The hedge fund industry in Australia has experienced significant growth over the past year, with some estimates placing funds under management increasing from around US $0.7 billion in 2001 to US $1.1 billion in 2002. It is likely that these estimates are on the conservative side. The reasons for this growth are both demand and supply driven, with an increasing appetite among institutional investors for alternative investments, the entry of new players (both local and foreign), as well as the existence of substantial domestic retail demand. Looking ahead, will all the above drivers continue to foster such growth in the industry and are there any other factors which are likely to impact assets managed in hedge funds in 2003?

Institutional investors are becoming more comfortable investing in hedge funds, the more so given the prolonged poor performance of equity markets and the increasingly popular perception of domestic bonds as a less effective long term investment. As recently as 2000, only two institutional investors were reported to have invested in hedge fund products. The situation is changing, with more than 10 institutions having invested in the asset class in 2002, though not all of these allocations are managed by local managers. This trend seems likely to continue as consultants become more willing to recommend hedge funds as a suitable asset class for superannuation funds in particular. A recent research survey covering over 160 superannuation funds indicated that Australian institutional investors will likely increase their allocation to hedge funds by more than 20% in the next two years, and none of the survey participants expected to decrease their allocations. There appears to be a more active search for investments which have the potential to add diversification and return benefits. Notable institutional investors have included REST, CSS/PSS, Westcheme and AvSuper.

One of the features of the Australian financial marketplace is the ready availability of quality people, both with investment expertise as well as design and structuring skills. On the investment side this extends from the equity markets to fixed income, derivatives and foreign exchange. It would not be unreasonable to believe that if equities continue to show lackluster performance, then more long-only managers may consider the option of setting up their own hedge funds. Over the last year about 20 funds were launched in Australia and these have raised more than US $150 million. Absolute Capital, Eclectic Capital, Dingo Capital and Challenger have among them raised over US $50 million. The introduction of an incubator program in mid 2001 (by Bank of Bermuda) and the commencement of similar programs by other institutions will help reduce the financial hurdles facing new startups, and small managers are becoming increasingly able to attract both working and trading capital.

As indicated, much of the money being allocated at the institutional level is not finding its way to local managers. To the extent that funds of funds are deemed by some institutions and consultants as more appropriate vehicles for a first foray into hedge fund investing, some of the overseas fund of funds groups are often preferred on the basis that they are able to demonstrate longer term investment track records and well-tested processes. One result of this development is that many Australian hedge fund managers are turning to these offshore funds of funds for allocations of capital.

A further issue is the current taxation environment. In general, onshore investors allocating to offshore funds are subject to Foreign Investment Fund taxation on the gains from those investments. This appears to make locally domiciled unit trusts simpler from a tax perspective, although other arrangements appear to be able to achieve the same tax outcomes at lower cost. The tax environment is also relevant to the local managers themselves, in that the ability of local hedge fund managers to attract offshore capital is constrained by the fact that income earned in Australia by local funds will be subject to Australian tax. This has given rise to a number of managers opting to create offshore funds alongside their local offerings.

Hedge funds are also becoming increasingly attractive to retail and high net worth investors in Australia. Apart from the well-known success of the Man-IP product range, there were several new retail fund launches in 2002. The Global Diversified Strategies Fund managed by Colonial First State was launched in late October 2001 through January 2002, with more than 60% of the assets raised in this initial period (USD6 million as of January 2002) being from retail investors. Colonial has increased locally-sourced funds under management considerably since then. Challenger's market neutral Australian equities fund has also been successful, both in terms of assets raised and investment performance. Although the majority of Australian retail hedge fund assets are managed outside Australia, there are some funds, such as Basis Capital, which are benefiting directly from the growth of the local fund of funds industry.

In addition, the introduction of listed absolute return funds in October 2002 gives retail investors greater flexibility and ease of access to hedge fund products. By offering daily liquidity and a lower minimum investment requirement, listed hedge fund products bridge the gap between traditional unit trusts and hedge funds. It is expected that retail investors will continue to be a significant source of hedge fund capital in Australia.

There are some locational issues which Australian hedge fund professionals also need to face. The first of these factors is the possibility of a "brain drain", either to centres with greater proximity to large sources of capital (e.g. Hong Kong in this time zone) or to areas which from a tax perspective make more sense to offshore investors. The second factor is the capacity of the Australian equity markets themselves to absorb the capital which local managers may wish to deploy.

In summary, there is a complex interplay of forces which are acting to expand the supply of Australian capital flowing into hedge funds while simultaneously favouring the offshore managed product over the local. Additionally, Australian-focussed hedge funds themselves will continue to face a number of constraints, partly driven by tax and partly by liquidity and diversification factors, which seem likely to keep their growth rates below those of hedge fund allocations - both retail and institutional - in general.