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Hedge funds savaged

Date: Wednesday, January 14, 2009
Author: John Collet, SMH.com.au

Lack of transparency and complexity in financial products are always potential hazards, no more so than for small investors.

Hedge funds are the ultimate in opaque investment vehicles. It has taken the free fall in asset prices and the credit squeeze to do it but the hedge fund industry's reputation is now in tatters and only the strongest and best-performing will survive.

Australian financial institutions that offer access to overseas hedge funds have frozen redemptions temporarily or are in the process of closing their funds down.

Hedge funds promise to produce "absolute" returns, or positive returns even in down markets.

Unlike in the US, where only the wealthy and sophisticated can invest in hedge funds, in Australia anyone can invest in the funds.

The crash and burn of the hedge fund run by Bernard L. Madoff Investment Securities in the US just before Christmas has highlighted the risks. The New York-based business has reportedly lost up to $US50 billion ($71 billion) in a giant Ponzi scheme. Bernard Madoff, a pillar of the investment community and former chairman of the Nasdaq exchange, was last month arrested and charged with fraud.

Rick Di Mascio, chief executive and founder of Inalytics, a firm that evaluates managers for big investors such as superannuation funds, says the alleged fraud perpetrated by Madoff highlights the "fundamental lack of transparency within the hedge fund industry".

"As a result, some hedge fund investors have had to resort to ridiculous methods such as employing detectives or investigators to try to establish what is going on - this surely cannot be right," he says.

The main way into hedge fund investing for small investors in Australia is through the so-called funds of hedge funds. This is where the investor invests in a single fund run by a local fund manager, which in turn invests in dozens of hedge fund managers, most of which are small businesses in the US or the Cayman Islands.

The diversified investments were supposed to reduce risk. The managers' spiel was they researched carefully the underlying funds they selected. As for producing positive returns in down markets, that promise has proved difficult to fulfil.

Granted, in the past year the main funds of hedge funds have lost about 20 per cent, or about half of the losses on sharemarkets. But more significantly, in the past five years they have produced average annual returns of between minus 1 per cent and a positive 3 per cent when cash would have returned about 6 per cent.

The published returns are probably much lower because the vehicles through which they invest are tax inefficient, which is why the hedge funds are best accessed through self-managed super funds.

The managers of the funds are in the process of freezing redemptions as a result of struggling to meet redemption requests.

Even in normal times, the underlying investments tend to be illiquid and take time to sell. BT Investment Management has temporarily frozen redemptions from its BT Global Return Fund, as has DWS in its Strategic Value Fund.

Perhaps seeing the writing on the wall, some managers have closed their funds. Colonial First State has closed its Global Diversified Strategies Fund. It announced the closure last May and said at the time it could take up to 18 months for investors to receive all their money back but it will probably take longer. Investors' capital now locked away in these funds should be safe but the fallout in the sector in the US has a long way to run.

Many managers are likely to be closing their doors. Most hedge funds borrow to invest and the banks are going to be less willing to lend to them. The future of the industry looks grim but the better hedge funds will survive and may still make sense for institutional investors, such as super funds with the resources to research them thoroughly.

Share investors may will be very unhappy with the performance of their shares but at least their shares are liquid and the businesses and financial reporting of the majority of listed companies is transparent.

The same cannot be said for the majority of hedge funds.

This story was found at: http://www.smh.com.au/articles/2009/01/12/1231608615053.html