Road Test: a safe hedge fund for SMSFs?

Co-founder of the Switzer Report
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So called ‘long/short equity funds’, once the domain of the institutional market, are starting to gain some traction with self-managed super funds (SMSFs) and other retail investors as fund managers introduce retail versions of the product.

These sorts of products are technically classified by the Investment Rating Agencies as being in the ‘hedge fund category’, and while a bit of a misnomer, the phrase is enough to scare away many trustees. With that pretext, we thought a product road test of the ‘Blackrock Australian Equities Opportunities Fund’ might be a good way to review the category of ‘long/short equity funds’ and see if there is such a thing as a safe hedge fund.

What is a long/short fund?

A long/short fund is like a normal equities fund in that it invests in shares. Buying shares is known as a ‘long’ position and these shares are expected to rise in value. Long positions are complemented by short selling other shares, that is, shares expected to fall in value. ‘Shorting’ is selling something that you don’t actually own. To do this, the fund manager ‘borrows’ the stock from another institution or bank, and returns it at a later date. If the price of the stock falls, a profit is made by buying the stock back at a lower price, and conversely, if the price of the stock rises, a loss will be crystalised when the stock is repurchased.

Effectively, the fund seeks to establish long positions in the most attractive stocks, and short positions in the least attractive stocks to enhance potential returns in both rising and falling markets.

Understanding beta

Most long/short funds are, in a ‘net’ sense, long and aim for a portfolio beta of 1.0. This is a statistical measure of how closely the portfolio is correlated to the overall market. A beta of 1.0 means the portfolio should give ‘market performance’ – for example, if the overall market goes up 10%, the portfolio should go up 10%. They then adjust the portfolio by taking long and short positions according to their active investment style to (hopefully) generate better than ‘market performance’.

The ‘net’ long position is achieved by taking long and short positions, which typically might look like this:

  • Gross Long Position: 160%
  • Gross Short Position: 60%
  • Net Long Position: 100%

The BlackRock Australian Equity Opportunities Fund

From the world’s largest asset manager, the BlackRock Australian Equity Opportunities Fund is the retail version of the BlackRock Equitised Long Short Fund (BELSF). The latter has been in operation since November 2001 and as the chart demonstrates, makes a fairly powerful case for long/short investing.

The Australian Equity Opportunities Fund invests in units of the BlackRock Equitised Long Short Fund. The objective of the fund is to return 8% (before fees) above the S&P/ASX200 Accumulation Index over rolling three-year periods.

The fund manager uses an active quantitative approach (BlackRock calls it “scientific”) to exploit market inefficiencies, by systematically calculating forecast returns across a wide universe of stocks. Earnings expectations, relative value, earnings quality, market signals and style timing are all inputs to the model.

Complementing the broad-based construction of the portfolio, the fund also seeks shorter-term return opportunities by participating in dividend re-investment plans, initial public offerings (IPO)/secondary market offers, and managing index changes.

Key details are:

What we like

  • the performance. For the nine months to the end of September, the fund has returned (net of fees) 16.69%, compared with the Accumulation Index return of 12.45% – an outperformance of 4.24%. As the retail fund has only been in existence for around 12 months, a better guide may come from the underlying BELSF fund, where the performance since inception in Dec 2001 has been 16.55% pa (gross of fees), an outperformance of 9.39% pa;
  • The base management fee of 0.30% pa is low; and
  • the manager’s investment approach.

What we don’t like

  • For a direct investor, the minimum investment size of $100,000 takes the fund out of reach for some SMSFs. If you invest through a platform, such as a Macquarie or BT Wrap, the minimum investment size will be lower and based on the platform’s rules;
  • The performance fee. It isn’t unreasonable to have one, however, it is paid on any outperformance relative to the benchmark, not outperformance relative to the fund’s objective. For example, if the fund’s performance is the Accumulation Index + 4.0%, the manager takes a performance fee of 1.2%, leaving the investor with a return of Index + 2.8%.

A hedge fund that is safe?

No investment is ever 100% safe, but it is probably wrong to think of long/short funds as hedge funds. However, they are definitely on the higher side of the risk spectrum and an SMSF with growth objectives should consider what an appropriate weighting for an investment like this would be.

BlackRock suggests that within an equities portfolio, perhaps up to 20% could be allocated to alternatives like long/short funds, with the other 80% in a mix of core and satellite holdings. My sense is this is a little high.

The bottom line

If your fund had a growth or high growth objectives, an overall weighting of around 5% of your total fund would be as far as I would go.

BlackRock is not alone in providing a retail long/short equities fund – others include the Regal Long Short Australian Equity Fund, Perpetual Wholesale Share-Plus Fund and the Acadian Wholesale Australian Equity Long/Short Fund.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

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