A difficult year
Selecting the correct hedge fund to match the risk profile
“IDON’T LIKE LOSSES, sport. Nothing ruins my day more than losses,” says Gordon Gekko, Wall Street’s most infamous movie character. For those in the hedge fund investment sector this year has certainly been one of losses, with more casualties set to come.
Despite that there are some hedge funds that have performed positively in contrast to the general market, as one of the overall objectives of hedge funds is to achieve returns uncorrelated to the rest of the market. Those funds currently feeling the pain would be those that are highly correlated to equity performance and some are recording large and very public capital losses.
“If an investor selects the correct hedge fund that matches his risk profile, then the probability of things going wrong are small,” says Louis Bekker, multi-manager at BJM. “The mandate of the fund is absolutely key and the risk/return profile of the fund must suit that of the investor. You must consider whether the fund is adopting a long/short strategy, a market neutral approach, is it a fixed income fund or a multi-strategy fund where the mandate is extremely wide and straddles all the asset classes. One of the most important things an investor deciding to opt for a hedge fund can do is to go through a fund of funds where the risk profile would be more appropriate to him than a single manager fund.”
Bekker says contrary to popular belief that all hedge funds are acutely high risk there are some very conservative hedge funds available, such as those in the fixed income category that have posted the most positive returns of all hedge funds this year. “Hedge funds are becoming more acceptable as an investment avenue, and offshore pension funds are even allocating 30% to 45% of their weightings to such funds.”
Hedge funds are often viewed as a “black box,” with investors having no idea where their funds are being allocated and what the performance is until they hear horrendous media reports of their massive losses. Bekker says the opposite is true. “If requested, fund of hedge fund managers can receive daily reports of their holdings and can identify at any time where the risk exposures are. That’s unlike a conventional unit trust, where reporting is monthly and sometimes even quarterly for the more detailed insights.
“Hedge fund investors are able to see exactly where their alpha (outperformance to the benchmark) is coming from. All of the reputable financial institutions offering hedge funds would have established compliance and risk committees and the investment decisions and strategies of the managers are constantly monitored and in the finest detail.”
Bekker says for those investors who want to be in hedge funds the allocation should be around 10% to 15% of their total portfolio. “But before running into such funds the use of a financial adviser is highly recommended. Financial advisers will construct a financial plan that meets the unique risk return requirements of a client to ensure the client is not overly exposed to a single asset or investment. The risks can be enormous if you go into an inappropriate fund or with the wrong weighting compared to the rest of your assets and the fees a planner may charge would be worth it.”
For those moving to the high-risk end of the hedge fund spectrum the private equity and commodity hedge funds (where returns
in 2008 have been exceptional) promise the greatest alpha. However, significant volatility risks do come from the heavy gearing and nature of the financial instruments used in their strategies. Bekker says an investor may want to allocate a 2% to 3% weighting to those higher risk funds. But again, that’s dependent on the investor’s risk profile and should be done with the assistance of a financial adviser.
A fund of hedge funds would require a minimum investment of around R50 000 to R100 000, whereas in sharp contrast the single manager fund minimums would range from R1m to R10m. On the sensitive topic of fees, the annual fee is usually 1% flat on the value of the portfolio, but that can go up to 2%. Performance fees are high and can range from 10% to 20% on the outperformance of the hurdle rate.
Bekker says the benchmarks in hedge funds are usually the STeFI (short-term fixed interest) or inflation plus 5%, sometimes even 10%. “Those are very high thresholds, and hedge fund managers need to be constantly performing if they’re to meet and surpass them. Many funds get capped (closed off from further inflows) when they reach R400m to R500m. That’s small, but they need to be kept liquid in order to meet their mandates and be competitive.
Bekker says the remainder of 2008 and possibly 2009 could remain volatile, with the high possibility of more substantial losses in the hedge fund industry and investors shouldn’t try and “go it alone”.