HEDGE YOUR BETS

Hedge funds have long been re­garded with scep­ti­cism. But new reg­u­la­tions will make these in­vest­ments eas­ier and safer for or­di­nary in­vestors

Financial Mail - Investors Monthly - - Contents -

The past 18 months have been unusu­ally busy for SA’s hedge fund in­dus­try as it made the tran­si­tion to the reg­u­lated space. The re­sult of this tran­si­tion is that re­tail in­vestors can now buy into cer­tain of these funds with sim­i­lar ease and trans­parency as they can with unit trusts.

Prior to these changes, hedge funds were largely the do­main of in­sti­tu­tional in­vestors look­ing for down­side pro­tec­tion in port­fo­lios de­signed for that pur­pose. A small num­ber of so­phis­ti­cated in­vestors with the re­sources to meet min­i­mum in­vest­ment thresh­olds en­joyed the same ben­e­fits.

Even with these changes, de­signed to in­tro­duce pow­er­ful in­vest­ment port­fo­lio di­ver­si­fi­ca­tion for re­tail in­vestors, as­sets un­der man­age­ment in hedge port­fo­lios re­main small. Ac­cord­ing to fig­ures pub­lished at the end of Fe­bru­ary by the As­so­ci­a­tion for Sav­ings & In­vest­ment SA, the hedge fund in­dus­try rep­re­sents less than 1% of SA’s reg­u­lated sav­ings and in­vest­ment pool.

This is de­spite growth in the 2016 cal­en­dar year of R5.3bn to bring the in­dus­try’s to­tal as­sets un­der man­age­ment to R67.4bn.

The scope for growth, there­fore, is con­sid­er­able. But so is the chal­lenge the in­dus­try faces to tap into the new­found re­tail in­vestor mar­ket.

That chal­lenge is de­fined partly by a greater ap­pre­ci­a­tion from in­vestors for the ben­e­fits that hedge funds hold. It would not be an ex­ag­ger­a­tion to say that the broader mar­ket views hedge funds with a fair de­gree of scep­ti­cism thanks to scan­dals in­volv­ing US hedge fund man­agers. US funds, how­ever, op­er­ate in an un­reg­u­lated space in which over­sight is all but ab­sent.

The lo­cal hedge fund in­dus­try could not be fur­ther re­moved from that. The move over the past 18 months to a reg­u­lated space in which trans­parency and proper risk man­age­ment are cor­ner­stones of daily prac­tice was largely driven by the in­dus­try.

This tran­si­tion, though not re­quir­ing an over­haul of stan- dards or op­er­a­tions, has come with strict reg­u­la­tions from the Fi­nan­cial Ser­vices Board (FSB). This re­lates to re­port­ing, risk man­age­ment and gov­er­nance as well as a re­quire­ment for fund man­agers to pro­vide liq­uid­ity of at least R1m if their funds have less than R50m as­sets un­der man­age­ment.

These mea­sures are needed to pro­tect in­vestors against un­scrupu­lous be­hav­iour, but more im­por­tant than that is the need to con­vince them that hedge funds are cred­i­ble in­stru­ments.

His­tory will back the in­vest­ment case for prop­erly ex­e­cuted hedge fund strate­gies. But in the ab­sence of peace of mind and ease of in­vest­ment, the hedge fund man­agers are fight­ing an up­hill bat­tle.

“We haven’t seen a huge in­flow of cash into the mar­ket,” says Alexia Kobusch of Nau­tilus. “The gate­keep­ers to the re­tail mar­ket tend to be your in­de­pen­dent fi­nan­cial ad­vis­ers and un­less they un­der­stand the prod­uct they’re sell­ing, they’re not nec­es­sar­ily go­ing to of­fer it to their re­tail clients.”

This re­luc­tance to of­fer in­vestors a new way to di­ver­sify their port­fo­lios is also partly due to the tra­di­tional illiq­uid na­ture of hedge funds. Un­like unit trusts that of­fer daily liq­uid­ity, hedge funds, though priced daily, tra­di­tion­ally only have monthly liq­uid­ity.

This has been due to the na­ture of these funds, and also be­cause in­vestors’ needs have dif­fered from the re­tail mar­ket in which one may have to liq- ui­date a po­si­tion or with­draw funds at short no­tice.

Some man­agers have adapted their strate­gies or funds to ac­com­mo­date this need, though it re­mains to be seen to what ex­tent that will be­come stan­dard prac­tice. The ap­peal of at­tract­ing new re­tail money into funds may en­cour­age more man­agers to adopt this strat­egy.

In terms of the reg­u­la­tions around hedge funds, the FSB has stip­u­lated that re­tail funds need only meet a 30-day liq­uid­ity thresh­old, while qual­i­fied funds have a 90-day liq­uid­ity grace pe­riod.

For in­vestors, a more pru­dent mea­sure of a fund’s suit­abil­ity could be the size of as­sets un­der man­age­ment.

Eu­gene Vis­agie, head of hedge fund in­vest­ments at No­vare, points out that the cost of ad­min­is­ter­ing funds has in­creased as a re­sult of the new FSB re­quire­ments. In ex­treme cases these higher costs may threaten the vi­a­bil­ity of a fund or man­age­ment com­pany, though the more likely

For in­vestors, a more pru­dent mea­sure of a fund’s suit­abil­ity could be the size of as­sets un­der man­age­ment

sce­nario is a higher to­tal ex­pense ra­tio for in­vestors.

“To run a manco you need quite a sub­stan­tial amount of as­sets to make it vi­able, so it’s a bal­anc­ing act,” he says. “The cost of run­ning these struc­tures was slightly more cost-ef­fec­tive in the un­reg­u­lated space. I would say you can’t re­ally run a fund of less than R50m, and you can’t do it ef­fi­ciently for less than R100m.”

The ad­di­tional costs and ad­min­is­tra­tive bur­den have strength­ened the case for man­age­ment com­pa­nies that have the in­fra­struc­ture and skills to meet the FSB’s re­port­ing, gov­er­nance and risk man­age­ment re­quire­ments.

The likes of No­vare, Sanne and Pre­scient have there­fore found new sources of busi­ness as smaller or bou­tique fund man­agers opt to out­source these re­spon­si­bil­i­ties to con­tain their costs.

Adapt­ing to the new en­vi­ron­ment has not been easy for fund man­agers. Apart from mak­ing the tran­si­tion and set­ting up struc­tures or pro­cesses as re­quired by the reg­u­la­tions, they have also had to deal with tough mar­ket con­di­tions.

Vis­agie says some man­agers have there­fore taken a step back from rais­ing new in­vest­ment dur­ing this tran­si­tion pe­riod. This, to­gether with muted in­ter­est thus far from the re­tail mar­ket, has contributed to a less than ideal en­vi­ron­ment for the in­dus­try.

“We are def­i­nitely see­ing in­creased in­ter­est,” Vis­agie says. “But the learn­ing curve is tak­ing a lot longer than any of us ex­pected it would be. And we have to pack­age it in a way that is more ap­pro­pri­ate to the re­tail mar­ket, which is used to us­ing a Lisp [linked in­vest­ment ser­vice provider] or plat­form. So we have to repack­age our port­fo­lios to en­sure they meet clients’ re­quire­ments.

“I do think there is an op­por­tu­nity from the re­tail in­vestors. If you look at the growth in the Euro­pean mar­ket, it was phe­nom­e­nal and I’m con­fi­dent we’ll see some­thing sim­i­lar. We just need to over­come some of these hur­dles; it’s not as if the doors have been shut, it’s just to get par­tic­i­pants com­fort­able and ed­u­cate them that these port­fo­lios can de­liver pos­i­tive re­turns.”

It would be safe to say that the lo­cal in­vest­ment in­dus­try has not been pre­sented with as en­tic­ing a growth op­por­tu­nity as is the case with re­tail hedge funds. All mar­ket com­men­ta­tors have ex­pressed a de­sire to un­leash this op­por­tu­nity, but do so in the knowl­edge that win­ning over new cus­tomers won’t hap­pen overnight.

As one man­ager points out, the true value of hedge funds to of­fer pro­tec­tion to in­vestors may just de­pend on a se­ri­ous mar­ket cor­rec­tion or col­lapse. The prospect of such a col­lapse and the value de­struc­tion that would re­sult is some­thing no in­vestor truly wants to con­tem­plate.

And it would be un­seemly for hedge fund man­agers to gloat in such cir­cum­stances, de­spite the per­fect ex­am­ple such events would present for the value of di­ver­si­fy­ing a port­fo­lio though in­vest­ment in a hedge fund.

Eu­gene Vis­agie of No­vare

Alexia Kobusch of Nau­tilus

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