Wednesday, December 17, 2008

EBI's Performance

As I've reported, Everest Brown and Babcock Alternative Investment Trust (EBI.AX) has been in a lot of strife with investors. The main issue has been the discount of the stock price to NAV. The company proposed to delist the fund as a solution to that problem. But some large investors wanted to appoint a new manager or wind up the fund instead. Just how bad is the underlying investment performance of the fund?

Using the U.S. risk free rate, the beta and annual alpha of EBI's NAV relative to the Credit Suisse Tremont Hedge Fund Index were 1.68 and -4.32% for the life of the fund. Results for the HFRI index are almost identical. Using the RBA's cash rate instead the statistics are 1.66 and -2.72%. The high beta is expected due to the fund being leveraged into a portfolio of hedge funds via a swap facility provided by Macquarie Bank. I think that the correct risk free rate to use is the U.S. risk free rate. This is as the underlying funds are denominated in US Dollars and I assume Macquarie's swap is in terms of USD. Assuming fees of 1% + a 2% annual performance fee (20% annual performance * the 10% incentive rate) over the first two years of the fund when gains were positive means an average fee of 2.33%. On the face of it this indicates about 1.5% a year of negative skill. I wouldn't call this a disastrous situation though it's clearly not good that they don't at least earn their fees.

A complication arises though because the fund is supposedly hedged into Australian Dollars so that the returns reported in Australian Dollars are the same (or close to the same numbers) as the underlying funds report in U.S. dollars. To do this we could short the US Dollar and go long the Australian Dollar which can be accomplished by buying Australian Dollar futures contracts (for example the contract traded on the CME). Apart from the change in the exchange rate this contract earns the difference between the Australian Dollar and U.S. Dollar risk free rate.* An average of 2.63% over the life of EBI. And then this needs to be mulitiplied by the leverage ratio which is roughly equal to the beta. Assuming a perfect hedge we would need to deduct this earning of 4.3% per annum from the estimate of alpha!

But looking at the annual report, EBI never had a full hedge (in forwards) and by December 2007 only had a very small hedge in place. So at this point I got really confused and thought up various scenarios none of which I'm clear about. Perhaps Macquarie is doing the hedge and pocketing the interest differential while charging Everest the Australian rate for the leverage in the swap. So Macquarie takes Everest's money adds a loan to it and invests it in US hedge funds then sets up a hedge to remove the currency risk, earns the interest differential on the hedge and pays back Everest the USD percent returns earned by the hedge funds but in Australian Dollars?

Maybe someone can help me out. I think the only real way to know is to see the agreement between Macquarie and Everest and that's not in the annual report. The annual report doesn't even say that the counterparty is Macquarie.

Here is how the fund's NAV stacks up against the index in USD:

* This is why the Australian Dollar contract normally has a price below the spot price and the two prices converge towards expiry.

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