Clearing the Volatility Hedge

Our CEO, Chris Gosselin writes for Alan Kohler's Eureka Report this week.

Read his article - Clearing the Volatility Hedge here.

BUFFETT PULLS AHEAD

Warren Buffett's $1 million bet in January 2008 that an equity Index fund would beat a suite of fund of hedge funds over 10 years has recently received significant press coverage.

The bet was between Buffett and Protégé Partners, a New York hedge fund of funds. Protégé selected five funds of hedge funds to compete against Buffett's selection of a Vanguard fund tracking the S&P 500 Index.  A charity chosen by the winner will receive the $1 million when the bet ends on December 31, 2017.

As on January 1, 2013, after five years and half way through the bet, Buffet's choice of index fund has finally moved ahead of the fund of funds for the first time, having returned 8.69% compared with the five fund-of-funds return of 0.13%.  At the end of the previous year the Index fund lagged by 0.38%.

The identity of the underlying funds has never been disclosed. However the results of the Dow Jones Credit Suisse Hedge Fund Index have been used as a proxy, as it has roughly tracked the hedge funds chosen, after adjusting for extra fees.

A number of points need to be raised with respect to the performance of the hedge fund of funds. Firstly fund selection can be like stock selection, choosing the best manager is critical to performance.

Secondly Fund of Funds traditionally underperform single funds.  They may provide great diversification, but that generally dampens returns even if it does provide much lower volatility.

The main point is that the Index fund had a very significant drawdown of almost -37% in 2008 while the hedge funds fell -24% and deep drawdowns significantly damage the value of compounding. For example, assuming an average return of 5.5% pa over 10 years, $100 accumulates to $170.81 over that time. However assuming a 40% market pullback in year 5 the value declines to $78.41.  Even if the 5.5% returns commence again at this point until the end of ten years the value only rises to $97.1 0.  Over the decade the investor loses 3%. 

Read the entire article from Sean Webster, AFM Research and Database Manager here.

ATTACHED FILESBuffet Pulls Ahead (pdf format)

In spite of a couple of negative days on European and US markets the ASX200 just doesn't want to take a breather, even after rising over 25% from the lows of last June. While most fund managers, and even some brokers are concerned the market might be getting ahead of itself, there seem to be plenty of investors who are determined not to miss out - even though they would go near equities just six months ago.

AFM's Research Manager, Sean Webster has taken a look at the curious behavior of the VIX, the so called Fear Index, and it reverse correlation to the market: Taking a lead from an article published by Adam Hamilton in the US, the logic seems curious - that if the market has had a strong rally, investors lose their caution and become complacent. However the reality is often that the market is overbought, and therefore has a higher probability of a correction.

The cost of insurance however, as measured by the VIX, falls simply because there's less demand for protection. The reverse applies when the market has fallen sharply, and therefore stocks may offer better value: All of a sudden the cost of protection (the VIX) skyrockets as investors try to buy insurance after the event.

Sean's article and associated charts can be seen here. It's a moot point of course whether the VIX leads the market, or the market leads the VIX. What it does show however is that potential risk is always around the corner and investors ignore risk at their peril.

Meanwhile there's plenty of media coverage about incidents (some actual, some alleged) of insider trading, both in Australia and overseas. Last Saturday's AFR contained an interview with Belinda Gibson from ASIC and covered the attempt by an offshore fund manager trying to gain early access to a local broker's research and information. Aspects of trading in Heinz in the US ahead of Warren Buffett's recent proposed purchase are being investigated, and a major US hedge fund is also in the SEC's sights.

However as we argue in this article, institutional investors, including hedge funds get access to information not generally available to ordinary investors, whether by their added research capacity, by investor briefings directly from the company itself, or through broker presentations. There may be no insider trading involved, but there is certainly no level playing field either.

This week's now for something completely different contains not one but two completely different clips. We hope you share our appreciation of The Two Ronnies, who still make me laugh even though the material is now well dated. Our second clip is far from amusing but well worth watching: Last Monday's "Australian Story" on the EasyBeats' lead singer Stevie Wright on ABC TV was a chilling reminder of the dangers of drugs. It's a long clip, so if you're short of time watch it from about 4 minutes onwards. The program is re-broadcast on the ABC at 12:30pm Saturday afternoon. Record it and play it to your children.

Otherwise enjoy the week-end.

Regards,

Chris.

Potential risk is always around the corner, or bubbling just beneath the surface. Ignore it at your peril.

A recent article (January 2013) by Adam Hamilton of Zeal LLC examines the role of the VIX as a leading indicator for the S&P 500. In the current bullish climate for equities and very low levels of volatility this might be a timely reminder that risk is often present when least expected.

We have reproduced the chart from the Zeal article and also added a chart of the ASX and a local volatility index. Meanwhile the full Zeal article can be found in this link.

Hamilton points out that the US market has had a strong rally with stocks at their best levels is 5 years and the S&P 500 (SPX) recording 8 new cyclical highs in 13 days. However the gains have been marked by very high levels of complacency by investors, and as contrarians would be aware, most investors become bullish only after major rallies.

The issue for investors is how best to measure the bullishness or complacency of the market. Over time a number of indicators have been developed with the best based on the option trading concept of implied volatility. Given that traders buy options to bet on future price moves investors can analyse how fast they expect markets to move in the near term. The most well known indicator here is the VIX. It is commonly known "the fear gauge" i.e., the higher the implied volatility the more fear is being reflected in the VIX and vice versa.

Hamilton's article notes that the author prefers to use VXO index as opposed to the VIX and details the rationale for this. In summary the VXO looks at near-term at the money S&P 100 options, as opposed to the VIX which amongst other differences uses the S&P 500.

Read the entire article from Sean Webster here.

ATTACHED FILESIs low volatility a sign of low risk, or investor complacency? (pdf format)

An article by Tony Boyd in Saturday's AFR bought up the key words of "hedge funds" and "insider trading" which is always good for a headline if nothing else. The Article was focused on ASIC's concern that some investors might be trying to access broker research on specific companies prior to it being released to all clients, and thus being generally available.

This has some serious implications especially as a number of overseas funds have been caught up in insider trading investigations, most recently SAC Capital in the US where an individual is under investigation by the SEC, which has resulted in redemption notices for over $1.7bn being lodged by the fund's external investors. That's a significant chunk of external money, which reportedly only makes up about 50% of the total external FUM - the balance being internal - founders' and staff.

Back to the AFR, where the article focused on a large global, offshore fund trying to access a broker's research prior to general release. As an ex broker I can recall plenty of instances of some investors knowing what's in the research pipeline, and there's obviously a grey area between company information, and broker disseminated information. There's no doubt that large institutional investors, including hedge funds get access to information not generally available to retail investors, whether by their added research capacity, or by investor briefings directly from the company itself, or through broker presentations.

This became more and more of an issue as institutions established formal broker panels post the '87 crash, with a heavy weighting to the quality of individual research analysts as part of the process. Meanwhile many institutional fund managers promote the number of company visits they make each year as one of their key strengths. Even though they may not be provided with what might be conventionally termed inside information, they are certainly ahead of the information curve compared with retail investors.

The difficulty here is how strictly to draw the line between "dodgy, and deliberate" inside information, such as that being investigated over option trading in Heinz's stock prior to last week's proposed acquisition by Warren Buffett, and "general information" provided by brokers or management.

The reality is that institutional investors, hedge funds or otherwise, will ALWAYS be at an information advantage. They have the resources to analyse research, they often have access to company management, and they certainly get first look at placements, which are often only offered to institutional and large shareholders. So where does one (or in this case ASIC) draw the line?

Of course anything "deal" related is over the line, but at what point does "unfair" advantage come in. If I go out onto the footy park (not a good sight), or a fun run (what's fun about a fun run?) there are plenty of other competitors (usually 99% of them) who have an advantage over me courtesy of age, training, excess alcohol intake (mine not theirs) not to mention the use of supplements or even legally prescribed peptides.

I'm all in support of transparency and a level playing field in broker research, but it is incredibly hard to define, and harder to enforce.

The Australian equity market rally has now seen the ASX200 rise over 8% YTD, and 26% over the past 12 months, driven not only by the rotation out of cash and term deposits which drove the high yielding banks higher, but more recently also into previously unloved discretionary consumer and retail sectors.

As a result some of the concentrated, high conviction funds which had struggled over the previous 3 to 4 years have enjoyed stellar, above market performance. Meanwhile the risk averse long short and market neutral funds which had previously protected investors' capital have struggled to find value at current prices. This has been further exaggerated by some aggressive price moves amongst their short positions where valuations have been stretched even further.

In this environment active and absolute return funds as a whole are likely to underperform, as indicated by the table below based on 53% of funds which have to date reported January results:

These are averages, and there have been some significant outliers. 21% of funds in the AFM index outperformed the ASX200's return of 4.95% in January, and 35% have achieved this over the past 12 months. Conversely, 11% of fund returns for January to date have been negative, while 14% have returned negative performances over the past 12 months.

The improved performance and sentiment is welcome, but following 7 straight positive months, and gains in many stocks of over 100% in 2012, it is worth remembering that risk is always present around the corner, often when it is least expected.

This reiterates the focus on the need for research and investors' understanding. We have just completed collating industry figures covering fund and strategy performances not only for 2012, but also for five and ten years since 2008 and 2003 respectively. What the data clearly shows is that over the longer term the average absolute return fund has performed above (5 years) or in line (10 years) with the ASX200 but at a fraction of the market's volatility.

For a copy of AFM's "Volatility eats Returns" report please email us.

Finally, Now for something completely different this week, the 2 Ronnies Name Dropping; or if you find something a bit more risque amusing, try this one.

Regards,

Chris.

In this issue:

• New website
• 2012 Fund Results
• Japanese End Game
• Performance Fees
• Shaken not Stirred

We're back after the Christmas & New Year break - greatly and gratefully refreshed, and relishing the challenges and opportunities of 2013. The break wasn't all sun, sand and swimming though. Those of you who have visited our new website over the past few weeks will have noticed significant changes, including a new look and feel with additional content and free access to the Fund Selector, Fund Profiles News and the Library. Feedback from users has been positive, but further suggestions or comments are always welcome.

Looking back, 2012 was dominated by macro risks combined with politics and politicians - never a good mix. However the immediate threats to Europe were resolved by the "whatever it takes" approach, the US stepped back from the fiscal cliff and there does seem to be a recovery of sorts underway, and China appears to have avoided the hard landing scenario many were fearing.

Australia's equity gained 14.6% in 2012, and 20.2% on an accumulation basis with most of the gains coming in the final six months of the year as global risks subsided and interest rates fell to historical lows, leading to a search for yield which resulted in the big four banks and Telstra gain 30 to 40%, while the materials sector struggled. In this environment equity based hedge funds averaged gains of 12.18% with the best performing fund returning over 50% and the worst falling more than 40%. Manager and fund selection remains vital!

It seems unsurprising therefore that markets are experiencing a definite change to "risk on" based on feedback from a range of fund managers and investors. However that doesn't mean there aren't significant risks remaining, as some of the issues have just been deferred. Concerns remain in Australia that the price side of the P/E ratios have moved and there may be some delay in earnings. Another risk on the horizon seems to be the advent of the currency wars as the US, Europe and now Japan all compete to drive their currencies lower.

This article from macro manager Blue Sky Apeiron outlines their views on the possible outcomes and dangers that Japan's new policies are creating. Interesting and sobering, and if their suspected scenario comes to pass Australia will feel the effects given Japan's position of our second largest trading partner.

Elsewhere one of the major challenges the absolute return sector faces is the necessity to provide value in return for the fees charged. Downward pressure on fees continue, but this article in AFM's "Understanding Hedge Funds" series argues that it is not merely the size of the fees but the way they're structured that will come under scrutiny. We remain firmly of the view that paying high fees for the best managers is a sound investment, and paying fees for poor performance should lead to a change of manager.

And now for something completely different. Personally I have never enjoyed drinking exotic cocktails, but seeing the skills involved in making them might be a different matter - even in Russia.

Have a good week-end.

Regards,

Chris.

Welcome to the last edition of Hedge Clippings for 2012. It has been an eventful year here at AFM, but I guess when you're monitoring over 320 actively managed and absolute return funds that's always going to be the case.

First up, today we have released a new version of the Fund Monitors website. We hope you find it an improvement, but feel free to provide feedback (good or bad) and comments. If you're a previous user we suggest you press 'control + F5' on your keyboard to clear any cobwebs from the previous version. The new website will build and expand on coverage of fund performance and news feeds, including videos and research library.

Secondly, in October we launched an investable version of the E5 Equity Model Portfolio which we had used to track the performance of a small group of Australian actively managed equity funds. Over the previous five years the model portfolio had returned close to an annualised 15% with a volatility of less than 6%. Branded the AFM Prism Active Equity Fund, it is open to wholesale and sophisticated investors with a minimum investment of $250,000.

From a staffing perspective we welcomed a new administration manager (not my strongest suit), Alexis Scott who has transformed the office, but is still working on my time management. I think it's a case of the difficult we do at once, with the impossible taking a little longer. In January we look forward to welcoming a new Head of Research, and in February will launch the Prism Select Portal that will include selected research on 'best of breed' funds, with interactive online application functionality and reporting.

Meanwhile although there's still one month's data to come, year to date performance has ranged between great, good, ok, average, poor and unacceptable. All this does is confirm the diversity and range of funds, and skill of the various managers. YTD the best performing fund has returned investors 62% while the worst has fallen by -40%. In round terms just over 80% of funds have provided positive returns, while 30% have outperformed the ASX200.

Making it doubly difficult for investors is that many of the best performers have lifted their returns after a difficult few years, while some of the more disappointing had previously avoided risk in more troubled markets. Some, and we would argue the best, have provided the consistency of good risk adjusted returns year in and year out. Our 2012 Fund Review due out in late January will sort the wheat from the chaff.

And 2013 will probably see more of the same - a variety of performance and risk, no doubt with more new entrants and a few calling it a day. Life goes on, and we are eagerly looking forward to it. Maybe, hopefully, next year will see less political influence on the macro scene than the one just (almost) past.

And on that note I'd like to wish all readers compliments of the holiday season, and a happy, healthy and prosperous New Year.

Regards,

Chris.

Investors would be required to pass an online exam before investing in complex or risky products under a proposal by Greg Medcraft, the chairman of the Australian Securities and Investments Commission.

Medcraft told The Australian Financial Review he believes existing disclosure documents are no longer effective and new technology and innovative approaches are needed to protect investors.

Investors would be required to take "e-learning module" tests that could take up to two hours. The tests would examine investors' knowledge of financial products including margin loans, contracts for difference, derivatives and hybrid securities.

Potential investors could be shut out for 30 days if they failed the exam, which would have password protection to stop cheating.

"We have to start thinking about tools for investors which are not just disclosure," Medcraft told the newspaper.

"PDS [product disclosure documents] are not working for some [investors] and often it is not because they don't understand, they just don't have time. We are in a world where everyone is busy and I think we just have to start thinking more creatively."

The ASIC proposal follows the collapses of Banksia Securities, Trio Capital and MF Global, which hit many investors hard.

To read the entire article from Cara Waters at Smart Company.com.au, click here.

Or read this related article from Business Spectator here.

(Reuters) - U.S. asset manager Legg Mason Inc (LM.N) said on Thursday it will buy Fauchier Partners, one of London's oldest fund-of-hedge-funds firms, from BNP Paribas Investment Partners (BNPP.PA), the latest deal in the fast-consolidating sector.