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Do hedge funds have a place in retail investment portfolios?

Glenn Freeman  |  04 Nov 2016Text size  Decrease  Increase  |  

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There is growing uptake of hedge funds among retail investors in some markets, and Australians may follow suit.

 

In our current period of financial market volatility and low interest rates, many Australian retail investors are hunting high and low for sources of return.

Increasingly, we're seeing mention of hedge funds--traditionally institutionally-focused products--and their appeal for retail investors. But are they suitable for your portfolio?

Of course, the answer to this question depends on your individual circumstances. However, Craig Stanford, head of alternative investments, Morningstar Investment Management, believes they have a lot to offer individual investors, if used carefully.

"Absolutely. The key problem with most portfolios--from the largest institutions down to the small mum and dad investors, is that they're overexposed to equities and equity-like risk.

"Even in a balanced portfolio, which has some exposure to fixed income and other investments, even though only 60 to 70 per cent of capital Is allocated to equities, they can contribute as much as 90 per cent of the portfolio risk because equities are so much more volatile than fixed income, at least three-times as volatile.

"That's the key problem we see with most portfolios today…it makes sense to diversify some of that risk away," Stanford says.

Retail hedge funds are becoming increasingly popular abroad. Europe's UCITS and the 40 Act mutual funds in the US are two examples he mentions.

"But the problem with a lot of them is that they are quite constrained--there might be limits on the leverage they can use, or what they can short, or how they can short…for instance, they might not be able to hold commodities.

"For the managers we tend to use, we prefer the least constrained managers possible, because we can do the research and manage those risks ourselves," Stanford says.

Going short

Short-selling is a key component of hedge funds.

"Hedge fund managers want to target their risk-taking to areas they feel they are best suited to, or that they know the most about. They want to remove the impact of market events, or stuff that they're not really able to control that well.

"Someone running a hedge fund doesn't want to run the market risk, so they sell short--either equities indices, to reduce their market impact, or a specific company which they think will not do well, or which they think will not do as well as some of the companies in which they are long," Stanford says.

As an example, he refers to the potential to go long ANZ Bank, if you think it's going to outperform other Australian banks, while shorting the Australian financials index.

"It's really about focusing your bets, removing that industry or market risk and increasing exposure to what you want…it's about generating returns when things go down, not just when they go up," he says.

However, he emphasises the importance of knowledge and experience for investors considering playing in this space.

"You've got to really know what you're doing. I don't think the average mum and dad investor is in any way equipped to analyse the average hedge fund. You need to use the services of people who know what they're doing."

Two and 20

Traditionally, hedge funds operated a two and 20 fee structure--charging a 2 per cent management fee and a 20 per cent fee for any outperformance of the index.

However, Stanford believes this is an oversimplified and quite dated way to think about fees. "Average fees today are a bit below that, but the basic model is that there is a management fee that is closer to 1.5 per cent and a percentage of outperformance, which would probably range between 10-20 per cent."

While acknowledging the obvious importance of understanding the fees charged and how they are applied, Stanford emphasises that fees shouldn't be viewed in isolation, but in context with the potential performance on offer.

"I have friends [in the financial sector] that come here from overseas, and they say they've never really been asked about fee arrangements, if at all, whereas in Australia they spend about two-thirds of each meeting discussing fees.

"There's often no regard to the returns after fees, which is really what it's all about," he says.

More from Morningstar

ANZ reports 18pc fall in profit

Low volatility a mirage

 

Glenn Freeman is Morningstar's senior editor.

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