees, questions about whether today's successful trading techniques can accommodate a flood of new money and, last but not least, words of caution from two of the world's most successful investors, Warren Buffett and Sir John Templeton.

Buffett weighed into the hedge fund debate at the annual meeting of his company, Berkshire Hathaway, last month. Answering a shareholder's question on hedge funds, he said: "They are in the midst of a fad and charge fees that on average are four times higher than other money managers'. It is not going to be a great experience in aggregate for investors."

Sir John, 90, the founder of the US$20 billion Templeton Fund empire, told the London Financial Times last year, that hedge funds would inevitably produce lower returns than mutual funds (unit trusts) because of their much higher fees.

So how significant are these fees? The OM-IP fund's investment statement details the following: initial sales fee, 4 per cent; consulting fee, 0.5 per cent a year; management fee, 2 per cent a year, plus an incentive fee of 20 per cent of net appreciation and net new profits; brokerage expenses, 3.1 per cent a year; annual fee payable to MAN Australia of 0.5 per cent a year; and a valuation services fee of 0.15 per cent a year.

What that adds up to is anyone's guess, and in civilised countries the law says this information must be summarised for potential investors.

With bond yields low and stockmarkets faltering, money is flowing into hedge funds, raising the question of how it can be put to work.

With many of the best funds closed to new money, a prominent British journalist made the comment recently that he wouldn't invest in any hedge fund that would accept his money.

The CSFB-Tremont data illustrates why hedge funds are becoming so popular; their short, medium and long-term performance has been pretty impressive.

But while these figures are after the hedge funds annual fees have been deducted, in many cases most people will be buying into what they call "funds of funds" - a collection of individual hedge funds.

Funds set up in that way have an additional hefty fee structure. These can top 3 per cent a year, which would turn the CSFB-Tremont's Index's 10 per cent a year for five years into a less exciting 7 per cent a year.

Hedge fund

A managed fund that uses a variety of strategies to make a profit. These can include trading commodities, options and futures, borrowing to invest and "selling short" in the hope of profiting from a fall in the market.

* Brent Sheather is a Whakatane investment adviser