The long and the short of hedge funds

If a hedge fund doubled your money in just a year, you would expect it to be shouting it from the rooftops.

Regal Fund Management's absolute return fund returned an eye-catching 96 per cent last year, and has averaged 40 per cent annual returns since its inception in 2004.

Yet the hedge fund's chief investment officer, Philip King, is quick to divert attention to its less aggressive and volatile investment options.

"We'd probably prefer to keep the focus on our market neutral [fund]," King says.

"The thing we'd like to emphasise is we've annualised 20 per cent over the last five or six years when the market's had a lot of volatility."

It is a reflection on the Australian investment psyche, where hedge funds and short selling still evoke negative connotations.

Having developed a formidable reputation in hedge fund management - and, in particular, shorting - in London, King returned to Sydney in 2005 to join Regal, a boutique fund founded by his brother Andrew.

Regal last year sold 30 per cent of its equity to Ascalon Capital Managers, a subsidiary of Westpac. Together they are working to demystify the hedge fund industry.

"I think there is a real equity ownership culture in Australia," King says from Regal's boardroom, which offers sweeping views of Sydney Harbour. "The concept of shorting is not well understood."

The head of alternatives research at Zenith Investment Partners, Daniel Liptak, says the negativity has been perpetuated by chief executives, who blamed shorters for pushing their companies to the brink during the global economic crisis, rather than admitting to their own problems earlier.

It was a view given further currency by the Australian Securities and Investments Commission's decision to ban short selling to reduce instability after the collapse of Lehman Brothers.

The ban was also designed to reduce "rumourtrage", where traders may spread negative rumours about a company they are trying to short.

"It [short selling] is misunderstood on a number of fronts - it's seen as evil in a general sense," Liptak says.

In Australia, superannuation funds hold more than $1000 billion in assets. The Australian Trade Commission estimates the size of the hedge fund sector at $46.8 billion.

A report by John Evans, an associate professor at the University of NSW's Australian School of Business, found the average allocation to hedge funds in Australia had risen from 2.5 per cent in 2008 to 3 per cent last year, and is expected to hit 3.6 per cent in 2012.

"Given that Australian institutional investors tended to use hedge funds in their investment strategy earlier than most other developed countries, it is surprising this has not led to a greater allocation, and the development of a larger Australian hedge fund industry," Evans wrote.

Regal's investment offerings, which like most hedge funds use short selling and leveraging through derivatives, have consistently outperformed benchmark indices and traditional funds.

For King, it is a no-brainer.

"The classic analogy is that a traditional long-side manager is fighting with one arm tied behind his back, whereas we're able to use two hands," he says.

"We can go short and we can go long and it's a strong reason why we should be able to outperform."

King says the key to shorting is to focus on long-term macro trends, rather than the popular belief that regards shorting as opportunistic and focused on the short term.

Regal's absolute return fund has delivered spectacular results but it is also the hedge fund's most aggressive investment offering. Closer to most risk appetites are Regal's market neutral and long-short funds, which have achieved annualised returns of well over 20 per cent since their inception.

In March, Regal issued its first retail product, a long-short fund available to any investor willing to pitch in a minimum $50,000.

The long-short fund incorporates a "130/30" investment strategy, widely used by hedge funds globally, where 130 per cent of the fund's capital is held in long positions, funded by 30 per cent held in short positions (netting to 100 per cent).

While the hedge fund industry is more developed in the US and Europe, it is dogged by global perceptions of opacity and less than robust regulation - an idea strenuously fought by the Alternative Investment Management Association, the global hedge fund trade association.

In February, ASIC announced it would be releasing a regulatory guide by the end of the year, targeting improved disclosure for retail investors from hedge funds.

In a consultation paper, the regulator's commissioner and chairman-elect, Greg Medcraft, warned of the risks involved in some hedge fund investments.

"Hedge funds, because of their diverse investment strategies, complex structures and use of leverage, short-selling and derivatives can pose more diverse and complex risks for investors than traditional funds," he said. "Investors need the knowledge to assess factors such as how their money is to be invested, who makes key decisions, how the assets will be valued, and how investors can withdraw their money."

Typical wisdom would suggest higher returns are invariably a product of higher risk. While long positions are limited by the capital invested, short positions that are losing money can quickly get out of hand as share prices can rise without limit.

The nature of short-selling also pits the shorter against the market, taking a stance that the rest of the market has got it wrong and is overpricing the company.

King acknowledges that the success of a hedge fund lies in management skill, inherent in the fact that with short selling investors are able to diversify risk away from the whims of the broader market.

"On some measures [long-short funds] perhaps have higher levels of risks than a straight long-only product," King says. "But the thing we'd like to emphasise is that a lot of the additional risk is uncorrelated with the market.

"If the stockmarket crashes [a long-only fund] will struggle to provide positive returns, whereas we can choose what risks we expose the portfolio to."

Even if the market is performing strongly, it seems traditional funds do not necessarily deliver the goods.

One of the biggest revelations last year was that Australia's largest super funds barely outperformed inflation in the past decade (which many analysts blamed on excessive fees). The industry recorded an average return of 4.5 per cent since 2000, barely keeping pace with average inflation of 3.1 per cent.

Investors with a portfolio of government and highly rated corporate bonds would have received an average 6.4 per cent over the same period.

Liptak says Australian investors are obsessed with performance and management fees charged by funds, often overlooking net returns.

"The idea that fees are very relevant to the end return ... is forcing people into being lazy, chuck [money] in the market and not look at net-of-fee returns," he says.

Regal takes a 20 per cent cut out of profits earned on its long-short fund which are above the ASX300 index performance. While the annual net return may exceed, for example, an industry super fund, many investors might baulk at the perception of high headline performance fees.

King attributes this to the lack of maturity of the Australian hedge fund market.

"There's a lot more focus on fee levels than we find offshore," he says. "Offshore investors are used to paying for the quality of a product."

Liptak says it will be hard to change the mindset of Australian investors, with a tax and superannuation system geared towards ownership of real estate and shares.

Taking a short view on a stock, he says, therefore takes "quite a bit of a leap" in the way of thinking.

"I think we've had such a long period of time without a correction [before the global crisis] that the Australian population as a whole was lulled into a false sense of security," Liptak says.

"All people have an optimistic view of the future. Nobody wakes up thinking they're going to die at the end of the day."