At the end of 2007 and the start of 2008, investors searched for asset classes that could provide positive returns. Many parts of the property, equity and fixed-income markets suffered downturns last year and into the first three months of 2008 following the problems in the US sub-prime market and the spread of the credit crunch.

One sector to which investors have turned is listed hedge funds. According to the Association of Investment Companies (AIC), the listed hedge fund sector accounted for 23 per cent by value of all investment company new issues in 2007. This made hedge funds the fourth largest AIC sector, with assets of more than £6.6 billion.

Performance-led
This interest is not surprising given the performance of many funds of hedge funds last year. For example, according to Morningstar, between 1 January 2007 and 7 January 2008, Invesco Perpetual Select Hedge returned 38.31 per cent while Thames River Multi Hedge (30.62 per cent), Absolute Return Trust (23.16 per cent), Tapestry Investment Company (17.56 per cent) and Dexion Absolute (13.78 per cent) all delivered strong positive performances.

Funds of hedge funds benefited from being able to invest in underlying funds that can short stocks, and other investments, and hold asset classes that provide diversification away from equities and bonds. For example, some of the out-performance of Thames River Multi Hedge last year came from holding funds that took short positions on the
sub-prime market.

Generally, however, funds of hedge funds have found 2008 more challenging, with some struggling to deliver positive total returns, which comprise the share price movement and distributions after fees. These include Absolute Return (0 per cent), Alternative Investment Strategies (-9.8 per cent), Dexion Absolute (-5.7 per cent), HSBC European Absolute (-4.9 per cent), Invesco Perpetual Select Trust Hedge
(-4.6 per cent), KGR Absolute Return (-0.6 per cent), Tapestry Investment Company (-2.5 per cent) and Thames River Multi Hedge (-2.6 per cent) over the six months to 2 June 2008, according to Killik & Co.

Over the same six months, the MSCI World index returned 0.16 per cent while the FTSE 100 was down 3.91 per cent and the FTSE All Share fell 4.16 per cent.

In contrast, Close AllBlue delivered a total return of 16.5 per cent after fees, according to Killik & Co. Other strong performers included BH Macro (10.5 per cent) and Dexion Trading (8.7 per cent).

Strategic decisions
A significant determinant of returns has been the allocation to specific strategies by funds of hedge funds. Ian Collier, director of Dexion Capital Guernsey, says the largest strategy – long/short equity funds – has suffered from the dislocation between good- and poor-quality stocks. He adds that such an environment, however, creates investment opportunities. ‘Many hedge fund managers believe the second half of the year will be good.’

Dexion Trading’s return of 8.7 per cent over six months to 2 June 2008 was due to its investments in macro and systematic trading funds, says Collier. ‘These strategies have been boosted by the fact it has been relatively easy to call reductions in interest rates and some currency movements.’

He says a fund like Dexion Absolute is designed to provide diversification across a number of strategies and away from equities. The idea is that if one hedge fund strategy underperforms, another strategy should offset this. Over time, this should reduce risk.

Listed funds of hedge funds generally offer tax and liquidity attractions. Mike Warren, investment director of Thames River Capital, points out that the gains of offshore funds of hedge funds without distributor status are subject to income tax. But investors in listed funds of hedge funds face capital gains tax (CGT): ‘This difference has become even more significant with the introduction of a flat rate of CGT of 18 per cent from
6 April 2008.’

Jason Day, director of Allenbridge, argues that listed funds provide daily liquidity, whereas investors in offshore open-ended funds may have to wait up to three months to redeem their capital. But Day adds that when buying a listed fund of hedge funds, investors should first check the discount control mechanism of the trust.  

Popular vehicles
Despite the challenging year for funds of hedge funds, some are still trading at
a premium to net asset value (NAV). These include Absolute Return Trust
(3 per cent), Dexion Trading (0.2 per cent), KGR Absolute Return (0.9 per cent) and Thames River Multi Hedge (3.2 per cent). The fact that trusts are trading at a premium, of course, reflects their popularity. Some trusts have issued new ‘C’ shares to meet this demand.

Mark James, executive director of alternative investments at ABN Amro Bank, says listed hedge funds and funds of hedge funds have raised £1.2 billion this year through issuing new shares.

He says five funds have each raised more than £100 million. This exceeds
the £900 million raised by this stage last year. In the whole of 2007, hedge funds raised £2.5 billion on the London Stock Exchange.

For example, Dexion Absolute, which is in the FTSE 250, raised £461 million
in December 2007 and £134 million in February 2008. James also points to Absolute Return Trust raising £125 million in January and Dexion Trading raising £78 million in March. Thames River Multi Hedge raised £383 million last year and £106 million earlier this year.

When ‘C’ shares are issued, they are kept separate from the main shares until 85 per cent have been invested, says Collier. At this point, they are converted into the main shareholding. Generally, the new shares invest in the existing underlying funds held by the listed trusts.

But Collier says ‘C’ shares enable trusts to tweak their allocations by giving more money to certain funds and new funds and less to other existing funds.  ‘Normally, changing the allocation in this way would involve making subscriptions and redemptions, which is less clean,’ he points out.

Mick Gilligan, director of fund research at Killik & Co, says Close AllBlue has been on a premium of 3.75 per cent and is issuing new shares at a premium of two per cent. Issuing new shares can reduce the price of a trust, but intermediaries and managers argue that it can support the trust.

For example, Gilligan argues that Close AllBlue is moving to the main stock market. This can provide support as index-tracking funds and other investors buy the fund.

Size and costs
Collier says increasing the size of a fund of hedge funds through new issues has advantages for investors: ‘Increasing assets can reduce the total expense ratio (TER) because there are a number of fixed costs, including the board of directors and the running of the company. The larger the company, the more liquid its shares become. This makes it easier for shareholders to sell their shares.’

Some intermediaries and fund buyers are cautious about funds of hedge funds, and one of their main objections centres on the charges. According to the AIC, the average TER for hedge funds including performance fees is 1.99 per cent, 1.28 per cent excluding performance fees. This compares to an average of 1.73 per cent and 1.41 per cent respectively for listed investment companies excluding venture capital trusts.

These TERs, however, include both single funds and funds of hedge funds.
One intermediary who is less than enamoured with the sector points out that ‘Most investors buy funds of hedge funds because they want to make returns of around eight per cent a year. But, in many cases, to achieve this the fund needs to generate a return of 15 per cent.