Hedge Fund Investment Guide For Australians: Getting Started

Hedge funds are complex investment vehicles that employ aggressive strategies to generate returns in both rising and falling markets. They are accessible only to a select group of qualified investors due to their high-risk nature and stringent entry requirements. In Australia, hedge funds are even more exclusive, with only 1 in 5 Australians, or the highest-earning quintile, being able to invest directly. These requirements include earning over $250,000 per year for at least two consecutive years or having over $2.5 million in assets.

Despite these barriers, Australia's hedge fund industry has experienced rapid growth since 2000, with assets under management increasing from a negligible amount at the turn of the century to over A$60 billion by 2007. This growth can be attributed to the country's superannuation laws, which mandate a 9% employer contribution to pension plans, resulting in a large pool of funds available for investment.

Investing in hedge funds comes with significant risks and potential drawbacks, including high fees, illiquidity, volatility, and the possibility of substantial losses. However, they can also provide diversification benefits and the potential for higher returns, making them appealing to investors seeking to hedge against market volatility.

Who can invest in hedge funds in Australia?

Hedge funds are generally only accessible to high-net-worth individuals or institutional investors. In Australia, the requirements to invest in hedge funds are less stringent than in some other countries, such as the US.

Individual Investors

In the US, an individual investor must be an accredited investor, meaning they have a net worth of at least $1 million (excluding their primary residence) and an annual income of over $200,000 ($300,000 if married). In Australia, there are no net worth requirements, and individuals only need $50,000 AUD to invest in hedge funds. This makes it possible for people with average incomes to invest.

Institutional Investors

Institutional investors, such as fund managers, superannuation funds, universities, banks, and other institutions that own assets or hold them in trust for others, can also invest in hedge funds. This means that even if you cannot invest as an individual, your superannuation fund may be investing in hedge funds as part of a pool of members.

Sophisticated Investors

In Australia, hedge funds are also accessible to "sophisticated investors", defined as people earning over $250,000 per year for at least two consecutive years or with over $2.5 million in assets.

Barriers to Entry

Despite the lower barriers to entry in Australia, hedge funds are still out of reach for most average Australians due to their high cost. Hedge funds often require minimum initial investments of $100,000 to upwards of $2 million, and they carry high fees, including asset management fees and performance fees.

What are the investment tools used?

Hedge funds use a variety of tools to achieve their investment goals. Here are some of the most common investment tools and strategies employed by hedge funds:

• Leverage: Hedge funds often employ leverage, or borrowed money, to increase their purchasing power. This can involve taking out loans, using margin, or utilising lines of credit to magnify their returns. While this can lead to higher profits, it also increases the potential for larger losses.
• Derivatives: Derivatives are financial contracts whose value is derived from an underlying asset, such as shares, commodities, or market indices. Hedge funds use derivatives to manage risk, gain or reduce exposure to certain assets, and profit from market movements.
• Short Selling: Hedge funds may borrow securities from a broker and sell them on the market, hoping to buy them back at a lower price and return them to the lender for a profit. This strategy allows them to profit from falling markets.
• Alternative Investments: Hedge funds may invest in alternative assets such as high-yield bonds, synthetic assets, derivatives, unlisted shares, or other hedge funds. These investments provide exposure to different markets and can help diversify their portfolios.
• Active Management: Hedge fund managers play a crucial role in the fund's success. They actively decide what to invest in and how much, utilising their expertise and industry knowledge to make investment decisions.
• Funds of Hedge Funds: Some hedge funds invest in other hedge funds, known as funds of hedge funds. This adds an extra layer of complexity and risk, as it can be challenging to understand the underlying investments and associated risks.
• Arbitrage: Hedge funds may take advantage of price differences between similar investment options or across different exchanges. They can simultaneously buy and sell the same or similar securities on different exchanges to profit from small price differences.
• Long/Short Strategies: Hedge funds may employ long/short strategies, taking long positions in securities expected to increase in value and short positions in securities expected to decrease in value. This allows them to profit regardless of market direction.
• Fixed-Income Strategies: Hedge funds may take both long and short positions in fixed-income assets, such as bonds, to preserve capital and provide solid returns with minimal volatility.
• Event-Driven Strategies: Hedge funds may focus on corporate events such as restructurings, mergers, acquisitions, bankruptcies, or takeovers. They aim to profit from temporary stock mispricing or incorrect market valuations during these events.
• Global Macro Strategies: These funds invest in a wide range of assets and attempt to profit from broad market swings caused by economic or political events. They analyse various economic factors such as currency values, monetary policies, and unemployment levels to make investment decisions.

What are the fees and minimums?

In Australia, hedge funds are only accessible to sophisticated investors or high-net-worth individuals. To qualify as a sophisticated investor, you must meet certain criteria, such as earning over $250,000 per year for at least two consecutive years or having over $2.5 million in assets. These criteria ensure that hedge funds are only accessible to a small fraction of the population.

When it comes to fees and minimums, hedge funds typically have substantial requirements. Minimum initial investment amounts can range from $100,000 to upwards of $2 million. Additionally, hedge funds are not as liquid as stocks or bonds, and investors may only be able to withdraw their money after a certain period or during specific times of the year.

Hedge funds also come with significant fees. They usually charge an asset management fee, which can range from 1% to 2% of the invested amount. On top of that, there is often a performance fee, which can be up to 20% of the fund's profit. These fees can significantly impact the overall return on your investment. Therefore, it is crucial to carefully consider the potential returns, risks, and fees associated with hedge funds before making any investment decisions.

It is worth noting that hedge funds in Australia are subject to high barriers to entry, and as a result, they have enjoyed relative anonymity. However, despite these barriers, the industry is significant, with the Australian Trade Commission estimating that Australian hedge funds had $46.8 billion in assets under management as of September 2010.

How do hedge funds differ from private equity?

Hedge funds and private equity funds are two prominent types of investment funds, each offering unique opportunities and challenges for investors. While both aim to generate high returns for their clients, they differ in several ways, including their approaches, investment strategies, and risk profiles.

Investment Focus

Hedge funds typically invest in publicly traded assets, such as stocks, bonds, currencies, derivatives, and other alternative assets. They employ various strategies, including leveraging, short-selling, and trading non-traditional assets, to achieve returns. The primary objective of hedge funds is to maximize returns while hedging losses, hence the name.

On the other hand, private equity funds invest in private companies or buyouts, with a focus on long-term value creation. They invest directly in companies by either purchasing private firms or buying a controlling interest in publicly traded companies. Private equity funds aim to increase the value of their portfolio of companies, thereby enhancing returns for their investors.

Risk and Return

Hedge funds aim for high returns using aggressive strategies and sophisticated financial instruments, such as derivatives. These strategies carry significant risk, and investors must accept that some risk is unavoidable. Hedge funds are considered an "alternative investment class," appealing to high-net-worth individuals willing to take on significant risks for potentially higher rewards.

Private equity funds also carry a higher risk profile compared to other asset classes, but they offer the potential for substantial returns. Historical data suggests that private equity has consistently outperformed public equity by a considerable margin. Private equity investments typically involve a long-term focus, and investors may have to wait years before seeing returns.

Liquidity

Hedge funds offer more liquidity, allowing investors to withdraw funds relatively easily. The lock-up period for hedge funds is usually shorter, ranging from months to a year, as they primarily invest in highly liquid assets.

Private equity investments, on the other hand, are illiquid and have a long-term focus. Investors in private equity funds are typically locked-in for extended periods, ranging from five to ten years or more. Withdrawing funds during this period can be challenging, as private equity investments require time for the company to turn around and generate profits.

Access and Investment Amounts

Hedge funds are exclusive to accredited investors, typically high-net-worth individuals or organizations. The minimum investment amounts for hedge funds vary widely, ranging from $25,000 to $2 million, depending on the fund.

Private equity funds are also generally open only to accredited investors and qualified clients. The minimum investment in private equity funds is usually very high, starting at several million dollars, although some funds may accept investments as low as $100,000.

Regulatory Environment

Both hedge funds and private equity funds are subject to regulations, but the regulatory frameworks differ. Private equity firms face more stringent rules, especially in areas like transparency and investor protection. In the US, the Securities and Exchange Commission (SEC) proposed rules requiring private equity firms to provide quarterly reports on fees, expenses, and performance.

Hedge funds, on the other hand, are less regulated than mutual funds, granting them the freedom to explore a wider range of investments and strategies. However, this lighter regulation also increases the risk of fraud and operational risks, such as lack of managerial experience and non-compliance.

How to start a hedge fund in Australia?

Establishing a hedge fund in Australia is a complex process that requires a good understanding of the rules and regulations set by the Australian Securities and Investments Commission (ASIC). Here is a step-by-step guide on how to start a hedge fund in Australia:

Understand the Concept of a Hedge Fund:

Firstly, it is important to understand what a hedge fund is and how it works. A hedge fund is a pool of money contributed by individual investors and other sources, such as superannuation funds and banks. The fund is managed by a fund manager, whose main goal is to maximise returns and minimise risks for investors. Hedge funds employ various investment strategies, including hedging, to generate active returns.

Comply with Regulatory Requirements:

In Australia, the ASIC classifies hedge funds as managed investment schemes. To start a hedge fund, you will need two things: a registered Australian public company and an Australian Financial Services (AFS) licence. The AFS licence allows you to provide financial advice and services. To obtain this licence, you must demonstrate relevant qualifications, such as a bachelor's degree or its equivalent, pass an exam, and have professional experience and training. Additionally, ensure that you understand the regulations and requirements set by ASIC for managed investment schemes, especially if your fund has more than 20 members.

Register a Public Company:

The next step is to create a registered public company. This involves obtaining an ABN, ACN, business name, and TFN for the company. You will also need to appoint directors and officeholders. It is important to note that the owners of the company should be aware of their civil liability. If the company breaks any rules, a member who has suffered loss or damage can sue. Ensure that all documents submitted to ASIC include the scheme number (ASRN) or an ABN.

Develop a Compliance Plan:

Hedge funds are required to have a compliance plan. Appoint an auditor to oversee this plan and ensure that the fund complies with reporting requirements. The responsible entity must also lodge a 5111 form, an annual statement, and a solvency resolution. Additionally, a financial and director's report must be submitted online through ASIC annually.

Understand Investment Strategies:

Hedge funds use complex investment strategies that aim for positive or less volatile returns in both rising and falling markets. These strategies may include the use of derivatives, alternative investments, and leverage. It is important to understand the risks associated with these strategies, such as leverage risk, liquidity risk, and concentration risk.

Determine the Fund Structure:

The structure of the hedge fund will depend on the types of investors you wish to work with and their needs, such as tax status, voting rights, and the ability to use leverage. Common structures include stand-alone, master/feeder or umbrella funds, and segregated portfolio companies.

Appoint Key Personnel:

You will need to appoint an investment manager who can demonstrate their competency and meet the financial and staffing requirements. Additionally, you will need to appoint an administrator, an independent auditor, a custodian and/or prime broker, legal counsel, and a tax advisor. These individuals will control and run the hedge fund.

Understand Investor Requirements:

In Australia, there is no net worth requirement for investors, and hedge funds may invite people with average incomes to invest. However, it is important to understand the requirements for accredited investors in other countries, as these may apply to your potential investors.

Develop a Marketing Strategy:

Consider how you will attract investors and build your fund under management (FUM). Think about your track record and how your model scales. You may need to invest in marketing to attract external investors and grow your FUM.

Seek Professional Advice:

Starting a hedge fund is a complex process with many legal and financial considerations. Consult with professionals such as lawyers, accountants, and financial planners to ensure you are complying with all regulatory requirements and making the best decisions for your fund.

Frequently asked questions