Two Australian hedge funds have been caught in the collapse of a high-profile US fund.
The collapse of Beacon Hill Asset Management is likely to wipe 2 to 5 per cent off the assets of Coastal Capital's Magnum Diversified Performance Fund and Deutsche Asset Management's Strategic Value Fund.
It's hardly devastating for the funds' investors but this latest collapse is a reminder of the riskiness of the largely unregulated hedge-fund sector.
The US regulator, the Securities and Exchange Commission (SEC), is still to get to the bottom of what went wrong with Beacon Hill.
US reports suggest Beacon Hill, which invested in mortgage-backed securities, got into trouble in July but did not reveal the full extent of the losses to its investors until mid-October perhaps to buy time in the hope of turning things around.
In the US, home buyers take out 30-year fixed-rate loans and when interest rates fall home buyers are free to switch into cheaper mortgages without penalty.
The lowering of US interest rates has seen an increase in US home buyers refinancing their mortgages. This is likely to have contributed to the fund's losses but hedge fund experts in the US say the extent of the losses cannot be totally explained by a failure of its investment strategy; there may have been fraud involved.
Coastal and Deutsche invested in the Beacon Hill's Bristol fund, which is believed to have lost at least half $US300 million ($535 million) of its assets.
Across its three funds, it's estimated Beacon Hill has lost at least $US700 million, making it the largest hedge-fund loss since the collapse of the $US400 million Manhattan Investment Fund two years ago.
Hedge-funds strategies are difficult to understand but they can take both the usual long positions on securities, as well as short positions where the manager bets that the price of the security will fall. Some trade options or bonds, or buy and sell undervalued securities, but they are free to invest in almost any market.
Their strategies vary enormously but what they tend to have in common is the promise of "hedging'' against downturns in investment markets.
With sharemarkets recording their worst performances since the 1929-30 crash, fund managers believe retail investors and superannuation funds are receptive to investments that promise to deliver positive returns in all market conditions.
Figures provided by the Alternative Investment Management Association (AIMA), the body representing hedge fund managers, shows Australians have pumped more than $6 billion into hedge funds.
Because of the inherent risk of investing in individual hedge funds, Australian fund managers have been rolling out fund-of-fund products that spread their investment in up to 30, mostly US-based, hedge funds. Only a handful of these retail funds of funds has track records of more than one year, with more being launched almost monthly.
Damien Hatfield, head of hedge funds at Colonial First State and AIMA chairman, says $4 billion is in fund-of-fund products and $2 billion in single-strategy funds.
Cynics say the rollout of hedge funds may be just the latest example of fund managers launching niche products that hype high returns. Managers rolled out Asian funds as the tiger economies peaked just before the Asian economic crises of 1998. Technology funds were launched at the height of the dotcom bubble in early 2000.
Supporters insist that well-diversified hedge funds are low-risk investments and will in time be vindicated.
It has been a tough period for investment markets generally, says Peter Frohlich, the managing director of Coastal Capital.
The barometer of global stockmarket, the MSCI global shares index, is down 23 per cent in the six months to September 30 (in Australian dollar terms).
Frohlich says the 5 per cent loss of the Coastal Magnum Diversified Performance Fund for the September quarter, most of it due to its exposure to Beacon Hill, should be seen in the context of the performances of overseas stockmarkets.
The Coastal fund had an exposure of almost 9 per cent to Beacon Hill the highest exposure to any manager. It lost 0.03 per cent for the year to the end of September.
Some industry participants take issue with hedge-fund managers talking about their returns with respect to sharemarket returns. Grant Kennaway, the head of managed funds research with investment researcher Lonsec, believes that hedge-fund managers have made a "bit of a rod for their own backs''.
"They have been hammering away at the retail market, saying that they are into positive returns and that they should be able to stay positive regardless of market conditions,'' says Kennaway.
He says the appropriate benchmark is the 4.75 per cent cash rate because this is the riskless return investors can get for their cash.
Dominic McCormick, investment consultant and chief investment officer of Select Asset Management, points out that the US cash rate is 1.25 per cent. He says a low cash rate generally limits the returns that can be made from many hedge fund strategies.
Well-diversified hedge funds, with one or two exceptions, are struggling to even match the US cash rate, leaving little room for investing in hedge funds that "blow up''.
The Deutsche Strategic Value Fund has had a particularly difficult September quarter, losing about 5 per cent. Some of this loss is due to its investment in Beacon Hill, but Deutsche will not disclose how much. The fund lost 0.6 per cent for the year to the end of September.
Coastal Capital's Frohlich says hedge-fund collapses will occur again, which is why he invests in 25 underlying managers.
"It is a big-money game and running a hedge fund is a great way to get rich quick and, frankly, that will always attract those who do not want to play by the rules,'' he says.
Deutsche Asset Management's director, David Zobel, says: "Look at your corporate failures and it is very hard to pick up things like fraud. It happens in companies and it happens in hedge funds.
"It is still an attractive asset class compared with traditional asset classes [shares and bonds].''
Despite the Beacon Hill failure and the poor returns of most fund of hedge funds, Kennaway still thinks there is room for a small allocation to hedge funds in investors' portfolios but says investors' expectations of returns are too high. He worries that so much money is going into hedge funds that that the bar may be lowered on the quality of underlying hedge funds being used by the big fund of funds.
McCormick says that a year or two ago, when many of the fund-of-fund products were launched, their managers spoke of annual returns, over three- to five-year periods, of 15 to 20 per cent.
One or two years of returns of a couple of per cent means hedge funds have to return more than 25 per cent if they are to live up to their promises. McCormick believes annual returns for well-diversified hedge funds are likely to be closer to 8 per cent. Deutsche has revised down the likely returns of its fund from 12-15 per cent a year over three to five years, when the fund was launched three years ago, to 8-10 per cent.
