The jury is still out, writes Barbara Drury.
Volatile sharemarkets have provided fertile soil for hedge funds over the past two years because of their promise to deliver positive returns in all market conditions. But with global sharemarkets on the mend, hedge fund returns are falling short of early forecasts. And with most of the half dozen or so retail hedge fund of funds having less than two years' track record, the jury is still out on where they fit in a diversified portfolio.
A hedge fund of funds is simply a managed fund that invests in a wide range of hedge fund strategies and managers - generally no less than 18 - in order to reduce risk, provide diversification and preserve capital.
The average retail hedge fund of funds returned 9.3 per cent in the year to September 30 - a respectable figure, but below the 12 to 15 per cent returns most funds promised when they came to market, and less than the 11.4 per cent delivered by the ASX 200.
A relative newcomer, Colonial First State's Global Diversified Strategies Fund, was the top performer, with a one-year return of 11.6 per cent. Deutsche's Strategic Value Fund, the oldest in the sector, returned 4.8 per cent a year over the three years to September 30.
David Bell, the head of hedge funds at Colonial, says that during the recent bear market investors realised that markets don't go up forever and that there are benefits in maintaining a diversified portfolio.
"Equities have had a good year, but that's not disastrous for hedge funds - they should perform a little better even in a strong equity market," he says. Colonial is aiming for a 10 per cent annual return and recommends a three- to five-year minimum investment.
Lonsec investment analyst Richard Everingham says the funds went to market promising returns of 12 to 15 per cent, and they haven't achieved that. "Now they say their target is high single digits to low double digits."
Hedge funds use a variety of strategies to deliver positive returns, even when the markets they invest in are falling.
Oscar Martinis, the head of distribution at Hedge Funds of Australia, says the group's flagship retail product, the Diversified Investments Fund (DIF), aims to deliver equity-like returns with bond-like levels of volatility and low correlations to traditional asset classes.
DIF is the only fund with an AA rating from van Eyk Research, and one of two funds (along with BT's Global Return Fund) with a "recommended" rating from Lonsec - its second-highest rating.
"In a lot of people's minds, hedge funds are high risk/high return, but the universe of hedge funds is very broad; some are high risk/high return and some are low risk/low return," Martinis says.
Over the two years to September 30, DIF returned 7.3 per cent a year with a standard deviation (a measure of volatility) of just 1.8 per cent, compared with average volatility of about 4 per cent for bonds.
But whereas DIF's underlying asset allocation is similar to a traditional balanced fund, Martinis says the group's "speedboat" retail fund, the Strategic Investments Fund, employs high-risk strategies to produce high returns with high volatility.
There are two schools of thought about where hedge funds fit in for personal investors.
David Bell explains that the same fund could replace a portion of the growth component of a portfolio, because of its underlying exposure to equities and offshore investments, or it could replace part of the defensive component of a portfolio because it has similar levels of volatility to fixed interest.
With a minimum investment of as little as $1000, hedge fund of funds are being aimed squarely at the broad retail market. However, Lonsec's Everingham recommends investors hold no more than 10 per cent of their portfolio in hedge funds.
Martinis says the products are best suited to pre-retirees and retirees, including those on an allocated pension, who want to protect their nest egg from market fluctuations with consistent positive returns.
