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